Emerging Markets

Highlights Global growth is peaking, but US growth is losing momentum relative to its peers. This has historically been negative for the greenback. Chinese monetary policy is no longer on a tightening path, and might ease going forward. As discounting mechanisms, cyclical currencies should outperform. Our bias is that non-US growth will outperform growth in the US over the next 12-18 months. This will lead to capital reallocation away from the US dollar. While US bond yields could rise towards 2%, real interest rates will remain low compared to history. Our recommendations remain the same: the DXY will struggle to punch above the 94-95 level, but will ultimately touch 80. Feature Chart I-1US Growth Momentum And The Dollar US Growth Momentum And The Dollar US Growth Momentum And The Dollar The DXY index is up for the year, but has twice failed to punch the 94 level. The first leg of the rally from January to March occurred within a context of rising global yields, led by the US. The second leg, starting in June was triggered by a perceived hawkish shift from the Federal Reserve. The common denominator for both legs of the rally was that US growth was outperforming growth in the rest of the world. But that is beginning to change. Bloomberg consensus forecasts show a sharp reversal in US growth momentum, relative to its peers (Chart I-1). Historically, this has put a firm ceiling on the greenback. Cycles And The US Dollar The dollar tends to fare worse early in the cycle when growth is rising but inflation is falling (Chart I-2). Admittedly, inflation prints in some developed markets like the US and Canada have been rather strong. But to the extent that these prints reflect transitory factors, it should allow global central banks to remain accommodative, supporting growth. The remarkable thing about Chart I-1 is that the rotation in growth from the US towards other countries has been broad based. Countries such as Canada, New Zealand, Brazil and Mexico are seeing a bottoming in growth momentum relative to the US (Chart I-3). Chart I-2The Dollar Fares Poorly Early In The Cycle Why The Ultimate Low In The Dollar Is Nigh Why The Ultimate Low In The Dollar Is Nigh Chart I-3A Rotation Of Growth From The US A Rotation Of Growth From The US A Rotation Of Growth From The US This bottoming in growth momentum is occurring at the same time as local central banks are becoming more orthodox about monetary policy. The Reserve Bank of New Zealand has ended quantitative easing. The Bank of Canada has cut asset purchases in half. Brazil, Mexico and Russia, among other emerging market countries are hiking interest rates. While it is true that inflation in some developed and emerging markets like Canada, the UK, Brazil and Russia is perking up, for most developed markets as a whole, inflation is actually surprising to the upside in the US (Chart I-4). China has been tightening policy amidst very low inflation. Currencies tend to be driven by real rates. A growth rotation away from the US, in addition to more orthodox monetary policies outside the US, will be negative for the greenback. Chart I-4US Relative Inflation And The Dollar US Relative Inflation And The Dollar US Relative Inflation And The Dollar What About Chinese Growth? Chinese growth expectations are still cratering relative to the US. The fiasco around the China Evergrande Group has also led to speculation that this could become a systemic event. For developed market currencies, especially those linked to China like the Australian dollar, this is a market-relevant event. Admittedly, offshore markets have started discounting a bigger depreciation in the RMB (Chart I-5). That said, the RMB has been rather resilient against the dollar suggesting that the risk of this becoming a systemic event is rather low (Chart I-6). Chart I-5The Evergrande Risk Is Not Yet Systemic The Evergrande Risk Is Not Yet Systemic The Evergrande Risk Is Not Yet Systemic Chart I-6Chinese Equities And The RMB Have Decoupled. Chinese Equities And The RMB Have Decoupled. Chinese Equities And The RMB Have Decoupled. We believe currency markets are sending the right signal. For one, the Evergrande debacle is occurring at a time when China is no longer tightening monetary policy. Chart I-7 shows that cyclical currencies in developed markets tend to be coincident with the Chinese credit impulse. As such, any easing in monetary policy will put a bottom in these currencies. Over the years, the Chinese bond market has become more and more liberalized. This two-way risk implies that zombies companies should be allowed to fail while unicorns flourish. It is true that regulatory control has been front and center in the current Chinese equity market malaise. That said, our bias is that liberalization is a reason why portfolio inflows into China continue to accelerate, as the economy moves closer to market-determined prices (Chart I-8). This has supported the RMB, a big weight in the Fed trade-weighted dollar. Chart I-7Chinese Policy And DM Currencies Chinese Policy And DM Currencies Chinese Policy And DM Currencies Chart I-8An Unrelenting Increase In Chinese Inflows An Unrelenting Increase In Chinese Inflows An Unrelenting Increase In Chinese Inflows A lot of EM debt is denominated in US dollars, which could be reprised for default risk. But on this basis, the Fed is ahead of the curve. This was the very reason the Federal Reserve introduced swap lines in 2020 with foreign emerging market central banks and made swapping FX reserves for dollars a permanent facility in its toolkit for monetary policy this year. Non-US domestic authorities have ample ability to decide which entities they allow to fail, and which they bail out from their USD obligations. Cross-currency basis swaps, a proxy for the cost of obtaining dollars offshore, remain well behaved (Chart I-9). Chart I-9No USD Funding Stress So Far In Developed Markets No USD Funding Stress So Far In Developed Markets No USD Funding Stress So Far In Developed Markets For developed market currencies, the implication is that China risks are currently overstated, while any upside surprise has not been meaningfully discounted. Gauging Investor Positioning The dollar tends to be a momentum currency. But at turning points, it pays to be a contrarian. Let’s begin with what is priced in. First, the overnight index swap curve (OIS) suggests that markets expect the Fed to hike interest rates faster than other G10 central banks (Chart I-10). This will not occur in a world where growth is stronger outside the US, and other central banks are well ahead in their tapering of asset purchases, pursuing much more orthodox monetary policy. Chart I-10The Market Remains Bullish On Fed Rate Hikes The Market Remains Bullish On Fed Rate Hikes The Market Remains Bullish On Fed Rate Hikes Chart I-11Speculators Are Bullish On ##br##The Dollar Speculators Are Bullish On The Dollar Speculators Are Bullish On The Dollar Second, at the beginning of this report, we highlighted the fact that the dollar is up this year. Part of the reason has been a pilling in of speculators into long greenback positions (Chart I-11). As a trading rule, it has usually been profitable to wait for net speculative positioning and moving averages to roll over before entering fresh dollar short positions (Chart I-12). On this basis, tactical investors might be a bit early, but its is also the case that the macroeconomic environment is moving against the dollar. Once markets start paying attention to the fact that global growth will rotate from the US, pinning the Fed into a more dovish stance, the dollar will quickly depreciate.   