China

Executive Summary The US Still Dominates Economic Output The US Still Dominates Economic Output The US Still Dominates Economic Output While the Ukraine war has been positive for the greenback, there is a slow tectonic shift away from the dollar as China rethinks holding concentrated foreign currency reserves. In the near term, the dollar faces positive macro variables and still-rising geopolitical tensions. Longer term, as global trade slows and countries gravitate into regional trading blocs, the dollar will need to fall to narrow the US trade deficit. By the same token, the Chinese RMB could weaken in the near term but will stabilize longer term. China will promote its currency across Asia. Currency volatility will take a step-function higher in this new paradigm. Winners will be the currencies of small open economies, especially in resource-rich nations. Trade Recommendation Inception Date Return LONG GOLD 2019-12-06 27.7% Bottom Line: Cyclical forces continue to underpin the dollar, such as rising US interest rates, a slowdown in global growth, and a safe haven premium from still-high geopolitical tensions. That said, the dollar is overbought, expensive, and vulnerable to reserve diversification over the longer term. While tactical long positions make sense, strategic investors should not chase the dollar higher. Feature Currency market action this week focused on two key central bank meetings: the Federal Reserve and the Bank of England. The Fed raised rates by 50 basis points while the BoE raised by 25 points, yet the market expectation differs. In the US, markets imply that the Fed can keep real interest positive while engineering a soft landing in the economy. In the UK (and Euro Area), markets see more acute stagflationary risks and assign a higher probability to a policy error. This situation, together with rising geopolitical risk, has put a bid under the dollar. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Brewing in the background is the prospect that the Ukraine war and US sanctions on Russia could have longer-term consequences on the dollar. Specifically, Russia and China are now locked into a geopolitical partnership to undermine US geopolitical dominance, including the dollar’s supremacy. While this discussion will inevitably come with some speculation about what will happen in the future, what does the evidence say so far? More importantly, what are some profitable investment opportunities that could arise from any shift? The Russo-Chinese Rebellion Chart 1The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending The US Needs To Externally Finance Defense Spending From Russia’s and China’s point of view, the United States threatens to establish global hegemony. The US possesses the world’s largest economy and most sophisticated military. It has largely maintained its preponderance in these spheres despite the rise of China, the resurgence of Russia, and the formation of the European Union as a geopolitical entity (Chart 1). If the US succeeds in its current endeavor of crippling Russia’s economy and surrounding it with NATO military allies, the world will be even more imbalanced in terms of power, while China will be isolated and insecure. To illustrate this point, NATO’s military spending is much higher than that of the Shanghai Cooperation Organization (SCO), which is not nearly as developed a military alliance (Chart 2). Hence Russia and China believe they must take action to counter the US and establish a global balance of power. When Presidents Vladimir Putin and Xi Jinping met on February 4 to declare that their strategic partnership will suffer “no limits,” which means no military limits, they declared a new multipolar era and warned against US domination under the guise of liberalism. If China allows Putin to fail in his conflict with the West, the Russian regime will eventually undergo a major leadership and policy change and China will become isolated. Whereas if China accepts Russia’s current strategic overture, China will be fortified. Russia can be immensely supportive of China’s Eurasian strategy to bypass US maritime dominance and improve supply security (Chart 3). Chart 2NATO Vs SCO: US Threat Of Dominance FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The consequence of this Russo-Chinese alliance will be to transact in a currency that falls outside sanctions by the US. This will be no easy feat. The US dollar still monopolizes the world’s monetary system, even though the US is likely to lose economic clout over time.  Chart 3China Cannot Reject Russia FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​ De-Dollarization And A Brewing USD Crisis? Fact Versus Fiction A reserve currency must serve the three basic functions of money on a global scale – providing a store of value, unit of account, and accepted medium of exchange. This status gives the dominant reserve currency an “exorbitant privilege,” a range of advantages including the ability to run persistent current account deficits and impose devastating sanctions on geopolitical rivals. Since the turn of the century, the US has struggled to maintain domestic political stability and has failed to deter challenges to its global leadership posed by Russia, China, and lesser powers. Lacking public support for foreign military adventures after Iraq and Afghanistan, Washington turned to economic sanctions to try to influence the behavior of other states. The results have been mixed in terms of geopolitics but cumulatively they have been neutral or positive for the trade-weighted dollar. The US adopted harsh sanctions against North Korea in 2005, Iran in 2010, Russia in 2012, Venezuela in 2015, and China in 2018. The primary trend in the dollar was never altered (Chart 4). Chart 4A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar A Chronicle Of Sanctions And The Dollar Yet sweeping sanctions against Russia and China are qualitatively different from other sanctions– as they are among the world’s great powers. The extraordinary sanctions on Russia in 2022 – including cutting off its access to US dollar reserves – have proven deeply unsettling for China and other nations that fear they might someday end up on the wrong side of the US’s foreign policy. Russia’s own experience proves that diversification away from the dollar is likely to occur. From a peak of 47% in 2007, Russia reduced its dollar-denominated foreign exchange reserves to 16%. It cut its Treasury holdings from a peak of over 35% of international reserves to less than 1% today. Meanwhile Russia increased its gold holdings from 2% in 2008 to 20% (Chart 5). The Russians accelerated their diversification away from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. However, the world is familiar with Russian economic isolation. The West embargoed the USSR throughout the Cold War from 1949-1991. The dollar rose to prominence during this period, so it is not intuitive that Russia’s latest withdrawal from the global economy will enable other countries to abandon the dollar when they have failed in the past due to lack of alternatives. What is clear is that there is no clean or easy exit today from a dollar-denominated financial system. But there are a few lessons from Russia: The ruble has recouped all the losses since the implementation of sanctions. It runs a large current account surplus and has stemmed capital outflows. Another factor has been a sharp reduction in its dependence on the dollar. This will cushion the inflationary impact of US sanctions. Going forward, Russia will be much more insulated from the US dollar but at a terrible cost to potential economic growth (Chart 6). A dearth of US dollar capex into Russia will cripple productivity growth. The lesson for other US rivals will be to take economic stability into account when engaging in geopolitical rivalry.  Chart 5Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... Russia Was Able To Dump Treasurys... The dollar has been unfazed by the Russian debacle. The victims have been other reserve currencies such as the euro, British pound, and Japanese yen, which are engulfed in an energy crisis from Russia’s actions.  Chart 6...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ...But The Economic Impact Will Remain Severe ​​​​​​ The key question that matters for investors will be what China will do. As one of the largest holders of US Treasurys, a destabilizing exit would have dramatic currency market impacts and could backfire on China. The trick will be to continue exiting this system without precipitating domestic instability. What Will China Do? China has learned two critical lessons from the Russo-Ukrainian conflict, with regard to raising the appeal of the RMB. First, the economic impact of US sanctions can still be devastating even when you have diversified out of dollars. Second, access to commodities is ever more important. As such, any strategy China chooses will need to mitigate these risks. China started diversifying away from the dollar in 2011 and today holds $1.05 trillion in US Treasurys. A little less than half of its foreign exchange reserves are denominated in dollars (Chart 7). This has been a gradual diversification that has not upended the current monetary regime. More importantly, China’s diversification accounts for the bulk of the shift by non-allies away from treasuries. Their share of foreign-held treasuries has fallen from 41% in 2009 to 23% today (Chart 8). Chart 7China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings China Has Lowered USD Reserve Holdings ​​​​​​ Chart 8US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... US Allies Still Willing To Hold USDs... ​​​​​​ China’s diversification has helped drive down the overall foreign share of US government debt holdings (excluding domestic central banks) from close to 50% in the middle of the last decade to 36% today (Chart 9). It has also weighed on the dollar. China can and will speed up its diversification from the dollar in the wake of the Ukraine war. While Americans will say that China only need fear such sanctions if it attacks Taiwan or other countries, China will not rest assured. Beijing must respond to US capability, not the Biden Administration’s stated intentions. A new Republican administration could arise as soon as January 2025 and take the offensive against China. The US and China are already engaged in great power rivalry and Beijing cannot afford to substitute hope for strategy. China ran a $224 billion current account surplus in 2021, so part of its strategy could be to reduce the pool of savings that need to be recycled every year into global assets. Since 2007 China has sent large amounts of outward direct investment into the world to acquire real assets and natural resources. The Xi administration tried to bring coherence to this outward investment by prioritizing different countries and investments adhere to China’s economic and strategic aims. The Belt and Road Initiative is the symbol of this process (Chart 10). Going forward, China will continue this process. It will also recycle more of its savings at home by increasing investment in critical industries such as energy security, semiconductors, and defense. Chart 9...But A Slow Diversification From US Debt Persists FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict The key priorities will remain a Eurasian strategy of circumventing the US navy. Building natural gas pipelines and other infrastructure to link up with Russia is an obvious area of emphasis, although it will involve tough negotiations with Moscow. China will also prioritize Central Asia, the Middle East, South Asia, and mainland Southeast Asia as areas where its influence can grow with limited intervention by the US and its allies (Chart 11). Chart 10The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress The Belt And Road Initiative In Progress ​​​​​​   Chart 11China Outward Investment Will Need To Be Strategic FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict Chart 12The RMB Could Dominate Intra-Regional Asean Trade FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict As China invests more at home and in other countries, financing and invoicing deals in the renminbi will grow. While the dollar is the transactional currency globally, it is far less relevant when considering local trading blocs. The euro dominates intra-European trade, suggesting China can try to expand RMB invoicing for intra-Asian trade (Chart 12). Even then, however, the yuan faces serious obstacles from China’s inability or unwillingness to extend security guarantees to its partners, failure shift the economic model to consumerism, persistent currency controls, closed capital account, and geopolitical competition with the United States. Investors should pay close attention to shifts occurring at the margin. The number of bilateral swap lines offered to foreign central banks by the People’s Bank of China has grown (Chart 13), with a total amount of around 4 trillion yuan. This allows the PBoC to use its massive foreign exchange reserves, worth about US$3.2 trillion, to back yuan liabilities. As China continues to grow and increases the share of RMB trade within its sphere of influence, the yuan will rise as an invoicing currency (Chart 14). This could take years, even decades, but a shift is already underway. Chart 13The People's Bank Of Asia? FX Consequences Of The US-Russia Conflict FX Consequences Of The US-Russia Conflict ​​​​​​ Chart 14China Is Growing In Economic Importance China Is Growing In Economic Importance China Is Growing In Economic Importance ​​​​​​ In the near term, any US sanctions on China will hurt the RMB. Combined with hypo-globalization, China’s zero-Covid policy, narrowing interest rate differentials, and flight from Chinese assets, it is too soon to be positive on the RMB in the context of US-China confrontation (Chart 15). Longer term, China’s ability to ascend the reserve currency ladder will require a more radical change in Chinese policy to move the dollar. Chart 15CNY And US Sanctions CNY And US Sanctions CNY And US Sanctions Where Does The Euro Fit In? The biggest competitor to the US dollar is the euro, which took the largest chunk out of the US’s share of the global currency reserve basket in recent decades (Chart 16). Yet the EU could suffer a long-term loss of security, productivity, and stability from Russia’s invasion of Ukraine and the ensuing energy cutoff with Russia. Chart 16The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The Dollar Remains A Reserve Currency The EU will have to spend more on energy security and national defense. This will lead to an increase in debt securities that other countries could buy, which offers a way for countries to diversify from the dollar. However, Europe does not provide China or Russia with protection from US sanctions. The EU is allied with the US, it imposed sanctions on Russia along with the US, and like the US is pursuing extra-territorial law enforcement with its sanctions. When the US withdrew from the 2015 Iran nuclear deal, the EU disagreed technically, but in practice it enforced the sanctions anyway. The euro is hardly a safer reserve currency than sterling or the yen for countries looking to quarrel with the United States. The fact is that all of these allied states are likely to cooperate together in the event that any other state attempts to revise the global order as Russia has done. Not necessarily because they are democracies and share similar values but because they derive their national security from the US and its alliance system. The takeaway is that the euro will become a buying opportunity if and when the security environment stabilizes. Then diversification into the euro will occur. But it will not become a landslide that unseats the dollar, since the euro will still have a higher geopolitical risk premium. Investment Takeaways The historical evidence suggests that US sanctions have not weighed on the dollar. In the case of the Russo-Ukrainian conflict, it has been positive for the greenback. That said, there is a slow tectonic shift from the dollar, as each economic powerhouse evaluates the merits of holding concentrated foreign currency reserves. In the near term, the dollar will continue to be driven by traditional economic variables – global growth, real interest rate differentials, and the resilience of the US economy. That remains a positive. Geopolitical tensions reinforce the dollar’s current rally. Longer term, as globalization deteriorates and countries gravitate into regional trading blocs, the dollar will need to adjust lower to narrow the US trade deficit. By the same token, the RMB could weaken in the near term but will need to stabilize longer term, if Beijing wants it to be considered an anchor and store of value for other Asian currencies. Chart 17Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises Silver Demand Could Explode Higher As Currency Volatility Rises The key takeaway is that currency volatility will take a step-function higher in this new paradigm. The winners could be the currencies of small open economies, especially in resource-rich nations. A world in which economic powers increasingly pursue national interests is likely to be inflationary. These powers will deplete the external pool of global savings, as current account balances wind down in favor of national and strategic interests. They will also likely encourage the demand for anti-fiat assets as currency volatility takes a step-function higher. Gold is likely to do well is this environment, but silver could be on the cusp of an explosion higher. The metal has found some measure of support around $22-23 per ounce even as manufacturing bottlenecks have hammered industrial demand. Long-only investors should hold both gold and silver, but a short gold/silver position makes sense both economically and from a valuation standpoint (Chart 17). Geopolitical Housekeeping: We are closing our Long FTSE 100 / Short DM-ex-US Equities trade for a gain of 19.5%. We still favor this trade cyclically and will look to reinstate it at a future date. We are also booking gains on our short TWD-USD trade for a return of 5.8% — though we remain short Taiwanese equities and continue to expect a fourth Taiwan Strait geopolitical crisis.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary More Chinese Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest The Politburo meeting last Friday signaled that China is determined to achieve the 5.5% annual growth target set earlier this year. Policymakers vowed to accelerate the implementation of existing pro-growth measures and hinted that they may scale up stimulus due to domestic challenges and external uncertainties. However, Chinese policymakers are facing an “impossible trinity” of eliminating domestic COVID cases and avoiding an overshoot as they stimulate the economy, while trying to achieve a high rate of economic expansion. The Politburo did not mention any plans to boost income and consumption via direct fiscal transfers to households, a sector that has been a weak link in China’s economy in the past two years. China’s consumption growth and demand for housing will not recover any time soon without meaningful aids to shore up household income.  Bottom Line: Policy stimulus measures announced so far fall short of what is required to lift the economy. Given constraints on household consumption and the property market, China’s economic growth is set to underwhelm and Chinese stock prices will underperform their global counterparts.     China’s top leaders have pledged to provide more support to the economy. The Politburo meeting last week indicated that the 5.5% growth target set for 2022 will be maintained and stimulus measures will be accelerated. Chinese stocks in both on- and offshore markets rebounded sharply following the positive rhetoric. Related Report  Emerging Markets StrategyA Whiff Of Stagflation? In our view, however, Chinese authorities are facing an “impossible trinity” as they simultaneously attempt to achieve three goals: (1) pursuing a dynamic zero-Covid policy, (2) delivering decent economic growth, and (3) not resorting to “irrigation-style” massive stimulus. The pro-growth measures announced last week by the government lack the needed elements to generate a quick and strong rebound in the economy, particularly in the household and property sectors. Hence, the rebound in Chinese stock prices will unlikely progress into a cyclical rally (over a 6- to 12-month time span). We maintain our neutral allocation in Chinese onshore stocks and an underweight stance on the MSCI China Index, within a global portfolio. An “Impossible Trinity” The messages from the Politburo meeting highlight policymakers’ determination to shore up the economy. However, the authorities are not backing away from the zero-COVID policy, which is taking a heavy toll as cities are forced into lockdown to contain outbreaks. In addition, the Politburo reiterated the housing policy principle that “housing is for living, not for speculation” and did not mention concrete measures to boost household consumption. Thus, the biggest challenge for China to achieve its growth target this year is how to normalize economic activity without resorting to another round of “irrigation-style” stimulus while keeping domestic COVID cases at bay. In an environment of frequent lockdowns, monetary and fiscal easing have limited effect as the private and household sectors are averse to taking risks. China’s zero-COVID policy comes with hefty economic costs. April’s PMI showed sharp declines in a wide range of business activities due to the prolonged lockdown in Shanghai and several other cities (Chart 1). The new orders, new export orders, and imports subindexes in the manufacturing PMI and services PMI, all fell to their lowest levels since Q1 2020 when COVID first hit China (Chart 2). Chart 1April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities April PMIs Show Widespread Declines In Business Activities ​​​​​​ Chart 2PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 PMI Subindexes Fell To Lowest Levels Since Q1 2020 Going forward, even if China manages to avoid a Shanghai-style month-long lockdown, the dynamic zero-COVID policy will have devastating ramifications on the economy. Notably, March economic data from the city of Shenzhen, China’s technology center, suggests that even a week-long lockdown has had large impact on the local economic activity. Chart 3Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown Severe Economic Disruptions In Shenzhen Due To A Week-Long City Lockdown In contrast with the extensive outbreak in Shanghai, Shenzhen was able to contain its COVID cases at an early stage and endured a citywide lockdown for only one week in mid-March. However, Shenzhen’s export growth contracted by 12.8% year-on-year (YoY) in March, a stark contrast from the 14.7%YoY increase in exports on a national level. The city’s imports fell by 11.9%YoY, also significantly lower than China’s total import growth, which was flat (Chart 3). Retail sales of consumer goods in Shenzhen shrank by 1.6%YoY in March and home sales plummeted by a stunning 90%YoY during the week of March 13-20. On the national level, the Politburo has called for an acceleration in infrastructure investment through frontloading local government special purpose bonds (SPB) and fast-tracking infrastructure project approvals. However, the lack of details has created questions regarding the magnitude of incremental stimulus, or whether the stepped-up policy effort will involve an increase in SPB or a general bond quota for local governments. Chart 4Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown Construction Activity Started Softening In March, Before Shanghai Lockdown The stringent COVID containment methods will also undermine the effectiveness of China’s pro-growth measures. As expected, China’s construction activity PMI tumbled in April amid the lockdowns, but the new orders and business expectations components in the construction PMI had already started to slide in March (Chart 4, top and middle panels). Moreover, employment in the labor-intensive construction sector also declined substantially in March and April (Chart 4, bottom panel). The deterioration in these indicators is consistent with our view that even short and less draconian lockdowns spark considerable disruptions in business activities. Bottom Line: There is a low likelihood that China will deviate from its existing zero-COVID policy for the rest of this year. As such, boosting the economy via stimulus will be challenging due to frequent interruptions to economic activities. No Bazooka For Consumers China’s household consumption, which accounts for about 40% of the country’s aggregate demand, has been a weak link in the economy during the past two years. Last week’s Politburo meeting pledged to stabilize employment, create new jobs and encourage hiring from small and medium enterprises (SMEs). However, there was no mention of any large-scale fiscal transfer to households via cash or subsidy payments, which suggests that pro-consumer measures are not in the stimulus package. Chart 5Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle Retail Sales In China Have Been The Weak Link In The Economy In The Current Cycle China’s retail sales growth has been muted in the current business cycle, a deviation from past economic recoveries when a revival in the general economy and moderate pro-consumption stimulus helped to lift household spending growth substantially above the rate of nominal GDP expansion (Chart 5). Since the pandemic, however, government stimulus to the household sector has been insufficient to revive consumption, due to the negative impact lockdowns have on both labor market demand and the service sector activities. Compared with the US and Europe, China’s fiscal transfer to the household sector has been very limited since the first wave of COVID in early 2020 (Chart 6). Local governments handed out vouchers in Q2 2020 aimed at boosting consumption, but the amounts were dismal and have had a minimal effect on the sector. Chart 6IMF Fiscal Monitor Database: Fiscal Response To The COVID-19 Pandemic China’s Trilemma China’s Trilemma Presently the RMB value in direct payments to the household sector is even smaller: some cities including Shenzhen distributed consumption vouchers ahead of the May holiday week. Nonetheless, the total value of consumption vouchers this year is estimated at around RMB 2billion. The amount, even with a multiplier effect of 3 on consumption, will be less than 0.1% of China’s monthly retail sales in nominal value. Hence, the coupons are unlikely to make any significant difference to the aggregate household spending. Bottom Line: Household consumption will be severely curtailed as lockdowns wreak havoc on the economy and household income, and the government so far has not provided meaningful direct transfers to the public. Rebound In Housing Demand Doubtful The Politburo encouraged local governments to further relax local housing policies, such as lowering mortgage rates and down payment ratios, and easing restrictions on home sales and purchases. However, we do not expect that these policies alone will restore homebuyers’ confidence amid short-term factors such as COVID outbreaks/lockdowns, and longer-term factors like slowing household income growth, high household debt and poor demographics (Chart 7A and 7B). Chart 7AProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Chart 7BProperty Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics Property Market Is Challenged By Slower Household Income Growth, High Household Income Debt And Poor Demographics China’s household sector was struggling prior to recent lockdowns. The growth rate of national disposable income per capita slowed by more than two percentage points (in nominal terms) in Q1 this year compared with Q4 2019 (Chart 7A, top panel). In addition, the PBoC’s quarterly urban depositor survey (released before the Shanghai lockdown) in Q1 showed subdued confidence in future household income (Chart 8). Households’ willingness to save hit a record high and is even more elevated than in early 2020; on the other hand, the propensity to invest has dropped to a multi-year low (Chart 9).  