Emerging Markets

Executive Summary Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Markets remain alert for indications of what Russia will do next. Last week, President Vladimir Putin threatened “catastrophic consequences” if G7 states are able to impose a price cap on Russian oil sales. A sharp drop in output – more than 3mm b/d – would send prices sharply higher, and could not be replaced in 2H22. KSA and the UAE are signaling their limited ability to significantly increase oil output ahead of US President Joseph Biden’s visit to the region later this week. Our simulation of demand losses of ~500k b/d in 2H22 and ~1.0mm b/d in 2023 suggests Brent could fall $7/bbl to $108/bb in 2H22 and $8/bbl to $109/bbl in 2023, all else equal. A Russian court decision last week briefly halted flows on the Caspian Pipeline Consortium’s (CPC) 1.3mm b/d line moving Kazakh oil to the Black Sea through Russia, adding a new variable into supply-side modeling. A trivial fine was levied, but a larger message was delivered. Sporadic force majeure declarations and output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA), continue to make supply assessments difficult. Bottom Line: Tight supply fundamentals will keep oil markets volatile and biased to the upside, despite recurrent recession fears overwhelming demand expectations.  While a deep recession cannot be discounted, we remain focused on the objective fact of physically tight markets, and Russia's political-economy considerations affecting the evolution of prices. Feature Anyone who has spent time in trading markets will appreciate the implications of a $65-at-$380/bbl bid-ask spread on Brent. This two-way quote represents worst cases scenarios on the demand and supply sides of the market. And huge uncertainty. The bid comes from Citi’s recession-driven view, while the offer is courtesy of JP Morgan’s worst-case supply-shock assessment – i.e., Russia pulling 5mm b/d off the market if G7 states impose a price cap on its exports.1 Related Report  Commodity & Energy StrategyCopper Prices Decouple From Fundamentals Of late, demand-side concerns are driving markets, along with other technical factors we discussed in last week’s report on copper: low liquidity in trading markets; elevated global policy uncertainty, as seen by the two-way quote above; worries Fed tightening will overshoot the mark as it attempts to control hotter inflation, and an expansion of Russia’s economic war that now engulfs Ukraine.2 The latter point touches on events that cross commodity markets globally: Russia is threatening “catastrophic consequences” if G7 states impose a price cap on its oil sales. This goes directly to the supply side, as it most likely entails a dramatic gesture to reduce crude oil output sharply – i.e., more than 3mm b/d – which would send prices soaring. Russia’s coffers are in excellent shape at present, given the high prices its oil, gas and coal producers have been able to fetch since it invaded Ukraine.3 In our modeling, if Russia were to cut the 2.3mm b/d of crude and condensate it sent to Europe last year, Brent prices would move above $140/bbl.4 Higher volumes taken off the market would result in higher prices. These factors all interact with each other producing feedback loops – e.g., higher uncertainty causes lower liquidity in hedging markets and wider bid-ask spreads on smaller volumes – affecting decisions on everything from capex levels to headcounts. Demand Concerns Consume Markets Last month, we lowered our Brent forecast for this year and next to $110/bbl and $117/bbl, respectively, on the back of a sharp downgrade in global growth expectations from the World Bank. The Bank’s forecast prompted us to reduce our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast, and, for next year, to 1.8mm b/d. Given the obvious concern in markets, we simulated another hit to demand of 500k b/d in 2H22 and 1.0mm b/d next year, due to a further markdown in real GDP growth. This scenario brings our demand growth expectation down to 1.5mm b/d this year and 800k b/d next year. In this simulation, the lower GDP growth takes our average price expectation for 2H22 to $108/bbl and $109/bbl next year, or $7/bbl and $8/bbl lower, respectively (Chart 1). The lower demand we model here is offset to some degree by our maintained hypothesis that OPEC 2.0 – particularly its core producers Saudi Arabia and the UAE – will temper production somewhat (Chart 2), so as not to produce very large unintended inventory accumulations (Chart 3). Chart 1Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower Further GDP Weakness Would Push Brent Lower This concern is particularly acute if these producers receive new information that demand is slowing more than they expected. We are certain this will come up when US President Biden is in Riyadh later this week to meet Saudi Crown Prince Mohammed bin Salman Al Saud (MBS), to again discuss, among other things, the Kingdom’s ability and willingness to increase supply. Chart 2Core OPEC 2.0 Will Temper Production Increases... Core OPEC 2.0 Will Temper Production Increases... Core OPEC 2.0 Will Temper Production Increases... Chart 3...To Avoid Unintended Inventory Accumulations ...To Avoid Unintended Inventory Accumulations ...To Avoid Unintended Inventory Accumulations Russia Exerts Supply-Side Influence Russia is at war with Ukraine and the West – i.e., the G7 and NATO states arming and actively seeking to limit its access to revenues from the sale of hydrocarbons. Russia is treating this as a war, and it is operating on multiple fronts, in addition to its kinetic engagement with Ukrainian forces. In a market as finely balanced and uncertain as the current one, small, unexpected shifts in supply or demand can have outsized effects. Last week, for example, a decision by a Russian court briefly halted flows on the Caspian Pipeline Consortium’s (CPC) 1.3mm b/d line moving Kazakh oil to the Black Sea. This boosted prices more than 5% over the ensuing couple of days. Flows were allowed to resume after trivial fine was paid and prices fell. But a larger message was delivered. This remains a powerful lever Moscow can use at a moment’s notice to tighten supplies. Opportunities elsewhere in oil-producing provinces also are continuously cultivated by Russian operatives to influence supplies. Sporadic public demonstrations and force majeure declarations have led to output losses in Libya, where Russian mercenaries actively support Khalifa Haftar’s Libyan National Army (LNA). This continues to make supply assessments difficult. Libya currently produces ~ 650k