Chart I-12A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly A Sentiment Trading Rule Will Wait For The Dollar To Roll Over More Broadly Often forgotten is that the dollar has tended to move in long cycles, usually 10 years between bull and bear markets. The US trade deficit (excluding oil) is hitting new fresh highs this year. These deficits need to be financed by foreign purchases of US securities, either by debt issued or equity raised. Investors could demand a discount to keep financing these deficits. Should the Congressional Budget Office estimates of the current trajectory of US deficits hold true, the dollar has about 10-15% downside from current levels (Chart I-13). Chart I-13Balance Of Payments Bode Negatively For The Greenback Balance Of Payments Bode Negatively For The Greenback Balance Of Payments Bode Negatively For The Greenback Our geopolitical strategists assign 80% odds to the passage of a bipartisan infrastructure bill, and 65% odds to the passage of a reconciliation bill. Either way, the US fiscal picture is set to deteriorate at a time when the Fed is comtemplating scaling back Treasury purchases. Interestingly, 10-15% downside in the US dollar is exactly what is needed to realign the currency competitively (Chart I-14). Consumer prices have been rising globally, but this has been especially pronounced in the US. To the extent that we live in a globalized world with flexible exchange rates, this should allow more competitive countries to see an increase in their trade balances. This is exactly what is occurring, with the US trade deficit hitting new lows. Chart I-14The Dollar Is Expensive On A PPP Basis The Dollar Is Expensive On A PPP Basis The Dollar Is Expensive On A PPP Basis Risks To The View Currency forecasts are obviously fraught with risks. The biggest risk to the view is a broad-based equity market correction, that reinvigorates inflows into US safe-haven bonds. We are cognizant that this is a risk worth monitoring. For example, investors are preferring to park cash in US Treasurys over gold, two competing safe-haven assets (Chart I-15). This has usually been positive for the greenback. But it also suggests investors view the Fed is going to be orthodox in monetary settings, tightening policy faster than the market expects. This boils down to a judgment call. The US market is much more vulnerable to rate changes than other markets (Chart I-16). As such, a hawkish shift by the Federal Reserve could significantly tighten financial conditions (through a stock market correction), setting the stage for an ultimate low in the dollar equity outflows. Chart I-15Safe-Haven Dollar Flows Face Technical Resistance Safe-Haven Dollar Flows Face Technical Resistance Safe-Haven Dollar Flows Face Technical Resistance Chart I-16Higher Bond Yields Will Be Negative For The US Market. Higher Bond Yields Will Be Negative For The US Market. Higher Bond Yields Will Be Negative For The US Market. Given this two-way risk, we are reintroducing our long CHF/NZD position that correlates well with currency volatility (Chart I-17). We are also long the yen on this basis. In terms of housekeeping, our long AUD/NZD trade was stopped out for a loss. As we iterated in our Aussie report, a lot of pessimism is embedded in the AUD, making it a potent candidate for a powerful mean-reversion rally. We recommend reinstating this position at current levels (a nudge above our stop loss). Chart I-17Buy CHF/NZD As A Hedge Buy CHF/NZD As A Hedge Buy CHF/NZD As A Hedge Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Data out of the US this week was strong: PPI continues to accelerate in the US, rising 8.3% year on year in August while CPI also remains strong at 5.3% on the headline print. Pricing pressures remain acute in the US. The empire manufacturing survey surprised to the upside in September. The headline number was 34.2 versus expectations of a 17.9 reading. Admittedly, this was driven by an increase in selling prices. Retail sales were surprisingly strong in August, with the control group rising 2.5% month on month versus expectations of a flat number. The US dollar DXY index was relatively flat this week. The markets are at a crossroads, gauging whether strong US data will maintain momentum or revert to a lower equilibrium. Our bias is towards the latter, but admittedly, there are two-way risks to this view.  Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Euro area data remains robust: Industrial production printed a solid 7.7% year-on-year growth in July. The trade surplus for July rose to €20.7 bn. The euro fell by 0.6% this week. The ECB has engineered a dovish tapering of asset purchases, but it remains the case as the interest rate expectations between the euro area and the US are at bombed out levels. This should support positive euro area surprises. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been on the weak side: Core machinery orders rose 11.1% year on year in July. Exports were strong in August, rising 34% while imports rose 40%. The yen was flat against the dollar this week. Currency volatility is currently depressed, and Japan has been performing poorly economically. To the extent that this is pandemic related, it sets the JPY up for a playable coil spring rebound. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 UK data remains on the mend: Industrial production came in at 3.8% year on year, above expectations. Average weekly earnings, including bonus payments, are rising 8.3% year on year as of July. Job gains continue. The July report pushed the unemployment rate from 4.7% to 4.6%. CPI and RPI remain rather sticky around the 3-5% level. House prices rose 8% year on year in July. The pound fell by 0.4% this week. The broad trend in the pound will now be dictated by what happens to both the dollar and the euro. The BoE is more hawkish than the Fed and the ECB should support gilt yields and the pound. A slowing in US economic momentum is also bullish for the sterling. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was slated to slow as we expected, and recent numbers highlight this: There were 146K job losses in August. This was well split between part time and full time. NAB business confidence and current conditions moderately improved in August. House price inflation is tracking the global wave, rising 16.8% year on year in Q2. The AUD fell 1% this week. We discussed the AUD at length in our report two weeks ago and believe current weakness is unwarranted. We are reinstating our long AUD/NZD trade this week. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The was scant data out of New Zealand this week: The current account deficit widened in Q2 to -3.3% of GDP. Q2 GDP was an upside surprise but will likely be torpedoed in Q3 by COVID-19. The NZD was down 0.25% this week. We continue to believe the NZD will fare well cyclically, likely touching 75 cents, but our bias remains that hawkish expectations from the RBNZ are already well priced. This will make the kiwi lag other commodity currencies like the Aussie. We are reinstating our long AUD/NZD trade. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada this week has been robust: The labor report was strong. Hiring came in at 90K, with a favorable tilt towards full-time work. The unemployment rate fell from 7.5% to 7.1%. The CPI report was equally robust. Core CPI was at 3.5% year on year with most measures of the BoC’s underlying gauge inching higher. Housing starts remained strong in August at 260K, a slight dip from July’s 271K. The CAD was up by 0.44% this week. Last week’s currency report was dedicated to the loonie. With strong oil prices, a relatively hawkish central bank, and easing on tightening pressures from China, the loonie should remain well bid. A minority government will also be bullish for the loonie, as we highlighted last week. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: PPI came in at 4.4% in August, an increase from July. The Swiss franc was down 0.22% this week. We are going long CHF/NZD as a hedge against rising currency volatility. Being long the yen also makes sense in this environment. However, given our view that risk sentiment will stay ebullient, the franc will lag the bounce in other cyclical currencies on a longer-term horizon. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Norwegian data is surprising to the upside: CPI was 3.4% year on year in August, above expectations. PPI rose 50% year on year in August. The trade balance posted a healthy surplus of NOK 42.6bn in August. The NOK was up 0.5% this week. We continue to be bullish Scandinavian currencies as a cyclical play on a lower US dollar. The NOK benefits from bombed-out valuations and a more orthodox central bank. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The most important data from Sweden this week was the CPI report: CPI rose from 1.7% to 2.1% in August. CPIF, the Riksbank’s preferred measure, accelerated to 2.4%. The SEK was flat this week. A bottoming in the Chinese credit impulse will be a positive impact on growth-sensitive Sweden. Meanwhile, this week’s positive CPI report should pare back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Strategic Holdings Tactical Holdings Limit Orders Closed Trades