Chart 8Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chinese Households' Subdued Confidence In Future Income Chart 9More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest More Households Intend To Save Than To Invest Chart 10Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Chinese Households' Declining Appetite For Purchasing Real Estate Assets Despite lower interest rates and easier monetary conditions, Chinese consumers’ medium- to long-term loans continued to trend down in Q1, which indicates a declining appetite for purchasing real estate assets and durable goods (Chart 10). COVID-related restrictions have exacerbated matters and weighed heavily on the demand for housing. Home sales from 30 Chinese cities were down by 56% in April from a year ago (Chart 11). House prices have started to deflate in tier-3 cities. Deflation will likely spread to tier-1 and -2 cities due to a pandemic-driven decline in income and confidence. ​​​Furthermore, the unemployment rate has picked up, especially among younger workers (Chart 12). Job and income dynamics normally improve after the overall economic cycle bottoms. Therefore, without any measures to boost household income, the demand for housing will remain a drag on the economy in the near term.   Chart 11Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Chart 12Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Labor Market Dynamics Deteriorated Rapidly Bottom Line: The real estate market has been vital to business cycle recoveries in China since 2009. However, the property market will not recover anytime soon without a substantial boost to household income and a normalization in social and economic activities. Investment Conclusions The policy rhetoric from the Politburo meeting helped to shore up market confidence last Friday. Nevertheless, we do not think that the stimulus measures will be sufficient to produce a rapid business cycle recovery or a sustainable stock market rally (Chart 13A and 13B). Chart 13AIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Chart 13BIt Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks It Is Too Early To Call A Bottoming In Chinese Stocks Given the negative forces from rolling lockdowns and shrinking demand, China’s economy requires a massive government stimulus via direct transfers to households and SMEs. Yet, Beijing is neither ready to abandon its dynamic zero-Covid policy nor provide “irrigation-type” stimulus, especially for households and the property market. The policy stimulus measures announced so far still fall short of what is required to lift the economy. In light of the constraints on household consumption and the property market, economic growth in China is set to underwhelm and stock prices will likely underperform their global counterparts. Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations

Executive Summary Three Problems For European EPS Three Problems For European EPS Three Problems For European EPS The Chinese economic slowdown in response to COVID lockdowns represents a major headwind for European profits in 2022. Weaker global growth creates another hurdle. The energy crisis is the third major problem for European profit growth this year. European profits must be revised downward for 2022, but the impact on 2023 EPS will be small. Cyclical sectors are particularly exposed to these three headwinds, which will hurt profitability this year. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Within defensive sectors, favor healthcare and communication services versus utilities and consumer staples. Bottom Line: A downward revision of European profits will constrain the ability of European equities to rally in the coming quarters; however, it does not portend another major down leg in European stocks. Nonetheless, the downward revision still points to further underperformance of cyclical equities. Within the defensive sectors, healthcare and communication services are more appealing than utilities and consumer staples shares.     The earnings season has begun. According to the MSCI index, Eurozone profit margins are at a 14-year high following a sharp rebound in profits after the pandemic-induced collapse of 2020. Faced with a war in Ukraine and surging inflation, investors worry that this robust profit picture will not last. We share these worries. The near-term outlook for European profits has deteriorated significantly. While the inflation surge amplified by the Ukrainian crisis is an important problem for European firms, it is not the only one. European businesses must also cope with the effect of a growth slowdown in the US goods sector. Moreover, Chinese growth is likely to plunge in response to the tightening lockdowns across the country. As a result, we fear that current earnings estimates for 2022 are too optimistic. Nonetheless, European stocks are unlikely to collapse further. The valuation cushion amassed during the first quarter market shake-out already embeds some downside for 2022 earnings. Additionally, 2023 earnings have much more limited downside than this year’s EPS. Three Problems For European EPS Chart 1European Earnings Profile European Earnings Profile European Earnings Profile Three major problems indicate that the current European earnings estimates for 2022 are too optimistic: namely, China’s economic slowdown, a global economic deterioration, and the consequences of the Ukrainian war on the European economy (Chart 1). China’s Slowdown This publication has regularly highlighted that, even if the Chinese credit impulse is already trying to bottom, the lagged effect of the previous slowdown in credit flows would continue to hurt European growth in the first half of 2022. China’s COVID outbreak and Beijing’s severe policy response only accentuate this headwind. European profits are even more sensitive to Chinese economic fluctuation than European economic activity, which points to a meaningful drag on profitability. Many relationships highlight our concerns: So far, the weakness in the Chinese credit impulse is still consistent with a rapid deterioration of forward earnings growth and could lead to a contraction in forward EPS (Chart 2, top panel). The Chinese new orders index is falling rapidly. The elevated likelihood that China endures even more lockdowns in the coming months implies a sharper drop in orders and further weakness in European EPS (Chart 2, second panel). The CNY is depreciating again, which often coincides with a deflationary shock in global industrial goods that Europe produces. Unsurprisingly, a weaker RMB correlates well with narrowing operating profit margins in the Eurozone (Chart 2, bottom panel). Korean business conditions are deteriorating in response to the softening of the Chinese economy. A weaker RMB will further hurt business sentiment in the peninsula, especially if Chinese lockdowns broaden. The Korean economy is a key barometer of global business conditions because of its high cyclicality. BCA’s EM strategy team anticipates an additional softening in Korea,  which portends weaker European profits and margins (Chart 3). Chart 2China's Troubles Trouble Europe Profits China's Troubles Trouble Europe Profits China's Troubles Trouble Europe Profits Chart 3Listen to Korea Listen to Korea Listen to Korea Global Economic Weakness The global growth weakness goes beyond China’s troubles. US economic activity is slowing down in response to higher yields, higher inflation, and the disappearance of pent-up demand following a splurge on goods by consumers during the pandemic. As a result, Q1 GDP growth fell to -1.4% from a quarterly annualized rate of 5.5% in Q4 2021. The weakness in the ISM New Orders-to-Inventory ratio points to continued softness through Q2. EM are not immune to these vulnerabilities either. EM consumers are suffering greatly from surging food and fuel costs. Moreover, EM interest rates continue to rise briskly and the ensuing liquidity removal points to fainter growth ahead. Chart 4The Weaker ISM NOI Is Worrisome The Weaker ISM NOI Is Worrisome The Weaker ISM NOI Is Worrisome The impact of weaker global economic activity on European earnings is straightforward: A falling US ISM New Orders-To-Inventories ratio is a prelude both to slower earnings growth and to narrower profit margins in the Eurozone (Chart 4). Global exports growth has collapsed to 5.5% from more than 20% prior year and is likely to deteriorate further. Historically, weaker global shipments are associated with a slowdown in European forward earnings growth (Chart 4, third panel). Global economic surprises have rebounded this year, but, as we showed two weeks ago, they are likely to move back below zero in the near future. This is a noisy series, but negative surprises often prompt downward revisions to earnings estimates. The Energy Shock Europe is facing an exceptional energy shock that is hurting the region’s growth prospects. Now that Russia is curtailing gas shipments to Poland and Bulgaria, more energy disruptions are likely, which will further hamper domestic growth prospects across the region, while simultaneously elevating the cost of goods sold for firms. However, not all countries will be hit equally by a Russian energy embargo among the major economies. Germany and Italy have the most to lose, while France and the UK are the least at risk (Chart 5). The impact of an oil supply shock on European earnings is negative. When oil prices rise because of strong global aggregate demand, European earnings handle rising energy prices well because the increasing sales volume creates a powerful offset. However, our simple model that accounts for the evolution of oil demand and global policy uncertainty highlights that we do not face a demand shock, but rather a supply shock (Chart 6), which implies that most sectors will suffer from higher energy prices. Chart 5Varying Vulnerabilities To Russia’s Energy Showdown The Three Forces Hurting European Earnings The Three Forces Hurting European Earnings Chart 6Oil's Rally Is Supply-Driven Oil's Rally Is Supply-Driven Oil's Rally Is Supply-Driven Chart 7European Margins Under Pressure European Margins Under Pressure European Margins Under Pressure The inflation passthrough from energy to everything else is not strong enough to protect profit margins. Yes, HICP is elevated, but European PPIs are rising much more rapidly. Historically, such an inability to pass on higher production costs results in slower European profits growth and contracting operating profit margins (Chart 7). The current weakness in consumer confidence and the expected drag on business confidence underscore that pricing power will likely deteriorate from here, which will accentuate the negative impact on profits from the current energy shock. Wage Costs: Not A Problem For Now Wage costs are the one bright spot for European profit margins. European negotiated wages are expanding at a very low rate of 1.6%. Unit labor costs are only expanding at 2.4%, a rate similar to last decade when European core inflation averaged 1%. Chart 8Wages Do Not Hurt Margins Wages Do Not Hurt Margins Wages Do Not Hurt Margins Historically, rising wage rates correlate with rising profitability, not declining margins (Chart 8). This relationship seems paradoxical, but European wages only increase when global aggregate demand is very strong. Due to the degree of operating leverage of European equities, the impact of robust aggregate demand on revenues swamps the impact of accelerating wage growth on production costs. Hence, it will probably take a wage growth rate much higher than the experience of the past 20 years for salaries to start hurting margins. While this is possible, we are many quarters away from this risk becoming reality. Bottom Line: European forward earnings estimates for 2022 are far too elevated in view of the headwinds European businesses are currently facing. The combination of weaker Chinese economic activity, slowing global growth, and a supply-driven energy shock will force significant downward revisions to this year’s EPS. Related Report  European Investment StrategyPlenty Of Risks For Cyclical Stocks 2023 EPS should fare better. Chinese authorities are increasingly supporting their economy and this stimulus will impact activity when the lockdowns end. This process will prompt a boom later this year. Global growth will recover once the energy shock recedes. Decelerating European PPI will also help profit margins recover. Following their severe decline in the first quarter, European equities have already embedded a significant valuation cushion to compensate for the transitory shock to earnings. European stocks will not be able to advance meaningfully while 2022 earnings estimates weaken, but they are unlikely to make new lows either. Three Problems For Cyclicals vs Defensives The same three factors that hurt the outlook for European profits for 2022 also confirm that cyclical equities should underperform defensives in the near term. China’s Slowdown Cyclicals are extremely sensitive to a Chinese economic slowdown: The past weakness in the Chinese credit impulse is consistent with a further downgrade of the profit expectations for European cyclicals stocks compared to that of their defensive peers (Chart 9). A deterioration in China’s PMI New Orders heralds a period of weakness in the earnings of cyclical equities. A weak Chinese yuan leads to poor relative earnings (Chart 9). The deterioration in Korean business confidence and the poor performance of Korean equities also leads to weakness in both the earnings and profit margins of cyclical equities relative to those of defensive stocks (Chart 9). Global Growth Weakness The earnings outlook for cyclical sectors relative to defensives is negatively affected by slowing global economic activity: A deterioration in global economic surprises often results in a period of anemic cyclicals’ earnings (Chart 10). The rapidly declining ISM New Orders-to-Inventories ratio is synonymous with underperforming cyclicals’ earnings as well as a contraction in their relative profit margins because of their heightened degree of operating leverage (Chart 10). Weaker global exports confirm the continued risks to cyclicals’ earnings. Chart 9China Is A Threat To Cyclical Equities China Is A Threat To Cyclical Equities China Is A Threat To Cyclical Equities Chart 10Global Growth Threatens Cyclical Stocks Global Growth Threatens Cyclical Stocks Global Growth Threatens Cyclical Stocks The Energy Shock There is no clear relationship