b/d, according to the US EIA, down from ~ 1.12mm b/d in 4Q21. As in many things, Russia’s playing a game of chess with its opponents and forcing them to react to its threats and decisions. And this strategy is not limited to Ukraine, the EU or oil. For example, the seizure of Shell’s ownership in the Sakhalin-2 LNG facilities by Russia’s state-owned Gazprom was described by The Journal of Petroleum Technology (JPT) as a “backdoor” nationalization of Shell’s interest. This will have long-term consequences far removed from the Ukraine War, and could affect LNG deliveries to Japan and South Korea, which will become critical in a super-tight LNG market going into winter. This couldn’t be more timely, as Japan and South Korean – in a first-ever event – attended the end-June NATO meeting.5 Investment Implications Russia’s war against Ukraine has multiple dimensions, all of which can impact oil and gas prices going forward. Despite the obvious concerns over a deep recession reducing global oil demand – and commodity demand generally – we continue to focus on the objective fact of physically tight markets, and Russia's political-economy considerations affecting the evolution of prices. This informs our view that prices will remain volatile with a significant bias to the upside. Small, unexpected shocks in a fundamentally tight market on the supply side support our view prices will move higher.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish Whether the EU can avoid rationing – and fill its natural-gas storage – ahead of winter will depend on what Russia does with its exports of the gas exported on Nord Stream 1 (NS1) and other pipes (Chart 4). We believe Russia will cut off most of its exports to the EU before winter sets in. It likely will use use the current 10-day maintenance on NS1, which began Monday, as a pretext to cut supplies, in retaliation for the EU cutting off crude oil and refined products imports. President Putin of Russia most likely will offer to keep the gas flowing so inventories can be refilled, in return for the EU lifting sanctions it imposed following Russia's invasion of Ukraine. Precious Metals: Bullish June headline US CPI was reported at 9.1% yoy, continuing the streak of rising prices. The Fed will need to aggressively hike rates to bring price levels lower, raising the risk of plunging the US into a recession. Recession fears will reduce long-term bond yields and should support gold prices. While high inflation is good for gold, the yellow metal saw investment outflows during May and June, as investors opt for the USD as a safe-haven asset. Ags/Softs: Neutral Food prices fell for the third straight month in June, but still are near historic highs following Russia’s invasion of Ukraine.6 Wheat prices fell by 5.7% in June but was still higher by 48.5% compared to 2021 (Chart 5).7 This might be down to recession fears, or, more likely, due to better crop conditions, seasonal availability from new harvests in the northern hemisphere, and more exports from Russia. The UN’s FAO warned factors that drove global prices higher still persist. Russia is expected to harvest one of its largest wheat crops since the fall of the Soviet Union.8 According to the 2022/23 USDA outlook, there will be less supplies and consumption, higher exports and stocks.9 Chart 4 Russia Pulls Oil, Gas Supply Strings Russia Pulls Oil, Gas Supply Strings Chart 5 Wheat Price Level Going Down Wheat Price Level Going Down   Footnotes 1     Please see Citigroup says oil prices could tumble to $65 by the end of the year if a recession whacks demand, published by businessinsider.com on July 5, 2022, and Oil could hit $380 if Russia slashes output over price cap, J.P.Morgan says, published by reuters.com on July 4, 2022. 2     Please see Copper Prices Decouple From Fundamentals published on July 7, 2022. 3    Please see Russia sees extra $4.5 billion in July budget revenue on higher oil prices published by reuters.com on July 5, 2022. 4    Please see Oil, Natgas Prices Set To Surge, which we published on May 19, 2022.  It is available at ces.bcaresearch.com. 5    Please see Japan and South Korea's Attendance at the Upcoming NATO Summit Could Worsen Global Tensions, published by time.com on June 16, 2022. 6    Please see Global food prices may be falling, but economist warns Asia’s food costs could still soar published by CNBC on July 11, 2022. 7     Please see Wheat, Corn Prices Tempered- Easing Global Food Cost Concerns published by University of Illinois on July 1, 2022 . 8    Please see Dollar rises to 20-year highs, sends grains lower published by FarmProgress on July 12, 2022. 9    Please see Grain: World Market and Trade published by USDA on July 12, 2022.   Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed in 2022

Executive Summary Following an unprecedented exodus by foreign investors, Indian stocks’ absolute valuations have cheapened significantly. A breakdown in crude oil prices will help put a floor under Indian firms’ profit margins. India’s decent domestic fundamentals indicate that non-financial firms’ topline (revenues) should hold up. That entails only a limited drop in EPS, given that margin compression is late. Lower commodity and crude prices will help tame inflationary pressures; and will necessitate less rate hikes from the Reserve Bank of India (RBI). The rupee might be at a risk in the near run as the broad US dollar overshoots, but the currency’s medium- and long-term outlooks are positive. That said, Indian stocks’ relative valuations versus their EM and Emerging Asian peers remains far too expensive to recommend an upgrade just yet. Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Bottom Line: Equity investors should stay underweight this bourse in EM and Emerging Asia portfolios for now, but place this market on an upgrade watchlist. Absolute return investors should remain on the sidelines given the strong headwinds faced by global equities. Fixed-income investors should continue to accord a neutral allocation to India in EM and Emerging Asian domestic bond portfolios. Feature Indian equity markets witnessed an unprecedented exodus of foreign investors over the past nine months. Net equity outflows, at $36 billion since October last year, have now reversed the entire foreign equity inflows of $38 billion that took place during the preceding 18 months. Indian stock prices – which are highly sensitive to foreign investor inflows – have fallen in tandem (Chart 1). Chart 1Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Indian Markets Have Witnessed An Unprecedented Exodus By Foreign Investors Chart 2India Has Rcecntly Underperformed As China Has Outperformed India Has Rcecntly Underperformed As China Has Outperformed India Has Rcecntly Underperformed As China Has Outperformed The large selloff by foreigners has been instrumental to India’s recent mild underperformance relative to its EM and Emerging Asian counterparts (Chart 2, top panel). We had tactically downgraded Indian stocks to underweight in March this year, which has so far worked out well.  