Economy

Special Report

Highlights There is no evidence of a decline in US corporate credit or bank lending spreads over the past few decades, meaning that any excess savings effect structurally depressing interest rates is occurring in the Treasury market. We note the possible mechanisms of action for excess savings to lower government bond yields, by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. To investigate the impact that excess savings may be having on bond yields, we define historical periods of abnormal yields based on the gap between long-maturity Treasury yields and the potential rate of economic growth. This reflects our view that potential growth is the equilibrium interest rate under normal economic conditions. Since 1960, there have been three major episodes when the difference between bond yields and economic growth was large and persistent, but the first two seem to be easily explained by the stance of US monetary policy rather than by a savings/investment imbalance. The excess savings story better fits the facts after 2000. We do find evidence that a global savings glut lowered bond yields during the early-2000s, and it may have even modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, the effect of the global savings glut was relatively insignificant compared to what has prevailed over the past decade. Excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so for cyclical reasons that spanned several years rather than as a result of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, as long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion despite a reduction in savings and significantly stronger growth. The historical impact of FOMC meetings on the structural decline in long-maturity US Treasury yields strongly implies that fixed-income investors have been guided by the Fed to expect a lower average Fed funds rate. It is our view that the Fed has a backward-looking neutral rate outlook, informed by an incomplete understanding of the economic circumstances of the latter half of the last expansion. A low neutral rate narrative has become entrenched in the minds of investors and the Fed itself, and we regard this as the primary factor anchoring yields at the long-end of the maturity spectrum. This phenomenon is only likely to dissipate once short-term interest rates rise and a recession does not materialize. While the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Feature Chart II-110-Year US Treasury Yields Are The Lowest Relative To Headline Inflation In Over 60 Years For many investors, one of the most striking features of the pandemic, especially over the past year, is how low US long-maturity government bond yields have remained in the face of the highest headline consumer price inflation in four decades (Chart II-1). To many investors, this has provided even further evidence of a structural “excess savings” effect that has kept interest rates well below the prevailing rate of economic activity. The theory of secular stagnation, revived by Larry Summers in late 2013, is a related concept, but many investors believe that interest rates will remain low even in a world in which the US economy is growing at or even above its trend. The fundamental basis for this view is the idea that over the longer term, the real rate of interest is determined by the balance (or imbalance) between desired savings and investment, and that advanced economies have and will continue to experience excess savings – defined as a chronically high level of desired savings relative to the investment opportunities available. According to this view, in order for the actual level of savings to equal investment, interest rates must fall. Chart II-2Do Excess Savings Explain This Gap? (Spoiler: No) This report challenges the view that excess savings are mostly responsible for the current level of long-term bond yields in the US. We agree that excess savings have played a role in explaining changes in long-term bond yields at different points over the past 20 years; we also agree that it is normal for interest rates in advanced economies to trend down over time in response to a demographically-driven decline in potential growth. But our goal is not to explain the downtrend in interest rates over time. Instead, we aim to explain the gap between the level of long-term bond yields today and the prevailing rate of economic activity, or consensus forecasts of the trend rate of growth (Chart II-2). We do not believe that this gap is economically justified, nor do we believe that it is driven by excess savings. We conclude that the Fed’s backward-looking neutral rate outlook is the primary factor anchoring US Treasury yields at the long-end of the maturity spectrum. This is only likely to change once short-term interest rates rise and a recession does not materialize; it suggests that investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Excess Savings And Interest Rates: Defining A “Mechanism Of Action” Households, businesses, and governments can directly purchase debt securities in capital markets, but they do not typically provide loans directly to borrowers. Direct lending usually occurs through the banking system, which means that excess savings would only lower interest rates in the economy through one of the following ways: By lowering the Fed funds rate By lowering long-maturity government bond yields relative to the Fed funds rate, by reducing either the term premium or investors’ expectations for the average Fed funds rate in the future By lowering corporate bond yields relative to duration-matched government bond yields By lowering lending rates on bank loans relative to banks’ cost of borrowing Charts II-3-II-5 highlight that there is no evidence of a structural decline in corporate credit spreads or bank lending rates relative to the Fed funds rate, so we can rule out this effect as a mechanism of action for excess savings to have structurally lowered interest rates. Chart II-6 highlights that interest paid on bank deposits lags the Fed funds rate, so we can also rule out the idea that excess deposits force the Fed to keep the effective Fed funds rate low. Chart II-3No Evidence Of A Structural Decline In Corporate Credit Spreads… Chart II-4…Or Auto Loan Rate Spreads… Chart II-5…Or Personal Loan Rate Spreads… Chart II-6...Or Bank Deposit Rate Spreads This means that if excess savings are depressing interest rates in the US, that the effect is truly occurring in the Treasury market. As noted, this could occur by lowering the current policy rate, expectations for the policy rate in the future, or the term premium on long-maturity bonds. Related Report  The Bank Credit AnalystR-star, And The Structural Risk To Stocks All of these effects are certainly possible. Keynes’ paradox of thrift highlights that excess savings can manifest itself as a chronic shortfall in aggregate demand, which would persistently lower the Fed funds rate as the Fed responds to a long period of high unemployment. This could also lower the term premium on long-maturity bond yields in a scenario in which the Fed repeatedly engages in asset purchases to help stabilize aggregate demand. As well, domestic excess savings could lower the term premium on long-maturity bond yields, as aging savers directly purchase government securities as part of their retirement portfolios. Finally, foreign capital inflows could also cause this effect, especially if they originate from countries with chronic current account surpluses that use an increase in US dollar reserves to purchase long-maturity US government securities. Table II-1 summarizes these possible mechanisms of action for excess savings to lower US government bond yields. With these mechanisms in mind, we review the past 60 years to identify periods of “abnormal” bond yields, with the goal of understanding whether excess savings appear to explain major gaps. Table II-1Possible Mechanisms Of Action For Excess Savings To Lower Long-Term Government Bond Yields Identifying Periods Of “Abnormal” Long-Maturity Bond Yields Chart II-7There Have Been Three Distinct Periods Of Abnormal Long-Maturity Bond Yields Chart II-7 shows the difference between nominal 10-year US Treasury yields and nominal potential GDP growth. Panel 2 shows an alternative version of this series using the ten-year median annualized quarterly growth rate of nominal GDP in lieu of estimates of potential growth, which highlights a generally similar relationship. This approach to defining “abnormal” long-maturity bond yields reflects our view that the potential rate of economic growth is the equilibrium interest rate under normal economic conditions. To see why, given that GDP also effectively represents gross domestic income, an interest rate that is persistently below the potential growth rate of the economy would create a strong incentive to borrow on the part of households and especially firms. Chart II-7 makes it clear that the relationship has been mean-reverting over time, but that