between energy prices and the outlook for the profits of cyclical equities relative to those of defensive stocks. Nonetheless, we may deduce that, if elevated energy prices hurt aggregate profits, they will also hurt cyclical profits, since the latter exacerbate the fluctuation of the former. Moreover, Europe’s elevated stagflation risk is consistent with sagging profits for cyclicals relative to those of defensives, because cyclicals experience greater pain from deteriorating economic activity than the benefit they enjoy from higher inflation. Bottom Line: The problems faced by the Chinese economy as well as the risks to global growth are consistent with an underperformance of the profits of cyclical stocks compared to those of defensive equities. Moreover, while higher energy prices are not necessarily a problem for cyclical equities, the elevated perceived stagflation risk is consistent with downward revisions for the relative earnings of cyclicals. This picture indicates that cyclical equities are still vulnerable to some downside relative to the broad market in the near term. A Look at Individual Sectors Chart 11Sectoral Degrees Of Operating Leverage The Three Forces Hurting European Earnings The Three Forces Hurting European Earnings We may distill the impact of China’s problems, the global economic slowdown, and the energy shock on sectoral earnings. A simple starting point is to look at their degree of operating leverage. Based on this observation, financials and consumer discretionary stocks are the sectors most at risk from weaker revenue growth, while utilities are the least exposed (Chart 11). A more complete picture may be gleaned from each sector’s pricing power. Energy Chart 12Improving Energy Margins Improving Energy Margins Improving Energy Margins The energy sector enjoys a significant margin tailwind from the oil supply shock (Chart 12). Nonetheless, this boost is long in the tooth and a pullback is likely if Brent falls toward the $94/bbl level expected by BCA’s Commodity & Energy team in the second half of 2022, and $88/bbl level in 2023. Hence, it is likely that the near-term benefits for the energy sector’s profits are already fully discounted and that the sector could suffer a significant setback in the coming quarters. Industrials The pricing power of industrials (as approximated by the gap between CPI and PPI) is still strong, which creates a tailwind for relative earnings (Chart 13). However, this robustness is under threat in the current environment in which global industrial production, global trade, and global capital goods orders are decelerating (Chart 14). Hence, a period of downgrade for the earnings of industrials relative to the broad market is likely in the coming months. Chart 13Robust Pricing Power For Industrials... Robust Pricing Power For Industrials... Robust Pricing Power For Industrials... Chart 14...But For How Long? ...But For How Long? ...But For How Long? Financials Chart 15Financials Are Under Siege Financials Are Under Siege Financials Are Under Siege The relative pricing power1 of financials is rapidly deteriorating, despite the recent increase in German yields (Chart 15). Moreover, it is likely to remain weak in a context in which core CPI has yet to decrease. Finally, the potential for a European recession in 2022, or at least, a severe growth slowdown, should lift non-performing loans. As a result, this sector’s earnings could experience a significant downgrade in the near term. Tech The sector’s pricing power was in an uptrend, but it has started to deteriorate in recent quarters (Chart 16). This evolution indicates that that tech earnings and profit margins are likely to suffer relative to the broad market, especially in light of the sector’s high degree of operating leverage. Consumer Discretionary Stocks This sector is suffering from a complete collapse of its pricing power (Chart 17). Additionally, tumbling consumer confidence in Europe and around the world is a significant drag on near-term sales. Consequently, earnings growth as well as profit margins are likely to lag the overall market. Chart 16Crucial Tech Tailwind Dwindling Crucial Tech Tailwind Dwindling Crucial Tech Tailwind Dwindling Chart 17A Problem For Consumer Discretionary Stocks A Problem For Consumer Discretionary Stocks A Problem For Consumer Discretionary Stocks Materials European materials sector’s profit margins stand at a 19-year high compared to that of the broad market. However, relative profit growth has collapsed. The bad news for the sector is that its pricing power is rapidly deteriorating because of surging input costs. It suggests that relative profit growth will become negative as relative profit margins contract (Chart 18). Utilities The pricing power of utilities is plunging because retail electricity prices are not rising as fast as input costs. The negative impact of this adverse pricing on profit margins is consequential (Chart 19). Governments around Europe are likely to continue to pressure this sector to limit the increase in electricity prices to households, which means that utilities are likely to lag other defensive sectors. Chart 18Materials' Outlook Deteriorating Materially Materials' Outlook Deteriorating Materially Materials' Outlook Deteriorating Materially Chart 19Crunch Time For Utilities Crunch Time For Utilities Crunch Time For Utilities Consumer Staples Chart 20Staples Under Duress Staples Under Duress Staples Under Duress The consumer staples sector is facing a similar pricing power problem to that of consumer discretionary stocks: input costs are rising rapidly relative to selling prices (Chart 20). Nonetheless, the earnings of staples will prove more resilient than that of their discretionary counterparts because the staples’ sales volumes are less sensitive to both deteriorating global consumer confidence and falling household real incomes. However, consumer staples equities have already greatly outperformed consumer discretionary stocks. Thus, much of the good news in terms of relative earnings is well discounted and the additional outperformance will be limited. Healthcare Chart 21Healthcare Stocks Still Have Pricing Power Healthcare Stocks Still Have Pricing Power Healthcare Stocks Still Have Pricing Power The pricing power of the healthcare sector remains positive, but it is not as strong as it was ten years ago. Hence, profits growth has scope to improve further compared to the rest of the market (Chart 21). Beyond favorable pricing power dynamics, the industry is insulated from weaker global growth relative to the rest of the broad market. Importantly, the healthcare sector sports one of the lowest degrees of operating leverage in Europe, which will also boost its relative profitability in the current environment. Healthcare is our top defensive sector right now, despite its valuation premium. Communication Services Chart 22Telecom Will Prove Resilient Telecom Will Prove Resilient Telecom Will Prove Resilient The profit growth and profit margins of the European communication services sectors are already under duress because pricing power remains negative. Nonetheless, the contraction in relative growth rates of earnings is extended (Chart 22). Telecom revenues did not benefit from a boost when the economy rebounded after the economic contraction in 2020. This stability is now an asset because the sector will not struggle from slowing global economic activity. In this context, the cheap communication services sector remains an attractive defensive play in Europe. Bottom Line: Looking at sectors individually confirms that the outlook for profit growth is worse for cyclicals than it is for defensive stocks. The recent relative strength in industrials and materials earnings is likely to buckle in response to weaker global growth, while the defensive characteristics of healthcare and communication services will shine. Utilities are under stress, as they stand at the confluence of higher energy prices and the explicit desire of politicians to limit the impact of these higher energy costs on households. Favor healthcare and communication services versus utilities and consumer staples.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes   1     In the case of financials, we use core CPI as a proxy for the sector’s costs. Eurostat does not publish a PPI for the sector and the main costs are related to labor costs.   Tactical Recommendations Cyclical Recommendations Structural Recommendations

Listen to a short summary of this report.         Executive Summary The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The number of births collapsed during the pandemic. While the preliminary evidence suggests that fertility rates are starting to recover in most developed economies, they remain well below the level necessary to maintain a stable population. Aging populations are putting strain on pension and health care systems. They are also threatening to undermine geopolitical influence. The conventional wisdom is that there is not much that can be done to lift fertility rates. While it is true that government subsidies to encourage parents to have more children are not especially effective, other policies, such as cheaper child care, are more promising. Rather than discouraging property investment, China is likely to increase housing supply in order to make family formation more affordable. This could boost commodity demand. More contentiously, the use of IVF technologies to select for certain traits such as higher intelligence in children could open up a new front on the geopolitical battlefield that few analysts are expecting. Regardless of government policy, birth rates will eventually rise of their own accord because both cultural and genetic evolution will select for families that wish to have more children. In the long run, faster population growth will lead to stronger corporate sales, which is a plus for equities. Over a shorter-term horizon, however, the global dependency ratio could end up increasing, as the number of retirees rises while the number of children that parents need to support goes up. This could put upward pressure on interest rates and bond yields. Bottom Line: Contrary to popular opinion, global fertility rates may be bottoming and could rise significantly over the long run. While this trend will eventually benefit stocks, it is likely to come at the expense of higher bond yields.    Dear Client, We tactically downgraded global equities from overweight to neutral on February 28th. As we discussed last week in our report entitled “Here Comes Goldilocks,” we see a more fortuitous environment emerging in the second half of the year, which suggests that stocks will likely be higher over a 12-month horizon. This week, we step back from recent market action to focus on a long-term investment theme of great importance: demographic change. Contrary to the conventional wisdom that sees birth rates continuing to fall over the next few decades, we argue that developed economies may be on the cusp of a strong and sustained baby boom.  I will be visiting clients in the San Francisco Bay Area next week. Instead of our regular report, we will be sending you a Special Report written by Irene Tunkel, BCA’s Chief US Equity Strategist. Irene will discuss inflation regimes and their implications for US equities. Best regards, Peter Berezin, Chief Global Strategist Baby Bust At the start of the pandemic, some speculated that with little else to do, couples would spend more time in bed, leading to a mini baby boom. As it turned out, the exact opposite happened: Birth rates plunged around the world. In the US, the number of babies born in January 2021 was about 10% lower than one would have expected based on the pre-pandemic trend. Similar shortfalls were observed in the UK, France, Italy, Spain, and Japan (Chart 1). In China, the number of births fell by almost 30% between 2019 and 2021 to the lowest level since 1949 (Chart 2). Chart 1The Birth Rate Has Recovered Since The Start Of The Pandemic But Remains Below Levels Consistent With A Stable Population The Coming Stork Wars The Coming Stork Wars Chart 2The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 The Number Of Babies Born In China Has Fallen By Close To 30% Since 2019 While the pandemic continues to restrain fertility in China, the latest data from developed economies suggest births have rebounded. Nevertheless, birth rates remain far below the level necessary to maintain stable populations. A recent study in The Lancet estimated that more than three-quarters of countries would have below-replacement fertility rates by the end of the century. The study estimated that the global population would peak at 9.7 billion in 2064 and decline to 8.8 billion by 2100. Alarm Over Low Birth Rates Low birth rates have become a major cause of concern for policymakers. Aging populations are putting strain on pension and health care systems. The OECD expects the old-age dependency ratio to double from 30% to 60% by 2075 (Chart 3). Pension spending in the OECD is projected to rise by 1.4% of GDP over the next 40 years. Chart 3Conventional Forecasts Expect The Population To Grey Over The Coming Decade The Coming Stork Wars The Coming Stork Wars Chart 4The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century The UN Projects China's Working-Age Population Will Shrink By 400 Million Over The Remainder Of The Century Health care spending is likely to grow at an even faster pace. In the US, the Congressional Budget Office sees federal government-financed health care spending rising from 5.7% of GDP to 9.4% of GDP by 2050. As has been the case in Japan and Russia, and could be the case in China, a shrinking population threatens to undermine geopolitical influence. The UN estimates that China’s working-age population will decline from about 1 billion to less than 600 million by the end of the century. By 2100, Nigeria’s working-age population is projected to approach China’s (Chart 4). It is difficult to be an economic and military superpower if you do not have enough workers and soldiers.   