Highlights The odds of a stronger recovery in EM oil demand next year are rising, as vaccines using mRNA technology are manufactured locally and become widely available.1 This will reduce local lock-down risks in economies relying on less efficacious COVID-19 vaccines – or lacking them altogether – thereby increasing mobility, economic activity and oil demand. Our global crude oil balances estimates are little changed to the end of 2023, which leaves our price expectations mostly unchanged: 4Q21 Brent prices are expected to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively (Chart of the Week). The balance of risks to the crude oil market remain to the upside in our estimation. In addition to a higher likelihood of better-than-expected EM demand growth, we expect OPEC 2.0 production discipline to hold, and for the price-taking cohort outside the coalition to continue prioritizing investors' interests. We remain long commodity index exposure – S&P GSCI and COMT – and, at tonight's close, will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE) on the back of increasing local mRNA vaccine production in EM economies. Feature As local production of COVID-19 vaccines employing mRNA technology spreads throughout EM economies, the odds of a stronger-than-expected recovery in oil demand next year will increase. The buildout of production and distribution facilities for this technology is progressing quickly in Asia – e.g., Chinese mRNA tech joint ventures are expected to be in production mode in 4Q21 – Latin America, Africa, and the Middle East.2 Accelerated availability of more efficacious vaccines globally will address the "fault lines" identified by the IMF in its July 2021 update. In that report, the Fund notes a major downside risk to its global GDP growth expectation of 6% this year remains slower-than-expected vaccine rollouts to emerging and developing economies.3 The other major risk identified by the Fund is too-rapid a winddown of policy support in DM economies, which would lead to tighter financial conditions globally. Our global demand expectation is driven by GDP estimates from the IMF and World Bank. The implication of that assumption is the powerful recovery in DM oil demand seen this year will slow while EM demand picks up next year (Chart 2). We proxy DM oil demand with OECD oil consumption and EM demand with non-OECD consumption. We continue to expect overall oil demand to recover by just over 5.0mm b/d this year and 4.4mm b/d next year (Table 1). Chart of the WeekOil Forecasts Hold Steady Oil Forecasts Hold Steady Oil Forecasts Hold Steady Chart 2Higher EM Oil Demand Expected in 2022 Higher EM Oil Demand Expected in 2022 Higher EM Oil Demand Expected in 2022 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Upside Price Risk Rises For Crude Upside Price Risk Rises For Crude Global Oil Supply To Remain Steady Hurricane Ida will have removed ~ 30mm barrels of US offshore oil output by the time losses are fully tallied, based on IEA estimates. Even so, in line with the US EIA, we expect offshore US oil production will recover from the damage caused by the storm in 4Q21 and be back at ~ 1.7mm b/d on average over the quarter. This will allow oil prices to ease slightly from current elevated levels over the balance of the year. Inland, US shale-oil output remains on track to average ~ 9.06mm b/d this year, 9.55mmb/d in 2022 and 9.85mmb/d in 2023, in our modeling (Chart 3). We expect production in the Lower 48 states of the US to remain mostly steady going forward. Production from finishing drilled-but-uncompleted (DUCs) shale-oil wells is the lowest it's been since 2013.  Output from these wells will remain relatively low for the rest of the year. This supply was developed during the COVID-19 pandemic, as it was cheaper to bring on than new drilling. For 2022 and 2023 overall, our model points to a slow build-up in US shale-oil output as drilling increases. Going into 2022, we expect continued production discipline from OPEC 2.0, and for the coalition to continue to manage output in line with actual demand it sees from its customers. The 400k b/d being returned monthly to the market over August 2021 to mid-2022 will accommodate demand increases. However, it will be monitored closely in the event demand fails to materialize, as has been OPEC 2.0's wont over the course of the pandemic. Chart 3US Shale-Oil Output Mostly Stable US Shale-Oil Output Mostly Stable US Shale-Oil Output Mostly Stable Oil Markets To Remain Balanced We see markets remaining balanced to the end of 2023, with OPEC 2.0 maintaining its production-management strategy – keeping the level of supply just below the level of demand – and the price-taking cohort led by US shale-oil producers remaining focused on maintaining margins so as to provide competitive returns to investors. On the demand side, EM growth will pick up as DM growth slows. Given our fundamental view, global crude oil balances estimates are little changed to the end of 2023 (Chart 4). This allows inventories to continue to draw this year and next, then to slowly rebuild as production increases toward the end of 2023 (Chart 5). Falling inventories will keep the Brent forward curve backwardated – i.e., prompt-delivery oil will trade higher than deferred-delivery oil. Chart 4Markets Remain Balanced... Markets Remain Balanced... Markets Remain Balanced... Chart 5...And Oil Inventory Continues To Draw ...And Oil Inventory Continues To Draw ...And Oil Inventory Continues To Draw The backwardated forward curve means OPEC 2.0 producers will continue to realize higher delivered prices on their crude oil than the marginal shale-oil producer, which hedges its production 1-2 years forward to stabilize revenue. This is the primary benefit to the member states in the producer coalition: a backwardated curve pricing closer to marginal cost limits the amount of revenue available to shale-oil producers, and thus restrains output to that which is profitable at the margin. Investment Implications Our supply-demand outlook keeps our price expectations mostly unchanged from last month's forecast. We expect 4Q21 Brent prices to average $70.50/bbl, while 2022 and 2023 prices average $75 and $80/bbl, respectively, as can be seen in the Chart of the Week. WTI prices will continue to trade $2-$4/bbl below Brent over this interval. With fundamentals continuing to support a backwardated forward curve in Brent and WTI, we continue to favor long commodity-index exposure, which benefits from this structure.4 Therefore, we remain long the S&P GSCI and the COMT ETF, which is an optimized version of the GSCI that concentrates on positioning in backwardated futures contracts. The upside risk to oil prices resulting from increasing local production of mRNA vaccines in EM economies that had relied on less efficacious vaccines undoubtedly will increase mobility and raise oil demand, if, as appears likely, the impact of this localization is realized in the near term. This also could boost commodity demand generally, if it allows trade and GDP growth to accelerate in EM economies, which supports our long commodity-index view. The rollout of mRNA technology into EM economies also suggests EM GDP growth could increase at the margin with locally produced mRNA vaccines becoming more available. This would redound to the benefit of trade and economic activity generally.5 It also could help unsnarl the movement of goods globally. The wider implications