there have been three major episodes when the difference between bond yields and economic growth was large and persistent. The first episode occurred from 1960 to the late 1970s, and saw government bond yields average well below the prevailing rate of economic growth. We do not see this period as having been caused by an excess of desired savings relative to investment. As we discussed in our November Special Report,1 this gap represented a period of persistently easy monetary policy which contributed to excessive aggregate demand and a structural rise in inflation. The second major episode is also easily explained, as it occurred in response to the first. Following a decade of high inflation, Fed chair Paul Volcker raised interest rates aggressively beginning in 1979 to combat inflationary expectations, which led to a two-decade period of generally tight monetary policy. Like the first period, this was not caused by an imbalance between desired savings and investment. The third episode has prevailed since the late-1990s, and has seen a negative yield/growth gap on average – albeit one that has been smaller than what occurred in the 1960s and 1970s. From 2000 to 2007, the gap was generally negative, although it turned positive by the end of the economic cycle. It was modestly negative on average from 2008 to 2010, and only became persistently negative starting in 2011. The gap fell to a new low during the COVID-19 pandemic, and remains wider today than at any point during the last economic recovery. It is these post-2000 periods of a persistently negative yield/growth gap that should be closely investigated for evidence of an excess savings effect. The Global Savings Glut As noted, prior to 2000, the yield/growth gap in the US seems clearly explained by the Fed’s monetary policy stance, not by an excess savings effect. So the question is whether there is any evidence of excess savings having caused this negative gap since 2000. In our view, the answer is yes, but the effect was relatively small compared to what prevails today. We do find evidence of a global savings glut during the early-2000s. Chart II-8 highlights that the private and external sector savings/investment balances in China and emerging markets more generally were persistently positive during the 2000s. Chart II-9 highlights that multiple estimates of the term premium declined around that time – especially during Greenspan’s “conundrum” period of between 2004 and 2005. Chart II-8There Was A Global Savings Glut Prior To The Global Financial Crisis Chart II-9The Global Savings Glut Does Seem To Have Lowered The Term Premium On US 10-Year TreasurysChart II-10 breaks down the components of the 10-year yield into the 5-year yield and the 5-year/5-year forward yield, and highlights that the negative correlation between the two components lasted for only one year. Overall, the 10-year Treasury yield was lower than potential growth for roughly two years as a result of the global savings glut effect.       Chart II-10Still, The Global Savings Glut Effect Did Not Last Long And Was Not Especially Large In Magnitude This was a significant event, and it may even have modestly contributed to the excessive household credit demand that ultimately caused the global financial crisis. But as a deviation from equilibrium, it was relatively insignificant compared to what has prevailed over the past decade. Excess Savings And US Household Deleveraging Chart II-11Most Of The Post-2007 Decline In 10-Year Yields Is Attributable To Lower Long-Term Fed Funds Rate Expectations Chart II-11 highlights that, relative to June 2007 levels, the vast majority of the cumulative decline in the 10-year Treasury yield has occurred because of a decline in implied long-term expectations for the Fed funds rate, rather than a major decline in the term premium. The chart also shows that almost all the decline in implied long-term interest rate expectations since 2007 occurred during the 2008/2009 recession. This normally occurs during a recession as investors price in a low average Fed funds rate at the short end of the curve; the anomaly is that these expectations remained permanently low even as the economy recovered and as the Fed raised interest rates from 2015 to 2018. To us, Chart II-11 also underscores that the Fed’s asset purchases are not the main culprit behind low long-maturity bond yields today, given that the decline in long-term expectations for the Fed funds rate persisted even as the Fed stopped purchasing assets in 2014. It is not difficult to see why investors lowered their long-term Fed funds rate expectations in the immediate aftermath of the global financial crisis, even as economic recovery took hold. Chart II-12 highlights that the “balance sheet” nature of the 2008/2009 recession unleashed the longest period of US household deleveraging in the post-WWII period, and Chart II-13 highlights that this occurred despite extremely low interest rates – and in contrast to other countries like Canada that did not experience the same loss in household net worth. Chart II-12Household Deleveraging Did Lower The Neutral Rate For Several Years Following The Global Financial Crisis Chart II-13The US Balance Sheet Recession Structurally Impaired Credit Demand For Several Years After 2008     Given that interest rates represent the price of borrowing, it is entirely unsurprising that a US balance sheet recession led to a persistent period in which credit growth was essentially unresponsive to interest rates, as households struggled to rebuild wealth lost during the recession and were unable to, or uninterested in, releveraging. This is another way of saying that the neutral rate of interest fell during that period, which we agree did occur. It is also accurate to characterize the US as having experienced a sharp increase in desired savings over that period, as highlighted by the explosion in the US private sector financial balance in the initial years of the last economic recovery (Chart II-14). Chart II-14Excess Savings Surged After 2008, But Eventually Normalized. Long-Term Rate Expectations Ignored The Normalization. So excess savings did certainly play a role in lowering long-term investor expectations for the Federal funds rate during the last economic cycle, but it did so because of cyclical reasons that spanned several years rather than because of demographic effects or other structural factors unrelated to the business cycle. That is an important distinction, because while Chart II-14 shows that this excess savings effect eventually waned in importance, long-term investor expectations for the Fed funds rate remained low in the second half of the last economic expansion. Chart II-15Growth Was Historically Weak Last Cycle, But Only Because Of The First Few Years Of The Expansion Chart II-15 highlights that the cumulative annualized growth in real per capita GDP during the last economic cycle was significantly below that of the average of previous expansions, but this was only the case because of the very slow growth period between 2008 and 2014. Per capita growth during the latter half of the expansion was comparable to that of previous expansions, and this occurred while the Fed was raising interest rates. And yet, investors only modestly raised their long-term interest rate expectations during that period. In our view, it is this fact that holds the key to understanding why investors’ long-term rate expectations are still low today. An Alternative Explanation For Today’s Extremely Low Long-Maturity Bond Yields Chart II-16Fixed-Income Investors Have Been Guided By The Fed To Expect A Low Average Fed Funds Rate Chart II-16 highlights that, since 1990, all of the structural decline in US 10-year Treasury yields has occurred within a three-day window on either side of FOMC meetings. This strongly suggests that fixed-income investors have been guided by the Fed to expect a low average Fed funds rate, which is consistent with how similar 5-year/5-year forward US Treasury yields are in relation to published FOMC and market participant estimates of the average longer-run Fed funds rate (as shown in Chart II-2). This raises the important question of why the Fed did not revise up its expectation for the neutral rate during or following the second half of the last economic expansion, when growth was much stronger than during the first half. In our view, one of the clearest articulations of the Federal Reserve’s understanding of the neutral rate of interest was presented in a 2015 speech by Lael Brainard at the Stanford Institute for Economic Policy Research. Brainard noted the following: “The neutral rate of interest is not directly observable, but we can back out an estimate of the neutral rate by relying on the observation that output should grow faster relative to potential growth the lower the federal funds rate is relative to the nominal neutral rate. In today’s circumstances, the fact that the US economy is growing at a pace only modestly above potential