Emerging Markets

Executive Summary Is Factor Investing Dead? Is Factor Investing Dead? Is Factor Investing Dead? After decades of outperformance, in the past few years equity factors have started to underperform the broad indexes. But this may just be because US-centric factor research and US-dominated global factor indexes have masked an underlying divergence in the behavior of factor premiums in major countries/regions. In this report, we identify differences in smart beta strategies in the US, euro area (EMU), UK, Japan, Canada, Australia, and emerging markets (EM). Quality and Minimum Volatility factors are the most consistent across all markets. However, the magnitude of the factor premiums varies significantly among certain countries/regions. These variations can be attributed to a factor’s differing exposure to the same sector in specific countries, as well as the diverse performance of the same sector in specific countries. Value/Growth is an inferior framework to sector positioning. Quality remains a better factor than Growth.   Bottom Line: Factor investing is still a viable investing approach, but investors should consider that factor premiums have diverged among major countries/regions. Factor strategies may be less profitable in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country/region. Feature Chart 1Diverging Factor Performance DIVERGING FACTOR PERFORMANCE DIVERGING FACTOR PERFORMANCE Late last year, quant hedge fund AQR announced it would cut back resources because poor performance had induced significant investor outflows.1 Based on MSCI’s diversified multi-factor (DMF) index, which is a bottom-up 4-factor-index (value, momentum, quality and size) optimized using Barra equity models,2 the global DMF index underperformed the MSCI ACWI by 21% between March 2018 (when the relative performance peaked) and the end of January 2022, even though it had outperformed by 373% over the previous 20 years (Chart 1, top panel). Many clients have asked: Is factor investing dead? As shown in Chart 1, however, MSCI Global DMF’s recent poor relative performance was driven largely by a 23.6% underperformance from the developed markets (DM), especially the US (33% underperformance) and Japan (23.6% underperformance), while the DMF index in the emerging markets (EM) lagged its benchmark by only about 1% in the same period. We have advocated a simple approach to factor allocation to smooth out the cyclicality of individual factors by equally weighting five time-tested factors: Quality, Momentum, Minimum Volatility (Min Vol), Value and Equal Weight. Our equally-weighted-5-factor aggregate (EW5) index is less volatile than the more sophisticatedly optimized DMF; it therefore suffered less underperformance in the same period. However, even with this approach, the regional divergence is still notable, with the EW5 factor index in the developing markets underperforming its benchmark by 9%, while the EM EW5 factor index outperformed its benchmark by about 5.5% (Chart 1, panels 2 and 3). Interestingly, the EW5 index for Japan looks more like that for the US than it looks like the Japanese DMF (Chart 1, panels 4 and 5). This highlights the importance of factor allocation methodology. Table 1US Dominance In Global Markets Is Factor Investing Dead? Is Factor Investing Dead? US equities dominate the global equity index by market capitalization. Momentum and Quality, the two best performing factors globally, have even higher weightings in US companies than the broad benchmark, as shown in Table 1. An academic paper published in 2019 based on studies of the US and 38 international stock markets indicates that the US is the only country with a statistically significant, economically meaningful and robust post-publication decline of long-short equity factor returns.3 This is because the US is the most researched market and large mispriced anomalies are arbitraged away quickly after they are identified in academic publications, which results in lower strategy returns. Most quant funds are US-focused, which may explain the ill fortunes of some quant funds. Smart beta strategies are long-only factor strategies, instead of long-short strategies. At the aggregate level, the MSCI factor indexes in developed markets and emerging markets performed much better than in the US, in line with the academic findings (Chart 1, panels 2, 3, and 4). Yet, the Japanese DMF index’s relative performance peaked in October 2012 and has been in a consistent down trend since that time (Chart 1, panel 5). Our research shows that Japan is not an anomaly. Factor divergence among countries exists not only at the aggregate level, but also at the individual factor level. Factor Performances Diverge Among Countries/Regions Factor returns in the US, UK, EMU, Japan, Canada, Australia, and EM, both in absolute and relative terms, have had notable divergences in the past 20 years, as shown in Table 2.4 Several observations from Table 2: Quality and Min Vol are two factors with positive premiums in all countries. In terms of magnitude, however, Min Vol premiums in the US, Japan and Australia are the closest to zero, while the EM scores the highest. Quality premium in Australia is also close to zero while the UK stands out. Momentum is the best performing factor in all countries/regions except in Japan where it has a slightly negative premium. The ineffectiveness of Momentum in Japan may be due to its cultural biases. Momentum tends to fare better in countries that promote individuality (unlike Japan) and where self-attribution and overconfidence are more pervasive. EM is the only market where our five preferred factors (Momentum, Quality, Min Vol, Value and Equal Weight) have had positive premiums, even though the Value premium is not statistically different from zero, while the Growth premium is negative. Despite the well-telegraphed underperformance of Value versus Growth in the US and global markets, this has not been the case in Japan, Canada, and the EM. Momentum, Quality, Min Vol and Value in the EM and Canada have much higher absolute returns than in the US. This aspect cannot be fully explained by the overall index performance difference between these countries and the US. Even though Momentum, Quality, Min Vol and Value in the UK and euro area have returned much less than their US counterparts, the magnitude of the underperformance of each factor is much smaller than what the overall index performance divergence would imply. Table 2Factor Performance Divergence* Is Factor Investing Dead? Is Factor Investing Dead? The widely quoted explanation for the impressive factor performance in the EM, especially in the Chinese A-share market, is that emerging markets have higher trading costs such that it’s harder to arbitrage away the mispriced anomalies. It’s true that trading cost is higher in the EM than in the US, which explains why there are fewer EM-dedicated quant funds than US-focused quant funds. Trading cost alone, however, cannot fully explain the exceptionally large premiums in EM Momentum, Quality and Min Vol compared with the US. In fact, the market with the best factor relative performance since the end of 2001 has been the UK (Chart 2) where trading costs are comparable to the US. The EM is the second in terms of relative returns even though it is more volatile than the euro area. Canada has also performed better than the US, while Australia has been the least favorable market to harvest any factor premium. Japan behaves more like the US, yet with higher volatility. The risk-adjusted active return, defined as the average of the return difference (between EW5 and benchmark) divided by the volatility of the return difference, on an annualized basis using monthly returns, is illustrated in Chart 3. The chart shows both the full-period (from December 2001 to January 2022) risk-adjusted active return (RAAR) and four-year moving RAAR to demonstrate how factors have evolved in each market. Several observations can be made from Chart 3: In the past 20 years, factor premiums (aka active factor returns) in the US have gone through three stages: High premium, low positive premium and then sharply declining premium to negative territory. The last stage started about four years ago. The US factor premium is at its lowest level in the past 20 years and is also the lowest among the seven countries/regions (Chart 3, panel 5). This supports the argument that too many quant funds trade with each other in the US equity market, resulting in lower and lower factor returns. Japan shares a similar pattern with the US, but on a much smaller scale (Chart 3, panel 4). Canada and Australia are similar because their indexes are dominated by financials and commodities. The four-year RAAR trends oscillate in a similar fashion in both countries, but the Canadian cycle seems to lead the Australian cycle by about 2-1/2 years. Canada has a meaningfully positive average factor premium and its four-year RAAR is near a historical low. In contrast, Australia’s average premium is close to zero and its four-year RAAR is still above previous lows (Chart 3, panels 6 and 7). The EMU is the only market with a positive four-year moving RAAR, currently at the well-established lower bound (Chart 3, panel 2). The UK has the highest average premium. It is the only market in which the four-year RAAR has had large cyclical swings and only two brief periods in negative territory (Chart 3, panel 1). EM is the only market where the four-year RAAR has improved since the Covid-19 pandemic started in March 2020 (Chart 3, panel 3). Chart 2Factor Relative Return Performance* FACTOR RELATIVE RETURN PERFORMANCE* FACTOR RELATIVE RETURN PERFORMANCE* Chart 3Risk-Adjusted Active Performance RISK-ADJUSTED ACTIVE PERFORMANCE* RISK-ADJUSTED ACTIVE PERFORMANCE* Bottom Line: US-centric factor research and the US-dominated global factor indexes have masked different behaviors of factors in various countries/regions. Thus, it is important to analyze each market instead of drawing investment conclusions from US-based research. What Drives The Divergence In Quality Premium? The Quality factor has been consistently rewarded, but the magnitude of the Quality premium varies significantly among countries/regions, and non-US countries have low correlations with the US, as shown in Table 2 (on page 4) and Charts 4 and 5. Chart 4Quality Performance Divergence* QUALITY PERFORMANCE DIVERGENCE* QUALITY PERFORMANCE DIVERGENCE* Chart 5Quality Premium* Country Correlation Is Factor Investing Dead? Is Factor Investing Dead? MSCI Quality is defined by three accounting measures: Return on equity (ROE), debt-to-equity and five-year volatility of EPS YoY growth. Earnings may be affected by accounting standards. Countries have different accounting standards, which may explain part of the country divergence in Quality. Our research focuses on an important aspect of Quality, which is persistence, i.e., a Quality stock today will be a Quality stock in the future. The implication is that the Quality factor index has a low turnover