of a successful expansion of locally produced mRNA vaccines leads us to recommend EM equity exposure on a tactical basis. At tonight's close, we will be getting long the DFA Dimensional Emerging Core Equity Market ETF (DFAE). As this is tactical, we will use a tight stop (10%) for this recommendation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Natural gas demand is surging globally. Record-breaking heat waves in the US are driving demand for gas-fired generation required to meet space-cooling demand. In addition, in the June-August period, the US saw record LNG exports. Europe and Asia are competing for the fuel as both prepare for winter. Brazil also has been a strong bid for LNG, as drought there has reduced hydropower supplies. In Europe, natural gas inventories were drawn hard this past winter as LNG supplies were bid away to Asia to meet space-heating demand. This is keeping Europe well bid now as winter approaches (Chart 6). The US Climate Prediction Center last week gave 70-80% odds of a second La Niña for the Northern Hemisphere winter. Should it materialize, it could again drive cold artic air into their markets, as it did last winter, and push natgas demand higher. Our recommendation to get long 1Q22 $5.00/MMBtu calls vs short 1Q22 $5.50/MMBtu calls last week was up 17% as of Tuesday's close. We remain long. Base Metals: Bullish The slide in iron ore prices from its ~ $230/MT peak earlier this year can be attributed to weak Chinese demand, and the possibility of its persistence through the winter and into next year (Chart 7). The world’s largest steel-producing nation is aiming to limit steel output to no higher than 2020 levels, in a bid to reduce industrial pollution. According to mining.com, provincial governments have directly asked local steel mills to curb output. Regulation in this sector in China will continue to reduce prices of iron ore, a key raw material in steel production. Precious Metals: Bullish The lower-than-expected reading on the US core CPI earlier this week weighed on the USD, and propelled gold prices above the $1,800/oz mark. While markets expected lower consumer prices for August to diminish the Fed’s resolve to taper asset purchases by year-end, we do not think the lower month-on-month CPI number will delay tapering. The timing of the Fed's initial rate hike – expected by markets to occur after the tapering of the central bank's asset-purchase program – will depend on the US labor force reaching "maximum employment." According to BCA Research's US Bond Strategy, this criterion will be met in late-2022 or early-2023. Low-interest rates, coupled with persistent inflation until then, will be bullish for gold prices. Chart 6 Upside Price Risk Rises For Crude Upside Price Risk Rises For Crude Chart 7 CHINA IMPORTED IRON ORE GOING DOWN CHINA IMPORTED IRON ORE GOING DOWN   Footnotes 1     Please see Everest to bring Canadian biotech's potential Covid shots to China, other markets published on September 13, 2021 by indiatimes.com. 2     Examples of this include Brazil's Eurofarma to make Pfizer COVID-19 shots for Latin America, published by reuters.com; Biovac Institute to be first African company to produce mRNA vaccines, published be devex.com; and mRNA Vaccines Mark a New Era in Medicine, posted by supertrends.com. The latter report also discusses the application of mRNA technology to other diseases like malaria. 3    Please see Fault Lines Widen in the Global Recovery published 27 July 2021 by the Fund. 4    Backwardation is the source of roll yield for long-index exposure.  This is due to the design of these index products, which buy forward then – in backwardated markets – roll out of futures contract as they approach physical delivery at a higher level and re-establish their exposure in a deferred contract. 5    The lower realized efficacy of Sinopharm and Sinovac COVID-19 vaccines and high reinfection rates in economies using these vaccines are one of the key risks to our overall bullish commodity view.  Please see Assessing Risks To Our Commodity Views, which we published on July 8, 2021. It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Please note that next Friday September 24 at 10am EDT, we will host a webcast featuring a debate between my colleague Peter Berezin and me. The topic of debate is whether investors should overweight EM in a global portfolio. Please join us by registering via this link.   Highlights Chinese internet companies’ ROE will drop, warranting lower equity valuations. However, their ROE and equity multiples will not fall to the levels of listed state-owned enterprises (SOEs). Evergrande’s partial default on its liabilities will likely reinforce credit tightening that has been underway in China over the past 12 months. EM ex-TMT stocks also remain vulnerable. Continue underweighting EM in global equity and credit portfolios. Feature This is the September issue of Charts That Matter. We begin by addressing the issues concerning Chinese internet companies that have been subject to intense debate among investors. We then present key charts on overall EM and various asset classes along with brief commentary. Are Chinese Internet Stocks Investable? There is an ongoing debate in the investment community as to whether Chinese equities in general and Chinese TMT stocks in particular will remain investable. Our short answer is: they will remain investable but mind their valuations. In our opinion, “investable” means that they will from time to time offer medium- and long-term investment opportunities. Our hunch is that they may do so in the future. Nevertheless, we do not think that Chinese TMT stocks presently offer a good buying opportunity. In fact, their share prices have material downside from current levels. In our recent report and webcast, we identified the primary risks to Chinese platform companies: Higher uncertainty about their business model = a higher equity risk premium. Government regulating their profitability like those of mono- and oligopolies = low multiples. These companies performing their social duties in the form of redistributing profits from shareholders to Chinese peoples. Beijing’s involvement in their management and in the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges. Although these companies will remain investable, investors should bear these risks in mind and give careful consideration to what multiples they pay for such stocks. Going forward, Chinese platform companies’ return on equity will be considerably lower than they have been or what their current multiplies imply. A lower return on equity warrants a lower equity multiple. Chart 1Chinese Growth Stocks Are Not Cheap Chinese Growth Stocks Are Not Cheap Chinese Growth Stocks Are Not Cheap On the whole, the current valuations of Chinese internet stocks are still high. Chart 1 shows trailing and 12-month forward P/E ratios for Chinese MSCI Growth Investable Index at 34 and 31, respectively. A downshifting return on equity and high uncertainty around these businesses herald lower equity valuations to come. Besides, in the case of several companies, there are also political underpinnings of this regulatory crackdown. In the case of Alibaba, a mainland government official has recently noted that Alibaba’s chairman, Jack Ma, has been acquiring media companies across the country, and now owns nearly 30 provincial-level media companies, as well as the South China Morning Post in Hong Kong. Beijing will not tolerate the control of or influence over domestic media from anyone outside the inner leadership circle. In this context, it is probable that Alibaba’s businesses will remain subject to severe regulatory pressures. How much lower should these companies’ multiples drop to become attractive? Meaningfully lower, but not to the level of multiples of listed state-owned enterprises (SOEs). Here are two reasons why these platform companies will not trade at multiples of SOEs in China: First, many existing SOEs operate in cyclical industries – commodities, industrials, autos, and banks – that structurally have low equity multiples. By contrast, platform companies operate in non-cyclical sectors that structurally have lower business cycle volatility and, therefore, should trade at higher equity multiples than cyclical industries. Second, many SOEs often had losses because they operated in non-oligopolistic industries. Faced with intense competition they had to cut prices to support volumes and employment. By contrast, platform companies’ profitability will be suppressed and capped by new government policies, but they will remain profitable because they operate in oligopolistic industries. In short, platform companies’ ROEs will be higher than those of traditional/”old-economy” SOEs. All in all, our bias is that platform companies’ valuation multiples will contract further but will not be as low as Chinese, Russian, or Brazilian SOEs have been. Bottom Line: Investors should be mindful of further de-rating in Chinese TMT/platform company stocks. These stocks are not yet out of woods. On Property Market Clampdown And Evergrande's Default Evergrande will likely default on some of its liabilities but there will be a bailout or roll-over of its other debt.  