Emerging Markets

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas China Spreads The Wealth Around China Spreads The Wealth Around Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 China Spreads The Wealth Around China Spreads The Wealth Around Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade China Spreads The Wealth Around China Spreads The Wealth Around While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan China Spreads The Wealth Around China Spreads The Wealth Around Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) China Spreads The Wealth Around China Spreads The Wealth Around Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights US crude oil output will continue its sharp recovery before leveling off by mid-2022, in our latest forecast (Chart of the Week). The recovery in US production is led by higher Permian shale-oil production, which is quietly pushing toward pre-COVID-19 highs while other basins languish. Permian output in July was ~ 143k b/d below the basin's peak in Mar20, and likely will surpass its all-time high output in 4Q21. Overall US shale-oil output remains ~ 1.1mm b/d below Nov19's peak of 9.04mm b/d, but we expect it to end the year at 7.90mm b/d and to average 8.10mm b/d for 2022. We do not expect US crude oil production to surpass its all-time high of 12.9mm b/d of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means larger shares of free cashflow will go to shareholders, and not to drilling for the sake of increasing output. While our overall balances estimates remain largely unchanged from last month, we have taken down our expectation for demand growth this year by close to 360k b/d and moved it into 2022, due to continuing difficulties containing the COVID-19 Delta variant. Our Brent crude oil forecasts for 2H21, 2022 and 2023 remain largely unchanged at $70, $73 (down $1) and $80/bbl. WTI will trade $2-$3/bbl lower. Feature Chart 1US Crude Recovery Continues US Crude Recovery Continues US Crude Recovery Continues Global crude oil markets are at a transition point. The dominant producer – OPEC 2.0 – begins retuning 400k b/d every month to the market from the massive 5.8mm b/d of spare capacity accumulated during the COVID-19 pandemic. For modeling purposes, it is not unreasonable to assume this will be a monthly increment returned to the market until the accumulated reserves are fully restored. This would take the program into 2H22, per OPEC's 18 July 2021 communique issued following the meeting that produced this return of supply. Thereafter, the core group of the coalition able to increase and sustain higher production – Kuwait, the UAE, Iraq, KSA and Russia – is expected to meet higher demand from their capacity.1 There is room for maneuver in the OPEC 2.0 agreement up and down. We continue to expect the coalition to make supply available as demand dictates – a data-dependent strategy, not unlike that of central banks navigating through the pandemic. This could stretch the return of that 5.8mm b/d of accumulated spare capacity further into 2H22 than we now expect. The pace largely depends on how quickly effective vaccines are distributed globally, particularly to EM economies over the course of this year and next. US Shale Recovery Led By Permian Output While OPEC 2.0 continues to manage member-state output – keeping the level of supply below that of demand to reduce global inventories – US crude oil output is quietly recovering. We expect this to continue into 1H22 (Chart 2). Chart 2Permian Output Recovers Strongly Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak The higher American output in the Lower 48 states primarily is due to the continued growth of tight-oil shale production in the low-cost Permian Basin (Chart 3). This has been aided in no small part by the completion of drilled-but-uncompleted (DUC) wells in the Permian and elsewhere. Chart 3E&Ps Favor Permian Assets Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Since last year’s slump, the rig count has increased; however, compared to pre-pandemic levels, the number of rigs presently deployed are not sufficient to sustain current production. The finishing of DUC wells means that, despite the low rig count during the pandemic, shale oil supply has not dipped by a commensurate amount. This is a major feat, considering shale wells’ high decline rates. Chart 4US Producers Remain Focused On Shareholder Priorities US Producers Remain Focused On Shareholder Priorities US Producers Remain Focused On Shareholder Priorities DUCS have played a large role in sustaining overall US crude oil production. According to the EIA, since its peak in June 2020, DUCs in the shale basins have fallen by approximately 33%. As hedges well below the current market price for shale producers roll off, and DUC inventories are further depleted, we expect to see more drilling activity and the return of more rigs to oil fields. We do not expect US crude oil output to surpass its all-time high of 12.9mm b/ of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means only profitable drilling supporting the free cashflow that allows E&Ps to return capital to shareholders will receive funding. US oil and gas companies have a long road back before they regain investors' trust (Chart 4).   