and its sector composition does not change much over time. As such, we can take a snapshot and see the relationship between Quality and sector exposure. The sector weights of the broad benchmark in each market are shown in Table 3. Notably, the US and EM have the highest exposure to the Tech sector while both the UK and Australia have little. Although Australia and Canada are both regarded as commodity-driven markets, they have dissimilar exposures to non-Financials: Australia is concentrated in Materials and Healthcare, while Canada has a more even exposure in Energy, Industrial, Materials and Tech. Table 3Broad Market Sector Compositions Is Factor Investing Dead? Is Factor Investing Dead? Given that Quality is measured on profitability, capital structure and earnings stability, does Quality show universal sector preference? The answer is both Yes and No. Yes, because Quality is universally underweight Financials, Energy and Utilities (Table 4). It is also overweight Tech and underweight Real Estate in all markets, except Australia. Tech has outperformed Financials, Utilities and Energy in general (except for Canada), therefore, these three sector tilts may explain the universal existence of Quality premium (Chart 6). Table 4Quality Index Sector Deviations Is Factor Investing Dead? Is Factor Investing Dead? Chart 6What Drives Quality Premium? WHAT DRIVES QUALITY PREMIUM? WHAT DRIVES QUALITY PREMIUM? However, the commonality ends here. Canadian Tech has underperformed Financials by a very large margin (Chart 6, panel 3), which would have caused a huge underperformance in Quality; Quality indexes in the UK and EMU have benchmark exposures to Tech. So what else have contributed to Quality’s outperformance in these three countries/regions? A look at their exposures to other sectors reveals the answers. In the UK, EMU and Canada, Quality indexes have also overweight tilts in Industrials, Consumer Discretionary and Consumer Staples (Table 4). These three sectors have all outperformed their respective benchmarks in the past 20 years, as shown in Table 5. The table also shows that Consumer Staples is the only sector that has outperformed in all markets, yet both US and Australian Quality indexes underweight this sector. Table 5Sector Performance* Is Factor Investing Dead? Is Factor Investing Dead? In addition, in both the UK and Canada, Quality overweights Materials, which is a top outperforming sector in the UK, but an underperforming sector in Canada. Materials also outperforms in the EMU, yet EMU Quality underweights it. Despite the impressive overall outperformance since 2001, the Quality factor in DM has suffered in the past few years, especially since the Covid 19-induced selloff in March 2020. Quality relative performance in EM peaked long before DM but has stood out as the only significant outperformer since March 2020. This is because profitability in Quality has improved in EM but deteriorated in the US and other DM countries as shown in Charts 7 and 8. Chart 7Quality Premium Driver: ROE* QUALITY PREMIUM DRIVER: ROE* QUALITY PREMIUM DRIVER: ROE* Chart 8Quality Premium Driver: EPS* QUALITY PREMIUM DRIVER: EPS* QUALITY PREMIUM DRIVER: EPS* Chart 9Quality Premium Driver: Valuation* QUALITY PREMIUM DRIVER-VALUATION* QUALITY PREMIUM DRIVER-VALUATION* Valuation-wise, Quality indexes in the UK and Canada are at their cheapest levels since 2013, while Japan has become more expensive. Meanwhile, Quality valuation in the US, EMU and Australia is in line with their respective historical average5 (Chart 9). Bottom Line: Quality premium is driven by profitability and has strong sector preferences. The divergence of Quality premium among countries indicates that the same sector in different countries does not necessarily share the same behavior relative to its own benchmark. Sector behaviors in each market have not been as consistent as globalization would have implied, even though “global sectors” have become a well-accepted concept. What Drives The Min Vol Premium Divergence? Beside Quality, Min Vol has consistently outperformed in all the countries/regions in the past 20 years, even though the premiums in the US and Japan are close to zero, as shown in Table 2 on page 4. Over time, however, Min Vol’s relative performance is very cyclical. At the global aggregate level, this cyclicality is determined by its defensive nature given its positive correlation with the relative equity return ratio of Defensives/Cyclicals and negative correlation with bond yields. It is no surprise that the strong recovery in global equities and the rise in bond yields have caused Min Vol to underperform the broad market since March 2020. What is surprising, however, is the magnitude of the underperformance, which cannot be explained by historical relationships (Chart 10). Chart 10What Drives Global Min Vol Premium? WHAT DRIVES GLOBAL MIN VOL PREMIUM? WHAT DRIVES GLOBAL MIN VOL PREMIUM? Looking at the global aggregate only, however, can provide misguided information, because Global Min Vol is dominated by the US (56.81%) and Japan (9.88%), where Min Vol has performed the worst. In the most recent cycle since March 2020, the US is the only country where Min Vol has deviated sharply from the historical relationship with the relative performance of defensives/cyclicals and with bond yields, incurring the largest relative performance drawdown ever, erasing all the relative gains achieved in the previous two decades (Chart 11A). Japanese Min Vol also suffered large drawdown, but was in line with the defensives/cyclicals, albeit undershooting what implied by the bond yield (Chart 11B). The relative performance of Min Vol in the UK, Canada, EM, and Australia all behaved in line with what is implied by the historical relationships with bond yields and defensives/cyclicals, while Min Vol in EMU does not have a close correlation with defensives/cyclicals (Charts 11 C-G). Chart 11AUS Min Vol Premium US MIN VOL PREMIUM US MIN VOL PREMIUM Chart 11BJapan Min Vol Premium JAPAN MIN VOL PREMIUM JAPAN MIN VOL PREMIUM Chart 11CUK Min Vol Premium UK MIN VOL PREMIUM UK MIN VOL PREMIUM Chart 11DEMU Min Vol Premium EMU MIN VOL PREMIUM EMU MIN VOL PREMIUM Chart 11ECanada Min Vol Premium CANADA MIN VOL PREMIUM CANADA MIN VOL PREMIUM Chart 11FAustralia Min Vol Premium AUSTRALIA MIN VOL PREMIUM AUSTRALIA MIN VOL PREMIUM   Chart 11GEM Min Vol Premium EM MIN VOL PREMIUM EM MIN VOL PREMIUM Min Vol has become the worst performing factor since March 2020, led by the US, Japan, and EMU, while the UK has been almost flat, as shown in Table 6. This is in stark contrast to its historical track record (Table 2 on page 4) but can be explained by its defensive tilt in a strong equity market. Currently, Min Vol’s general defensive nature is reflected by its overweight in Consumer Staples and underweight in Consumer Discretionary, overweight in Communication Services and underweight in Energy in all markets. In interest-rate-sensitive sectors, Min Vol overweighs Utilities in all markets except Japan and underweights Financials in all markets, except EM (Table 7). Table 6Min Vol Was The Worst Performer Since The Covid-Induced Recovery* Is Factor Investing Dead? Is Factor Investing Dead? Table 7Min Vol Index Sector Deviations Is Factor Investing Dead? Is Factor Investing Dead? Communication Services in the UK and Australia bucked the trend, outperforming the broad market. UK Financial also opposed the trend but did not outperform. In addition, the UK is overweight in Real Estate, which did much better than the broad market (Table 8). Table 8Sector Performance Since March 2020 Is Factor Investing Dead? Is Factor Investing Dead? Chart 12Min Vol Premium Divergence: Valuation* MIN VOL PREMIUM DIVERGENCE:VALUATION* MIN VOL PREMIUM DIVERGENCE:VALUATION* Min Vol in EM has an overweight in Financials, which also outperformed. In addition, EM Consumer Discretionary resisted the general trend, coming in under its benchmark by 17% annualized; an underweight in this sector contributed to EM’s Min Vol’s performance. Why has US Min Vol performed so badly? According to a GAA Special Report published in January 2020, extreme overvaluation of Min Vol relative to the broad market could induce poor subsequent performance in near future. US Min Vol reached peak valuation relative to the market in 2019, and the subsequent underperformance was accompanied by sharp multiple contraction. Currently, Min Vol’s relative valuation is in line with historical average in the US, implying the turnaround since November 2021 may have further staying power (Chart 12). Bottom Line: Global Min Vol’s defensive tilts explain its underperformance since March 2020. However, divergences in the magnitude of underperformance among countries is explained by different sector exposures and the varying performance of some sectors in different countries, in addition to relative valuation. Chart 13Value Vs. Growth: Is This Time Different? VALUE VS. GROWTH: IS THIS TIME DIFFERENT? VALUE VS. GROWTH: IS THIS TIME DIFFERENT? Is It Time To Overweight Value Versus Growth? This is one of the most frequently asked questions over the past few years, especially after the turnaround in AQR last year hit the newswire. The impressive performance of AQR so far this year has prompted more heated debate on the sustainability of the “Revenge of Value” after Value's longest streak of underperformance).6 The recent rebound in the relative performance of Value versus Growth has been driven by extremely oversold conditions, very cheap valuation and faster EPS growth led by the rise in global bond yields. Even though sector exposures change over time for Value and Growth, sector exposures to Financials and Tech have been stable since 2010 at the global aggregate level (Chart 13). The large bets in Financial, Utilities and Tech are universal, as shown in Table 9. Other sector exposures in specific countries vary significantly. For example, the US Value/Growth split is basically between Tech, Communication Services and Consumer Discretionary versus the other eight sectors. These three sectors are dominated by a few mega-cap stocks. The other eight sectors are a mixed bag of cyclicals, defensives, and interest rate sensitives, which have different macro drivers. It does not make sense to overweight them together. It is important to note that Consumer Staples and Healthcare are overweight in Growth outside the US and EMU. Table 9Sector Tilts In Value And Growth Is Factor Investing Dead? Is Factor Investing Dead? In addition, Growth has similar sector preferences as Quality (Table 4 and Table 9), which explains the high correlation between the two factor premiums (Chart 14A), However, Quality has been a much better factor than Growth outside the US and Australia. In the US, Quality and Growth are almost the same with a stable correlation, but Quality has been inferior to Growth in Australia (Chart 14B). Chart 14AClose Correlation* Between Quality And Growth CLOSE CORRELATION* BETWEEN QUALITY AND GROWTH, BUT... CLOSE CORRELATION* BETWEEN QUALITY AND