Notably, India’s recent underperformance versus the EM benchmark has been mostly due to investors rushing back into Chinese stocks, which had fallen to very low levels earlier this year. Indian stocks’ performance has been at par with EM ex-China equities in recent months (Chart 2, bottom panel). That said, global macro backdrops are changing gradually. Oil prices have begun to break down, which is a net positive for India, a large crude oil importer. India’s domestic growth indicators also appear to be decent – pointing to a steady top-line (revenues) outlook. This bourse therefore might begin to look attractive again to foreign investors whose Indian equity holdings are now quite low. On the negative side, India’s relative valuations versus EM and Emerging Asia remains very stretched – both by regular measures and in cyclically adjusted terms (Chart 3). Weighing all the pros and cons, we recommend that equity investors stay underweight this bourse in EM and Emerging Asia portfolios for the time being, but put it on an upgrade watchlist. Absolute return investors should remain on the sidelines given the strong headwinds faced by global equities.  Is The Multiple Compression Over? The ongoing selloff in Indian stocks can be attributed to derating (Chart 4). The trailing P/E ratio has fallen substantially from a pandemic high of 39 to 21; whereas the forward P/E has also fallen from 24 to 19. Chart 3Indian Markets Are Still Very Expensive In Relative Terms Indian Markets Are Still Very Expensive In Relative Terms Indian Markets Are Still Very Expensive In Relative Terms Chart 4The Ongoing Selloff In India Can Be Attributed To Multiple Derating The Ongoing Selloff In India Can Be Attributed To Multiple Derating The Ongoing Selloff In India Can Be Attributed To Multiple Derating   That said, the contraction of multiples, one of the two drivers1 of stock prices, appears to be at a late stage. The reasons are as follows. Chart 5Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins Falling Commodity Prices Will Help Put A Floor Under Indian Firms' Profit Margins As we explained in our previous report on India, commodity prices are the sole source of current inflation in this economy. Receding global commodity prices will therefore rein in the inflationary pressures in general, and producer prices in India in particular. The top panel of Chart 5 is showing that Indian producer prices track global commodity prices closely. Hence, the former is set to decelerate significantly in the next few months. What this means for Indian firms is that their cost of raw materials will ease up. At the same time, since global commodity prices have much less of an impact on India’s consumer inflation, the latter will not subside as much. In other words, CPI will rise relative to PPI, as shown in the middle panel of Chart 5. When this happens, it is usually a positive for firms’ profit margins (Chart 5, bottom panel). As such, in the coming months, one can expect firms’ margins to have some support. If we consider only crude oil, we see a similar dynamic. Any drop in crude prices (shown inverted in Chart 6) do help boost Indian firms’ margins, albeit with a few months lag. Hence, in the months ahead, as crude prices break down, firms’ margins will also find a floor sooner rather than later.  Profit margins, in turn, are a major driver of stock multiples (Chart 7). India’s multiples have already fallen to pre-pandemic levels in anticipation of more margin compression in the future. If margins do not compress as much, it’s reasonable to expect that further multiple contractions would also be limited. Chart 6Weaker Crude Prices Are Also Positive For Indian Firms' Margins Weaker Crude Prices Are Also Positive For Indian Firms' Margins Weaker Crude Prices Are Also Positive For Indian Firms' Margins Chart 7As Margins Compression Ends, So Will Equity Multiple Derating As Margins Compression Ends, So Will Equity Multiple Derating As Margins Compression Ends, So Will Equity Multiple Derating   The message is the same if we look at India’s cyclically adjusted P/E (CAPE) ratio: it too has cheapened to the lower end of the past 10-years’ range – thereby already discounting a massive amount of EBITDA margins compression (Chart 8). Chart 8India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression India's CAPE Has Fallen Meaningfully, Already Discounting Material Margin Compression A similar argument can be made in regard to firms’ interest costs. Indian firms’ interest expenses might not rise as much if inflation can be reined in without substantial rate hikes by the RBI. Indeed, India’s headline and core CPI remain largely range-bound (Chart 9) − unlike in most developed economies as well as in Latin America and EMEA. Odds are that they would subside marginally with easing commodity prices. If so, the central bank would be less inclined to raise interest rates considerably. Chart 9Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Rangebound Headline And Core CPI Mean Too Many Rate Hikes Are Unlikely Chart 10 shows that India’s trailing P/E has fallen to pre-pandemic averages – already discounting a significant amount of future rate hikes. If interest rates do not rise as much as feared previously, further derating of stocks will also be limited.   