Demand Growth To Slow We expect global demand to increase 5.04mm b/d y/y in 2021, down from last month's growth estimate of 5.4mm b/d. We have taken down our expectation for demand growth this year by ~ 360k b/d and moved it into 2022, because of reduced mobility and local lockdowns due to continuing difficulties in containing the COVID-19 Delta variant, particularly in Asia (Chart 5).2 We continue to expect the global rollout of vaccines to increase, which will allow mobility restrictions to ease, and will support demand. This has been the case in the US, EU and is expected to continue as Latin America and other EM economies receive more efficacious vaccines. Thus, as DM growth slows, EM oil demand should pick up (Chart 6). Chart 5COVID-19 Delta Variant's Spread Remains Public Health Challenge Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Chart 6EM Demand Growth Will Offset DM Slowdown EM Demand Growth Will Offset DM Slowdown EM Demand Growth Will Offset DM Slowdown Net, we continue to expect demand for crude oil and refined products to grind higher, and to be maintained into 2023, as mobility rises, and economic growth continues to be supported by accommodative monetary policy and fiscal support. If anything, the rapid spread of the Delta variant likely will predispose central banks to continue to slow-walk normalizing monetary policy and interest rates. Global Balances Mostly Unchanged Chart 7Oil Markets To Remain Balanced Oil Markets To Remain Balanced Oil Markets To Remain Balanced Although we have shifted part of the demand recovery into next year, at more than 5mm b/d of growth, our 2021 expectation is still strong. This is expected to continue next year and into 2023 although not at 2021-22 rates. Continued production restraint by OPEC 2.0 and the price-taking cohort outside the coalition will keep the market balanced (Chart 7). We expect OPEC 2.0's core group of producers – Kuwait, the UAE, Iraq, KSA and Russia – will continue to abide by the reference production levels laid out in 18 July 2021 OPEC communique. Capital markets can be expected to continue constraining the price-taking cohort's misallocation of resources. These factors underpin our call for balanced markets (Table 1), and our view inventories will continue to draw (Chart 8). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Our balances assessment leaves our price expectations unchanged from last month, with Brent's price trajectory to end-2023 intact (Chart 9). We expect Brent crude oil to average $70, $73 and $80/bbl in 2H21, 2022 and 2023, respectively. WTI is expected to trade $2-$3/bbl lower over this interval. Chart 8Inventories Will Continue To Draw Inventories Will Continue To Draw Inventories Will Continue To Draw Chart 9Brent Prices Trajectory Intact Brent Prices Trajectory Intact Brent Prices Trajectory Intact   Investment Implications Balanced oil markets and continued inventory draws support our view Brent and refined-product forward curves will continue to backwardate, even if the evolution of this process is volatile. As a result, we remain long the S&P GSCI and the COMT ETF, which is optimized for backwardation. We continue to wait for a sell-off to get long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ETF).   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 The US EIA expects natural gas inventories at the end of the storage-injection season in October to be 4% below the 2016-2020 five-year average, at 3.6 TCF. At end-July, inventories were 6% below the five-year average (Chart 10). Colder-than-normal weather this past winter – particularly through the US Midwest and Texas natural gas fields – affected production and drove consumption higher this past winter, which forced inventories lower. Continued strength in LNG exports also are keeping gas prices well bid, as Asian and European markets buy fuel for power generation and to accumulate inventories ahead of the coming winter. Base Metals: Bullish The main worker’s union at Chile's Escondida mine, the largest in the world, and BHP reached an agreement on Friday to avoid a strike. The mine is expected to constitute 5% of total mined global copper supply for 2021. China's refined copper imports have been falling for the last three months (Chart 11). Weak economic data – China reported slower than expected growth in retail sales and manufacturing output for July – contributed to lower import levels.  Precious Metals: Bullish Gold has been correcting following its recent decline, ending most days higher since the ‘flash crash’ last Monday, facilitated by a drop in real interest rates. The Jackson Hole Symposium next week will provide insights to market participants regarding the Fed’s future course of action and if it is in fact nearing an agreement to taper asset purchases. According to the Wall Street Journal, some officials believe the program could end by mid-2022 on the back of strong hiring reports. This was corroborated by minutes of the FOMC meeting which took place in July, which suggested a possibility to begin tapering the program by year-end. While the Fed stressed there was no mechanical relationship between the tapering and interest rate hikes, this could be bearish for gold, as real interest rates and the bullion move inversely. On the other hand, political uncertainty and a potential economic slowdown in