GROWTH, BUT... Chart 14BQuality Is Superior To Growth Outside US And Australia QUALITY IS SUPERIOR TO GROWTH OUTSIDE US AND AUSTRALIA QUALITY IS SUPERIOR TO GROWTH OUTSIDE US AND AUSTRALIA Finally, Value and Growth behave very differently in various market-cap segments, as shown in Table 10. Despite the well-telegraphed underperformance of Value versus Growth by the media, Value has consistently outperformed Growth in Canada, EM and Japan. Furthermore, mid-cap Value has also outperformed mid-cap Growth universally. Image Bottom Line: Value is extremely cheap and the rebound from an extremely oversold condition has been supported by the relative earnings trend and a rise in interest rates. Yet the mixed bag of sector exposure makes the Value/Growth allocation inferior to sector allocation. Investors who want to focus on Growth are advised to look for Quality outside of the US and Australia. Conclusions Related Report  Global Asset AllocationValue? Growth? It Really Depends! The US-centric factor research and media coverage have masked an underlying divergence of factor premiums in specific countries/regions. Factor premiums in the UK, EMU, Canada, and EM have been stronger than in the US, while Japan and Australia have been weaker. This divergence can be explained by different sector exposures of the same factor, along with varying behaviors of the same sector in specific countries/regions. While factor investing is not dead, it may be less profitable to utilize in the US, Japan, and Australia. We suggest that global investors implement smart beta strategies on an individual country basis to better capture the factor premium in each country. Even though Quality, Min Vol and Momentum have been outperformers in the past 20 years, all factors have embedded cyclicality. We do not advocate factor timing and reiterate our long-standing approach of equally weighting the five factors to smooth out the cyclicality of individual factors. Value/Growth is a popular style split; however, it is an inferior framework to sector positioning. In addition, Quality is a better factor than Growth, which is already included in our five-factor approach.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1      Please see "Quant Hedge Fund Icon AQR Cuts Back as Investors Exit," Chief Investment Officer, dated November 15, 2021. 2     Please see "MSCI Diversified Multiple-Factorindexes Methodology," MSCI.com, dated May 2018. 3     Please see "Anomalies across the globe: Once public, no longer existent?" Journal of Financial Economics, Volume 135, Issue 1, January 2020, Pages 213-230. 4    Historical data for all MSCI factor indexes in major markets is available for this period 5    Since Jan 2013 based on MSCI data availability. 6     Jessica Hamlin, "AQR Posts Record Performance in January," Institutional Investor, dated February 9, 2022.

Dear client, This week we are sending you a joint Special Report with my colleague Chester Ntonifor, Foreign Exchange Strategist. The Special Report provides our outlook on the RMB. I trust that you will find the report very insightful. Best regards, Jing Sima China Strategist Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. That said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Failure Of Iran Deal Tightens Oil Supply Failure Of Iran Deal Tights Oil Supply Failure Of Iran Deal Tights Oil Supply The US and Iran suspended their attempt to negotiate a nuclear deal on March 11. Countries often get cold feet before major agreements but there are good reasons to believe this suspension will be permanent. A confirmed failure to restore the US-Iran strategic détente will lead to Middle Eastern instability. Iran will be on a trajectory to achieve nuclear weapons in a few years while Israel and the US will have to underscore their red lines against weaponization. The Strait of Hormuz will come under threat again. The immediate impact on oil prices should be positive: sanctions will continue to hinder Iran’s exports, while Iranian conflict with its neighbors will sharply increase the odds of oil disruptions caused by militant actions. Not to mention the Russia-induced energy supply shock. However, a decisive move by the Gulf Arab states to boost crude production would counteract the effect of Iranian sanctions and drive oil down. The Gulf Arabs will be more inclined to coordinate with the Biden administration as long as the Iran deal is ruled out. Thus oil volatility is the main implication beyond any short term oil spike.     Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 36.8% Bottom Line: Go long US equities relative to global; long US and Canadian stocks versus Saudi and UAE stocks. Stay long XOP ETF, S&P GSCI index, and COMT ETF for exposure to oil prices and backwardation in oil forward curves. Feature The current Iran talks would have restored Joint Comprehensive Plan of Action (JCPA), which created a strategic détente between the US and Iran. Iran froze its nuclear program while the US lifted sanctions. President Barack Obama negotiated the deal in 2015, without congressional approval, while President Donald Trump nullified it in 2018, arguing that it did not restrict Iran’s ballistic missile development or support for regional militant groups. Chart 1Bull Market In Iran Tensions Will Be Super-Charged Bull Market In Iran Tensions Will Be Super-Charged Bull Market In Iran Tensions Will Be Super-Charged Since then there has been a bull market in Iran tensions (Chart 1), a secret war in which sporadic militant attacks, assassinations, and acts of sabotage occurred but neither side pursued open confrontation. These attacks can be significant, as with the Iran-backed attack on the Abqaiq refinery in Saudi Arabia, which took 6mm b/d of oil-processing capacity offline briefly in September 2019. The implication of this trend is energy supply disruption. Now the trend will be super-charged in the context of a global energy shortage. If no US-Iran détente is achieved, the Middle East will be set on a new trajectory of conflict, or at least a nuclear arms race and aggressive containment strategy. Since Trump turned away from the US-Iran détente and reimposed sanctions on Iran we have given a 40% chance of large-scale military conflict, according to our June 2019 decision tree (Diagram 1). The basis for such a conflict is Iran’s likelihood of obtaining nuclear arms and the need of Israel, its Arab neighbors, and the US to prevent that from happening. Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree US-Iran Talks Break Down US-Iran Talks Break Down Between now and then, tit-for-tat military exchanges will increase, posing risks to oil supply in the short and medium run. Without a major diplomatic breakthrough that halts Iran’s nuclear weaponization, a bombing campaign against Iran will be the likeliest long-term consequence, due to the fateful logic of Israel’s strategic predicament (Diagram 2). Diagram 2Over Medium Term, Unilateral Israeli Military Action Is Possible US-Iran Talks Break Down US-Iran Talks Break Down Why Rejoining The US-Iran Deal Was Unlikely Under the Biden administration’s new plan, Iran would have frozen its nuclear program once again while Biden would have relaxed US “maximum pressure” sanctions on Iran, opening the way for foreign investment and the development of Iran’s energy sector and economy. The basis for a deal was the belief among some US policymakers that engagement with Iran would open up its economy, reducing regional war risks (especially in Iraq), expanding global energy supply, and fomenting pro-democratic sentiment in Iran. Also the Washington military-industrial complex wanted to reduce the US’s commitment to the Middle East and arrange a grand strategic “pivot to Asia” so as to counter the rise of China. Up till August 2021, we viewed a deal as likely, but that view changed when Iran’s hawkish or hardline faction came back into the presidency. Biden had a very small window of opportunity to negotiate with outgoing Iranian President Hassan Rouhani, who negotiated the original 2015 deal and whose administration fell apart after President Trump withdrew from the deal. When the hawkish Iranian faction took back power, this opportunity slipped. Iran’s hawks were vindicated for having opposed détente with the US in the first place. Since then we have argued that strategic tensions would escalate, for the following reasons: The Iranians could not trust the Americans, since they knew that any new deal could be torn up as early as January 20, 2025 if the Republican Party took back the White House. Indeed, former Vice President Mike Pence recently confirmed this view explicitly. The Iranians were not compelled to agree to the deal because high oil prices ensured that they could export oil regardless of US sanctions (Chart 2). The US no longer has the diplomatic credibility to galvanize a coalition that includes the Russians and Chinese to isolate Iran, like it did back in 2014-15. Chart 2Iranians Not Compelled To A Deal, Can Circumvent Sanctions Iranians Not Compelled To A Deal, Can Circumvent Sanctions Iranians Not Compelled To A Deal, Can Circumvent Sanctions As for Iran’s weak economy spurring social unrest and forcing Supreme Leader Ayatollah Ali Khamenei to agree to a deal, the US has had maximum pressure sanctions in place since 2019 and it has not produced that effect. Yes, Iran is ripe for social unrest, but the regime is consolidating power under the hardliners rather than taking any risky course of opening up and reform that could foment pro-democratic and pro-western demands for change. With oil revenues flowing in, the regime will be more capable of suppressing domestic opposition. The Americans could not trust the Iranians because they knew that they would ultimately pursue nuclear weapons regardless of any short-term revival of the 2015 deal. The Iranians have a stark choice between North Korea, which achieved nuclear weaponization and now has a powerful guarantee of future regime survival, and countries like Ukraine and Libya, which gave up nuclear weapons or programs only to be invaded by foreign armies. Moreover the Iranian nuclear deal lacked popular support, even among Obama Democrats back in 2015, not to mention today in the wake of the deal’s cancellation. The deal’s provisions would have begun expiring in 2025 under any conditions. The Israelis and Gulf Arabs opposed the deal. The Russians also switched to opposing the deal and made new demands at the last minute as a result of the US sanctions imposed on Russia in the wake of its invasion of Ukraine. The Russians do not have an interest in Iran obtaining a nuclear weapon and they supported the 2015 deal and the 2021-22 renegotiation while demanding their pound of flesh in the form of Ukraine. But they also know that Israel and the US will use military force to prevent Iran from getting the bomb, so they are not compelled to join any agreement. Crippling US sanctions over Ukraine likely caused them to interfere with the deal. Our pessimistic view is now confirmed, with the suspension