while core inflation remains restrained suggests that the nominal neutral rate may not be far above the nominal federal funds rate, even now. In fact, various econometric estimates of the level of the neutral rate, or similar concepts, are consistent with the low levels suggested by this simple heuristic approach.”2 Chart II-17The Fed, Wrongly, Sees The 2019 Experience As Having Confirmed A Low Neutral Rate... Given how the Fed determines the neutral rate is, two factors explain why the Fed’s estimates of the neutral rate have not increased (and, in fact, fell modestly in March). First, core inflation remained below 2% from 2015-2019, despite the fact that the economy was clearly growing at an above-trend pace during this period in the face of Fed rate hikes. We have noted in previous reports the role that the 2014 collapse in oil prices had on household inflation expectations. The latter were already vulnerable to a disinflationary shock, given how negative the output gap had been in the first half of the expansion.3 We do not think that the decline in inflation expectations that occurred following the 2014 collapse in oil prices reflects a low neutral rate, but rather we believe that the Fed saw this as a conundrum that supported the expectation of a low average Fed funds rate. The second event explaining the Fed’s persistently low long-term rate expectations is the fact that the Fed was forced to cut interest rates in 2019, which we believe it saw as confirmation that the stance of monetary policy had become either meaningfully less easy or openly tight. From the Fed’s point of view, this perspective was also supported by recessionary indicators, such as the inversion of the 2-10 yield curve (Chart II-17), and popular (but now discontinued) econometric estimates of the real neutral rate of interest, such as those calculated by the Laubach-Williams model (panel 3). Chart II-18...Without Appreciating The Damaging Impact The China-US Trade War Had On Global Activity However, this view entirely ignores the fact that the US and global economies were negatively impacted in 2018 and 2019 by a politically-motivated nonmonetary shock to aggregate demand: the China-US trade war, which also impacted or targeted several major advanced economies. Chart II-18 highlights that global trade uncertainty exploded during this period, which severely damaged business confidence around the world and caused a slowdown in global industrial production. Tighter Chinese policy also likely contributed to the slowdown in global activity, but the bottom line is that factors other than US monetary policy contributed to economic weakness during this period, and that it is incorrect to infer from the 2018/2019 experience that interest rates rose to or exceeded the neutral rate of interest. In short, it is our view that the Fed has simply become backward-looking in how it perceives the neutral rate of interest; it has not yet observed a period when the Fed funds rate has risen to its estimate of neutral but is unambiguously still easy. Fixed-income investors, having demonstrably anchored their own assessments to those of the Fed over the past 30 years, have had no basis to come to a meaningfully different conclusion. We believe that the Fed’s backward-looking low neutral rate outlook has now become entrenched in the minds of investors and the Fed itself, and is the primary factor anchoring yields at the long-end of the maturity spectrum. This will probably only change once short-term interest rates rise and a recession does not materialize. As a final point, we clearly acknowledge that private savings increased massively during the pandemic. Investors who are inclined to see excess savings as the primary driver of low bond yields will point to this fact. But this was a forced increase in savings, rather than a desired one. The rise in household sector savings occurred mostly because of a substantial reduction in services spending, as pandemic restrictions and forced changes in behavior prevented the consumption of many services. The household savings rate has already returned to its pre-pandemic level in the US, and 5-year/5-year forward Treasury yields have risen to a higher point than they were prior to the onset of the COVID-19 pandemic. US households are likely to deploy a portion of their enormous stock of excess savings, as the pandemic continues to recede in importance, which is one of the main reasons to expect that the US economy will not succumb to a recession over the coming 12-18 months – and why investors and the Fed may soon be presented with evidence that warrants an increase in their long-term interest rate expectations. Investment Conclusions There are two important investment implications of the view that the Fed’s backward-looking neutral rate projection is the primary factor anchoring yields at the long end of the maturity spectrum. As we noted in Section 1 of our report, the first implication is that investors will likely be faced with a recession scare as the 2-10 yield curve durably inverts and as rate sensitive sectors of the economy, such as housing, inevitably slow in response to the extremely sharp rise in mortgage rates that has occurred over the past three months. We believe that it is ultimately the level of interest rates that matters for economic activity, rather than the change in interest rates. Large changes over short periods of time, however, create a degree of uncertainty about the trajectory of rates that temporarily impacts economic activity. This underscores that investors should not maintain an aggressively overweight stance toward global equities in a multi-asset portfolio, as it is likely that concerns about corporate profits will increase significantly at some point this year. The second investment implication is that US long-maturity bond yields could increase to much higher levels over the coming 12-24 months than many investors expect, in a scenario in which pandemic-driven price pressure dissipates, real wages recover, and no major politically-driven nonmonetary policy shocks emerge. We acknowledge that long-term interest rate expectations are unlikely to change until hard evidence of the economy’s capacity to tolerate interest rates above the Fed’s implied current estimate of the neutral rate emerges. This is a case, however, when we believe that investors should heed the now-famous words of Rüdiger Dornbusch: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” As such, while the nearer-term outlook more likely favors a neutral or at best modestly short duration stance within a fixed-income portfolio, investors should remain structurally short duration in response to a potentially rapid shift in long-term interest rate expectations from the Fed and fixed-income investors over the coming few years. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst "Gauging The Risk Of Stagflation," dated October 29, 2021, available at bca.bcaresearch.com 2 Lael Brainard, Normalizing Monetary Policy When The Neutral Rate Is Low, December 2015 3 Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com

Executive Summary Thai stocks’ recent outperformance had more to do with investors forsaking Chinese and Russian markets to rotate elsewhere, rather than Thailand’s bullish outlook. Thai domestic demand is still shaky as households are struggling with meagre income growth amid high indebtedness. Tight fiscal policy is another headwind. All this will delay the recovery in Thai corporate profits, without which a sustainable equity bull market is unlikely. On the positive side, the baht is much more competitive now, which is a boon for an economy where trade makes up 100% of GDP. The country’s travel and tourism revenues are also set to rise. Keep An Eye On Order Books For A Hint On A Sustainable Stock Rally Bottom Line: Equity investors should stay neutral for now; but put this bourse on an upgrade watchlist. Domestic bond investors should upgrade Thai local currency bonds from neutral to overweight in EM portfolios, and from underweight to neutral in Emerging Asian portfolios.   