Pro-Natal Subsidies: Little Bang for the Buck Governments are responding by adopting increasingly aggressive pro-natal policies. According to the UN, more than 50 countries have officially declared their intention to increase fertility rates (Chart 5). Chart 5Governments Are Actively Trying To Raise Fertility Rates The Coming Stork Wars The Coming Stork Wars Chart 6Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Fertility Rates Keep Dropping In OECD Countries Amid Rising Government Incentives Various European countries, ranging from Estonia, Germany, Greece, Finland, France, Italy, and Lithuania to the UK offer varying bonus payments to new parents. Japan and Singapore both have baby bonus schemes. South Korea, which has the lowest fertility rate in the world, recently increased the reward it pays to mothers from US$500 to US$1,700. The most significant pro-natal shift has come from China. After having officially abandoned its one-child policy in 2016, China announced last year that it will allow couples to have up to three children. We expect China to introduce generous subsidies to encourage childbirth over the next few years. Will such policies arrest the decline in birth rates? There are certainly reasons to be skeptical. Chart 6 shows that spending on family benefits in OECD economies rose from 1.5% to 2.1% of GDP over the past 40 years. Yet, the fertility rate fell from 2.25 to 1.66 over this period. Can Anything Turn the Tide? A number of structural forces have contributed to lower fertility rates. These include increased female labor market participation, readily available birth control, falling child mortality, and rising housing and educational costs. The availability of government-provided income support and health care has also arguably reduced the historic role that children have played in supporting their parents in old age. The conventional wisdom is that these forces will only strengthen in the future, ensuring that fertility rates keep dropping. I am not so sure. Are Children Inferior, Normal, or Veblen goods? While it is rather awkward to think of the decision to have children in economic terms, there is some logic to this approach. Economists tend to distinguish between substitution and income effects. The substitution effect for children is negative: As wages rise, the opportunity cost of having children goes up. In contrast, a number of studies have documented that the income effect is positive: Give a couple an extra $1 million, no strings attached, and that could push them over the line in deciding to have an additional child (in economic parlance, children are “normal” rather than “inferior”). Economists have long known that labor supply curves tend to be “backward bending” (Charts 7A & B). The classic example is that of leisure. As wages initially rise from low levels, people may seek to work more (and hence, consume less leisure). Eventually, however, if wages rise enough, people will cut back on work in order to enjoy the fruits of their labor. Chart 7ABackward-Bending Demand Curves May Also Apply To Children The Coming Stork Wars The Coming Stork Wars Chart 7BLower Child-Rearing Costs Would Improve The Demographic Problem The Coming Stork Wars The Coming Stork Wars The same sort of backward-bending demand curve may apply to children. As wages rise above a certain threshold, parents may decide that they can afford to have more children. Chart 8 shows that the correlation between per capita income and realized fertility has turned positive in developed economies. Chart 8Correlation Between Incomes And Realized Fertility Has Turned Positive In Developed Countries The Coming Stork Wars The Coming Stork Wars Looking out, it is possible that children will become “Veblen” goods, named after nineteenth-century economist Thorstein Veblen, who coined the term “conspicuous consumption.” With many luxury goods now available to the masses, what better way to signal that one has made it to the top than to have five kids in Manhattan or Beverly Hills? How Expensive Are Children, Really? Across most developed economies, women tend to end up having fewer children than they would like (Chart 9). While difficulty in finding a suitable spouse is sometimes cited as a reason, the financial hardship associated with parenting usually ranks higher. Chart 9Most Women Are Having Fewer Children Than They Desire The Coming Stork Wars The Coming Stork Wars Chart 10Depression Rates Among Children And Teenagers Have Been Increasing Over The Past Decade The Coming Stork Wars The Coming Stork Wars According to one recent estimate, it costs nearly $300,000, excluding college tuition, to raise a child in the US. This number, however, is conditional on what society currently deems appropriate for rearing children. If the incremental cost of a child were to decline, the slope of the budget constraint in Chart 7B would become flatter, implying that both the income and substitution effects would reinforce each other in the direction of having more children. Could society eventually conclude that the cost of having a child is not as large as widely perceived? The idea is not as far-fetched as it sounds. Having turned 50 this week, I find it interesting to look back at how much cultural norms towards kids have changed over the past few decades. Growing up in Hamilton Ontario, I remember taking the public bus alone at the age of 10 to school, the pool, or anywhere else I wanted to go. Are kids even allowed to leave the house unattended anymore? As Derek Thompson points out in a recent article in The Atlantic, American parents have nearly doubled the amount of time spent raising their kids. And what has the advent of helicopter parenting achieved? It is difficult to point to any concrete benefits. Depression rates among children and teenagers have soared (Chart 10). While the proliferation of social media has exacerbated childhood angst, the tendency for parents to try to shield their children from hardship and failure has probably only made things worse. Does Schooling Matter Much? Sticking with the issue of schooling, to what extent does the modern parental preoccupation with education actually benefit children? Probably a lot less than parents realize. IQ is highly correlated with educational achievement and many other favorable life outcomes (Chart 11). IQ scores are by far the best predictors of job performance, much better than fashionable concepts such as “emotional intelligence” (Chart 12). Chart 11IQ Tests Don’t Just Measure How Well You Can Do On An IQ Test The Coming Stork Wars The Coming Stork Wars Chart 12Cognitive Ability Matters A Lot For Job Performance The Coming Stork Wars The Coming Stork Wars In healthy, well-nourished populations, genetics explains about 50% of IQ variation at age ten and 80% in adulthood (Chart 13). In fact, IQ is almost as heritable as height (Chart 14). Chart 13The Heritability Of IQ Reaches 80% By Adulthood The Coming Stork Wars The Coming Stork Wars Chart 14IQ Is Almost As Heritable As Height The Coming Stork Wars The Coming Stork Wars When a child suffers from economic or social deprivation, improvements to their environment can have a large positive impact on their cognitive performance. However, beyond a certain environmental threshold, there is not much that parents can do. A recent study concluded that “there is only a marginal and inconsistent influence of parenting on offspring IQ in adolescence and young adulthood.” Table 1A Poisoned Chalice? Genetic Screening Can Raise IQ The Coming Stork Wars The Coming Stork Wars Even musical training, which parents often spend a fortune on, does not appear to generate any knock-on benefits for math or language skills. As much as I hate to say it, the evidence suggests that the most reliable way to enhance a child’s educational prospects is to endow them with high IQ genes. I will not speak to the questionable ethics of doing so, but as I discussed in my report on the rise and fall of human intelligence a few years ago, the technology is coming. Carl Shulman and Nick Bostrom estimate that genetic screening could boost average IQs by up to 65 points in five generations (Table 1).   The Stork Wars The ability to engineer high-IQ children through IVF technologies could open up a front on the geopolitical battlefield that few analysts are expecting. Such a battlefield for geopolitical supremacy will take place at a time when China and Russia, on the one side, and much of the West, on the other side, are moving in polar opposite directions on a variety of cultural issues. The empirical evidence suggests that there is a U-shaped relationship between gender equality and fertility rates. Both patriarchal societies, such as those in parts of the Middle East, and egalitarian societies, such as those in Scandinavia, have been able to maintain relatively high fertility levels. Between these two extremes, fertility rates are typically well below replacement. Whereas most Western nationals have sought to promote gender equality in recent years, China and Russia have shifted in a more traditionalist direction. Last April, China’s government shut down a number of feminist social media groups. This followed a statement by China's Education Ministry that the government would seek to “cultivate masculinity.” Boys were becoming “delicate, timid and effeminate,” a key government advisor declared. Ironically, both the traditionalist and egalitarian approaches could lift fertility rates, but at the cost of an ever-wider cleavage in the global culture wars. The Long-Term Outlook for Fertility Rates: Up, Up, and Away? In a world of abundant material resources, a steady or declining population is not an evolutionary stable equilibrium. As long as there are some selection pressures towards having more offspring, in the absence of offsetting forces, evolution will push up fertility rates.  In the pre-industrial era, parents with many children often struggled to keep enough food on the table. The correlation between parent and child fertility was close to zero, meaning that children who came from big families did not have more surviving offspring than children from small families. After the Industrial Revolution, the correlation turned positive, and by most indications, has been rising over the past few decades. Were it not for the positive correlation between parent and child fertility, global population levels would be even lower today. How high could birth rates climb if the cultural forces, which have suppressed fertility over the past century, abate? The natural tendency is to think that evolution works too slowly to matter. However, this represents a misreading of the evidence. When there are evolutionary disequilibria – that is, when the environment changes in ways that renders existing reproductivity strategies suboptimal – natural selection can work surprisingly fast. Contrary to the widespread notion that human evolution stopped before the Agricultural Revolution, a recent study in Nature found that 88% of physiological traits have undergone polygenic change during the past 2,000 to 3,000 years. Using plausible estimates of intergenerational fertility correlations, Jason Collins and Lionel Page calibrate a model of global population growth. In contrast to more conventional demographic models, they conclude that global population growth, rather than turning negative later this century, will accelerate. In their baseline model without any heritability effects, the global total fertility rate falls to 1.82 by the end of the century. Once heritability effects are included, the projected total fertility rate rises to 2.21 (Chart 15). The largest effects are for Europe and North America, the first two regions to undertake a demographic transition to (temporarily) low birth rates. The authors see the European median total fertility rate rising to 2.46 by the end of the century, with the North American rate increasing to 2.67. Chart 15Natural Selection Could End Up Boosting Fertility Rates Over The Long Run The Coming Stork Wars The Coming Stork Wars Notably, the support ratio – the ratio of workers-to-consumers – continues to fall in their model over the remainder of the century. They conclude: “Once the increase in number of children is taken into consideration, the higher number of children in the heritability model merely shifts the nature of the burden rather than ameliorating it.” Investment Conclusions The world is at a demographic inflection point. After rising steadily for four decades, the global support ratio has peaked (Chart 16). Baby boomers are beginning to leave the labor market en masse. While they were working, they accumulated a lot of assets. In the US, baby boomers hold more than half of all household wealth (Chart 17). Chart 16Less Workers And More Consumers Over The Next Decades Less Workers And More Consumers Over The Next Decades Less Workers And More Consumers Over The Next Decades Chart 17Baby Boomers Hold More Than Half Of Wealth In The US The Coming Stork Wars The Coming Stork Wars Going forward, rather than working and saving, baby boomers will spend down their wealth. The global pool of savings will shrink, putting upward pressure on equilibrium real interest rates and bond yields. Faced with the prospect of shrinking work forces, strained social security systems, and declining geopolitical influence, countries with low or negative population growth will offer increasingly generous subsidies to encourage couples to have more children. The resulting bigger budget deficits will further drain national savings. In and of themselves, government subsides are unlikely to significantly boost birth rates. More holistic policies will be needed, including steps to reduce the cost of child care and housing. Rather than discouraging property investment, China is likely to increase housing supply in order to make family formation more affordable. This could help support commodity demand.  Governments will try to influence the social and cultural narrative on family matters.In some cases, the impact could be quite innocuous, such as China’s decision to ban for-profit tutoring companies in order to ease pressure on students and parents. In other cases, the impact could be very contentious, leading to an escalation in the so-called culture wars. Regardless of the policy measures that governments adopt, birth rates will eventually rise of their own accord because both cultural and genetic evolution will select for families that wish to have more children. In the long run, faster population growth will lead to stronger corporate sales, which is a plus for equities. Over a shorter-term horizon, however, the global dependency ratio could end up increasing, as the number of retirees rises while the number of children that parents need to support goes up. On balance, therefore, we see demographic trends as being somewhat negative for stocks over the next one-or-two decades. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on  LinkedIn Twitter View Matrix The Coming Stork Wars The Coming Stork Wars Special Trade Recommendations Current MacroQuant Model Scores The Coming Stork Wars The Coming Stork Wars