of talks. True, informal talks will continue, diplomacy could somehow revive, and it is still possible for a deal to come together. But given our fundamental points above, we would give any durable diplomatic solution a low probability, say 5%. That means that the US and Iran will not engage, which means Iran will re-activate its regional militant proxies and begin pursuing nuclear weaponization. Iran has a powerful incentive to increase regime security before the dangerous leadership succession that looms over the nearly 83 year-old Khamenei and the threatening possibility of a Republican’s reelection in 2024. At present, it is unknown which side of the Iran nuclear deal talks suspended them. While the Iranians were not compelled by an international coalition to join the deal as they were in 2015, we cannot ignore the possibility the suspension in talks arises from a deal being reached between the US and core OPEC 2.0 producers (Saudi Arabia, the UAE, and Kuwait). Very simply, such a deal would entail that the Arab states increase output, to ease the global shortage, in return for the US walking away from the flawed Iran deal and pledging to work with Israel and the Gulf Arabs to contain Iran. Israel and the Gulf Arabs are increasingly aligned in their goal of countering Iran under the Abraham Accords, negotiated in 2020 by the Trump administration. If the US and Gulf states agreed, then the Gulf states are likely to increase production to ease the global shortage and prolong the business cycle, meaning that oil prices could fall rather than rise as their next move. Either way they will remain volatile as a result of global developments. What Next? Escalation In The Middle East The Iranians have made substantial nuclear progress since 2018, despite Israeli attempts at sabotaging critical facilities. Today Iran stands on the brink of achieving “breakout” levels of highly enriched uranium – levels at which it is possible to construct a nuclear device (Table 1). Table 1Iran Will Reach ‘Breakout’ Nuclear Capability US-Iran Talks Break Down US-Iran Talks Break Down The suspension of talks means the Iranians will soon reach breakout capacity, which will splash across global headlines. This news will rattle global financial markets as it will point to a nuclear arms race in the most volatile of regions. There is a gap of one-to-two years between breakout uranium enrichment and deliverable nuclear weapon, according to most experts.1 However, it is much easier to monitor nuclear programs than missile programs, which means western intelligence will lose visibility when it comes to knowing precisely when Iran will obtain a functional nuclear warhead that it can mount on a ballistic missile. The Iranians are skillful at ballistic missiles. The clock will start ticking once nuclear breakout is achieved and the Israelis and Americans will be forced to respond by underscoring their red line against weaponization. Starting right away, Israel and the US will need to demonstrate publicly that they have a “military option” to prevent Iran from achieving nuclear weaponization. They will refrain from immediate military action but will seek to re-establish a credible threat through shows of force. They will also redouble their efforts to use special operations and cyber attacks to set back the Iranian programs. The Iranians will seek to deter them from attacking and will want to highlight the negative consequences. The US-Iran talks were not only about the nuclear program but also about a broader strategic détente. The Iranians will no longer rein in their regional militant proxies, whether the militias in Iraq or the Houthis in Yemen or Hezbollah in Lebanon. In effect we are now looking at a major escalation of militant attacks in the Middle East at a time when oil is already soaring. In many cases the express intent of the Iran-backed groups will be to threaten oil supply to demonstrate the leverage that they have to intimidate the US and its allies and discourage them from applying too much pressure too quickly. Bottom Line: On top of the current oil shock, we are about to have a higher risk premium injected into oil from Middle Eastern proxy conflict involving Iran. If OPEC does not act quickly to boost production then financial markets face additional commodity price pressures, on top of the existing Russia-induced supply shock. Commodity And Energy Implications Our Commodity & Energy Strategist, Bob Ryan, outlines the following implications for the oil market: In BCA Research's oil supply-demand balances, while we recognized the Geopolitical Strategy view that the US-Iran deal would not materialize, nevertheless we assumed that Iran would return up to 1.3mm b/d of production by 2H22, which would have been available for export markets. This would have given a significant boost to oil supply as the market continues to tighten. Chart 3Failure Of Iran Deal Tights Oil Supply Failure Of Iran Deal Tights Oil Supply Failure Of Iran Deal Tights Oil Supply The failure of these barrels to return to the market will result in an oil-price increase of about $15/bbl in 2023, based on our modeling (Chart 3). We can expect backwardations to increase in Brent and WTI, as demand for precautionary inventories increases. The modelled prices include the oil risk premium of ~USD 9/bbl in H2 2022 and USD 5/bbl in 2023. Relative to 2021, we expect core- OPEC - KSA, UAE and Kuwait – and total US crude supply to increase by 1.7 mmb/d and 0.65 mmb/d respectively in 2022. Compared to 2022, core-OPEC supply will level off in 2023, and will increase by 0.6 mmb/d for total US. If the US has a deal with core OPEC, then, based on the reference production levels agreed by OPEC 2.0 in July 2021, core OPEC’s production capacity could cover a large bit of the volumes markets are short (Table 2). This is due to lower monthly additions of output that was supposed to be returned to markets – now above 1mm b/d – and the lost Iranian output (Table 2). Table 2OPEC 2.0 Reference Production Levels US-Iran Talks Break Down US-Iran Talks Break Down Per the OPEC 2.0 reference production schedule released following the July 2021 meeting in Vienna, Saudi Arabia’s output is free to go to 11.5mm b/d by May, the UAE's to 3.5mm b/d, and Kuwait's to just under 3mm b/d. Iraq also could raise output, but its output is variable and it will lie at the center of the new escalation in military tensions, so we do not count it as core OPEC 2.0 production. Assuming these numbers are consistent with actual capacity for core OPEC 2.0, that means Saudi Arabia could lift production by ~ 1.1mm b/d, UAE by ~ 0.5m b/d, and Kuwait by close to 0.3mm b/d. That’s almost 2mm b/d. These reference-production levels might be on the high side of what core OPEC 2.0 is able or willing to do. But they would be close to covering most of the deficit resulting from less-than-anticipated return of 400k b/d from OPEC 2.0 producers beginning last August ( ~ 1.2mm b/d). Most of Iran’s lost output also would be covered. More than likely, these barrels will find their way to market "under the radar" (i.e., smuggled out of Iran) over the next year or so. This was one reason our geopolitical strategists did not view Iran as sufficiently pressured to sign a deal. US shale-oil output will be increasing above the 0.9 mm b/d that we forecast last month for 2022, and the 0.5mm b/d we expect next year, given the sharp price rally prompted by the Russian invasion of Ukraine. Our Commodity & Energy Strategy service will be updating our estimate next week when we publish new supply-demand balances and price forecasts. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Over time, a significant share of these displaced Russian barrels will find their way to China, and the volumes being displaced will be re-routed to other Asian and western buyers. Investment Takeaways One of our key geopolitical views for 2022 is that oil producers have enormous strategic leverage, specifically Russia and Iran. The Ukraine war and now the suspension of US-Iran détente bears out this view. It is highly destabilizing for global politics and economy. One of our five black swans for 2022 is that Israel could attack Iran – this is a black swan because it is highly unlikely on such a short time frame. However, if the US-Iran deal cannot be salvaged, then the clock is ticking to a time when Israel and/or the US will have to decide whether to prevent Iran from going nuclear or instead choose containment strategy as with North Korea. Yet the Iran dilemma is less stable than the Korean dilemma because the Israelis are committed to preventing weaponization. The Israelis will not act unilaterally until the last possible moment, when all other options to prevent weaponization are exhausted, as the operation would be extremely difficult and they need American military assistance. If diplomacy fails on Iran, the two options for the future are a major war or a nuclear arms race in the Middle East. The latter would involve an aggressive containment strategy. The global economy faces a major new risk to energy supply as a result of this material increase in Middle East tensions. A stagflationary outcome is much more likely. Europe’s energy security will be far more vulnerable now as it tries to diversify away from Russia but faces a more volatile Middle East (Chart 4). Undoubtedly Russia and Iran recognize their tremendous leverage. China, India, and other resource imports face a larger energy shock if the Gulf Arabs do not boost production promptly. They certainly face greater volatility. China’s policy support for the economy will remain lackluster in an environment in which inflation continues to threaten economic stability. China’s internal stability was already at risk and now it will have to scramble to secure energy supplies amid a global price shock and looming Middle Eastern instability. China has no choice but to accept Russia’s decision to cut ties with the West and lash itself to China as a strategic ally for the foreseeable future (Chart 5). Chart 4The EU’s Two-Pronged Energy Insecurity US-Iran Talks Break Down US-Iran Talks Break Down ​​​​​ Chart 5China's Energy Insecurity China's Energy Insecurity China's Energy Insecurity ​​​​​ Chart 6AGo Long US And Canada / Short Saudi And UAE Go Long US And Canada / Short Saudi And UAE Go Long US And Canada / Short Saudi And UAE ​​​​​ Chart 6BGo Long US And Canada / Short Saudi And UAE Go Long US And Canada / Short Saudi And UAE Go Long US And Canada / Short Saudi And UAE ​​​​​ Geopolitical Strategy recommends investors go long US equities relative to global equities on a strategic basis. We also recommend long US / short UAE equities and long Canadian / short Saudi equities (Charts 6A and 6B). Chart 7Worst Case Oil Risk In Historical Context US-Iran Talks Break Down US-Iran Talks Break Down Unlike Ukraine, the onset of a new Middle East crisis may not come with “shock and awe.” Weeks or months may pass before Iran reaches nuclear breakout. But make no mistake, if diplomacy fails, Iran will ignite a nuclear race and activate its militant proxies, while its enemies will increase sabotage, rattle sabers, and review military options. The Iranians will not be afraid to threaten the Strait of Hormuz, their other nuclear option (Chart 7). A total blockage of Hormuz is not by any means imminent. But war becomes more likely if Iran achieves nuclear breakout and diplomacy continues to fail.