How Much Of An Earnings Squeeze Lies Ahead? Indian firms’ raw material and interest costs are likely to alleviate somewhat. Unit labor costs are also unlikely to rise much as wages remain subdued, and robust capital investments suggests that labor productivity gains would remain decent. All this will stop profit margins from contracting much further. And yet, for corporate earnings growth to continue, firms need rising revenues too. So, the next question is, how much top-line growth can be expected? Chart 11 shows the revenues of major non-financial corporations in India. They have already far surpassed their pre-pandemic levels in both local currency and US dollar terms. The outlook for their future revenues also appears to be satisfactory:  Chart 10Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Multiple Derating May Stop, As Already Discounted Rate Hikes Do Not Materialize Chart 11Indian Firms' Top Line Outlook Is Satisfactory Indian Firms' Top Line Outlook Is Satisfactory Indian Firms' Top Line Outlook Is Satisfactory   The purchasing managers’ indices for manufacturing and services are all at decent levels of expansion (Chart 12, top panel). Further, if the order books are of any indication, the expansion should continue in the foreseeable future (Chart 12, bottom two panels). Notably, India is not a major exporter of manufactured goods; and therefore, an impending contraction in global consumer goods consumption would not hurt it as much as it would many other EM economies. An industrial outlook survey by the RBI indicates that firms are expecting their capacity utilization and employment count to rise markedly in the near future. This points to a robust economy ahead (Chart 13). Chart 12Robust Order Books Indicate Economic Growth Will Stay Decent Robust Order Books Indicate Economic Growth Will Stay Decent Robust Order Books Indicate Economic Growth Will Stay Decent Chart 13Firms Are Expecting Rising Capacity Utilization And Employment Firms Are Expecting Rising Capacity Utilization And Employment Firms Are Expecting Rising Capacity Utilization And Employment         India’s bank credit impulse has accelerated strongly – which indicates rising economic activity. Industrial production usually follows suit with a couple of months lag, and this time should be no different (Chart 14). Chart 14Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Accelerating Bank Credit And Industrial Productions Indicate A Robust Economy Finally, strong post-pandemic capex growth indicates that bank loans have much further to accelerate. Notably, leverage in the Indian economy is still low. Bank credit has hovered at around only 50 - 55% of GDP over the past decade. Total debt levels including bond issuance by non-financial firms have also been flattish at a mediocre level of 65 - 70% of GDP. Limited leverage means there is plenty of room to borrow and kickstart a new capex cycle.  If that transpires, it will be very bullish for Indian stocks in general, and bank stocks in particular – which has the largest weight in the MSCI India index at 23% More importantly, a capex-led growth would boost Indian firms’ competitiveness and profits in the long run. Capex boosts labor productivity, which helps keep unit labor costs down. That, in turn, improves both competitiveness and profit margins. It will also contribute to alleviating structural inflationary pressures in the economy – as lower unit labor costs would keep prices down. The bottom line is that, given the decent economic growth outlook, the top line of most Indian corporations is unlikely to see a contraction in nominal terms. In that case, a minor drop in their profit margins from current levels would entail that EPS contraction, if any, will also be limited. In sum, the outlook for both drivers of India’s stock prices, multiples and EPS, is not as dire as it appeared earlier this year. That at least warrants to place India on an ‘upgrade watchlist’ in an EM equity basket from the current underweight status. The reason we are hesitant to upgrade it outright is that although India’s absolute valuation has eased, its relative valuation vis-à-vis EM and Emerging Asia remains highly stretched.  Finally, in terms of absolute stock prices, the risk-reward of global stocks remains poor as the Fed and US equity markets are on a collision course. As such, investors should wait out the ongoing turbulence before getting back to market. What About The Rupee?  Chart 15Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits Peaking Crude Prices Will Help Ameliorate Trade And Current Account Deficits The Indian currency has been depreciating versus the US dollar as both current and capital accounts were under downward pressure. That said, both are likely to get marginally better in the months ahead. High global commodity prices caused India’s trade deficits to slide to new lows in June. The current account balance is also weakening (Chart 15, top panel). If, however, commodity prices have peaked in this cycle (which is our view), India’s trade and current account deficits would ameliorate in the months to come. In regard to the capital account balance − which slipped into a rare deficit recently − the deterioration can be attributed to portfolio outflows. FDI and other capital flows, which are more stable in nature, continue to report decent inflows (Chart 15, bottom panel). Given that foreign portfolio repatriation has largely run its course, odds are that the capital account balance will switch back to surplus in the coming quarters. This is because while net portfolio outflows would recede significantly from current high levels, other components of the capital account will likely stay in surplus given the country’s decent long-term growth outlook. If so, that could mean that the depreciation of the rupee is also late. Chart 16 shows that changes in India’s capital flows greatly impact the Indian currency. While the ongoing risk-off sentiment globally may cause the dollar to overshoot in the near term, the rupee outlook is quite positive over the medium to long term.  Chart 16As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee As Portfolio Outflows Wane, Capital Account Will Be Back In Surplus, Benefitting The rupee Chart 17The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar The Rupee Is Extremely Cheap In PPP terms Vis-à-vis The US Dollar Incidentally, the rupee is already extremely cheap vis-à-vis the US dollar in PPP terms. Further depreciation, if any, should therefore be limited. It also makes the rupee attractive for long-term investors (Chart 17).   Notably, the rupee did well compared to other EM currencies over the past several years − in line with our view. It should continue to do so, as growth in India will likely stay stronger than most EM economies. That will attract capital from the rest of the world − beyond any near-term jitters − propping up the currency.  