Chart 1Thai Stocks' Recent Outperformance Will Not Linger Thai stocks have held up relatively well during the market turbulence of the past two months or so. Can this be a sign that the end of the Thai bear market is near (Chart 1, top panel)? We believe that this bourse is not about to experience a major breakout in absolute or in relative terms. Thai domestic demand is still shaky, and might take some more time to recover. This is because households’ real income growth remains lackluster, and they are saddled with high debts. This will hinder consumer demand from rising strongly even after the pandemic subsides. That, in turn, will also discourage capital investments. Notably, Thai stocks’ recent relative breakout is more due to a meltdown in Chinese and Russian markets following the Ukraine crisis rather than any major improvements in Thailand’s domestic fundamentals. Thai relative performance looks much less impressive versus the EM equity index excluding Chinese and Russian stocks (Chart 1, middle and bottom panels). That said, two major macro headwinds that had hamstrung this market over the past several years have eased. The baht is no longer expensive, and the country’s decimated travel and tourism revenues – which fell from 12% of the GDP before the pandemic to nearly naught – are also set to recoup some of the losses. All this warrants that investors maintain a neutral allocation to this bourse in EM and emerging Asian portfolios for now, but put it on an upgrade watchlist. As for domestic bonds, investors should upgrade Thai bonds to overweight in an EM local currency bond portfolio, and to neutral in Emerging Asian portfolios. The Economy: An Extended Bottoming Phase  Chart 2Thai Private Consumption Is Struggling The Thai economy is still in an extended bottoming phase. Top panel of Chart 2 shows that private consumption is barely at 2019 levels, and is still about 10% lower than what would be the pre-pandemic trend. Consumption clearly slows as new COVID-19 cases go up are. The latter have been on the rise again lately, and it could slow the pace of recovery again. This is at a time when durable goods sales have not recovered to even their pre-pandemic levels (Chart 2, bottom panel). More importantly, what could hinder the economic recovery beyond the pandemic is the fact that Thai households are quite depleted in terms of their purchasing power: Household incomes are severely impaired as average wage growth has been very poor. In fact, both private and government sector jobs have barely seen any rise in their real wages in the past six years (Chart 3, top panel). Given the current higher energy and transportation prices, that leaves households with little discretionary income to spend elsewhere.   Lack of employment opportunities is exacerbating the poor wages issue. Non-farm jobs have not grown at all since 2016. The number of manufacturing jobs has actually fallen by 10% during this period (Chart 3, bottom panel). All this has been a headwind to household income. Prospects of a strong job/wage recovery in the near future is also not high. One reason for this is that Thai banks have substantially retrenched their loans to the SME sector in the past couple of years. From a high of 30% of GDP in 2019, these loans are now down to 21% (Chart 4). Credit retrenchment of this order in the job-intensive SME sector has driven many companies out of business, shrinking job opportunities. It will take a considerable time to recoup all these jobs even when the pandemic subsides.  Chart 3Real Wages Have Stagnated For Years As Employment Stopped Growing Chart 4Massive Credit Retrenchment To SMEs Will Cost Jobs Notably, Thai households were already highly leveraged going into the pandemic. Household borrowing from banks and other financial institutions taken together now amount to a very high 90% of GDP. The top panel of Chart 5 shows that for almost a decade until 2015, Thai households were leveraging up incessantly. Those loans did help boost consumer demand during all those years. But now, when jobs are scarce and wage growth is paltry, households are shy to add more leverage to their balance sheets. This means a debt-fueled recovery in consumer demand is not in the cards. Notably, total domestic credit (including households and corporates)  had also surged in a similar fashion, and is now very high at 170% of GDP (Chart 5, bottom panel). Facing subdued demand, Thai manufacturing and shipments are also struggling. Weak sales mean businesses are struck with high inventories. Order books do not appear to be strong either (Chart 6). Chart 5High Household Debt Entails No Debt-Fueled Consumer Demand Recovery Chart 6Mediocre Orders Amid High Inventory Does Not Entail Strong Manufacturing Recovery The combination of rather high finished goods inventories and mediocre order books entail that a strong manufacturing recovery is not around the corner. If so, that could be a problem as only a sustained recovery in manufacturing can lead to a major breakout in Thai stock performance. Indeed, the first hints of an improving economy often come from the status of order books. At present, middling order book figures do not imply that Thai stocks are on the cusp of a major rally (Chart 7). Chart 7Keep An Eye On Order Books For A Hint On A Sustainable Stock Rally Chart 8Thai Profits Are Far Too Low Compared To Stock Prices Notably, Thai share prices have outpaced corporate profits since 2012. The listed companies’ EPS in US dollar terms are still languishing at around the same level as they were a decade back. As such, multiples have steadily risen over the past 10 years, and stocks are not cheap (Chart 8). Provided that the policy rate is already close to zero (with little room to fall), any multiple expansion-based rally in Thai equities is also unlikely. In sum, for a new bull market to develop, this bourse needs a sustained rise in corporate profits. But given the macro backdrop, that kind of sustained earnings expansion will take more time to materialize. What About Policy Support? Fiscal policy in Thailand will remain tight. In its fiscal budget, the government plans to spend about 5.5% less this year (October 2021 – September 2022) than the year before. Actual fiscal expenditure is indeed contracting in nominal terms. The IMF estimates that the fiscal thrust in 2022 will be a significantly negative 3% of GDP (Chart 9). As for monetary policy, the policy rate is already very low at 0.5% since early 2020. Yet, it hasn’t helped much in terms of credit growth. Meanwhile, thanks to a sharp rise in commodity prices, headline CPI has surged past the central bank’s upper inflation target band. CPI-excluding sectors affected by energy and food prices, however, are still very low (Chart 10). The lingering softness in domestic demand, weak employment and muted wages also indicate that deflationary pressures are more dominant in the Thai economy than are inflationary pressures. As such, the central bank is unlikely to raise interest rates in the foreseeable future. Chart 9Thai Fiscal Policy Is Very Restrictive Chart 10There Is No Genuine Inflation In sum, fiscal policy will tighten considerably this year and there will be little change in monetary policy. Altogether, these factors do not herald a strong recovery.  External Outlook Thailand’s external outlook has improved. One reason for that is the currency is now more competitive as it has cheapened significantly in real terms (Chart 11, top panel). For a small, open economy where external trade (exports + imports) makes up 100% of GDP, a competitive currency is a major positive. Right on cue, Thai export volumes, which have been falling for a decade relative to global and EM exports, appears to have bottomed (Chart 11, bottom panel). The country’s travel and tourism revenues are set to rise as well. Thailand has already relaxed various travel restrictions for foreign tourists and further relaxation will be in effect from April 1. The country hosted 40 million foreign tourists in 2019, earning about $60 billion in revenues. All this disappeared during the pandemic in the past two years, leading to a massive drop in the country’s services sector balance. In fact, those losses also pushed the Thai current account balance into deficit – even though the country’s goods balance held up well (Chart 12). Chart 11The Baht Has Cheapened Significantly In Real Terms, Improving Competitiveness Chart 12With Easing Travel Restrictions, The Current Account Balance Will Improve Going forward, even if a quarter of those lost revenues come back over the next year, that should be enough to push the current account and the balance of payments back into surplus. An improving balance of payments is a bullish development for the currency. Chart 13The Depreciation In The Baht Is Likely Over All this means that the baht depreciation is likely over. It has fallen about 10% against the US dollar since February last year when we first recommended that investors short the baht (Chart 13). We sent a special alert on February 18 this year announcing the closing of this trade. Upgrade Domestic Bonds Chart 14Thai Domestic Bond Returns Are Highly Dependent On The Baht Thai domestic bond returns in US dollar terms are highly contingent on the baht’s performance. Chart 14 shows that both have fallen materially over the past year. However, given that the baht has likely bottomed, Thai bonds’ total return in USD terms will get a boost from now on. The Thai currency could also be one of the more resilient currencies in EM going forward. Historically, the baht had tended to perform better than most other EM currencies during periods of global uncertainty. We are witnessing such a period in view of the rapidly rising US bond yields and the Ukraine crisis. A better-performing baht compared to other currencies would help boost Thai bonds’ total returns relative to other EM bonds. Notably, Thai bond yields have been falling relative to that of the GBI-EM (excluding Russia) index. This is reflecting the difference in the inflationary backdrop between Thailand and many other EM countries, especially in Latin America and EMEA. The relative yields, therefore, might fall further. Considering the above, we recommend that investors upgrade Thai domestic bonds from neutral to overweight in EM domestic bond portfolios (Chart 15). Relative to their Emerging Asian peers, we recommend a neutral allocation to Thai bonds. This is because inflationary pressures in Asia are very similar to those in Thailand. Meanwhile, Thai relative bond yields have already risen significantly versus their Emerging Asian counterparts since the height of the pandemic scare in early 2020. As such, the relative yield compression move is likely late (Chart 16, top panel). Considering that Thai bonds have already had a steep underperformance, and that the baht is also cheaper now, we recommend that investors upgrade Thai bonds to a neutral allocation in Emerging Asian portfolios (Chart 16, bottom panel).    