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1      See Ariel Eli Levite, “Can a Credible Nuclear Breakout Time With Iran Be Restored?” Carnegie Endowment for International Peace, June 24, 2021, carnegieendowment.org. See also Simon Henderson, “Iranian Nuclear Breakout: What It Is and How to Calculate It,” Washington Institute for Near East Policy, Policy Watch 3457, March 24, 2021, washingtoninstitute.org.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB And Real Interest Rates The RMB has overshot and will likely consolidate gains in the coming months. The said, the yuan remains underpinned by a current account surplus, positive real rates, and a valuation cushion. This will support modest appreciation over the next 12-18 months (Feature Chart). The dollar is likely to enter a period of weakness beyond the Russo-Ukrainian crisis, underpinning a firm RMB. Yield spreads between China and the US will narrow across the bond curve, slowing the pace of any RMB appreciation. In its quest to dominate Asian trade flows, China will also seek a stable yuan which can be an anchor for regional currencies. Low volatility in the Chinese bond and currency market will increasingly make it an attractive hedge for global portfolio managers. This will encourage RMB inflows. The financial sanctions on Russia from the ongoing Ukrainian conflict will accelerate Chinese diversification from US assets. It will also boost the use of RMB in global trade, lifting its share in global FX reserves. Bottom Line: In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been frontloaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Feature The RMB has been strong across the board versus most major currencies (Chart 1). Year-to-date, the DXY dollar index is up 2% while the CFETS basket is up 3%. This places the Chinese yuan as one of the best performing major currencies this year. Such a configuration where USD/CNY diverges from the broad dollar trend has been very rare in recent history (Chart 2). More importantly, this has occurred amidst very low volatility. Chart 1A Bull Market In Yuans A Bull Market In Yuans A Bull Market In Yuans Chart 2USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge USD/CNY And The Dollar Diverge In this Special Report, we try to understand the driving forces behind a rising RMB, to gauge its likely path going forward. In our view, while the yuan is vulnerable tactically, it is underpinned by strong structural forces that support modest appreciation over the next 12-18 months. The Chinese Economy, Interest Rates, And The RMB An exchange rate is simply a mechanism to equalize rates of returns across countries. For most currencies, the key determinants of this arbitrage window are real interest rate differentials. In China, while nominal interest rates vis-à-vis the US have been collapsing, real interest rate differentials are near a record high. This has been the key driver of a rising RMB (Chart 3). Real interest rates tend to matter because high and rising inflation destroys the purchasing power of any currency. Our bias is that higher real rates in China versus the US will persist and keep the RMB firm. Five key reasons underpin this view: The Chinese economy is expected to accelerate this year relative to the US. The IMF expects 4.8% GDP growth in China, versus 4% in the US. Bloomberg consensus estimates corroborate this view – 5.2% growth is expected for China this year, versus 3.6% for the US. Even the Chinese government’s GDP growth target this year is 5.5%, much higher than street estimates. US interest rates are likely to rise over the medium term, but so will those in China. The Chinese credit impulse has bottomed, and it is usually a good precursor to both stronger economic activity and higher relative government bond yields (Chart 4). Chart 3The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates The RMB And Real Versus Nominal Rates Chart 4Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse Interest Rate Differentials And The Credit Impulse While Chinese productivity growth is slowing, it remains structurally higher compared to that in the US or Europe. Stronger productivity growth suggests the neutral rate of interest in China will remain higher than in Western economies for years to come. This will continue to attract further fixed-income inflows. The RMB is a procyclical currency and tends to benefit when flows into emerging market assets in general, and Chinese stocks in particular, are fervent. While the Chinese authorities have cracked down on the property and information technology/communication service sectors, they have done so without causing widespread capital flight and hurting the RMB (Chart 5). Going forward, odds are that the interest from foreign bargain hunters will rise as these sectors reset from lower and much cheaper levels. It is well known that the Chinese economy has excess capacity, which is inherently deflationary (and positive for real rates). Like Japan, China has excess savings and deficient demand (Chart 6). However, in an inflationary world, this excess capacity can easily be exported, especially to the US, which is on the verge of overheating. A healthy trade balance in China suggests there is little reason for the RMB to depreciate meaningfully. Chart 6Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Excess Savings In China And Low Inflation Chart 5The RMB And Chinese Equities The RMB And Chinese Equities The RMB And Chinese Equities It is remarkable that despite being the largest commodity importer in the world, terms of trade in China is picking up. Rising terms of trade is usually synonymous with a stronger currency. On the flip side, a stronger currency will also temper inflationary pressures in China (Chart 7). Chart 7The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The RMB, Terms Of Trade And Inflation The bottom line is that real interest rates will remain relatively high in China, even as the US begins to tighten monetary policy while China eases. The reason is that the US economy is much more inflationary, and Chinese bond yields tend to rise when the PBoC stimulates growth. Market Liberalization And Portfolio Flows With attractive real yields, Chinese bonds have been gaining widespread investor appeal. Their inclusion in the world’s three major bond indices has been a seminal milestone in the process of liberalizing the Chinese fixed-income market. Chinese bonds have also acted as perfect portfolio hedges, moving inversely to US and global equities (Chart 8). The result has been significant portfolio inflows into Chinese bonds. As a reminder, Chinese bonds were initially included in the Bloomberg Barclays Global Aggregate Index (BBGA) in April 2019. Following that, they were added to the JP Morgan Government Bond - Emerging Market Index (GBI-EM) in February 2020. Finally, FTSE Russell announced their inclusion of in the FTSE World Government Bond Index (WGBI) as of October 2021. Since their inclusion, a net US$350 billion has flowed into Chinese bonds. We estimate that about 35% of that has been due to index inclusion. The amount of Chinese onshore bonds held by overseas investors has breached US$600 billion, a record high (Chart 9). Chart 9A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors A Healthy Appetite From Foreign Investors Chart 8RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge RMB Bonds As A Portfolio Hedge In a nutshell, the path of the RMB in the short term will follow relative growth dynamics between China and the rest of the world, but structural factors such the inclusion of RMB bonds in global portfolios will underpin strong inflows into the Chinese fixed-income market. The Dollar, Trade, And Lessons From The Ukrainian Conflict Chart 10China Is Destocking USDs China Is Destocking USDs China Is Destocking USDs Another factor to consider vis-à-vis the RMB is the dollar’s reserve status, and the overreach that it commands. Quite simply, transactions conducted in US dollars anywhere fall under US law. This means that if a company in any country buys energy from Iran and the transaction is done in US dollars, the Treasury has powers to sanction the parties involved. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to near 0% of total reserves. Even so, the world has witnessed how vulnerable the Russian economy has been to a cut-off from the Society For Worldwide Interbank Financial Telecommunication (SWIFT) messaging system. China is the largest holder of US Treasurys and what it decides to do with this war chest of savings is of critical importance. At a minimum, a few trends that have been underway in recent years are likely to accelerate. China will continue to destock its holding of Treasurys into gold and other currencies (Chart 10). This will put downward pressure on the dollar and boost the RMB. In fact, ever since China started destocking Treasurys in earnest in 2015, the DXY has been unable to sustainably punch through the 100 level. Trade flows in Asia remain rather buoyant, even as globalization has peaked (Chart 11A and 11B). With most Asian countries having China as a large trading partner, the logical step will be more and more invoicing in RMB. Most global trade hubs in history (such as Hong Kong for example) have always sought a stable currency with low volatility to instill confidence in trade. China is likely to also favor a stable RMB. Chart 11AChina Could Dominate Asian Trade China Could Dominate Asian Trade China Could Dominate Asian Trade Chart 11BAsian Trade Is Booming What Next For The RMB? What Next For The RMB? As Asian trade continues to expand, the PBoC can step in as the regional central bank and lender of last resort. It is notable that China is already engaging in this role. Since the global financial crisis, the number of bilateral swap lines offered to foreign central banks by the PBoC has ballooned (Chart 12). According to the most recent data (from the PBoC), the Chinese central bank had bilateral local currency swap agreements with central banks or monetary authorities in 40 countries and regions, with a total amount of around 4 trillion yuan. The People’s Bank of China has massive foreign exchange reserves, worth about US$3.2 trillion. This means it can provide swap agreements that will almost cover the totality of EM foreign dollar debt. The Cross-Border Interbank Payment System (CIPS) already allows the transfer and clearing of yuan-denominated payments. In 2021, the system processed US$12.7 trillion, a 75% increase in turnover from the previous year.1 While the system still largely relies on SWIFT messaging for most cross-border transactions, progress towards