Executive Summary German GeoRisk Indicator German GeoRisk Indicator German GeoRisk Indicator Russia and Germany have begun cutting off each other’s energy in a major escalation of strategic tensions. The odds of Finland and Sweden joining NATO have shot up. A halt to NATO enlargement, particularly on Russia’s borders, is Russia’s chief demand. Tensions will skyrocket. China’s reversion to autocracy and de facto alliance with Russia are reinforcing the historic confluence of internal and external risk, weighing on Chinese assets. Geopolitical risk is rising in South Korea and Hong Kong, rising in Spain and Italy, and flat in South Africa. France’s election will lower domestic political risk but the EU as a whole faces a higher risk premium. The Biden administration is doubling down on its defense of Ukraine, calling for $33 billion in additional aid and telling Russia that it will not dominate its neighbor. However, the Putin regime cannot afford to lose in Ukraine and will threaten to widen the conflict to intimidate and divide the West. Trade Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 14.2% Bottom Line: Stay long global defensives over cyclicals. Feature Chart 1Geopolitical Risk And Policy Uncertainty Drive Up Dollar Geopolitical Risk And Policy Uncertainty Drive Up Dollar Geopolitical Risk And Policy Uncertainty Drive Up Dollar The dollar (DXY) is breaking above the psychological threshold of 100 on the back of monetary tightening and safe-haven demand. Geopolitical risk does not always drive up the dollar – other macroeconomic factors may prevail. But in today’s situation macro and geopolitics are converging to boost the greenback (Chart 1). Global economic policy uncertainty is also rising sharply. It is highly correlated with the broader trade-weighted dollar. The latter is nowhere near 2020 peaks but could rise to that level if current trends hold. A strong dollar reflects slowing global growth and also tightens global financial conditions, with negative implications for cyclical and emerging market equities. Bottom Line: Tactically favor US equities and the US dollar to guard against greater energy shock, policy uncertainty, and risk-aversion. Energy Cutoff Points To European Recession Chart 2Escalation With Russia Weighs Further On EU Assets Escalation With Russia Weighs Further On EU Assets Escalation With Russia Weighs Further On EU Assets Russia is reducing natural gas flows to Poland and Bulgaria and threatening other countries, Germany is now embracing an oil embargo against Russia, while Finland and Sweden are considering joining NATO. These three factors are leading to a major escalation of strategic tensions on the continent that will get worse before they get better, driving up our European GeoRisk indicators and weighing on European assets (Chart 2). Russia’s ultimatum in December 2021 stressed that NATO enlargement should cease and that NATO forces and weapons should not be positioned east of the May 1997 status quo. Russia invaded Ukraine to ensure its military neutrality over the long run.1 Finland and Sweden, seeing Ukraine’s isolation amid Russian invasion, are now reviewing whether to change their historic neutrality and join NATO. Public opinion polls now show Finnish support for joining at 61% and Swedish support at 57%. The scheduling of a joint conference between the country’s leaders on May 13 looks like it could be a joint declaration of their intention to join. The US and other NATO members will have to provide mutual defense guarantees for the interim period if that is the case, lest Russia attack. The odds that Finland and Sweden remain neutral are higher than the consensus holds (given the 97% odds that they join NATO on Predictit.org). But the latest developments suggest they are moving toward applying for membership. They fear being left in the cold like Ukraine in the event of an attack. Russia’s response will be critical. If Russia deploys nuclear weapons to Kaliningrad, as former President Dmitri Medvedev warned, then Moscow will be making a menacing show but not necessarily changing the reality of Russia’s nuclear strike capabilities. That is equivalent to a pass and could mark the peak of the entire crisis. The geopolitical risk premium would begin to subside after that. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) However, Russia has also threatened “military-political repercussions” if the Nordics join NATO. Russia’s capabilities are manifestly limited, judging by Ukraine today and the Winter War of 1939, but a broader war cannot entirely be ruled out. Global financial markets will still need to adjust for a larger tail risk of a war in Finland/Sweden in the very near term. Most likely Russia will retaliate by cutting off Europe’s natural gas. Clearly this is the threat on the table, after the cutoff to Poland and Bulgaria and the warnings to other countries. In the near term, several companies are gratifying Russia and paying for gas in rubles. But these payments violate EU sanctions against Russia and the intention is to wean off Russian imports as soon as possible. Germany says it can reduce gas imports starting next year after inking a deal with Qatar. Hence Russia might take the initiative and start reducing the flow earlier. Bottom Line: If Europe plunges into recession as a result of an immediate natural gas cutoff, then strategic stability between Russia and the West will become less certain. The tail risk of a broader war goes up. Stay cyclically long US equities over global equities and tactically long US treasuries. Stay long defense stocks and gold. Stay Short CNY At the end of last year we argued that Beijing would double down on “Zero Covid” policy in 2022, at least until the twentieth national party congress this fall. Social restrictions serve a dual purpose of disease suppression and dissent repression. Now that the state is doubling down, what will happen next? The economy will deteriorate: imports are already contracting at a rate of 0.1% YoY. The manufacturing PMI has fallen to 48.1  and the service sector PMI to 42.0, indicating contraction. Furthermore, social unrest could emerge, as lockdowns serve as a catalyst to ignite underlying socioeconomic disparities. Hence the national party congress is less likely to go smoothly, implying that investors will catch a glimpse of political instability under the surface in China as the year progresses. The political risk premium will remain high (Chart 3). Chart 3China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency While Chairman Xi Jinping is still likely to clinch another ten years in power, it will not be auspicious amid an economic crash and any social unrest. Xi could be forced into some compromises on either Politburo personnel or policy adjustments. A notable indicator of compromise would be if he nominated a successor, though this would not provide any real long-term assurance to investors given the lack of formal mechanisms for power transfer. After the party congress we expect Xi to “let 100 flowers bloom,” meaning that he will ease fiscal, regulatory, and social policy so that today’s monetary and fiscal stimulus can work effectively. Right now monetary and fiscal easing has limited impact because private sector actors are averse to taking risk. Easing policy to boost the economy could also entail a diplomatic charm offensive to try to convince the US and EU to avoid imposing any significant sanctions on trade and investment flows, whether due to Russia or human rights violations. Such a diplomatic initiative would only succeed, if at all, in the short run. The US cannot allow a deep re-engagement with China since that would serve to strengthen the de facto Russo-Chinese strategic alliance. In other words, an eruption of instability threatens to weaken Xi’s hand and jeopardize his power retention. While it is extremely unlikely that Xi will fall from power, he could have his image of supremacy besmirched. It is likely that China will be forced to ease a range of policies, including lockdowns and regulations of key sectors, that will be marginally positive for economic growth. There may also be schemes to attract foreign investment. Bottom Line: If China expands the range of its policy easing the result could be received positively by global investors in 2023. But the short-term outlook is still negative and deteriorating due to China’s reversion to autocracy and confluence of political and geopolitical risk. Stay short CNY and neutral Chinese stocks. Stay Short KRW South Koreans went to the polls on March 9 to elect their new president for a five-year term. The two top candidates for the job were Yoon Suk-yeol and Lee Jae-myung. Yoon, a former public prosecutor, was the candidate for the People Power Party, a conservative party that can be traced back to the Saenuri and the Grand National Party, which was in power from 2007 to 2017 under President Lee Myung-bak and President Park Geun-hye. Lee, the governor of the largest province in Korea, was the candidate for the Democratic Party, the party of the incumbent President Moon Jae-in. Yoon won by a whisker, garnering 48.6% of the votes versus 47.8% for Lee. The margin of victory for Yoon is the lowest since Korea started directly electing its presidents. President-elect Yoon will be inaugurated in May. He will not have control of the National Assembly, as his party only holds 34% of the seats. The Democratic Party holds the majority, with 172 out of 300 seats. The next legislative election will be in 2024, which means that President Yoon will have to work with the opposition for a good two years before his party has a chance to pass laws on its own. President-elect Yoon was the more pro-business and fiscally restrained candidate. His nomination of Han Duck-soo as his prime minister suggests that, insofar as any domestic policy change is possible, he will be pragmatic, as Han served under two liberal administrations. Yoon’s lack of a majority and nomination of a left-leaning prime minister suggest that domestic policy will not be a source of uncertainty for investors through 2024. Foreign policy, by contrast, will be the biggest source of risk for investors. Yoon rejects the dovish “Moonshine” policy of his predecessor and favors a strong hand in dealing with North Korea. “War can be avoided only when we acquire an ability to launch pre-emptive strikes and show our willingness to use them,” he has argued. North Korea responded by expanding its nuclear doctrine and resuming tests of intercontinental ballistic missiles with the launch of the Hwasong-17 on March 24 – the first ICBM launch since 2017. In a significant upgrade of North Korea’s deterrence strategy, Kim Yo Jong, the sister of Kim Jong Un, warned on April 4 that North Korea would use nuclear weapons to “eliminate” South Korea if attacked (implying an overwhelming nuclear retaliation to any attack whatsoever). Kim Jong Un himself claimed on April 26 that North Korea’s nuclear weapons are no longer merely about deterrence but would be deployed if the country is attacked. President-elect Yoon welcomes the possibility of deploying of US strategic assets to strengthen deterrence against the North. The hawkish turn is not surprising considering that North-South relations failed to make any substantive improvements during President Moon’s five-year tenure as a pro-engagement president. South Koreans, especially Yoon’s supporters, are split on whether inter-Korean dialogue should be continued. They are becoming more interested in developing their own nuclear weapons or at the very least deploying US nuclear weapons in South Korea. Half of South Korean voters support security through alliance with the US, while a third support security through the development of independent nuclear weapons. The nuclear debate will raise tensions on the peninsula. An even bigger change in South Korea’s foreign policy is its policy towards China. President-elect Yoon has accused President Moon of succumbing to China’s economic extortion. Moon had established a policy of “three No’s,” meaning no to additional THAAD missiles in South Korea, no to hosting other US missile defense systems, and no to joining an alliance with Japan and the United States. By contrast, Yoon’s electoral promises include deploying more THAAD and joining the Quadrilateral Dialogue (US, Japan, Australia, India). Polls show that South Koreans hold a low opinion of all of their neighbors but that China has slipped slightly beneath Japan and North Korea in favorability. Even Democratic Party voters feel more negative towards China. While negative attitudes towards China are not unique to Korea, there is an important difference from other countries: the Korean youth dislike China the most, not the older generations. Negative sentiment is less tied to old wounds from the Korean war and more related to ideology and today’s grievances. Younger Koreans, growing up in a liberal democracy and proud of their economic and cultural success, have been involved in campus clashes against Chinese students over Korean support for Hong Kong democrats. Negative attitudes towards China among the youth should alarm investors, as young people provide the voting base for elections to come, and China is the largest trading partner for Korea. Korea’s foreign policy will hew to the American side, at risk to its economy (Chart 4). Chart 4South Korean Geopolitical Risk Rising Under The Radar South Korean Geopolitical Risk Rising Under The Radar South Korean Geopolitical Risk Rising Under The Radar President-elect Yoon’s policies towards North Korea and China will increase