Chart 15Upgrade Thai Domestic Bonds To Overweight In An EM Bond Portfolio Chart 16Upgrade Thai Domestic Bonds To Neutral In An Emerging Asian Portfolio Investment Recommendations Currency: The baht has fallen about 10% in nominal terms over the past year or so. It has cheapened significantly in real terms also – which has enhanced the economy’s competitiveness. Going forward, prospects of an improving balance of payments means the Thai currency will be one of the more resilient ones in the EM. Stocks: A sustainable rise in Thai corporate profits is still some way off. But a much cheaper currency and an improving balance of payments will help. One should not chase the recent Thai outperformance. It had more to do with investors forsaking Chinese stocks en masse to pile on elsewhere in EM, including Thai equities. Chart 17 shows that the Thai bourse saw an unusual amount of foreign net purchases over the past month. Some of these inflows are at risk of unwinding in the months ahead. Instead, equity managers should put this market on an upgrade watchlist to move its allocation from the current neutral to overweight in EM and Emerging Asian portfolios. Chart 17Some Of The Recent Foreign Equity Inflows Are At Risk Of Unwinding Domestic Bonds: Investors should upgrade Thai bonds from neutral to overweight in an EM basket, and from underweight to neutral in an Emerging Asian basket.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary Energy and National Security Will Drive the Market Our 2022 key views are broadly on track. Biden’s shift from domestic to foreign policy is dominating the other views.   However, Democrats still have a 65% chance of passing a reconciliation bill that will raise taxes to pay for green energy and prescription drug caps. Then gridlock will set in. The US is developing a new national consensus. Generational change is promoting the shift to proactive fiscal policy to address the country’s social unrest and rising foreign policy challenges. Polarization is still at peak levels in the short term but will fall over the coming decade as the US pursues “nation building” at home while confronting geopolitical rivals. The return of Big Government is being priced into the bond market today. But it will be Limited Big Government, as the sharp spike in inflation today will provoke a backlash. Recommendation Inception Level Inception Date Return Long Aerospace And Defense Vs. Broad Market (Cyclical)   30-Mar-22   Long Oil And Gas Transportation And Storage Vs. Broad Market (Cyclical)   30-Mar-22   Long Refinitive Renewable Energy Vs. Broad Market (Tactical)   30-Mar-22   Bottom Line: Investors dedicated to the US market should stay tactically defensive. Cyclically favor the new US policy consensus on national defense, infrastructure, cyber security, and energy security. Feature The title of our annual outlook was “Gridlock Begins Before The Midterms.” We argued that Biden would still have some room for legislative maneuver in the first half of 2022 but that checks and balances would grow as the year went on. Checks will grow due to (1) the looming midterm elections; (2) Biden’s falling political capital and need to rely on executive action; (3) rising foreign policy challenges. Of these, foreign policy has proven decisive, with Russia invading Ukraine and the US and Europe imposing economic sanctions. The resulting energy shock is adding to inflation, weighing on consumer confidence, stock market multiples, and investor sentiment (Chart 1). Having said that, we also argued that congressional Democrats still had enough political capital to pass a watered-down fiscal 2022 budget reconciliation bill before the scene of action shifted to the White House. The second quarter is the last chance for this prediction to come true – and we are sticking with our 65% odds. The reconciliation bill will be even more watered down than we expected. But the point is that fiscal policy – especially tax hikes – can still move markets in the second quarter, even though inflation, the Fed, and the war will have a bigger influence. Chart 1US Seeks National Security And Energy Security Related Report  US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms The war in Europe is clearly the most important political, geopolitical, and policy dynamic for investors this year. It is prompting some important congressional action that speaks to Biden’s room for maneuver in the first half of the year. In so doing it reinforces our long-term themes of “Peak Polarization” and “Limited Big Government.” As Americans face rising foreign policy challenges, a new bipartisanship is emerging, particularly on industrial and trade policy. Checking Up On Our Three Key Views For 2022 Here are our three key trends for 2022 with comments about their development over the past three months: 1.   From Single-Party Rule To Gridlock: We argued that the Biden administration would pass a watered-down reconciliation bill on a party-line vote by June at latest. Then Congress would grind to a halt for election campaigning, to be followed by Republicans taking one or both chambers of Congress, restoring gridlock and making it hard to pass major legislation from the second half of 2022 through 2024. This view is still generally on track. The basis for believing that a bill will still pass is that the Democrats are in trouble in the midterms and badly need a legislative victory. Public opinion polls suggest they face a beating reminiscent of President Trump and the Republicans in 2018 (Chart 2). Democrats trail Republicans in enthusiasm. Only about 45% of Democrats and 42% of Biden voters are enthusiastic to vote, while 50% of Republicans and 54% of Trump voters are enthusiastic. Men, who lean Republican, are more enthusiastic than women, by 51% to 38%, according to the pollster Morning Consult.1 With the economy and foreign policy rising as the most important issues of the election, Democrats have lost their key issues of health care and the pandemic. Notably Democrats have also lost ground on traditional strengths like education. However, the Ukraine war has put a new emphasis on energy security which Democrats are harnessing to repackage their climate agenda. Hence Democrats will make a last-ditch effort to pass a reconciliation bill before the summer campaigning gets under way. The “Build Back Better” plan was always going to be watered down but now it will be extensively revised. The bill will now have to be closer to neutral in its impact on the deficit so as not to feed inflation. Public opinion polls back in January, when the bill was primarily a social welfare bill, showed 61% of political independents in favor, not to mention 85% of Democrats. A majority of independents supported the bill even when asked about each provision separately and when the tax hikes were made plain.2 By halting progress on the left-wing version of the bill that the House of Representatives passed late last year, West Virginia Senator Joe Manchin saved his party from passing a highly stimulative fiscal bill in the middle of the biggest outbreak of inflation since the 1980s, when the output gap was virtually closed (Chart 3). Chart 2Democrats Not Faring Much Better Than Trump Republicans In 2018 Chart 3Output Gap Closed, No More Stimulus Needed Now Manchin will face a “Build Back Slimmer” bill that will be harder to oppose when Congress comes back from Easter.3 Our research over the past year suggests that Manchin is likely to vote for a bill that meets his main demands. The bill will be crafted for his approval. Manchin supports corporate tax hikes, funding for green energy transition (as long as it is not punitive toward certain sources or technologies), and a cap on prescription drug costs.4 Tax hikes, such as a minimum 15% corporate tax rate on book earnings, will be included, albeit diluted from the original proposals. Most investors have forgotten about the risk of tax hikes