independence is moving fast. The key point is that as China continues to rise as an economic power and increases the share of RMB trade within its sphere of influence, the yuan will naturally become the de facto Asian currency. This will allow the RMB to continue to gain international appeal (Chart 13). Chart 12The People's Bank Of Asia? What Next For The RMB? What Next For The RMB? Chart 13The RMB And International Appeal The RMB And International Appeal The RMB And International Appeal Valuation Concerns Most of the discussion above has focused on the cyclical outlook for the Chinese economy and bond yields, as well as the geopolitical ramifications from the Russo-Ukrainian conflict. While the macro environment is by far the most important driver of currencies, valuation and sentiment tend to matter as well. On this note: Our productivity model suggests the RMB is at fair value. Productivity in China remains higher than among its western trading partners, but the gap has been closing. This has flattened the slope of the fair-value model (Chart 14). That said, the US and Europe are generating much higher inflation than China, suggesting there is higher pressure for unit labor costs to rise in these countries. This will improve the competitive profile of the RMB. Our PPP model for the RMB, using an apples-to-apples consumer basket vis-à-vis the US suggests the RMB is undervalued by 11% (Chart 15). Historically, such levels of undervaluation have seen the RMB appreciate by 2% per year over the next 4 years (Chart 16). Chart 14The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends The RMB Is At Fair Value Based On Productivity Trends Chart 15The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices The RMB Is Cheap Based On Relative Prices   Chart 16Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Potential RMB Returns For Foreign Investors Valuation tends to be important because it is usually the trigger for imbalances to manifest themselves. Back in 2015-20162  when Chinese capital outflows (especially illicit flows) were rampant amongst global and Chinese concerns, the RMB also happened to be very overvalued. Today, such a risk is much limited. Concluding Thoughts The RMB and the dollar tend to move in harmony, and so a discussion of one entails talking about the other. We have characterized the dollar this year as caught in a tug of war. Specifically, aggressive rate hikes by the Federal Reserve will boost interest rate differentials in favor of the US but undermine the equity market via a derating in stocks. This will tighten financial conditions, nudging the Fed to pivot. On the other hand, less accommodation by the Fed will significantly unwind the rate-driven rally that has nudged the DXY close to 100.  On the other hand, the Chinese credit impulse has bottomed meaning bond investors will benefit from rising bond yields in China. Equity investors will also benefit from a cheaper market, as well as exposure to sectors that are primed to benefit as the global economy reopens. This combination could sustain the pace of foreign capital inflows. In the near term, USD/CNY is due for a bounce and could retrace to 6.5. It is also the case that a lot of the gains in the Chinese RMB have been front loaded, suggesting a flattish path ahead. Beyond the near term, we expect the DXY to hit 90 in the next 12-18 months, which will boost the RMB towards 6.0. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Reuters: https://www.reuters.com/markets/europe/what-is-chinas-onshore-yuan-clearing-settlement-system-cips-2022-02-28/ 2 Please see Chinese Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at cis.bcaresearch.com Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders   Forecast Summary

Executive Summary Tight Inventories Spike Metals Commodities' Watershed Moment Commodities' Watershed Moment Russia's war against Ukraine is a watershed moment, which will realign production, distribution and consumption of commodities globally. The development of new sources of the critical metals desperately needed to build out renewable energy grids and the drive to secure access to oil, gas and coal will intensify along political lines. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Local politics will intrude on this process, as left-of-center governments in important commodity-producing states secure their electoral victories and claim greater shares of commodity revenues. The rebuilding of defense systems, particularly in Europe, will compete with the renewable-energy transition. This will stress already-tight metals markets, where low inventories will predispose markets to higher volatility a la this week's oil, natgas and nickel price spikes. This will retard economic growth. In the short term, CO2 emissions will surge. Longer term, the transition to net-zero carbon emissions by 2050 will be pushed back years, as states compete for access to commodities. East-West trade restrictions and hoarding of commodities secured via trade within these respective blocs, as is occurring presently, will increase. Bottom Line: Russia's war against Ukraine is a watershed moment.  The development of new sources of the critical metals desperately needed to build out renewable energy grids, and the drive to secure access to oil, gas and coal will intensify. China, reinforced by Russia, will lead the East, while the US and its allies will lead the West, in a redux of the Cold War. Feature Russia's war with Ukraine provoked a watershed moment for Europe: Leaders suddenly realized they had to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy generation and grid. This occurred as inventories of the basic commodities required to achieve all of these objectives were stretched so tight that the mere threat of the cutoff of pipeline natural gas was enough to send benchmark EU natgas prices to a record $113/MMBtu, up nearly 80% from the previous day's close before it settled back to still-elevated levels (Chart 1). Oil inventories also were stretched extremely thin even before Russia launched its invasion of Ukraine 24 February (Chart 2). The situation is not improving, since, in the wake of the Ukraine war, numerous refiners and trading companies now are observing self-imposed sanctions against taking any Russian oil or refined products. It is worthwhile remembering this began before the US and UK announced they would ban all imports of Russian material this week.1 This will stretch supply chains by unknow durations – the movement of crude from Russia to a refiner could take months instead of weeks, until new trade patterns are established. Chart 1Little Flex In EU Gas Inventories Commodities' Watershed Moment Commodities' Watershed Moment Chart 2Little Flex In EU Gas Inventories Little Flex In EU Gas Inventories Little Flex In EU Gas Inventories   Global economic and policy uncertainty is massively elevated, with percent changes in oil and gas prices swinging on a double-digit basis daily. This makes it extremely difficult to bid or offer oil cargoes in the physical market or make markets (i.e., bid or offer) in the futures markets, which has the effect of compounding uncertainty and volatility. Fundamentals – supply, demand and inventories – take a back seat to fear and uncertainty in such markets. This makes it virtually impossible to assign a probability to any price outcomes based on supply and demand – the true definition of uncertainty in the Frank Knight sense – and to make long-term capex decisions over the long term.2 We raised our 2022 and 2023 Brent forecasts on the back of the massive uncertainty in the markets to $90/bbl and $85/bbl, respectively, right after Russia's invasion of Ukraine. We assume 1Q22 Brent will average $100/bbl. We expect core OPEC 2.0 producers – Saudi Arabia, UAE and Kuwait – will increase production beginning in 2Q22; US shale-oil output will rise, and ~ 1.2mm b/d of Iranian production will return to market in 2H22. Among the risks to our forecasts are a failure by core OPEC 2.0 to lift output (we expect an announcement at the end of this month when the producer coalition meets); lower-than-expected US shale output, and a failure to resolve the Iran nuclear deal with the US. Our modeling indicated these outcomes could lift Brent to between $120/bbl and $140/bbl by 2023 (Chart 3). We will be updating our forecasts next week.3 Chart 3Brent Forwards Lift Brent Forwards Lift Brent Forwards Lift EU's Watershed Metals Moment EU leadership is setting out to reverse decades of energy dependence on Russia, rebuild their militaries, and sustain a massive buildout of the continent's renewable-energy grid, all a result of the Ukraine war. This will require massive investment in metals mining and refining, along with steel-making capacity. Already, Germany is pledging to increase LNG import capacity and measures to reduce its dependence on Russian natural gas by 75% this year.4 The EU is looking to restore its natgas inventories to 90% of capacity before next winter, and has pledged to double down on renewables, in order to remove member-state dependence on Russian energy exports.5 These ambitious goals are up against the hard reality of scarce base metals supply globally. This will be exacerbated going forward by actions taken by and against Russia. The Russia-Ukraine crisis will destabilize metal markets, given supply uncertainty from Russia and its contribution to global supply. The commodities heavyweight constitutes 6%, 5% and 4% of global primary aluminum, refined nickel and copper production. Against the backdrop of very low global inventories in these metals (Chart 4), the prices of all three hit record highs over the last few days due to uncertain supply (Chart 5). LME nickel prices more than quadrupled on Tuesday as traders rushed to cover short positions and margin calls. Chart 4Low Inventories... Low Inventories... Low Inventories... Chart 5...Lead To Price Volatility ...Lead To Price Volatility ...Lead To Price Volatility Uncertainty has engulfed metal markets, with a Western ban on Russian metal imports still a possibility. Putin’s announcement regarding raw material export restrictions will further fuel supply uncertainty.6 As in the case of oil, private entities’ self-sanctioning, sanctions on the Russian financial system, and war-related supply chain disruptions are causing current Russian metal export disruptions.7 So far, Western sanctions on commodities have not directly interfered with metal flows from Russia. But markets are taking it day to day. Supply disruptions and sanctions force the formation of new trade patterns, as private entities aim to maximize arbitrage opportunities. For example, high European aluminum price spreads incentivized shipments from China, the world’s largest producer and consumer of refined aluminum. Normally, Europe relies on Russia for aluminum supplies. Rising European physical premiums for delivered metal, caused by Russian export disruptions, will see trading companies take advantage of arbitrage opportunities in other commodities as well. Europe's