Finally, as the rupee will be under less downward pressure with the improvement in the balance of payments, the RBI will be less intent to raise policy rates in a bid to mitigate currency depreciation. Less rate hikes, as explained before, is positive for stock prices. Investment Conclusions Currency: Amelioration in both terms-of-trade shock and in portfolio outflows will ease up the downward pressures on the rupee in the months ahead. It will also likely remain among the best performers in the EM world even as an overshoot in the broad US dollar in the near term remains a risk. Equities: The key risk to Indian equities are global developments: the rate hike cycles underway globally, slumping DM growth, a strong US dollar, mediocre Chinese growth, and the negative ramifications of the war in Ukraine. As such, Indian absolute stock prices remain vulnerable in the months ahead. Absolute return investors should therefore stay on the sidelines. India’s relative performance versus its EM counterparts has been highly contingent on relative multiple expansions (Chart 18). The recent diversion between them is therefore untenable. And if history is any guide, the relative multiples and relative stock prices should converge to the downside. This argues for staying cautious on India’s relative performance too. We recommend remaining underweight India in EM and Emerging Asian equity portfolios for now; but put this bourse on an upgrade watchlist in view of decent macro fundamentals in India and falling crude prices. Domestic Bonds: Indian government bonds are not as attractive to EM fixed-income investors as the yield differential vis-à-vis other EMs has already narrowed substantially. Going forward also, the yield differential might not move in India’s favor. The reason is that Indian yields will likely inch up, or at least stay firm, with the economy gaining traction (Chart 19). Chart 18India's Relative Performance Remains At Risk India's Relative Performance Remains At Risk India's Relative Performance Remains At Risk Chart 19Indian Bond Yields May Not Fall Much,As They Move With Economic Growth Indian Bond Yields May Not Fall Much,As They Move With Economic Growth Indian Bond Yields May Not Fall Much,As They Move With Economic Growth   Notably, an imminent slowdown in global trade will not hurt India’s growth as much as it would most other EM countries. That reduces the odds of Indian yields falling more relative to its EM counterparts. Chart 20Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially Stay Neutral On Indian Bonds As Their Yield Advantage Has Narrowed Substantially We downgraded Indian government bonds from overweight to a neutral allocation in EM and Emerging Asian domestic bond portfolios in March this year. That recommendation still makes sense (Chart 20). Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1     The other driver being the EPS (Earnings-per-share); discussed in the next section.

Executive Summary No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales Beijing’s plan to bring forward RMB 2.6 trillion of financing for infrastructure expenditures in H2 2022 is a considerable stimulus. However, this new funding will not result in new investments. Rather, it will, by and large, offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what has been approved in the budget plan earlier this year. Not only is the credit and fiscal impulse smaller in this cycle than in the previous ones, but also the multiplier effect will be lower. This will hinder the recovery in domestic demand. After the one-off rebound in economic activity following the lockdowns in April and May of this year, China’s business cycle recovery will be more U shaped rather than V shaped. Bottom Line: For absolute-return investors neither A-shares nor investable stocks offer an attractive risk-reward profile. Within a global equity portfolio, we continue to recommend a neutral allocation to China’s A-shares and an underweight allocation to Chinese investable stocks. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable stocks. Maintain the long A-shares / short offshore investable Chinese stocks position.   Alleged plans of an additional RMB 1.5 trillion local government (LG) special bond issuance in H2 2022 have prompted investors to speculate about whether this stimulus initiative is sufficient to produce a considerable acceleration in infrastructure investment.  This stimulus would be added to RMB 800 billion and 300 billion of policy bank funding for infrastructure that the government approved earlier in Q2 this year. Hence, the combined new infrastructure financing made available by Beijing is RMB 2.6 trillion. Below, we elaborate on how this RMB 2.6 trillion of additional infrastructure financing will be largely offset by a drop in LG revenues from land sales. In short, the stimulus will preclude downside in infrastructure investment rather than herald a major acceleration.  In addition, the economic recovery still faces substantial headwinds from other segments of the economy. We believe that, approached as a whole, China’s business cycle recovery will be more U shaped than V shaped. Quantifying Infrastructure Stimulus The degree of new financing for infrastructure is considerable. This RMB 2.6 trillion in new financing in H2 2022 is equal to 7% of planned 2022 LG aggregate expenditures, 6% of planned 2022 aggregate total central and local government spending including budgetary and managed funds, 14% of fixed-asset investment (FAI) in traditional infrastructure, and 2% of GDP.  The composition of general government spending is presented in Table 1. Table 1Structure And Composition Of Government Spending In China Making Sense Of China’s New Stimulus Making Sense Of China’s New Stimulus However, a caveat is in order: this new funding will not result in new investments. Rather, it will, by and large, offset the drop in LG revenues from land sales. The primary source of financing infrastructure investment is LG managed funds. LG managed funds budgets, however, are under severe stress because of the plunge in revenues from land sales. Notably, proceeds from land sales account for 23% of aggregate LG expenditures (Chart 1). Land sales have contracted by about 30% in the January-June period of this year, and there is little hope that they will pick up in H2 2022. The reason is that property developers’ financing is down by 30% and is unlikely to recover soon (Chart 2). Chart 1Land Sales Are Critical For LG Expenditures Land Sales Are Critical For LG Expenditures Land Sales Are Critical For LG Expenditures Chart 2No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales No Funding For Property Developers, No Land Sales Chart 3Property Developers Are Facing Debt Deflation Property Developers Are Facing Debt Deflation Property Developers Are Facing Debt Deflation As we have argued in our past reports, property developers carry a substantial inventory of real estate assets funded by a massive debt build-up (Chart 3, top panel). With housing prices beginning to deflate, property developers are about to face debt deflation – falling asset prices and a