China will support gold prices. Ags/Softs: Neutral Grain and bean crops are in slightly worse shape this year vs the same period in 2020, according to the USDA. The Department reported 62% of the US corn crop was in good to excellent condition for the week ended 15 August 2021, compared to 69% for the same period last year. 57% of the soybean crop was in good-to-excellent shape for the week ending on the 15th vs 72% a year ago. Chart 10 US WORKING NATGAS IN STORAGE GOING DOWN US WORKING NATGAS IN STORAGE GOING DOWN Chart 11 Permian Output Approaches Pre-Covid Peak Permian Output Approaches Pre-Covid Peak Footnotes 1 Please see our report of 22 July 2021, OPEC 2.0's Forward Guidance In New Baselines, which discusses the longer-term implications of this meeting and the subsequent communique containing the OPEC 2.0 core group's higher reference production levels. It is available at ces.bcareserch.com. 2 S&P Global Platts notes China's most recent mobility restrictions throughout the country will show up in oil demand figures in the near future. We expect similar reduced mobility as public health officials scramble to get more vaccines distributed. Please see Asia crude oil: Key market indicators for Aug 16-20 published 16 August 2021 by spglobal.com. Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Closed Trades

Dear Client, This week we are sending you a joint Special Report written by my colleagues Xiaoli Tang, Associate Vice President at BCA Research’s Global Asset Allocation, and Qingyun Xu, Associate Editor at China Investment Strategy. In the Special Report Xiaoli and Qing investigate the impact on global portfolios when adding onshore Chinese assets. Their findings confirm our view that Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. However, they conclude that to improve both the absolute and risk-adjusted returns of the onshore equity market, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. More importantly, they find that both hedged and unhedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, and Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios. I trust you will find it insightful. Next week the China Investment Strategy team will take our second of the two-week summer break. We will resume our publication on Wednesday, September 1st. Best regards, Jing Sima, China Strategist Highlights Global investors have become increasingly interested in Chinese onshore equities and bonds as part of their multi-asset portfolios as Chinese onshore equities and bonds have been included in major global stock and bond indexes. In this report, we investigate the impact on global portfolios when adding onshore Chinese assets. Three assets (stocks, bonds and stock-bond combinations) and six home currencies (the USD, JPY, EUR, GBP, CAD and AUD) are included in our portfolio analysis. Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. To improve both the absolute and risk-adjusted returns of the onshore equity market, however, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. Hedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, but higher absolute and risk-adjusted returns may be derived from unhedged bonds, thanks to the positive carry and negative correlation between the onshore Chinese bond index and CNY crosses. Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios, given the negative correlation between the performance of Chinese bonds and equities. Adding a stand-alone Chinese portfolio with equally weighted onshore bonds and equities to a typical 70-30 domestic equity-bond portfolio would significantly improve a non-USD investor’s risk-adjusted return. Global investors may access China’s onshore equity and bond markets through Stock Connect(s), Bond Connect and CIBM Direct. Risk management tools are also available via both onshore and offshore instruments. Feature In the past three decades, China’s financial markets have become the second largest in the world both in terms of equity capitalization and bonds outstanding. Pro-market financial reforms have made the onshore markets increasingly accessible to foreign investors (Appendix 1). As China’s domestic equities and bonds are gradually added to major global equity and bond indexes, the onshore markets have become too sizeable to be ignored by global investors. Chart 1China A Onshore Shares: Highly Volatile Driven By Policy Swings China A Onshore Shares: A Poor Long-Term Asset China A Onshore Shares: A Poor Long-Term Asset Gyrations in China’s equity market in July in response to regulatory changes imposed on various industries (internet, property, education, healthcare and capital markets), however, should be a reminder that volatility in this market is an ever-present aspect. The instability is driven by China’s profound cyclicality in credit, money and macroeconomic policies (Chart 1). Moreover, the unpredictability is exacerbated by periods of geopolitical tensions and domestic political events. We focus on the portfolio impact of adding onshore equities and bonds to global investors’ domestic portfolios with six different home currencies: the USD, euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD) and Canadian dollar (CAD). We also address how to access the onshore markets and what risk management tools are available. Many global investors already have a significant home bias in their portfolios, therefore this report will look at replacing part of a domestic portfolio with Chinese onshore assets. Part 1. Are Chinese Onshore Equities A Good Alternative For Global Equity Investors? 