Risk Profile Rising Since the Ukraine war began, rising European physical premiums in commodities ranging from metals to natgas indicate the continent – more so than others – is particularly vulnerable to Russian export disruptions. Europe’s reliance on Russian energy and its supply disruptions will raise operating costs for smelters and refiners on the continent, threatening smelter shutdowns similar to those we saw this past winter. Markets were expecting power price relief over the warmer months and higher smelting activity. Elevated fuel and power prices, however, will constrain metals refining in Europe, and could shut or close even more smelters, keeping refined metals supply scarce and prices high. Rebuilding Europe's Defenses EU leaders are scheduled to take up a new energy and defense funding proposal today, which media reports are describing as "massive" (no detail provided ahead of the meeting, of course). This program reportedly will be akin to the EU's $2 trillion COVID-relief fund.8 The EU's fast response to defense shortfalls comes against the backdrop discussed above regarding super-tight metals markets, which now face a further complication of unpredictable local politics in metals-producing states. Some of these states have voted left-of-center governments into office, which now appear to be intent on nationalizing mining operations.9 Chile, e.g., accounts for ~ 30% of global copper ore output, and is in the process of re-writing its constitution, which will change tax and royalty law, and could pave the way for nationalization of copper and lithium mines. This political risk compounds any long-term planning operations by consumers like the EU and producers. Investment Implications Energy markets – broadly defined to include oil, gas and coal along with the base metals required for renewables and their supporting grids and electric vehicles – are being rocked by Russia's war with Ukraine. Base metals, in particular, will have to find price levels that destroy demand among competing uses, if the EU's dual-track plan to build out its renewables generation and restore a military capability is approved. A "massive" funding effort in Europe, coupled with equally massive efforts in the US and China – both intent on building out their renewable generation and grids, as well as expanding their defensive capabilities – will be extremely difficult to pull off. Critical base metals inventories remain low, and prices are high because demand exceeds supply for the foreseeable future (Chart 6). Chart 6Tight Inventories Spike Metals Commodities' Watershed Moment Commodities' Watershed Moment The EU will join a world in which the other two great economic centers – the US and China – will engage in a geopolitical competition over access to and control of scarce base metals, oil, gas and coal resources. Russia will remain aggressive toward the West, at least until the Putin regime falls, and will play an ancillary role to China. Fossil fuels and base metals have been starved for capex for more than a decade. Governmental pronouncements will not reverse this. These markets will remain tight, and will get tighter in order to allocate increasingly scarce supply with rapidly growing demand. As such, we remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF, and the XME and PICK ETFs to retain exposure to base metals and bulks producers and traders.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Footnotes 1     Please see Russian tankers at sea despite ‘big unknown’ over who will buy oil, published by ft.com on March 7, 2022. 2     Please see Explained: Knightian uncertainty, published by mit.edu for discussion. 3    Please see Oil Risk Premium Abates, But Still Remains, which we published on February 25, 2022. 4    Please see Germany Revives LNG Import Plans to Cut Reliance on Russian Natural Gas in Marked Policy Shift, published by naturalgasintel.com on March 1, 2022. 5    Please see Climate change: EU unveils plan to end reliance on Russian gas, published by bbc.co.uk on March 8, 2022, and The EU plan to drastically ramp renewables to replace Russian gas, published by pv-magazine.com on March 9, 2022. 6    Please see Russia to Omit Raw Material Exports but Omits Details, published by Bloomberg on March 9, 2022. 7     Please see here for Which companies have stopped doing business with Russia? 8    Please see Ukraine: ECB governing council to meet as crisis intensifies, published on March 8, 2022 by greencentralbanking.com. 9    Please see Chile a step closer to nationalizing copper and lithium, published by mining.com on March 7, 2022, and Add Local Politics To Copper Supply Risks, which we published on November 25, 2021.   Investment Views and Themes Recommendations Strategic Recommendations

Executive Summary US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks ​​​​​​ The most recent examples of geopolitical and commodity price shocks similar the current one include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990 (Chart of the week). Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. As for commodity prices, the only thing that is certain in the next couple of months is that volatility will remain very elevated. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. This will keep geopolitical tension elevated.   Bottom Line: The drawdown in global and EM stocks in not over yet. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Feature Chart 1US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks US Equity Drawdowns During Geopolitical Crises/Commodity Shocks The world is experiencing geopolitical and commodity price shocks that have not been seen in over a generation. The most recent examples of this kind of shock include the Cuban missile crisis in 1962, the oil embargo of 1973 in response to the Yom Kippur War as well as the Gulf War of 1990. Chart 1 illustrates the current trajectory of the S&P 500 with selloffs that occurred during those three episodes. The magnitude of the S&P 500 selloff was 28% in 1962, 23% in 1973 and 20% in 1990. The S&P 500 is down only 11% from its peak. Based on the above three profiles, the current selloff in US stocks has further to go. This also means that non-US equities, including EM, will continue to suffer. What are the conditions needed for global stocks to bottom? In our opinion, a durable bottom in share prices will occur when measures of capitulation in equity markets reach their previous lows, commodity prices (particularly crude prices) decline and geopolitical tensions peak. We elaborate on each below. Equity Capitulation Neither of our capitulation indicators for the S&P 500 or for EM stocks have reached their previous lows. Chart 2 displays our capitulation indicator for US equities. Its construction is based on four equal-weighted components: the composite momentum indicator, the US equity sentiment indicator, industry group breadth and the advance-decline line (shown individually in Chart 7-8 below). Chart 2US Stocks Have Not Reached Their Selling Climax US Stocks Have Not Reached Their Selling Climax US Stocks Have Not Reached Their Selling Climax This indicator has not reached its lows of 2010, 2011, 2018 and 2020. In 2011 and 2018, the S&P500 selloffs were 19.5% and 19.8%, respectively. Hence, our best guess for the magnitude of an equity drawdown in this selloff is about 20%. This puts the potential S&P500 low at 3600-3700. The latter is consistent with the technical support (3-year moving average) that held up in 2011, 2016 and 2018 (Chart 2, top panel).  Chart 3 illustrates our EM equity capitulation indicator. Its four equal-weighted components are the composite momentum indicator, EM equity sentiment, industry group breadth and net EPS revisions (shown individually in Chart 9-10 below). We believe that EM share prices will drop until this capitulation indicator comes to the levels reached in the 2011, 2013 and 2018 selloffs. Chart 3The EM Equity Capitulation Has Further To Run The EM Equity Capitulation Has Further To Run The EM Equity Capitulation Has Further To Run Concerning the magnitude of further EM equity selloff, the next technical defense line for the MSCI EM stock index in USD is 10%, or in the worst-case scenario, 25% below current levels (Chart 3, top panel). The Commodity Shock Global share prices have become negatively correlated with commodity (primarily oil) prices and such an inverse relationship will likely persist for now. In fact, an important signal of the bottom in the S&P 500 during the 1990 oil spike was the peak in crude prices (the latter is shown inverted in Chart 4). In the case of the oil embargo of 1973-74, the oil market was not developed, and US share prices were negatively correlated with US 10-year Treasury yields (Chart 5). Chart 4The 1990 Oil Shock The 1990 Oil Shock The 1990 Oil Shock Chart 5The 1973 Oil Shock The 1973 Oil Shock The 1973 Oil Shock   Presently, given that US stocks were reacting negatively to rising US bond yields prior to the Ukraine crisis, it is reasonable to expect American share prices to bottom only when two conditions are satisfied: (1) oil prices start falling on a sustainable basis and (2) US bond yields do not rise much. How much will oil and other commodity prices rise? It is hard to know because multiple forces are in play. First, Russia is the second largest commodity exporter in the world (after the US). Russia’s crude oil exports account for 8.4% of global crude consumption, natural gas exports for 5.9% of global consumption and 3.4% for coal (Table 1). Across metals, Russia is a large producer too – 35.6% for palladium, 4.4% for nickel and 4.2% for copper (Table 1).  