high debt burden (Chart 3, bottom panel). Thereby, they have little appetite or capacity to expand their assets and leverage. Assuming land sales for the full year will decline by 30%, this drop would lead to an RMB 2.52 trillion reduction in LGs managed fund revenues in 2022 (Table 2). Hence, the new RMB 2.6 trillion infrastructure financing will be used to offset the RMB 2.5 trillion shortfall in LG managed funds budgets because of the plunge in land transfer proceeds. Table 2China: New Stimulus For Infrastructure in H2 2022 Making Sense Of China’s New Stimulus Making Sense Of China’s New Stimulus On the whole, there will be very little new funding available to boost infrastructure spending beyond what has been approved by the 2022 National People’s Congress (NPC) earlier this year. Chart 4The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate The Credit And Fiscal Impulse Will Be Moderate Hence, for this full year, there is no change to the aggregate fiscal spending impulse that incorporates central and local government budgetary spending as well as managed funds’ expenditures (Chart 4, top panel). The two scenarios for the non-government credit impulse are shown in the middle panel of Chart 4. The optimistic scenario assumes non-government credit will accelerate to 9.5% from 8.7%, and the pessimistic scenario is based on no acceleration in non-government credit growth. Finally, the bottom panel of Chart 4 illustrates the projections for the combined credit and fiscal spending impulse for the remainder of this year. Although the aggregate fiscal and credit impulse is non-trivial, it is smaller than those in 2020, 2016, 2013, and 2009. Bottom Line: The government has announced RMB 1.1 trillion in infrastructure funding and will likely raise the LG special bond quota by RMB 1.5 trillion. Yet, this RMB 2.6 trillion financing will only offset the shortfall in infrastructure financing from plunging land transfer revenue.  In brief, there is little new stimulus for infrastructure beyond what has been approved in the budget plan from early this year.   Economic Headwinds Chart 5China's Reopening Rebound China's Reopening Rebound China's Reopening Rebound Economic activity in China has rebounded following the reopening of the economy. Chart 5 illustrates that high-frequency data, such as car sales, house sales, commercial truck cargo, and steel production have all recently improved. We expect the one-off renormalization of economic activity following the lockdowns in April and May to give way to more subdued growth. The reason is that the mainland economy is facing several major headwinds: The real estate market is unlikely to recover meaningfully given the “three red lines” policy has not been eased, and many of property market excesses have not been purged. Hence, the question remains whether the Chinese economy can stage a robust recovery without the participation of the property market. We doubt it can because of the vital role that real estate has played in the economy in the past 20 years as the result of its large share in GDP and its impact on consumer and business sentiment. Since 2008, there has been no business cycle recovery in China without the property market firing on all cylinders (Chart 6). Chart 6All Economic Recoveries Were Accompanied By A Revival In The Property Market All Economic Recoveries Were Accompanied By A Revival In The Property Market All Economic Recoveries Were Accompanied By A Revival In The Property Market Chart 7China: The Willingness To Spend And Invest Is Very Low China: The Willingness To Spend And Invest Is Very Low China: The Willingness To Spend And Invest Is Very Low Rolling lockdowns will likely persist. This will weigh on household and private business confidence. Diminishing confidence will undermine the willingness to spend, invest, and hire. Our marginal propensity to spend indicators for households & enterprises remain very depressed (Chart 7). Low propensity to spend entails that the multiplier effect of fiscal and credit stimulus will be lower in this cycle than in the previous ones. Not only is the credit and fiscal impulse smaller than in the previous cycles but also the multiplier will be lower. This will hinder the recovery in domestic demand. Finally, Chinese exports are set to contract in H2 2022 because of shrinking demand for consumer goods (ex-autos) in the US and Europe as well as mainstream EM. Bottom Line: After the one-off rebound in economic activity following the lockdowns in April and May, the business cycle recovery will be more U shaped rather than V shaped. Investment Conclusions For absolute-return investors, neither A-shares nor investable stocks offer an attractive risk-reward profile.   Within the A-share market, our strongest conviction is to overweight interest rate-sensitive sectors like consumer staples, utilities, and healthcare. Consumer discretionary stocks should also be a slight overweight now.   We continue to recommend a neutral allocation to Chinese A-shares and an underweight allocation to investable stocks within a global equity portfolio. Relative to the EM equity benchmark, investors should continue to overweight A-shares and remain neutral on investable Chinese stocks.   Maintain the long A-shares / short offshore investable stocks position.   The yuan, like all other emerging Asian currencies, is still facing near-term downside risk versus the US dollar. Chinese onshore government bond yields will likely drop further.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes Cyclical Recommendations

Executive Summary Global risk assets are oversold, and investor sentiment is downbeat. In this context, a technical equity rebound cannot be ruled out. However, we do not think it will be the beginning of a major cyclical rally. The Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to continue hiking interest rates. There are many similarities between dynamics that prevailed in US tech stocks and in previous bubbles. While it is not our baseline view, the odds of a protracted bear market are nontrivial. Resource prices and commodity plays have more downside. The History Of Financial Bubbles: Is This Time Different? On A Bull Case, Bubbles And Commodity Prices On A Bull Case, Bubbles And Commodity Prices Bottom Line: The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term. Feature Among the most frequently discussed topics in recent client calls are the upside and downside risks to our baseline view. We elaborate on these risks in this report. To recap, our baseline view is as follows: EM and DM stocks have another 15% downside