altogether so stock investors may not be happy that the US is hiking taxes amid inflation. Earnings estimates for the year are not reflecting any negative news, whether energy shock, or weak consumer confidence, or new taxes (Chart 4). If the bill fails to pass, equity investors may well cheer, since they are worried about inflation rather than deflation and the bill will not truly be deficit-neutral. Chart 4Inflation, War, Potentially Tax Hikes Will Weigh On Earnings Estimates Given Democrats’ thin majorities in both houses (222 versus 210 seats in the House and 50 versus 50 seats in the Senate), a single defection in the Senate can derail the bill, so we cannot have high conviction that it will pass. We are sticking with our 65% subjective odds. Passage of a reconciliation bill will slightly help Democrats’ fortunes ahead of the midterm but Republicans are still highly likely to win at least the House of Representatives. So the transition to gridlock will still occur. Only very rarely do ruling parties gain seats in the midterms. Biden’s loss of support among women voters is a tell-tale sign that trouble looms, as was the case for the Obama administration at this stage in its first term (Chart 5). The implication for financial markets is that the budget reconciliation bill will bring a negative surprise in the form of tax hikes that will weigh on bullish or pro-cyclical sentiment in the second quarter, at least marginally. Chart 5Women Like Biden Less Than Obama, Who Suffered Midterm Losses Chart 6Biden's Energy Shock 2.   From Legislative To Executive Power: Similarly we anticipated a transition from legislative action to executive action over the course of 2022. After the budget reconciliation bill is decided, the president will have to rely on executive action to achieve any policy goals. We expected this trend to derive from Biden’s regulatory aims as well as from the need to respond to rising geopolitical challenges, especially the energy shock (Chart 6). This shock is the single biggest reason for the market consensus that Democrats will lose Congress this year. The chief equity sector winner was the energy industry, as we expected. Now Biden needs to encourage rather than discourage supply. Until Biden decides whether to lift sanctions on Iran, volatility will prevail in energy markets. But Biden will condone domestic energy production, with a view to alleviating shortages prior to 2024. He will abandon his left wing and adopt the Obama administration’s permissiveness toward domestic energy, which will help oil and natural gas rig counts to rise (Chart 7). Renewable energy policy will gain traction as it will now clearly be seen in the context of national security and energy security. It also combines trade policy with national security in the form of exports to allies. The US now has a free pass to help Europe diversify away from Russian energy. Not that the US can replace Russia but merely that it can make a dent in both oil and liquefied natural gas (Chart 8). Subsidies for green energy are still likely but not a carbon tax or punitive measures toward the fossil fuel industry. Chart 7Biden Revives Obama Truce With O&G Chart 8US Helps Europe Diversify Away From Russia 3.   From Domestic To Foreign Policy: We fully expected Biden to be forced to pay attention to foreign affairs in 2022, despite his desire to focus on the voter ahead of midterms. We argued that he would maintain a defensive or reactive foreign policy since he would not want to create higher inflation ahead of the midterms and yet oil producers like Russia or Iran would go on offensive due to energy shortage. While Biden has imposed harsh sanctions on Russia, we still define his foreign policy as defensive rather than offensive. First, Biden is reacting to a Russian attack and will not sabotage a ceasefire. Second, Biden is carving out exceptions to US sanctions rather than disciplining or coercing allies into adopting US policy. The administration’s chief foreign policy aim is to refurbish US alliances. Hence the US condones the EU’s continued energy imports from Russia, thus ensuring that Russian energy makes it into the global market, unless the Russians cut natural gas exports (Chart 9). Nevertheless a risk to our view is that Biden will start to adopt a more offensive foreign policy, especially if Democrats are floundering ahead of the midterms. He could turn more aggressive about sanction enforcement if Russia starts bombarding Kyiv again. Or he could slap broad sanctions on China for helping Russia bypass sanctions. To be clear, we fully expect secondary sanctions on China, based on US record of doing so, but we expect them to be targeted rather than broad (Table 1). Chart 9Russian Energy Still Reaches Global Market Table 1US Will Slap China With Sanctions Over Russia – Sooner Or Later Foreign policy will define US politics and policy in 2022. What matters for markets is whether the energy supply shock gets worse as a result of Biden’s handling of Russia and Iran. A worse energy shock will amplify stock market volatility. On one hand, if Biden suffers a humiliating foreign policy defeat, it will reinforce the negative trends for Democrats in the 2022-24 cycle. Since Republicans, especially former President Trump, would be expected to pursue an offensive rather than defensive foreign and trade policy (e.g. toward Iran’s nuclear program and China’s economy), global economic policy uncertainty would rise and investor risk appetite would fall in this situation (Chart 10). On the other hand, investors will be surprised if Biden achieves a remarkable domestic or foreign policy success that boosts Democrats’ odds in 2022. An early ceasefire in Ukraine combined with a reconciliation bill would give Biden and Democrats a boost. Global policy uncertainty might rise anyway but it would not be super-charged and it would be flat-to-down relative to US policy uncertainty. Democrats could conceivably retain control of the Senate in the latter case. Our quantitative election model says Democrats have a 49% chance of retaining the Senate (Chart 11). This means the election is too close to call, though subjectively we would agree with the model and bet on the Republicans since they only need to gain one seat on a net basis. The model shows Georgia and Arizona flipping back to the Republican side. If the economy and opinion polling improve between now and November, the swing states will see higher probabilities of Democrats staying in power but the model is trending against Democrats and shows their odds of victory falling in every state. Chart 10US Political Outlook Affects Relative Policy Uncertainty Chart 11Senate Race Too Close To Call, But Quant Model Now Tips Republicans Anything that pares Democrats’ expected losses in Congress will cause US economic policy uncertainty to rise since it goes against the consensus view. Moreover if Republicans only win the House, they will be obstructionist and disruptive in 2023-24, whereas if they win all of Congress they will have to produce bills and try to compromise with Biden. Thus a Republican House but Democratic Senate would imply an increase in policy uncertainty. By contrast, anything that hurts the Democrats will reinforce current expectations and imply that tax hikes might fail, or that they will freeze after the reconciliation bill, which would be marginally positive for US equity investors in an inflationary context. Bottom Line: Democrats still have a 65% subjective chance of passing a reconciliation bill that raises taxes. Investors should favor defensives over cyclicals. Checking Up On Our Strategic Themes For The 2020s Our central long-term thesis is that generational change, social instability, and foreign policy threats are generating a new national consensus in the United States, particularly on economic policy. Hence US political polarization is peaking in the short run and will decline over the long run. The new consensus rests on proactive fiscal policy and a larger government role in the economy to reduce social unrest and improve national security. Table 2 shows our three strategic US political themes. The past year’s inflation surge and the Ukraine war will affect these themes, so we make the following points: Table 2US Political Strategy Structural Themes 1.   Millennials/Gen Z Rising: Labor market participation is recovering rapidly from the pandemic. However, workers older than 55 years are not rejoining rapidly, implying that retirees are staying retired and not yet chasing rising wages. Prime age women, however, are rejoining the work force, in a sign that as kids get back to school mothers can return to work (Chart 12). The implication is that the labor shortage will continue for the foreseeable future due to the generational transition but not due to any shift toward traditional values or lifestyles among young women. 2.   