Is the partial default by Evergrande, a very large Chinese property developer, a sign of a bottom in Chinese offshore equity and bond markets or will it produce a full-blown credit crisis in China? This is a valid question because both outcomes are possible: a partial bankruptcy can be a culmination of all existing negatives and can trigger policy stimulus that will produce an economic recovery and a major rally (an example of this is the LTCM crisis in the US in 1998); or  a partial bankruptcy can lead to a credit crunch escalation becoming a systemic event. An example of this is Lehman Brothers’ bankruptcy in 2008. We will assign the highest probability to a third scenario: the well-telegraphed Evergrande default might not create a systemic crisis or crash. However, it will likely reinforce chronic credit tightening that has been underway in China over the past 12 months. This is negative for China and EM risk assets. Predicting the trajectory and speed of market adjustments – a crisis (wholesale selloff) versus a regular bear market interrupted by short-term rebounds – is impossible. That said, investors should stay put for now. On another note, during our webcast last week, a client asked whether restrictions on property developers’ leverage will hinder their ability and willingness to build. In turn, limited property supply will likely push up property prices, which is contrary to Beijing’s goals of curbing property price inflation. So, why are authorities pursuing this clampdown on property developers? Chart 2Property Starts And Prices Are Positively Correlated Property Starts And Prices Are Positively Correlated Property Starts And Prices Are Positively Correlated This is a very good question, and we have the following observations. In our view, authorities are clamping down on property developers’ leverage because historically there was a strong positive correlation between property starts and house prices (Chart 2). The basis for this positive correlation is that when property developers start more projects, they raise expectations via aggressive marketing of higher prices in future. As a result, people become more inclined to buy houses. In fact, more supply has not precluded property prices from surging and vice versa, as shown in Chart 2. Provided housing valuations (the house price-to-income ratios) are exceptionally high in China and high-income households have been buying multiple apartments, we can argue that (speculative) expectations for higher prices in the future have often been an important driver of demand. So, authorities are probably hoping to break this speculative cycle where higher prices breed higher prices. Aggressive marketing on the part of property developers – creating an atmosphere of euphoria around new property launches – has been an essential driver for surging house price expectations. Hence, authorities’ reasoning is that curbing property developers’ relentless debt financed expansion activity is essential for both (1) to restrain excessive house prices inflation (a social stability goal) and (2) to reduce risks of a future credit crisis (a financial stability goal). Finally, with many households/investors who own multiple properties (that are vacant rather than rented out), authorities hope that diminished expectations for future house price appreciation will bring some of these vacant properties to the market. If this occurs, the supply of residential properties for sale and rent will not drop dramatically despite lower starts by property developers. It is also critical to assess the implications of the ongoing carnage in Chinese offshore corporate bonds, where the epicenter of the selloff is property companies. The fact that property developers are experiencing a credit crunch and will be forced to deleverage has implications for China’s business cycle and other EM economies. Chart 3 illustrates that the periods of rising emerging Asian USD corporate bond yields (shown inverted on the chart) coincide with lower emerging Asian ex-TMT share prices. The link is as follows: the ongoing credit stress and deleveraging by mainland property developers means less construction and diminished demand for raw materials and industrial goods as well as possibly household white goods. There are thus negative implications not only for emerging Asian non-TMT stocks but also for overall EM. Bottom Line: Property construction in China will continue contracting (Chart 4). This will weigh on raw materials and industrial goods demand in China and beyond it. Chart 3Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Chart 4Chinese Housing: Sales And Starts Are Contracting Chinese Housing: Sales And Starts Are Contracting Chinese Housing: Sales And Starts Are Contracting   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Have EM Stocks Bottomed? Investor sentiment on EM equities has plunged close to its previous lows. However, this is a necessary but not sufficient condition to issue a buy recommendation. Critically, EM narrow money growth points to EPS deceleration in the next nine months. Yet, analysts’ net EPS revisions remain elevated and have not yet dropped to negative levels. Our bias is that EM net EPS revisions will be downgraded in the coming months. From a technical perspective, the EM equity index has failed to break above its 200-day moving average. This is a negative technical signal.  Chart 5 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 6 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 7 Have EM Stocks Bottomed? Have EM Stocks Bottomed? Chart 8 Have EM Stocks Bottomed? Have EM Stocks Bottomed? EM Underperformance Is Broad-Based Not only have EM TMT stocks massively underperformed their global peers, but also EM ex-TMT stocks have been underperforming their global counterparts. Besides, the EM equal-weighted stock index has failed to break above its previous highs. Failure to break above a resistance line is often a bad omen. Finally, EM ex-TMT share prices correlate with the average of AUD, NZD and CAD, and the latter remains in a corrective phase.  Chart 9 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Chart 10 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Chart 11 EM Underperfomance Is Broad-Based EM Underperfomance Is Broad-Based Red Flags For EM Periods of rising EM USD corporate bond yields coincide with lower EM share prices. EM corporate USD bond yields are rising (shown inverted below) and we expect more upside. Either US Treasury bond yields will rise and EM corporate spreads will stay broadly constant, or EM credit spreads will widen and US Treasury yields will stay range-bound. Either of these scenarios will produce higher EM corporate bond yields and, thereby, herald lower EM equity prices. Further, a breakdown in platinum prices is also raising a red flag for EM risk assets.  