in USD terms, the US dollar will continue overshooting and commodity prices will fall. Global yields are topping out, and the US yield curve will soon invert. Hence, defensive positioning for absolute-return investors is still warranted, and global equity and fixed-income portfolios should continue to underweight EM. The rationale is that US and EU demand for goods ex-autos, and hence global trade, is about to contract while the Fed is straightjacketed by high and broad-based inflation. China’s economy will be struggling to recover. In EM ex-China, domestic demand will relapse. Chart 1Will The S&P 500's Technical Support Hold? Will The S&P 500's Technical Support Hold? Will The S&P 500's Technical Support Hold? If one believes that the US equity bull market that began in 2009 is still alive (i.e. the March 2020 selloff is a short-lived red herring), odds are that the S&P 500 drawdown is over. The reasoning is that the S&P 500 is already down 23% from its 2021 peak, on par with the selloffs that occurred in 2011, 2015-16 and 2018 (Chart 1). However, if one believes that the structural bull market is over, the magnitude of the current equity selloff is likely to exceed the ones in 2011, 2015-16 and 2018. Hence, a bearish stance is still warranted. As we argue below, after a 12-year bull run, the excesses in the US equity market in general, and US tech stocks in particular, have become extreme. There are many signs of a bubble, or at least of a major top. Even though we risk overstaying in our negative view, our bias is that the global equity market rout is not yet over. A Bullish Scenario A (hypothetical) bullish case would look something like this: Weakening global and US growth and falling commodity prices bring down US inflation and Treasury yields. As US bond yields drop further, the S&P 500 rallies given their negative correlation of the past 18 months or so. As US inflation declines rapidly, the Fed makes a dovish pivot, reinforcing the risk asset rally and reversing the US dollar’s uptrend. Finally, Chinese stimulus produces a robust business cycle recovery in China that propels commodity prices higher and lifts the rest of EM out of the abyss. Chart 2Keep An Eye On Rising US Trimmed-Mean Inflation Keep An Eye On Rising US Trimmed-Mean Inflation Keep An Eye On Rising US Trimmed-Mean Inflation In our opinion, this scenario has no more than a 25% chance of playing out. Even if there are apparent signs of a US/global slowdown, elevated US core inflation and accelerating wages and unit labor costs would keep the Fed from dialing down its hawkishness Critically, even though US core PCE inflation has rolled over and will likely decline further, its trimmed-mean PCE inflation is rising (Chart 2). The latter means that inflation is broadening even as some volatile items like food, energy and used-auto prices deflate. As we have written extensively, wages and inflation are lagging variables. Despite the ongoing slowdown in the US economy, it will take many months before the underlying core inflation rate drops below 3%. We maintain that the Fed and the stock market remain on a collision course. An equity rally and easing financial conditions would make the Fed even more resolute to hike interest rates. The basis is that even if core inflation falls in the coming months, it would still be well above the Fed’s target of 2%. Notably, the Fed has recently communicated that its commitment to bring down inflation to 2% is unconditional. Chart 3The Anatomy Of The US Equity Bear Market In 2000-2002 The Anatomy Of The US Equity Bear Market In 2000-2002 The Anatomy Of The US Equity Bear Market In 2000-2002 This policy stance represents a major departure from the past several decades when the Fed was very sensitive to any tightening in financial conditions and often eased preemptively. In short, with inflation still well above its target, the Fed will, for now, err on the side of hawkishness if financial conditions ease. Importantly, US corporate profits will likely contract even if US real GDP does not shrink. As US corporate top-line growth slows and unit labor costs accelerate, profit margins will shrink. For example, the 2001-2002 recession was very mild – consumer spending did not contract at all, and housing boomed (Chart 3, top two panels). Yet, the S&P 500 operating earnings dropped by 30%, and the S&P 500 fell by 50% (Chart 3, bottom two panels). In brief, a devastating bear market does not necessarily require a hard landing. Concerning China, the recovery will likely be U-shaped rather than V-shaped with risks skewed to the downside. Finally, contracting global trade and falling commodity prices will continue, which are negative for EM currencies and assets. Notably, industry data from Taiwan’s manufacturing PMI suggest that the slowdown in the Asian and global economies is widespread. Taiwan’s substantial trade linkages with mainland China signify that the slowdown is not limited to the US and the EU but includes China too. Taiwanese PMI export orders of both semiconductor and basic material producers have plunged to 40 and 30, respectively (Chart 4). Barring a quick turnaround, global semiconductor and basic materials stocks have more downside. Even as US Treasury yields drop, the dollar will continue firming versus EM currencies, including those of Emerging Asian countries. In such a scenario, EM stocks and bonds will weaken further (Chart 5).  Chart 4A Broad-Based Contraction In Global Trade Is In The Cards A Broad-Based Contraction In Global Trade Is In The Cards A Broad-Based Contraction In Global Trade Is In The Cards Chart 5A Free Fall In EM Ex-China Stocks And Currencies A Free Fall In EM Ex-China Stocks And Currencies A Free Fall In EM Ex-China Stocks And Currencies   Bottom Line: The S&P 500 is oversold, and investor sentiment is downbeat. In this context, a technical equity rebound can occur at any moment. However, we do not think it will be the beginning of a major cyclical rally. A Bearish Case: Are US TMT Stocks A Bubble? What is a more bearish scenario than our baseline case? The bursting of bubbles or the unwinding of excesses would entail a more protracted and devastating bear market than the 15% drop in global share prices we currently expect. We can identify two major excesses in the global economy and financial system: In US TMT (Technology, Media & Entertainment and Internet & Catalog Retail) stocks and private equity In Chinese real estate. We have written extensively about property market excesses in China. Below we discuss the recent sharp selloff in commodities, which is partially linked