geopolitical risk in East Asia. The biggest beneficiary will be India. Both Korea and Japan need to find a substitute to Chinese markets and labor, which have become less reliable in recent years. South Korea’s newly elected president is aligned with the US and West and less friendly toward China and Russia. He faces a rampant North Korea that feels emboldened by its position of an arsenal of 40-50 deliverable nuclear weapons. The North Koreans now claim that they will respond to any military attack with nuclear force and are testing intercontinental ballistic missiles and possibly a nuclear weapon. The US currently has three aircraft carriers around Korea, despite its urgent foreign policy challenges in Europe and the Middle East. Bottom Line: Stay long JPY-KRW. South Korea’s geopolitical risk premium will remain high. But favor Korean stocks over Taiwanese stocks. Stay Neutral On Hong Kong Stocks Hong Kong’s leadership change will trigger a new bout of unrest (Chart 5). Chart 5Hong Kong: More Turbulence Ahead Hong Kong: More Turbulence Ahead Hong Kong: More Turbulence Ahead On April 4, Hong Kong’s incumbent Chief Executive, Carrie Lam, confirmed that she would not seek a second term but would step down on June 30. John Lee, the current chief secretary of Hong Kong, became the only candidate approved to run for election, which is scheduled to be held on May 8. With the backing of the pro-Beijing members in the Election Committee, Lee is expected to secure enough nominations to win the race. Lee served as security secretary from when Carrie Lam took office in 2017 until June 2021. He firmly supported the Hong Kong extradition bill in 2019 and National Security Law in 2020, which provoked historic social unrest in those years. He insisted on taking a tough security stance towards pro-democracy protests. With Lee in power, Hong Kong will face more unrest and tougher crackdowns in the coming years, which will likely bring more social instability. Lee will provoke pro-democracy activists with his policy stances and adherence to Beijing’s party line. For example, his various statements to the news media suggest a dogmatic approach to censorship and political dissent. With the adoption of the National Security Law, Hong Kong’s pro-democracy faction is already deeply disaffected. Carrie Lam was originally elected as a popular leader, with notable support from women, but her popularity fell sharply after the passage of the extradition bill and National Security Law, as well as her mishandling of the Covid-19 outbreak. Her failure to handle the clashes between the Hong Kong people and Beijing damaged public trust in government. Trust never fully recovered when it took another hit recently from the latest wave of the pandemic. Putting another pro-Beijing hardliner in power will exacerbate the trend. Hong Kong equities are vulnerable not merely because of social unrest. During the era of US-China engagement, Hong Kong benefited as the middleman and the symbol that the Communist Party could cooperate within a liberal, democratic, capitalist global order. Hence US-China power struggle removes this special status and causes Hong Kong financial assets to contract mainland Chinese geopolitical risk. As a result of the 2019-2020 crackdown, John Lee and Carrie Lam were among a list of Hong Kong officials sanctioned by the US Treasury Department and State Department in 2020. Now, after the Ukraine war, the US will be on the lookout for any Hong Kong role in helping Russia circumvent sanctions, as well as any other ways in which China might further its strategic aims by means of Hong Kong. Bottom Line: Stay neutral on Hong Kong equities. Favor France Within European Equities French political risk will fall after the presidential election, which recommits the country to geopolitical unity with the US and NATO and potentially pro-productivity structural reforms (Chart 6). France is already a geopolitically secure country so the reduction of domestic political risk should be doubly positive for French assets, though they have already outperformed. And the Russia-West conflict is fueling a risk premium regardless of France’s positive developments. Chart 6France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated The French election ended with a solid victory for the political establishment as we expected. President Emmanuel Macron gaining 58% of the vote to Marine Le Pen’s 42%. Macron beat his opinion polling by 4.5pp while Le Pen underperformed her polls by 4.5pp. A large number of voters abstained, at 28%, compared to 25.5% in 2017. The regional results showed a stark divergence between overseas or peripheral France (where Marine Le Pen even managed to get over half of the vote in several cases) and the core cities of France (where Macron won handily). Macron had won an outright majority in every region in 2017. Macron did best among the young and the old, while Le Pen did best among middle-aged voters. But Macron won every age group except the 50 year-olds, who want to retire early. Macron did well among business executives, managers, and retired people, but Le Pen won among the working classes, as expected. Le Pen won the lowest paid income group, while Macron’s margin of victory rises with each step up the income ladder. Macron’s performance was strong, especially considering the global context. The pandemic knocked several incumbent parties out of power (US, Germany) and required leadership changes in others (Japan, Italy). The subsequent inflation shock now threatens to cause another major political rotation in rapid succession, leaving various political leaders and parties vulnerable in the coming months and years (Australia, the UK, Spain). Only Canada and now France marked exceptions, where post-pandemic elections confirmed the country’s leader. The Ukraine war constitutes yet another shock but it helped Macron, as Le Pen had objective links and sympathies with Russian President Vladimir Putin. Macron’s timing was lucky but his message of structural reform for the sake of economic efficiency still resonates in contemporary France, where change is long overdue – at least compared with Le Pen’s proposal of doubling down on statism, protectionism, and fiscal largesse. The French middle class was never as susceptible to populism as the US, UK, and Italy because it had been better protected from the ravages of globalization. Populism is still a force to be reckoned with, especially if left-wing populists do well in the National Assembly, or if right-wing populists find a fresher face than the Le Pen dynasty. But the failure of populism in the context of pandemic, inflation, and war suggests that France’s political establishment remains well fortified by the economic structure and the electoral system. Whether Macron can sustain his structural reforms depends on legislative elections to be held on June 12-19. Early projections are positive for his party, which should keep a majority. Macron’s new mandate will help. Le Pen’s National Rally and its predecessors may perform better than in the past but that is not saying much as their presence in the National Assembly has been weak. Bottom Line: France is geopolitically secure and has seen a resounding public vote for structural reform that could improve productivity depending on legislative elections. French equities can continue to outperform their European peers over the long run. Our European Investment Strategy recommends French equities ex-consumer stocks, French small caps over large caps, and French aerospace and defense.   Favor Spanish Over Italian Stocks Chart 7Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks What about Spain? It is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023 (Chart 7). In the past few months, a series of strategic mistakes and internal power struggles have led to a significant decline in the popularity of Spain’s largest opposition party, the People’s Party. Due to public infighting and power struggle, Pablo Casado was forced to step down as the leader of the People’s Party on February 23, as requested by 16 of the party’s 17 regional leaders. It is yet to be seen if the new party leader, Alberto Nunez Feijoo, can reboot People’s Party. The far-right VOX party will benefit from the People Party’s setback. The latter’s misstep in a regional election (Castile & Leon) gave VOX a chance to participate in a regional government for the very first time. Hence VOX’s influence will spread and it will receive greater recognition as an important political force. Meanwhile the ruling Socialist Worker’s Party (PSOE) faces anger from the public amid inflation and high energy prices. However, Spanish Prime Minister Pedro Sanchez’s decision to send offensive military weapons to Ukraine is widely supported among major parties, including even his reluctant coalition partner, Unidas Podemos. The People’s Party’s recent infighting gives temporary relief to the ruling party. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for Feijoo and a pre-test for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The problem for Sanchez and the Socialists is that the stagflationary backdrop will weigh on their support over time. Bottom Line: Spanish political risk is likely to spike sooner rather than later, though Spanish domestic risk it is limited in nature. Madrid faces low geopolitical risk, low energy vulnerability, and is not susceptible to trying to leave the EU or Euro Area. Favor Spanish over Italian stocks. Stay Constructive On South Africa The political and economic status quo is largely unchanged in South Africa and will remain so going into the 2024 national elections. Fiscal discipline will weaken ahead of the election, which should be negative for the rand, but the global commodity shortage and geopolitical risks in Russia and China will probably overwhelm any negative effects from South Africa’s domestic policies. Rising commodity prices have propped up the local equity market and will bring in much-needed revenue into the local economy and government coffers. But structural issues persist. Low growth outcomes amid weak productivity and high unemployment levels will remain the norm. The median voter is increasingly constrained with fewer economic opportunities on the horizon. Pressure will mount on the ruling African National Congress (ANC), fueling civil unrest and adding to overall political risk (Chart 8). Chart 8South Africa's Political Status Quo Is Tactically Positive For Equities And Currency South Africa's Political Status Quo Is Tactically Positive For Equities And Currency South Africa's Political Status Quo Is Tactically Positive For Equities And Currency Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have lifted and the national state of disaster has ended, reducing social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs. While we recently argued that fiscal austerity is under way in South Africa, we also noted that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Already, the ANC have committed to maintaining a special Covid-19 social-grant payment, first introduced in 2020, for another year. This grant, along with other government support, will feature in 2024 and possibly beyond. Unemployment is at 34.3%, its highest level ever recorded. The ANC cannot leave it unchecked. The most prevalent and immediate recourse is to increase social payments and transfers. Given the increasing number of social dependents that higher unemployment creates, government spending will have to increase to address rising unemployment. President Cyril Ramaphosa is still a positive figurehead for the ANC, but the 2021 local elections showed that the ANC cannot rely on the Ramaphosa effect alone. The ANC is also dealing with intra-party fighting. Ramaphosa has yet to assert total control over the party elites, distracting the ANC from achieving its policy objectives. To correct course, Ramaphosa will have to relax fiscal discipline. To this outcome, investors should expect our GeoRisk indicator to register steady increases in political risk moving into 2024. The only reason to be mildly optimistic is that South Africa is distant from geopolitical risk and can continue to benefit from the global bull market in metals. Bottom Line: Maintain a cyclically constructive outlook on South African currency and assets. Tight global commodity markets will support this emerging market, which stands to benefit from developments in Russia and China. Investment Takeaways Stay strategically long gold on geopolitical and inflation risk, despite the dollar rally. Stay long US equities relative to global and UK equities relative to DM-ex-US. Favor global defensives over cyclicals and large caps over small caps. Stay short CNY, TWD, and KRW-JPY. Stay short CZK-GBP. Favor Mexico within emerging markets. Stay long defense and cyber security stocks. We are booking a 5% stop loss on our long Canada / short Saudi Arabia equity trade. We still expect Middle Eastern tensions to escalate and trigger a Saudi selloff.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Footnotes 1   The campaign in the south suggests that Ukraine will be partitioned, landlocked, and susceptible to blockade in the coming years. If Russia achieves its military objectives, then Ukraine will accept neutrality in a ceasefire to avoid losing more territory. If Russia fails, then it faces humiliation and its attempts to save face will become unpredictable and aggressive. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary Economic Growth in Q2 Will Be Much Softer Economic Growth In Q2 Will Be Much Softer Economic Growth In Q2 Will Be Much Softer China’s GDP headline growth in Q1 was better than consensus, but it does not capture the full economic impact of ongoing city lockdowns. Other than infrastructure investment, business activity data from March shows a broad-based slowing in growth momentum. Manufacturing investment decelerated, while both real estate investment and retail sales contracted from a year ago. Exports in value terms continued to grow rapidly through March. However, the resilient rate of expansion is unsustainable given a weakening global manufacturing cycle and softening external demand for goods. China’s domestic supply-chain disruptions will also weigh on its export sector’s activity. Home sales contracted sharply in the first three weeks of April, particularly in larger cities. The lockdowns, coupled with poor funding dynamics among real estate developers, suggest that the real estate sector will remain a huge drag on China’s economy this year. Bottom Line: Even though business activities will resume after the lockdown restrictions are lifted, we do not expect China’s economy to rebound quickly and strongly as it did in 2H20. From a cyclical perspective, we continue to recommend a neutral allocation to Chinese onshore stocks in a global portfolio.   