Chart 12 Red Flags For EM Red Flags For EM Chart 13 Red Flags For EM Red Flags For EM Have Chinese And Asian Stocks Hit An Air Pocket? Relative performance of emerging Asian equities versus the global stock index has broken below its previous lows. Technically, this entails a protracted period of underperformance. Neither emerging Asian ex-TMT nor Chinese investable ex-TMT share prices have been able to break above their major resistance lines. Failure to break above a resistance line is often a bad omen. Meantime, Chinese onshore stocks and corporate bonds have not sold off enough so that authorities panic and stimulate aggressively.  Chart 14 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 15 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 16 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? Chart 17 Have Chinese And Asian Stocks Hit An Air Pocket? Have Chinese And Asian Stocks Hit An Air Pocket? The US Dollar As A Litmus Test EM risk assets negatively correlate with the US dollar. The broad trade-weighted US dollar is holding above its 200-day moving average. Plus, investor sentiment on the greenback remains negative. Finally, the US dollar moves inversely with relative performance of global cyclical sectors versus global defensives (the dollar is shown inverted on chart below). The ongoing slowdown in China is bullish for the US dollar because the US economy is the least vulnerable to China’s economy. Overall, we expect the US dollar to continue firming in the coming months. Chart 18 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Chart 19 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Chart 20 The US Dollar As A Litmus Test The US Dollar As A Litmus Test Global Mining Stocks, Commodity Currencies And Commodity Prices The share prices of BHP and Rio Tinto have fallen dramatically in absolute terms. This reflects the plunge in iron ore prices and might also be a harbinger of a broader selloff in industrial metals. Further, the average of AUD, NZD and CAD also signals a correction in the broad commodities price index.  Chart 21 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Chart 22 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Chart 23 Global Mining Stocks, Commodity Currencies And Commodity Prices Global Mining Stocks, Commodity Currencies And Commodity Prices Is This Decoupling Sustainable? Industrial metals prices were historically correlated with the Chinese business cycle but have decoupled since early this year. Several commodity prices – like coal, steel and aluminum – have shot up due to production shutdowns as a part of the Chinese government’s decarbonization policies. However, it will be extraordinary if commodity prices continue advancing amid a protracted slowdown in China’s old economy.   Chart 24 Is This Decoupling Sustainable? Is This Decoupling Sustainable? Chart 25 Is This Decoupling Sustainable? Is This Decoupling Sustainable? Chinese Commodity Imports Have Contracted Reflecting a demand slowdown and the government’s willingness to dampen commodity price inflation, China has been shrinking its imports of several commodities. It has also released some of its strategic reserves for oil and certain industrial metals. High commodity prices are hurting profit margins of manufacturing and industrial companies leading them to lower output. Beijing is determined to curb and bring down key commodity prices to lessen the negative impact on overall growth and employment.  Chart 26 Chinese Commodity Imports Have Contracted Chinese Commodity Imports Have Contracted Chart 27 Chinese Commodity Imports Have Contracted Chinese Commodity Imports Have Contracted Chinese Stimulus: How Fast And How Large? In recent months, China has been injecting more liquidity into the banking system. Rising commercial banks’ excess reserves at the PBOC point to a bottom in the credit impulse in Q4 of this year. However, the credit impulse leads the business cycle by about nine months. This implies that the economy will not revive before Q2 next year at best. In fact, the aggregate building floor area started and the installation of electricity transmission lines are already contracting and will continue shrinking till Q2 next year.   Chart 28 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 29 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 30 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? Chart 31 Chinese Stimulus: How Fast And How Large? Chinese Stimulus: How Fast And How Large? An Inflation Dichotomy Between China And The US In China, consumer price inflation remains largely contained. However, in the US core consumer price inflation measures are still rising and are above 2%. An optimal exchange rate adjustment to redistribute inflation pressures from the US into China will require a stronger US dollar and a weaker RMB.  Chart 32 An Inflation Dichotomy Between China And The US An Inflation Dichotomy Between China And The US Chart 33 An Inflation Dichotomy Between China And The US An Inflation Dichotomy Between China And The US Inflation And Monetary Tightening In EM ex-China Core measures of inflation have been rising in many Eastern European and Latin American economies. Their central banks will hike interest rates further. This will hurt their domestic demand at a time when the recovery in these economies has been underwhelming. Monetary and fiscal tightening will offset benefits from reopening as their vaccination rates ameliorate.  Chart 34 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 35 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 36 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China Chart 37 Inflation And Monetary Tightening In EM ex-China Inflation And Monetary Tightening In EM ex-China What Drives EM Credit Markets? We downgraded our allocation to EM credit, currencies and equities from neutral to underweight on March 25, 2021. This strategy remains intact. The outlook for the key drivers of EM credit – EM/China business cycles and EM exchange rates – remains downbeat. In fact, EM credit markets – both investment grade and high-yield – have been underperforming their US counterparts and this trend will persist.  Chart 38 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 39 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 40 What Drives EM Credit Markets? What Drives EM Credit Markets? Chart 41 What Drives EM Credit Markets? What Drives EM Credit Markets? Our Relative Equity Value Strategies We have been recommending investors go long Chinese A shares / short Chinese investable stocks since March 4, 2021 and this strategy has been extremely profitable. The same is true for the short Chinese property developers / long overall index and short Chinese investable value stocks versus global value stocks strategies. Finally, our recommendation to be long global industrials / short global materials has so far been flat but we expect it to play out for the reasons elaborated in the linked report.  Chart 42 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 43 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 44 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Chart 45 Our Relative Equity Value Strategies Our Relative Equity Value Strategies Retail Equity Mania In Korea And Taiwan The retail mania continues in the Korean and Taiwanese stock markets. Retail investors are the main buyers while foreign investors and domestic institutional investors have been scaling back their exposure. Surging margin loans and equity trading volumes in Korea confirm ongoing equity euphoria. We continue overweighting Korean stocks and are neutral on Taiwanese stocks within an EM equity portfolio. The difference in our strategy is due to the potential geopolitical risks that Taiwan is facing. Chart 46 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 47 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 48 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan Chart 49 Retail Equity Mania In Korea And Taiwan Retail Equity Mania In Korea And Taiwan The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks DRAM and NAND prices have rolled over. This is a near-term risk to the absolute performance of Korean tech stocks. However, if global industrial stocks outperform, as we expect, Korean share prices will outperform the EM equity benchmark because the KOSPI is a good proxy play on global industrials within the EM universe. Although global semiconductor shortages remain widespread, the 6-month outlook for Taiwanese technology companies has rolled over too.  