1.1: Chinese Equities Have A Poor Long-Term Return-Risk Profile Chart I-1How Does China A Compare With Global Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? The extremely volatile nature of the MSCI China A onshore equity index (referred to as ‘China A’ in this report) is not a recent phenomenon. Although the volatility in China A has moderated since 2015, the stocks in the index remain highly cyclical and closely correlated with China’s credit growth. China A has gone through two full boom-bust cycles since December 2000 and the third up-cycle started in 2019 is being challenged, as shown in Chart I-1 panel 1. On a rolling three-year basis, China A’s volatility has steadily declined since its peak in early 2015 and is currently comparable to other markets. Meanwhile, its correlation with the rest of the world has steadily risen, standing at around 60% with major equity markets (Chart I-1, bottom 3 panels). The change in correlation with global equity markets could be linked to the launch of the Shanghai Stock Connect and Shenzhen Stock Connect as well as a more market-based RMB exchange rate in the past six years.  Compared with domestic equities for investors in the US, euro area, Japan, UK, Canada and Australia, however, China’s A-shares’ unhedged return-risk profile did not become more attractive after the launch of the Shanghai Stock Connect. As illustrated in Table 1, China A’s underperformance has spanned the entire upcycle in global equities starting in March 2009. It was only in the early years following China’s entrance into the WTO in 2001 that China A-shares performed better than their peers in Japan and the euro area. Table 1Return-Risk Profiles: China A Onshore Index vs Global Equity Indexes and CNY Crosses Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? USD/CNY exchange rate volatility has increased since the 2015 de-pegging from the US dollar, but remains at very low level compared with other CNY crosses. The People’s Bank of China (PBoC) primarily manages the RMB against the dollar by targeting a daily USD/CNY fixing rate, while allowing market forces to drive the RMB value against a basket of currencies in the China Foreign Exchange Trade System (CFETS) index. Chart I-2Correlations Between China A And DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Interestingly, even though CNY crosses with the euro, GBP, JPY, AUD and CAD have much higher volatility, the volatility in unhedged China A-shares in each of those currencies is similar to or lower than that in USD. For example, from December 2014 to July 2021, AUD/CNY had an annualized volatility of 8.8%, much higher than the 4.5% of the USD/CNY, yet the unhedged China A-share's volatility in AUD was 21%, lower than the 24% in USD. The reason lies in correlation, as shown Chart I-2. While China A-shares in CNY have a positive correlation with USD/CNY and JPY/CNY (i.e. China A-share prices tend to rise when China’s currency appreciates against the US dollar and Japanese yen), they have falling and negative correlations with the other four currencies. For equity investors in the US and Japan, exposure to the CNY would increase potential volatility to their home-currency portfolios, but the opposite would be true for investors in the euro area, the UK, Australia and Canada. In addition, Chinese onshore equity correlations with DM equities and EM-ex China equities were low, but have increased since 2015, making onshore shares less attractive for global equity investors looking to diversify. Bottom Line: Chinese onshore shares are a poor long-term asset for global equity investors. 1.2: Factor Strategies Work Well In The Onshore Market Despite Chinese equities’ poor long-term performance, applying a factor strategy to Chinese onshore stocks can create impressive results. In a GAA Special Report on smart-beta strategies for MSCI DM and EM markets, we concluded that a simple, equally weighted five-factor strategy would smooth out the cyclicality of individual factors and outperform the broad market. These five factors are value, equal weight (i.e. size), quality, momentum and minimum volatility, as defined and calculated by MSCI (see Box 1). When we apply the same methodology to the MSCI China A onshore market, the result is even more impressive as shown in Chart I-3. Box 1MSCI Factor Indices Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart I-3Factor Performance: China A Vs Global Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Since December 2004, the value and small cap factors  have outperformed the broad  benchmark by about 11%  and 47%, respectively, in the China A universe, despite sharp corrections since December 2016  for small cap  and Oct 2018 for value. In contrast, in the global universe, value and small cap have underperformed the global benchmark by 24% and 7%, respectively, in the same time frame (Chart I-3, panels 2 and 6.) This confirms anecdotal evidence that the onshore equity market was less efficient than its global peer, although efficiency has improved. Momentum is a consistent factor