A slew of economic data released during the past two weeks suggests that the negative effects from the COVID-induced lockdowns in China’s largest and most prosperous cities are starting to emerge. The closings, which will likely continue through the end of April, are causing disruptions in both production and demand just as the economy was already in a business downcycle. Other than infrastructure spending, business activity data from March illustrates a broad-based slowing in growth momentum. The longer-term impact of the citywide shutdowns is still to come. Related Report  China Investment StrategyThe Cost Of China’s Zero-COVID Strategy The economic benefits of Beijing’s enhanced stimulus measures will be delayed to 2H22 at the earliest. Moreover, as we discussed in our last week’s report, the post-lockdown recovery in the second half of this year will be much more muted than in H2 2020 . The external environment is less reflationary than in 2H20; China’s domestic demand and sentiment among corporates and households were already declining prior to the latest lockdowns. The deteriorating economic outlook will continue to depress the absolute performance of Chinese onshore stocks in the coming months (Chart 1). Furthermore, against a backdrop of rising US Treasury yields, the interest rate differentials between China and US have become negative for the first time in a decade. A yield disadvantage, coupled with risk-averse sentiment across global financial markets, has discouraged portfolio flows into China. We expect foreign investment outflows to continue in the near term before China’s economy stabilizes sometime in 2H22 (Chart 2). Chart 1Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Deteriorating Domestic Economic Fundamentals Are The Main Risk To Chinese Onshore Stocks... Chart 2...And Have Triggered Substantial Foreign Investment Outflows ...And Have Triggered Substantial Foreign Investment Outflows ...And Have Triggered Substantial Foreign Investment Outflows From a cyclical perspective, we maintain our neutral position on Chinese onshore stocks in a global portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com China’s Credit Conditions: Amble Supply Versus Lack Of Demand Although broad credit growth accelerated in March from the previous month, the improvement mainly reflects a sharp increase in local government bond issuance. Bank loan growth on a year-over-year basis has not improved yet. Loan demand for infrastructure investments escalated, supported by front-loaded fiscal supports in Q1 (Chart 3). However, private-sector credit demand remains very weak. The acceleration in the credit impulse –calculated as a 12-month difference in the annual change in credit as a percentage of nominal GDP –is much more muted when excluding local government bond issuance (Chart 4). Chart 3Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Infrastructure-Related Bank Loans And Investments Picked Up Sharply In Q1 Chart 4The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance The Rebound In Credit Impulse Is Much More Muted When Excluding Local Government Bond Issuance Sentiment among the corporate and household sectors has plunged to a multi-year low, following two years of stringent COVID-containment measures and last year’s regulatory clampdowns (Chart 5). Furthermore, the corporate sector’s propensity to invest weakened sharply in Q1, despite much looser monetary conditions (Chart 6). A worsening private sector’s sentiment suggests that demand for credit is unlikely to pick up imminently. Chart 5Private-Sector Demand For Credit Remains in The Doldrums... Private-Sector Demand For Credit Remains in The Doldrums... Private-Sector Demand For Credit Remains in The Doldrums... Chart 6...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions ...And Unlikely To Turn Around Imminently Despite Accommodative Monetary Conditions Chart 7Significant Foreign Investment Outflows In China's Onshore Bond Market Significant Foreign Investment Outflows In China's Onshore Bond Market Significant Foreign Investment Outflows In China's Onshore Bond Market The PBoC announced a 25bps cut in its reserve requirement ratio (RRR) rate on April 15, but has kept its policy rate unchanged. The move was below the market’s expectation of a 50bps RRR cut and/or a policy rate cut. While we still expect that the PBoC will trim the loan prime rate (LPR) in Q2, the recent acceleration in the RMB’s devaluation may make the central bank more cautious in reducing rates and further diverging from the hawkish US Fed and other major central banks  (Chart 7). China GDP: Above-Expectation Growth In Q1, Mounting Concerns In Q2 China’s year-over-year GDP growth in Q1 accelerated to 4.8% from 4.0% in Q4 last year, beating the market expectation of a 4.2% increase. The Q1 growth was mainly supported by strong infrastructure investments and exports (Chart 8). On a sequential basis, however, seasonally adjusted GDP growth in Q1 was 1.3% (non-annualized), slower than Q4’s reading of 1.6% and below its historical mean (Chart 9). Meanwhile, private- sector investment and household consumption remain subdued and activity in the housing sector worsened. Chart 8Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Economic Growth In Q1 Was Underpinned By Infrastructure Investments And Exports Chart 9Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean Q1 GDP Growth On A Sequential Basis Is Below Its Historical Mean The negative effect from broadening city-wide lockdowns and more supply-chain disruptions in Shanghai and surrounding cities in the Yangtze River Delta region will be much larger in Q2 than in Q1. We expect that year-over-year GDP growth in Q2 will drop well below 4%, sharply down from the 4.8% growth recorded in Q1. Furthermore, the aggregate economic impact from the lockdowns could reduce China’s real GDP growth in 2022 by 1ppt, which poses substantial risks to the country’s 5.5% annual growth target for this year. Exports Growth Set To Decelerate Although the growth of exports in value terms remained resilient in March, China’s exports will be challenged this year by the softening global demand for goods and domestic COVID-induced disruptions in the supply chain. A recent PBoC survey of 5,000 industrial enterprises shows that overseas orders dived sharply (Chart 10). In addition, global cyclical stocks have underperformed defensives. The underperformance has historically been a good leading indicator of a global manufacturing downturn, which will likely lead to a decline in demand for Chinese exports (Chart 11). The weakening external demand is also reflected in softening US demand and falling personal consumption expenditures on goods ex-autos (Chart 12).   Chart 10Overseas Orders For Chinese Industrial Enterprises Dived Sharply Overseas Orders For Chinese Industrial Enterprises Dived Sharply Overseas Orders For Chinese Industrial Enterprises Dived Sharply Chart 11Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Global Equity Sector Performance Points To A Relapse In Global Manufacturing Furthermore, China’s imports for processing trade, which historically has been highly correlated with China’s total exports growth, decelerated sharply in March. The drop heralds a slowdown in the growth of Chinese exports in the coming months (Chart 13). Chart 12External Demand For Chinese Export Goods Will Likely Dwindle External Demand For Chinese Export Goods Will Likely Dwindle External Demand For Chinese Export Goods Will Likely Dwindle Chart 13Slowing Processing Imports Point To A Deceleration In Chinese Export Growth Slowing Processing Imports Point To A Deceleration In Chinese Export Growth Slowing Processing Imports Point To A Deceleration In Chinese Export Growth   Port congestions and supply-chain disruptions worsened in April after the Shanghai lockdown began on March 28. COVID-related supply-chain disruptions in China’s key ocean ports and reduced shipping volumes will curtail activity of the country’s export sector in the short term. Real Estate Sector Will Remain A Drag On China’s Economy March’s data reflects a broad-based deterioration in housing market activities (Chart 14). The growth in real estate investment rolled over, and all floor space indicators contracted further in March. Moreover, households’ sentiment in the property market remains lackluster (Chart 15). Funding among real estate developers has plummeted to an all-time low, which will continue to dampen housing construction activities (Chart 16). Chart 14A Broad-based Deterioration In Housing Market Indicators In March A Broad-based Deterioration In Housing Market Indicators In March A Broad-based Deterioration In Housing Market Indicators In March Chart 15Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Housing Market Sentiment Shows Little Signs Of Revival Chart 16Housing Construction Activities Are Set To Slow Further Housing Construction Activities Are Set To Slow Further Housing Construction Activities Are Set To Slow Further Chart 17Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities Home Sales Worsened In April Amid COVID Flareups In Major Cities The March housing transaction data only captures some early indications from the recent round of lockdowns. The negative upshot on home sales will be greater in April. Figures for high-frequency floor space sold show a substantial weakening in home sales, particularly in tier-one and tier-two cities, through the first three weeks of April (Chart 17). The shrinkage in home sales will likely continue through Q2 and poses a significant risk for property investment and construction activities in H2. Regional governments are allowed to initiate their own housing policies, therefore, an increasing number of regional cities have slashed mortgage rates and/or down payment thresholds (Chart 18). However, the easing measures have failed to shore up demand for housing. In addition, pledged supplementary lending, which the government used to monetize massively excess inventories in the 2015/16 market, resumed its downtrend in March after a short-lived rebound earlier this year (Chart 19). Chart 18More Regional Cities Have Eased Local Housing Policies Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2 Chart 19PSL Injections Resumed Downward Trend In March PSL Injections Resumed Downward Trend In March PSL Injections Resumed Downward Trend In March Subdued Domestic Demand And Household Consumption Chart 20Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments Strong Pickup In Infrastructure Investment Growth Failed To Offset The Deceleration In Manufacturing And Real Estate Investments China’s domestic demand remained weak in March and will likely worsen in the next few months when more negative fallout from the recent lockdowns spill over to the aggregate economy.   Infrastructure investments picked up strongly in March. However, robust infrastructure investments were insufficient to fully offset the weakness in capital spending in the real estate and manufacturing sectors (Chart 20). The sluggish housing market and a deceleration in exports growth will likely slow China’s capital spending further in Q2. Growth in China’s imports in value terms contracted slightly in March; this was the first time since September 2020. Meanwhile, import growth in volume terms contracted sharply amid weak domestic demand and the early effects of supply-chain disruptions (Chart 21). Moreover, imports of major commodities in volume shrank deeper in March (Chart 22).  Chart 21Chinese Imports Value Growth Fell Into Contraction In March Chinese Imports Value Growth Fell Into Contraction In March Chinese Imports Value Growth Fell Into Contraction In March Chart 22The Volume Of China's Key Commodity Imports Contracted Further In March The Volume Of China's Key Commodity Imports Contracted Further In March The Volume Of China's Key Commodity Imports Contracted Further In March Household consumption has been a laggard in China’s economy in the past two years and the wave of city lockdowns are taking a heavy toll on consumption. Retail sales growth contracted in March, for the first time since August 2020 (Chart 23). Notably, online sales of goods also slowed to a multi-year low, highlighting not only subdued demand but also COVID-related logistic interruptions. Chart 23Retail Sales Growth Slipped Below Zero Retail Sales Growth Slipped Below Zero Retail Sales Growth Slipped Below Zero Chart 24Tame Core And Service CPIs Also Reflect Sluggish Household Demand Tame Core And Service CPIs Also Reflect Sluggish Household Demand Tame Core And Service CPIs Also Reflect Sluggish Household Demand Weakening core and service CPI readings also reflect a lackluster demand from consumers (Chart 24). We expect that the ongoing lockdowns will continue to weigh on service sector activity and household consumption, at least for the next couple of months (Chart 25). In addition, labor market dynamics are worsening rapidly and the nationwide urban unemployment rate rose to its highest level since mid-2020. The employment situation will also curb household consumption in the medium-term (Chart 26). Chart 26Labor Market Situation Is Deteriorating Sharply Labor Market Situation Is Deteriorating Sharply Labor Market Situation Is Deteriorating Sharply Chart 25Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Surging COVID Cases And Stringent Countermeasures Will Continue To Curb Service Sector Activities Table 1China Macro Data Summary Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2 Table 2China Financial Market Performance Summary Expect A Much Weaker Economy In Q2 Expect A Much Weaker Economy In Q2   Footnotes Strategic Themes Cyclical Recommendations