In turn, Russia and Ukraine production together accounts for 14% of global wheat consumption. Table 1Russia’s Global Share In Various Commodities Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. This latter factor makes it nearly impossible to gauge just how much supply of each individual commodity will be curtailed. Assuming in the near term that a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel and fertilizer. While ratcheting sales of resources to China is a saving grace for Russia, it might take some time until shipments can be rerouted and reorganized. Second, the US is pressuring allied nations in the Gulf as well as other countries like Venezuela to produce and bring more oil to the market. Finally, the surge in commodity prices is probably already destroying demand. Oil and wheat prices have risen to record highs in many EM currencies (Chart 36 and 37 below). This will push inflation higher and herald more rate hikes from central banks. High interest rates along with tight fiscal policy and eroding discretionary spending (due to high energy and food prices) entail weak demand in developing economies. Bottom Line: In the very short run, risks to many commodity prices are skewed to the upside due to supply constraints. Yet, enormous uncertainty over factors driving their demand and supply makes prices over the next three months impossible to forecast. During this period, individual commodity prices might be driven by idiosyncratic factors. The only thing that is certain in the next couple of months is that volatility in commodity prices will remain very elevated. Price surges might be followed by large drawdowns and vice versa. Geopolitical Tensions The Kremlin will continue its military assault until it establishes firm control over Kyiv and the Black Sea coast, including the city of Odessa. As we wrote in our March 2 report, Putin’s objective is to install a very loyal government in Kyiv and to control the territory east of the Dniepr river. It is not clear to us whether the Kremlin has the appetite to control the Ukraine territory west of the Dniepr river. Western Ukraine has always been very anti-Russian and Putin might realize that it will be too costly to capture and control it. We do not think Putin has ambitions to go beyond Ukraine (Moldova being an exception). That said, there is no doubt that the Kremlin will be presenting more demands to NATO and threatening if those demands are not met. Having incurred considerable costs, Russia will push to maximize its gains and secure a new, more favorable agreement with NATO. It is not clear how many geopolitical concessions or what security guarantees the US is willing to provide to Russia. On the whole, geopolitical tensions between Russia and NATO/the US will continue until there is a new deal between the parties. Investment Strategy Chart 6No Trend Change In EM And US Relative Equity Performance No Trend Change In EM And US Relative Equity Performance No Trend Change In EM And US Relative Equity Performance The drawdown in global and EM stocks in not over yet. Within a global equity portfolio, we continue to recommend underweighting EM and Europe and overweighting the US. Interestingly, the EM relative equity performance versus the global stock index has rolled over at its 200-day moving average, while the US’s relative performance has found a support at its 200-day moving average (Chart 6). Such a technical configuration suggests that EM stocks will continue underperforming for now while US equities will have another upleg in relative terms. The US dollar has more upside in the near term. This is consistent with the S&P500 outperforming and EM stocks underperforming. A rising US dollar bodes ill for EM fixed-income markets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Components Of Our US Equity Capitulation Indicator Not all components of our US Equity Capitulation Indicator have reached their previous lows. Given the backdrop of still expensive US equity valuations, heightened geopolitical risks, very elevated inflation and high inflation expectations as well as the little maneuvering room that the Fed has, odds are that US share prices will drop further. Chart 7Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Chart 8Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our US Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Not all components of our EM Equity Capitulation Indicator have reached their previous lows either. The share of industry groups above their 200-day moving average, analysts’ net EPS revisions as well as the momentum and equity sentiment indicators remain above their lows. Further downside in EM share prices is likely. Chart 9Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Chart 10Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator Components Of Our EM Equity Capitulation Indicator US Stocks Have Not Yet Reached Their Selling Climax The NYSE’s advance/decline line has broken down and is dropping, signifying a broadening equity rout. Yet, we doubt the US equity indexes will bottom when 35% of NYSE listed stocks are above their 200-day moving average. Finally, the US median stock has broken below its 200-day moving average. Given the fundamental backdrop, all of these technical signposts point to a larger than 10% correction in the S&P 500. Chart 11US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 12US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 13US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Chart 14US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax US Stocks Have Not Yet Reached Their Selling Climax Global Overall And Global ex-US Equities Although Global ex-US stocks are much more oversold than US stocks, their growth and profit backdrops are worse. As we argued in the front section of this report (Chart 6 above), odds are that US stocks will continue outperforming non-US stocks in the near term. Despite crashing, European stocks might not have found a support yet. Chart 15Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 16Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 17Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Chart 18Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities Global Overall And Global ex-US Equities European Stocks: Is A Support At Hand? Investor sentiment on European stocks has become depressed. Yet, European economies will decelerate due to the energy shock (natural gas prices have shot up two-fold since October 1) as well as falling consumer and business confidence. A bottom for euro area stocks might be lower than current prices. Chart 19European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? Chart 20European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? Chart 21European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? European Stocks: Is A Support At Hand? EM Equities: Cheap But Mind The Profit Outlook According to our cyclically adjusted P/E ratio, EM stocks are slightly cheap in absolute terms and are very attractive versus US equities. However, this valuation indicator should be used by long-term investors. In the short run and even from a cyclical perspective, this valuation indicator is not very useful. Besides, investor sentiment on EM equities was neutral in the middle of February. It might take more weakness before bad news get priced in EM share prices. Chart 22EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook Chart 23EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook Chart 24EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Equities: Cheap But Mind The Profit Outlook EM Profits In A Soft Spot As projected by our EM narrow money (M1) aggregate, EM corporate earnings will continue to disappoint. This is the key risk to EM share prices. In fact, EM EPS has been broadly flat over the past 15 years. That is why EM stocks appear cheap. Plus, EM ex-TMT stocks have not yet fallen much and downside risks remain. Chart 25EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chart 26EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chart 27EM Profits In A Soft Spot EM Profits In A Soft Spot EM Profits In A Soft Spot Chinese Investable Stocks Are At Their March 2020 Lows Offshore and onshore Chinese shares prices have been falling hard. Not only have Chinese corporate profit expectations been downshifting but also Chinese Investable stocks have been derating (their multiples have been compressing). This has been due to foreign investors projecting/extrapolating the US-Russia confrontation to a possible future US-China geopolitical standoff, and therefore possible sanctions the West can impose on China. Chart 28Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 29Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 30Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chart 31Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows Chinese Investable Stocks Are At Their March 2020 Lows China: No "All-In" Stimulus Yet The improvement in China’s total social financing has been entirely due to local government bond issuance. Corporate and household credit have not improved at all. Consistently, traditional infrastructure investment has probably bottomed. Yet, outside this sector the outlook is uninspiring. Property construction remains at risk, consumer spending is very sluggish and private business sentiment is downbeat. Chart 32China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 33China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 34China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet Chart 35China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet China: No "All-In" Stimulus Yet EM Woes: Energy And Food Prices Many low-income developing countries will be suffering from elevated food and energy prices. Oil and wheat prices in EM currencies have surged to all-time highs. This will lift headline inflation in many emerging economies, lead to monetary tightening and reduce household income available for discretionary spending. All of these and the lack of fiscal easing in many developing countries entail growth disappointments this year. Chart 36EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 37EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 38EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices Chart 39EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Woes: Energy And Food Prices EM Credit Spreads Are Widening Rapidly EM sovereign and corporate spreads have broken out. Such spread widening is not simply due to Russian credit. The pace of spread widening differs among countries. However, directionally, credit spreads seem to have embarked on a widening path. In a nutshell, Chinese USD corporate in general and property bond prices in particular are tanking (see below). This foreshadows the poor outlook for Chinese housing. Chart 40EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 41EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 42EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly Chart 43EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Spreads Are Widening Rapidly EM Credit Markets And EM Equities Historically, rising EM corporate USD bond yields led to a selloff in EM share prices. This is the cost of capital that matters for EM equities. Unless EM sovereign and corporate bonds yields start falling on a sustainable basis, EM equities will continue to struggle. Chart 44EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Chart 45EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Chart 46EM Credit Markets And EM Equities EM Credit Markets And EM Equities EM Credit Markets And EM Equities Global Resource Stocks The relative performance of global energy and basic materials versus the global equity index has bottomed. In the medium term, odds are that TMT stocks will underperform while resource companies outperform. Yet, the outlook for energy stocks and basic materials in absolute terms is complicated (in line with the elevated volatility in commodity prices we discussed in the front section). Notably, even though commodity prices have skyrocketed, basic materials and energy share prices have not yet broken out. It seems the market is doubting the sustainability of high commodity prices. Chart 47Global Resource Stocks Global Resource Stocks Global Resource Stocks Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Equity Capitulation, A Commodity Shock And Geopolitics Footnotes