for global markets. A GAA Special Report on momentum strategy shows that momentum works better in markets with higher individuality where self-attribution and self-confidence are more pervasive, according to Hofstede’s Cultural Dimension theory. This behavioral aspect is confirmed by the performance of momentum in China’s onshore market: in the early years, momentum did not work well, but strengthened after both Shanghai and Shenzhen shares were accessible to foreign investors via the two Stock Connects and mainland institutional investors became more prevalent (Chart I-3, panel 4) Quality is the most consistent factor for global markets because investors reward companies with solid fundamentals. As shown in (Chart I-3, panel 3), this factor has worked even better in the China A market than in the global universe. The fact that good fundamentals have generated superior equity return repels the “myth” that the China A market is a “casino” driven by individual investors, who totally ignore company fundamentals. The minimum volatility factor works in a similar fashion in the onshore Chinese market as in the global markets. Chart I-4Onshore Equity Market Can Be Improved By Smart-Beta Strategies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Factor timing can hardly generate consistent outperformance. BCA’s GAA team advocates equally weighting the five time-tested factors for the MSCI global universe. This approach also applies to China’s onshore market (Chart I-3, panel 1). Since all the factor indexes became available in August 2013, the equally weighted, five-factor portfolio has outperformed the benchmark by about 20% in total with similar volatility. On a rolling one- and three-year basis, this strategy also performs better than the benchmark (Chart I-4). Some investors may prefer a more active and quantitative approach; they should refer to CIS’s Special Report on factor investing in the A-share market. The CIS report recommends that global investors should opt for industry groups with above-median return on equity (ROE) and below-median ex-post beta when investing in the onshore market. ROE is a quality factor in MSCI (see Box 1 above) and below-median beta is a variation of low volatility. Bottom Line: Factor strategies can improve the return and risk profiles of China’s onshore equity market. Part 2. Chinese Onshore Bonds Chinese onshore bonds have attracted global investors because they offer much higher yields than DM government bonds (Chart II-1). At the same time, as shown in Chart II-2, Chinese onshore bond yields have low to negative correlations with major government bond yields. Thus, the onshore bonds offer potential risk diversification for global bond portfolios. Chart II-1Chinese Bonds Offer Higher Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-2Chinese Yields Have Low Correlation With DM Bond Yields Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For foreign DM government bonds, the conventional wisdom is to hedge foreign currency exposure because currency fluctuations outweigh bond volatility. A GAA Special Report shows that hedged foreign bonds have favorable return-risk profiles compared with domestic bonds in major DM countries. For EM local currency debt (based on the JP Morgan GBI-EM Global Diversified Local Currency Debt Index), USD investors should hedge their EM FX exposure while non-USD DM investors should not hedge. However, non-USD investors should avoid EM local currency debt if their objective is to maximize risk-adjusted return on the long-term horizon. Do Chinese bonds share the same traits as the EM aggregate? Our analysis suggests that Chinese bonds have historically provided better risk-adjusted returns to USD-based bond investors, hedged and unhedged. Thus, allocating a portion of the US Treasury portfolio to Chinese onshore bonds would improve a US bond portfolio’s return-risk profile. The Bloomberg Barclays (BB) China Treasury and Policy Bank Bond Index is used for the analysis. The index has a history starting in January 2004, even though it was included in BB's three flagship bond indexes only in April 2019.  On a hedged basis, Chinese onshore bonds deliver similar returns to global bonds as shown in Chart II-3. This is not surprising because interest-rate parity implies that the expected return on domestic assets equals the exchange-rate adjusted return on foreign currency assets, given foreign exchange market equilibrium. Unhedged returns, however, have outperformed both local and foreign government bonds for bond investors in the US, Japan, UK and the euro area since 2004 (Chart II-4). Carry was negative for USD-, GBP- and euro-based investors before the Global Financial Crisis, but has become positive since that time. The CNY has appreciated in general, albeit with greater movement against the non-USD crosses.  