Chart 50 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 51 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 52 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Chart 53 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss our view on China’s economy and financial markets. I will also address the topics that our clients are most concerned about, including China’s regulatory developments, inflation, and policy direction. The webcasts will be held on Wednesday, September 22 at 10:00 am EDT (English), and Thursday, September 23 at 9:00 am HKT (Mandarin). I look forward to discussing with you during the webcast. We will return to our regular publishing schedule on Wednesday, September 29. Best regards, Jing Sima, China Strategist Highlights China is facing cyclical inflationary pressures more than disinflationary ones. Prices of mining, raw materials and manufacturing goods have been rising at record rates. Chinese manufacturers are operating at close to full production, which suggests that there is little slack in demand. Despite soft headline readings in consumer prices, the costs of goods and services have rebounded to pre-pandemic levels. Prices for home durable goods, fuel and utilities have surged to multiyear highs. Measures to boost domestic demand will be limited as long as inflationary pressures continue and manufacturers produce at close to full capacity. Near-term policy support will likely focus on reducing costs for manufacturers and improving wage growth for lower-income households. We are initiating a trade: long industrial stocks/short A-shares.  Feature China’s Producer Price index (PPI) registered a 13-year high in August, at the time when the domestic economy continued to slow. On the other hand, consumer prices (CPI) - both headline and core CPI - have been lackluster. The acceleration in producer inflation and the demand dynamics raise the question whether China is in a stagflation, a situation in which prices climb but wages and demand do not follow. Consequentially, economy policy faces a dilemma between boosting demand and containing inflation. Inflationary pressures have been driven by pandemic-related factors and the supply-side constraints will likely continue into Q1 next year. These inflationary pressures, and more importantly, undercurrents in the inflation prints, will constrain Chinese policymakers’ efforts to reflate the economy. The recent rebound in Chinese infrastructure stocks is overdone. Material stocks are also vulnerable to price setbacks. Global commodity prices will soften, although from very elevated levels. Meanwhile, we are initiating a trade: long Chinese industrial stocks relative to the A-share market. Despite falling profit growth in recent months, China’s leadership is increasing its support, both cyclically and structurally, to the manufacturing sector. Inflation Or Deflation? The details in both the PPI and CPI readings indicate that China is facing more inflationary pressures than disinflationary ones. Producers are raising prices across the board. Although consumer prices will likely remain well below the PBoC's 3% inflation target for the year mainly due to low food prices, prices in some of the key consumer goods segments are rising at an alarming pace. The inflationary pressures will continue for producers, at least through the first quarter of 2022. The strength in August’s PPI was concentrated in mining and raw materials (Chart 1, top panel). Robust global demand and tight supply conditions supported high oil and base metals prices, while pushing up coal prices. Chart 1Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chinese Mining And Manufacturing Goods Prices Accelerated To Record Highs Chart 2Commodity Prices Held Up Despite A Slowing China Commodity Prices Held Up Despite A Slowing China Commodity Prices Held Up Despite A Slowing China We do not expect China’s infrastructure investment growth to pick up and support industrial metal prices. However, this year’s unsynchronized recovery in global demand and severe supply shortages have delayed the global commodity market’s price reaction to slowing Chinese demand (Chart 2). Moreover, as China’s environmental policy remains stringent during the upcoming winter, supply-side constraints from production cuts will partially offset the slowdown in China’s demand for mining and raw materials (Chart 3A and 3B). Chart 3ASupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Chart 3BSupply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Supply-Side Constraints And Chinese Production Cuts Likely To Continue Into Early 2022 Manufacturing goods inflation registered its topmost annual growth since data collection started in 1996 (Chart 1, bottom panel). Moreover, capacity utilization rates in the industrial and manufacturing sectors are at the highest levels since 2007, well above their means (Chart 4). Changes in manufacturing capacity are highly correlated with China’s export growth and tightly linked to PPI (Chart 5). Therefore, manufacturing goods prices will remain lofty as long as external demand stays robust and China’s manufacturers continue to produce near maximum output. Chart 4Chinese Manufacturers Are Producing Near Their Max Capacity Chinese Manufacturers Are Producing Near Their Max Capacity Chinese Manufacturers Are Producing Near Their Max Capacity Chart 5Robust Exports Have Been Supporting Strong Chinese Manufacturing Output Robust Exports Have Been Supporting Strong Chinese Manufacturing Output Robust Exports Have Been Supporting Strong Chinese Manufacturing Output The PPI’s weakest component has been consumer goods, which inched up by a mere 0.3% from a year ago (Chart 6). However, consumer goods only account for 25% of PPI, whereas industrial and manufacturing producer goods are 75%. In addition, the underlying data shows that among the four sub-components in the PPI’s consumer goods, only food prices have remained below their pre-pandemic levels (Chart 7, top panel). Prices in durable goods have rebounded strongly since March last year and clothing and daily sundry articles have recovered to their end-2019 rate of growth (Chart 7, mid and bottom panels).  Chart 6Producer Prices For Consumer Goods Remain Soft... Producer Prices For Consumer Goods Remain Soft... Producer Prices For Consumer Goods Remain Soft... Chart 7...But Food Prices Have Been The Main Drag ...But Food Prices Have Been The Main Drag ...But Food Prices Have Been The Main Drag The PPI’s price forces are consistent with the CPI, in which food has been the main drag. Core CPI, along with prices for consumer goods and services, have returned to pre-pandemic growth rates (Chart 8). Durable goods prices, such as home appliances, increased to a multiyear high in August. Fuel and utilities costs have also risen. This suggests that despite the soft CPI readings, inflation has flowed from producers to Chinese consumers through manufacturing goods. The passthrough will likely intensify into Q4 when domestic COVID-cases have been largely brought under control and the September – October holiday season will boost consumption for both goods and services. Chart 8Prices For Other Consumer Goods Categories Have Recovered Prices For Other Consumer Goods Categories Have Recovered Prices For Other Consumer Goods Categories Have Recovered Table 1A Look At China’s CPI Basket – Food Dominates Inflation, Deflation, Or Stagflation? Inflation, Deflation, Or Stagflation? We still expect that headline CPI will remain below the PBoC’s 3% inflation target for the year. Consumer durable goods prices are lightly weighted in China’s CPI, therefore, an acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates (Table 1). Chart 9Prices For Healthcare And Education Services On A Structural Downshift Prices For Healthcare And Education Services On A Structural Downshift