Peak Polarization: Polarization has fallen after the 2020 election, as expected, but will likely stay at or near peak levels over the 2022-24 election cycle (Chart 13). Chart 12Generational Shift Evident In Labor Participation Chart 13Polarization Near Peak Levels But Will Fall Over Long Run For example, Biden’s reconciliation bill will feed polarization in 2022, since it can only pass on a party-line vote. But its tax and spending programs will have majority support, will redirect funds from corporations that pay low effective tax rates toward corporations that provide renewable energy solutions. Domestic manufacturing will benefit. Another example: Another Biden-Trump showdown in 2024 will fuel polarization but 2024 or 2028 and subsequent elections will see fresh faces with updated policy platforms. The merging of trade protectionism and renewable energy exemplifies the new policy evolution. Again, with polarization at historic levels, domestic terrorism of whatever stripe is a pronounced risk in 2022 and the coming years. But any significant political violence will ultimately drive a new national consensus in favor of federalism. 3.   Limited Big Government: The story of the 2000s and 2010s was the revival of Big Government, first in the George W. Bush national security state, then in the Barack Obama liberal spending tradition, then in the big spending Republican tradition with Trump, and finally in the liberal tradition again with Biden. The combination of popular discontent at home and great power struggle abroad means that the US is unlikely to slash either social programs or defense spending. As for tax hikes, aggressive tax hikes are impractical. Biden may pass some tax hikes but the budget deficit will continue to expand over the long run (Chart 14). At the same time, the shift to Big Government is occurring with an American context. The geography, constitution, and political system militate against centralization. The return of inflation means that fiscal conservatism will also make a comeback, starting with Republicans in the House in 2023, who will oppose new spending as a standard opposition tactic. So while Big Government has returned, and bond investors are pricing this sea change by pushing up Treasury yields, nevertheless the market will also need to price the fact that the growth of government still faces structural limits. Chart 14Reconciliation Bill Will Have Miniscule Impact On Budget Outlook These structural themes face crosswinds in 2022. The Millennials and younger generations will not carry the day in the midterm election – the Baby Boomers and Greatest Generation will. Peak polarization will bring negative surprises for investors over the 2022-24 election cycle and potentially even in 2024-28 if Trump is reelected. A Democratic reconciliation bill will expand government programs in 2022, while Republicans will revert to big spending ways if they gain full control of government again in 2025. Nevertheless the evidence suggests that generational change, peak polarization, and limited big government will prevail over time. The younger generations favor more proactive fiscal policy. Fiscal policy will address social unrest and geopolitical threats. But big government will drive inflation, which will in turn force voters to impose limits on government over the long run. Bottom Line: The US will opt to inflate away its debt over the long run – but it will also need growth and some structural reform once the ills of inflation become fully absorbed by voters. The huge bout of inflation in 2022 is only the beginning of this political process, though it will also accelerate the process. Investment Takeaways Stocks tend to be flattish ahead of midterm elections. This includes elections when a united government becomes gridlocked as is likely in 2022-23. Equities tend to perform better after election uncertainty passes. The transition from single-party government to gridlock also tends to imply higher yields until after the election is over, at which point yields decline (Chart 15). Single-party governments can manipulate fiscal policy to try to stay in power. Chart 15Stocks Tend To Be Flat, Bond Yields High, Until After Midterm Elections Defensives are outperforming cyclicals on slowing growth, rising interest rates, rising labor costs and energy prices, and rising uncertainty. Our worst call for Q1 was our tactical long growth over value stocks. We made this trade knowing it went against our strategic approach, which has favored value over growth since we launched the US Political Strategy in January 2021. Our reasoning was that a geopolitical crisis would cause a temporary spike in energy prices but a longer drop in bond yields. In fact bond yields rose anyway. We still think tech is increasingly attractive, especially after the corporate minimum tax passes. The brief inversion of the 2-year/10-year yield curve suggests the US economy is flirting with recession. Other parts of the curve are not yet confirming this signal and there can be a long lead time between inversion and recession. However, there is not yet a ceasefire in Ukraine and certainly not a durable ceasefire. The US and Iran do not yet have a deal to avoid a major increase in geopolitical tensions. The risk of a bigger energy shock from Russia or Iran or both is significant and could shorten the cycle. We recommend going strategically long S&P 500 oil and gas transportation and storage relative to the broad market. We also recommend taking advantage of the lull in fighting in Ukraine to join our Geopolitical Strategy in going strategically long US defense stocks relative to the broad market. Tactically we recommend going long renewable energy since the Democrats’ pending reconciliation bill will benefit from broader public recognition of the need for the energy security of both the US and its allies (Chart 16). Chart 16Go Long Defense, Energy Storage, And Renewables Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See “National Tracking Poll,” Morning Consult and Politico, #2202029, February 5-6, 2022, assets.morningconsult.com. 2     Admittedly this poll is by a left-leaning organization but polling throughout 2021 supports the general conclusion that a majority of political independents support the key proposals. See Anika Dandekar and Ethan Winter, “Majority of Voters Still Want the Build Back Better Act Passed,” Data for Progress, January 4, 2022, dataforprogress.org. 3    See Nick Sobczyk and Nico Portuondo, “Democrats eye ‘Build Back Slimmer’ on reconciliation,” E&E News, March 24, 2022, eenews.net. 4    See Eugene Daniels, “The Left Gears Up to Take on Manchin Again,” Politico, March 29, 2022, politico.com. See also “Regan, McCarthy, Wyden talk revival of BBB,” The Fence Post, March 25, 2022, thefencepost.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary China’s Business Cycle Has Not Bottomed Recent data showed a substantial improvement in the economy in the first two months of the year. However, the optimism is not well supported by other industry and high-frequency data. China’s exports were resilient, while infrastructure investment also rebounded sharply on the back of front-loaded fiscal stimulus. Nonetheless, domestic demand in China remains in the doldrums. Housing market indicators show a further deterioration in home sales and prices in January and February. Consumption in tourism during the Chinese New Year and service sector activities were also weaker compared with the same period last year. While we expect policymakers to roll out more measures to shore up domestic demand, China’s economy will likely have a choppy bottom in the first half of 2022. We maintain our neutral position on Chinese onshore stocks in a global portfolio. In absolute terms, we are cautious and are looking for a better price entry point in Q2. Bottom Line: Economic data in the first two months of the year sent mixed signals, which suggests that China’s economy has not reached a solid bottom. Feature Newly released economic data from January and February (i.e. industrial production, fixed-asset investment, retail sales and property investment) all generated sizable positive surprises. However, other industry and high-frequency data sent conflicting messages. The improvement in China’s total social financing (TSF) in the past few months has been due to local government (LG) bond issuance (Chart 1). Corporate credit showed little advancement, while household loans were extremely weak (Chart 2). In addition, further contracting home sales paint a bleak picture of housing demand. Soft readings in the service sector Purchasing Managers' Index (PMI) and core consumer price index (CPI) suggest that consumption remains sluggish. Chart 1The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) Chart 2No Improvement In Corporate Or Household Demand For Credit Beijing is stepping up its pro-growth stimulus, particularly on the fiscal front. However, the country will unlikely undergo a strong recovery in its business cycle without a major reversal in the housing market and an improvement in demand from the private sector. Moreover, recent lockdowns to tame surging domestic COVID-19 cases amid China’s zero-tolerance pose major downside risks to the near-term economic outlook. Chinese equities sold off in response to lockdown news despite the release of better economic data earlier this month, highlighting investors’ weak sentiment. Chart 3China's Business Cycle Has Not Bottomed We maintain our neutral view on China’s onshore stocks relative to their global peers, but we are cautious on Chinese equities in absolute terms.  