to Chinese property construction. We also present the case for major excesses in US stocks. Chart 6 illustrates the history of bubbles of the past several decades: The Nifty-fifty (involving the 50 US large-cap stocks) bubble occurred in the 1960s and burst in the 1970s (not shown in the chart). The commodity bubble took place in the 1970s and burst in the 1980s. Japanese equity and property prices rose exponentially in the 1980s and deflated in the 1990s. The Nasdaq bubble occurred in the 1990s and was shattered in the early 2000s. Commodities/EM/China were the leaders of the 2000s, and they were devastated in the 2010s. We use iron ore in this chart because its price surged the most in the 2000s. FAANGM stocks, the Nasdaq 100 index and private equity were by far the biggest beneficiaries of the 2010s. No one can be certain about bubbles in real time because there are always superior fundamentals or persuasive stories that justify exponential price appreciation. That said, there are a lot of similarities between dynamics prevailing in US tech and private equity and in previous bubbles: In the past decade, FAANGM stocks, the Nasdaq 100 index and private equity companies registered gains comparable to the bubbles of the previous 60 years. Furthermore, as Chart 6 illustrates, the equal-weighted FAANGM index in inflation-adjusted terms rose 30-fold, much more than the bubbles of the previous decades. The Nasdaq 100 index and share prices of Blackstone, the largest private equity company, have risen by nearly 10-fold in real (inflation-adjusted terms) between 2010 and the end of 2021. Chart 6The History Of Financial Bubbles: Is This Time Different? On A Bull Case, Bubbles And Commodity Prices On A Bull Case, Bubbles And Commodity Prices The final phase of bubbles is often characterized by growing retail investor participation. This is exactly what happened with US tech/new economy stocks. Chart 7US TMT Stocks: Exponential Growth Rarely Ends Well US TMT Stocks: Exponential Growth Rarely Ends Well US TMT Stocks: Exponential Growth Rarely Ends Well Toward the end of the decade, not only retail but also institutional capital stampedes into the winners of the decade. This played out with US large-cap tech stocks as well as in private equity and private debt spaces. Inflows into private equity and private debt have been enormous. As a result of these inflows into US large-cap stocks, the market cap share of US TMT stocks as a percentage of total US market cap has surpassed 40%, its peak in 2000 (Chart 7). Bubbles often thrive during periods of low interest rates and crash when the cost of capital rises. This is exactly what has been happening in global financial markets since early 2019. The parameters of the overall US equity market were also excessive prior to this bear market. As of last year, the S&P 500 stock prices in real (inflation-adjusted) terms became as elevated relative to their long-term time trend as they were in the late 1960s and the late 1990s − the peaks of previous secular bull markets (Chart 8, top panel).   Chart 8The S&P 500 and Operating Profits: A Long-Term Perspective The S&P 500 and Operating Profits: A Long-Term Perspective The S&P 500 and Operating Profits: A Long-Term Perspective Chart 9Equity Issuance Marks Market Tops Equity Issuance Marks Market Tops Equity Issuance Marks Market Tops The S&P 500’s operating earnings in real terms have surpassed two standard deviations above its time trend (Chart 8, bottom panel). Some sort of mean reversion to its long-term trend is in the cards. US corporate profits have benefited from fiscal/monetary stimulus, low labor costs and pricing power. All of these are now working against profits.   Finally, new share issuance in the US mushroomed in 2021, another sign of a major top (Chart 9). Bottom Line: We are not entirely convinced that US TMT stocks are a bubble waiting to burst. Yet, the odds of this happening are nontrivial. This time might not be different. A Word On Commodities The selloff in the commodity space has been broad-based. Odds are that it will continue for the following reasons: A global business cycle downtrend is always bearish for commodity prices. In fact, oil prices are often lagging and are typically the last shoe to drop during global slowdowns. US sales of gasoline have started to contract. Besides, Saudi Arabia will likely increase its oil output and shipments following President Biden’s visit to the Kingdom next week. Chart 10Investors Have Been Long Commodity Futures Investors Have Been Long Commodity Futures Investors Have Been Long Commodity Futures As we have argued in recent months, China’s demand for commodities was contracting and, in our opinion, the rally in resource prices over the past 12 months was supported by investment demand for commodities, i.e., financial inflows into the commodity space. Many portfolios have bought commodities as an inflation hedge. When a hedge becomes a consensus trade and crowded, it stops being a hedge. Chart 10 demonstrates that net long positions in 17 commodities have been very elevated. The speed at which liquidation is taking place corroborates our thesis that it is investors not producers or consumers who have been caught being long commodities. China’s business cycle recovery will be U-shaped at best. Domestic orders point to weaker import volumes in the months ahead (Chart 11, top panel). ​​​​​​​Corporate loan demand has plunged suggesting that liquidity provisions by the PBoC might fail to produce a meaningful recovery in credit growth (Chart 11, bottom panel). Finally, technicals bode ill for commodity prices. As Chart 12 illustrates, copper prices and global material stocks have probably formed medium-term tops, and risks are skewed to the downside.  Chart 11China: The Economy Is Struggling To Gain Traction China: The Economy Is Struggling To Gain Traction China: The Economy Is Struggling To Gain Traction Chart 12A Major Top In Commodity Prices? A Major Top In Commodity Prices? A Major Top In Commodity Prices?   Bottom Line: Commodity prices and their plays have more downside. Investment Strategy The decline in commodity prices and the relentless US dollar rally will ensure that EM currencies, bonds and stocks continue to sell off even if the US equity market rebounds in the near term driven by lower Treasury yields. Global equity and fixed-income portfolios should continue underweighting EM. We also continue to short the following currencies versus the USD: ZAR, COP, PEN, PLN, PHP and IDR; as well as HUF vs. CZK, and KRW vs. JPY. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)