Prices For Healthcare And Education Services On A Structural Downshift In addition, there are some structural headwinds that will affect prices in the education and healthcare and medical services components, which together account for about 15% of the CPI. Healthcare prices have been on a policy-driven structural downshift since late 2017 and recent regulatory changes in the education industry will depress pricing power in that sector (Chart 9). Despite sluggish aggregate consumer prices, climbing prices in consumer durable goods, services and particularly, fuel and utilities, will likely force China’s leadership to take action on policy. Bottom Line: Price pressures for Chinese producers remain intense and consumers will feel the heat of escalating prices in durable goods, fuel and utilities. Inflation is threatening domestic demand, which is already slowing from its peak earlier this year. Implications On Policy Response Inflation readings –even though they are lagging economic indicators –bear significant forward-looking market implications because changes in inflation dynamics herald various policy responses. Despite slower economic growth, higher inflation coupled with accommodative monetary and fiscal policies may indicate that the economy is in a “goldilocks” stage and corporate profits can still benefit (Chart 10). Chinese onshore stocks reached record high recently (Chart 11). Chart 10Are Chinese Corporates In A 'Sweet Spot'? Are Chinese Corporates In A 'Sweet Spot'? Are Chinese Corporates In A 'Sweet Spot'? Chart 11Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 Accommodative Monetary Conditions Propelled Chinese Stock Prices To Highest Since 2015 However, underlying trends in China’s producer and consumer inflation prints raise the risks that policymakers may not deliver the ingredients needed for a “just right” scenario. Even though China has kept a loose monetary policy that we expect to extend into next year, inflationary pressures may force policymakers to either delay or reduce the magnitude of stimulus. Recent policy moves show that the authorities are focused on reducing input cost burdens and bumping up support for small- and medium-sized enterprises (SMEs), which are highly concentrated in mid- to downstream manufacturing and services sectors. In our view, the recent rhetoric from policymakers further reduces the odds of any broadly based stimulus to boost demand. Our view is based on the following observations: The elevated global input costs and limited price passthroughs to consumers are depressing Chinese manufacturers’ profit margins and incentives to expand production capacity. Despite strong exports and production, manufacturing investment has lagged that in infrastructure and real estate this year (Chart 12). Consumers, particularly lower-income households, are bearing most of the burdens; rising costs and slow wage growth are weakening their propensity to spend (Chart 13). Chart 12Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Slower Manufacturing Investment Recovery Than Infrastructure And Real Estate So Far This Year Chart 13Slow Wage Growth Limits The Pace Of Consumption Recovery Slow Wage Growth Limits The Pace Of Consumption Recovery Slow Wage Growth Limits The Pace Of Consumption Recovery The inflation prints came at the time when China’s top leadership shifted its structural policy goals to reduce income inequality and stabilize manufacturing share in the aggregate economy. The structural goals will likely be reflected in policy responses to the cyclical challenge.  Moreover, this year’s manufacturing production volume was growing twice as fast as producer prices, a reversal from 2017 when price increases outpaced production (Chart 14). Price changes are much more important to corporate profits than volume changes. A strong RMB and sharply escalating shipping costs have also reduced exporters’ pricing power and profits (Chart 15). In contrast, mounting prices across various commodities have allowed the upstream industrial sectors, which are dominated by SOEs, to deliver much stronger profits than the downstream and private sector (Chart 16). Chart 14Growth In Manufacturing Output And Prices Starting To Converge Growth In Manufacturing Output And Prices Starting To Converge Growth In Manufacturing Output And Prices Starting To Converge Chart 15Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability Strong RMB And Rising Shipping Costs Have Reduced Chinese Exporters' Profitability   It is unsurprising that authorities are increasing support to the private sector in order to maintain manufacturing share in the economy and keep the export sector competitive (Chart 17). A boost in infrastructure investment, on the other hand, would exacerbate upward pressure on commodity prices and mostly benefit upstream SOEs. Chart 16Upstream Industries Disproportionally Benefited From Surging Commodity Prices Upstream Industries Disproportionally Benefited From Surging Commodity Prices Upstream Industries Disproportionally Benefited From Surging Commodity Prices Chart 17Private Sector: Lower Profit Margin, Higher Costs Private Sector: Lower Profit Margin, Higher Costs Private Sector: Lower Profit Margin, Higher Costs Furthermore, stimulating the traditional sectors would not revive household consumption. The subdued recovery in consumption and prices for consumer staple goods is due to slow growth in lower-income household wages and a disrupted recovery in the services sector. Ramping up infrastructure investment can support headline GDP growth, but will do little to provide jobs and wages since China’s private sector provides 80% of all jobs and 90% of annual job creations. Lower-income households have a higher marginal propensity to consume. We expect the government to accelerate fiscal support measures to fortify wages among lower-income households. Bottom Line: Ongoing inflationary pressures and the underlying forces will likely thwart policymakers from stepping up their efforts to stimulate the old economy sectors. Investment Conclusions Chart 18Rebound In Infrastructure Stocks Should Be Short-Lived Rebound In Infrastructure Stocks Should Be Short-Lived Rebound In Infrastructure Stocks Should Be Short-Lived Chinese onshore stocks in the infrastructure, materials, and industrial sectors recently advanced strongly in the expectation that policymakers will ramp up their fiscal support in the old economy sectors, particularly infrastructure. Although we agree that infrastructure investment will improve, we maintain our view that a sizable rebound is highly unlikely this year. Hence, we do not expect that the rally in infrastructure stocks will be long-lasting (Chart 18).  We are probably too late in the cycle to re-initiate our long material/broad market trade in the onshore and offshore equity markets (Chart 19). We closed the trade in December last year when Chinese policymakers started pulling back stimulus, and in expectations that raw material prices would tumble. However, we underestimated the intensity of China’s de-carbonization efforts and protracted global supply-side constraints. Although global commodity prices will remain elevated into 2022, the price rallies from this year are not sustainable on a cyclical (6- to 12-month) basis. Therefore, we do not recommend material stocks as a cyclical play.  Chart 19Price Rally In Materials Stocks Unlikely To Sustain Price Rally In Materials Stocks Unlikely To Sustain Price Rally In Materials Stocks Unlikely To Sustain Chart 20Industrial Stocks May Be On A Structural Upcycle Industrial Stocks May Be On A Structural Upcycle Industrial Stocks May Be On A Structural Upcycle Instead, we recommend a long industrial/broad A-share market trade (Chart 20). Even though China is in a late business cycle and the upcoming stimulus will be mediocre at best, we think that the industrial sector will benefit from policy support for investment in the manufacturing sector and a faster pace in the sector’s capacity expansion.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes Market/Sector Recommendations Cyclical Investment Stance