On a cyclical time horizon (6 to 12 months), there are increasing odds that Chinese policymakers will stimulate the economy more aggressively, particularly in the 2nd half of the year. However, it is too early to turn bullish on Chinese equities (Chart 3). The ongoing war in Ukraine and elevated oil prices, coupled with risks of further lockdowns in China and a prolonged downturn in domestic demand, present significant near-term risks to the performance of Chinese equities. Investors should closely watch for more reflationary efforts from Beijing and we believe a better entry point to upgrade Chinese stocks may emerge in Q2.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Near-Term Outlook For The Housing Market Remains Bleak Real estate investment growth in January-February was surprisingly strong, according to data from China’s National Bureau of Statistics. However, headline growth in real estate investment deviates from the continued weaknesses in other housing market indicators (Chart 4). In addition, data on the production of some key construction materials showed little improvement (Chart 5). Chart 4Conflicting Signals From The January-February Housing Market Indicators Chart 5Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Demand for housing remains lackluster. February’s medium- to long-term household loan growth, which is mainly mortgage loans and is highly correlated with home sales, plunged to an all-time low (Chart 6). Meanwhile, the deep contraction in home sales growth continued in February, and sentiment among home buyers remains downbeat (Chart 6, bottom panel) Chart 6Demand For Housing Remains In The Doldrums Chart 7Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Although authorities have reiterated that they want to stabilize the property market, the policy measures have been only fine-tuned. Regional governments have been allowed to initiate their own housing policies and some cities have eased processes for home purchases.1 However, given that maintaining stable home prices is an overarching goal and China’s leadership is trying to avoid further inflating the home price bubble, it is doubtful that the government will allow significant re-leveraging in the property market (Chart 7). Chart 8 shows that funds to real estate developers have slowed to the lowest level since 2010, which will further dampen housing construction. Chart 8Housing Construction Activities Will Weaken Further In 1H22 Chart 9The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales Moreover, high-frequency floor space sold data shows a broad-based decline in housing sales in tier-one, two and three cities through mid-March (Chart 9). The latest spike in China’s domestic COVID-19 cases and regional lockdowns will likely weigh on home sales in the short term. Property investment and construction will remain at risk without a decisive rebound in home sales. A Disrupted Recovery In Household Consumption Both retail and online sales of consumer goods held up better than expected in January and February (Chart 10). However, the subdued underlying data highlight that the strong reading in retail sales in the first two months of the year may be less than meets the eye. Chart 10Although Growth In Retail Sales Rebounded In January-February... Chart 11...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels Service sector and passenger activities are still well below their pre-pandemic levels, two years after the first COVID lockdowns in early 2020 (Chart 11). Consumption in tourism during the Chinese New Year holiday was weaker than last year. Households’ propensity to spend also showed few signs of rebounding (Chart 12 & 13). Chart 12Travel Consumption Was Weak During The Chinese New Year Chart 13Households’ Propensity To Consume Continues To Trend Down Furthermore, both core and service CPI weakened in February, reflecting lackluster demand from consumers (Chart 14). Labor market dynamics have also worsened and the unemployment rate, particularly among young workers, has risen rapidly since the beginning of the year (Chart 15).  Chart 14Weak Core And Service CPIs In February Suggest Lackluster Household Demand Chart 15Labor Market Situation Is Worsening The ongoing fight against mounting new COVID cases in China will likely drag down service sector activities in the coming months (Chart 16A & 16B). Importantly, the new round of lockdowns and mobility restrictions are primarily in busier and more developed coastal metropolitans, such as Shenzhen and Shanghai. Therefore, the negative impact from social activity restrictions will be more substantive compared with previous lockdowns. Chart 16AEscalating New Cases In China Will Constrain Domestic Consumption Chart 16BEscalating New Cases In China Will Constrain Domestic Consumption Strong Rebound In Manufacturing Investment Growth In January-February Probably Not Sustainable A strong rebound in the growth of manufacturing investment helped to support overall fixed-asset investment in the first two months of the year (Chart 17). Robust external demand for China’s manufacturing goods has likely contributed to the pickup in manufacturing output and helped to sustain Chinese manufacturers’ near-maximum capacity (Chart 18). Chart 17Strong Pickup In Manufacturing Investment Growth Chart 18Robust Exports Support Chinese Manufacturing Output And Capacity Utilization While the volume of manufacturing output increased, prices that producers charge consumers have rolled over (Chart 19). Historically, prices have been more important in driving corporate profits than the volume of output. In addition, a strong RMB and sharply climbing shipping costs will also weigh on Chinese exporters’ profitability (Chart 20). Chart 19Manufacturing Output Picked Up While Prices Rolled Over Chart 20Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Chart 21Manufacturing Sector's Profit Margins Will Be Further Squeezed The elevated prices of oil and global industrial metals will continue to disproportionally benefit upstream industries, which are mainly composed of commodity producers. Meanwhile, the manufacturing sector’s profit margins will be squeezed by rising input costs and sluggish final demand (Chart 21). Chinese manufacturers’ profit growth will likely weaken through 1H22 and the downtrend may be exacerbated by the ongoing struggle to contain COVID cases.  The impact from recent lockdowns in the northern city of Jilin (an auto production center), Shenzhen (a high-tech manufacturing production and export hub), and Shanghai (a city with major ports and a key logistics provider) will disrupt China’s manufacturing production and curb investment in the near term. Infrastructure Sector Will Remain A Bright Spot Through 1H22 Related Report  China Investment StrategyAiming High, Lying Low Infrastructure investment staged a strong recovery in January-February on the back of front-loaded fiscal stimulus (Chart 22). LG bond issuance started to accelerate last November and will boost both traditional and new-economy infrastructure spending at least through 1H22. Our calculations suggest that fiscal thrust will rise to more than 2% of GDP this year, a sharp reversal from last year’s negative impulse of 2% (Chart 23). Chart 22Fiscal Stimulus Is At Work Chart 23Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 24Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment However, shadow bank activity, which historically had a tight correlation with infrastructure investment, remains downbeat (Chart 24). February’s reading of shadow bank credit was extremely weak, highlighting that local governments still face constraints in off-balance sheet leveraging through local government financing vehicles (LGFVs). The trend in shadow bank loans bears close attention in the coming months because it will signal whether the central government will allow more backdoor financing to help local governments fund their infrastructure projects. A continued soft reading in shadow bank activities will likely limit the upside in infrastructure investment growth. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary     Footnotes 1     Guangzhou lowered its down-payment ratio from 30% to 20%, along with a 20bp cut in mortgage rates. Zhengzhou marginally relaxed home purchase restrictions by allowing families who bring elderly relatives to live in the city to buy one extra home and also lifted the “definition of second home ownership by physical unit & mortgage history”. ​​​​​​​ Strategic Themes Cyclical Recommendations