Chart II-3Chinese Bond Performance In A Global Context Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-4Carry And Spot CNY Exchange Rate Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Unhedged Chinese bonds have much higher absolute returns and also much higher volatility when compared with hedged bonds. How do Chinese onshore bonds fare on a risk-adjusted return basis? Table 2 compares the risk-return profiles of hedged and unhedged Chinese bonds with local and hedged foreign DM bonds in two periods: one from January 2004 and the other from July 2017 when the Bond Connect was launched. Table 2Return-Risk Profiles: Chinese Onshore Bond Index Vs DM Local Bond Indexes Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Several observations from Table 2: In local currency terms, Chinese bonds have the best risk-adjusted return and the second lowest volatility – only higher than Japanese government bonds (JGBs) – both from January 2004 and from July 2017. Since the start of Bond Connect, the risk-adjusted return of Chinese bonds in CNY has strengthened significantly with higher return and lower volatility. In contrast, there has been a deterioration in DM local bonds and their corresponding hedged foreign government bonds’ return/risk profiles.   In the past four years, Chinese bonds have outperformed all DM local bonds when unhedged, both in terms of absolute return and risk-adjusted return. When compared with a hedged foreign government bond, however, the absolute return advantage has been offset by much higher FX volatility. Still, euro- and JPY-based bond investors enjoy higher risk-adjusted returns from unhedged Chinese bonds than their respective hedged foreign DM government bonds. However, GBP-based investors would be better off with hedged non-UK government bonds. For USD-based bond investors, unhedged Chinese bonds would only be slightly inferior to hedged non-US government bonds. On a hedged basis, Chinese bonds have lower returns and less volatility than local bonds (with the exception of Japan), but they have higher risk-adjusted returns than local bonds in all but the euro area. When compared with hedged foreign bonds, euro- and USD-based investors would do slightly better with the Chinese bonds while JPY- and GBP-based investors would earn slightly more with other DM government bonds. How much should a bond investor replace local bonds with Chinese ones? For illustration, Chart II-5 plots the efficient frontiers for bond investors in the US, euro area, Japan and the UK when hedged Chinese bonds are added to their respective domestic bond portfolios. This addition would reduce portfolio volatility for all domestic bond portfolios, regardless of time frame. This is especially impressive for JGB investors because JGBs already have the lowest volatility among DM bonds. Moreover, returns would be improved for USD- and JPY-based investors when Chinese bonds are gradually included in domestic bond portfolios up to the risk-minimizing point.  Chart II-5Adding Hedged Chinese Bonds Reduces Volatility For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For GBP- and euro-based investors, however, adding hedged Chinese bonds would reduce absolute returns, but significantly improve risk-adjusted returns for GBP-based bond investors. Interestingly, even though euro zone local bonds have had superior risk-adjusted returns to hedged Chinese bonds since 2017, their risk-adjusted returns would still increase by about 18% when 50% of their local-bond portfolio is allocated to Chinese bonds. What is more striking is how unhedged Chinese bonds impact the return/risk profiles of global investors’ domestic bond portfolios. Unlike DM foreign bonds, which have inferior risk-adjusted returns when foreign currency exposure is not hedged, unhedged Chinese onshore bonds actually enhance a domestic bond investor’s absolute and risk-adjusted returns, as shown in Chart II-6. This is because of Chinese bonds’ superior risk-adjusted return measured in CNY (Table 2), negative correlations with CNY crosses (Chart II-7) and low to negative correlations with DM government bonds (Chart II-2). Chart II-6Adding Unhedged Chinese Bonds Enhances Absolute and Risk-Adjusted Returns For All DM Domestic Bond Portfolios* Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? For US bond investors who seek to maximize risk-adjusted return, the domestic Treasury portfolio would be improved significantly if about 40-50% of their holding were allocated to unhedged Chinese bonds. In comparison, the ratios would be lower for bond investors in the euro area, Japan and the UK. The key message is that global investors do not need to hedge the RMB exposure when investing in the Chinese onshore bond market. Chart II-7Chinese Bond Correlation With DM Currencies Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart II-8Chinese Yuan Still Has Upside Potential Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? We still have a favorable cyclical outlook for the CNY against the US dollar, supporting the case not to hedge the currency. The CNY is at about one standard deviation below fair value even though the gap has been narrowing since mid-2020 (Chart II-8). We expect the CNY to keep appreciating in the coming years barring major disruptive geopolitical/political events. China’s relatively strong productivity growth should continue to support the currency’s rising fair value. On a cyclical basis, given that the US Fed is firmly staying behind the curve (capping the upside in real bond yields in the US), the differential in real interest rates between China and other major economies should remain favorable for the RMB.  Bottom line: In a search-for-yield environment, the return-risk profiles of dedicated DM government bond portfolios may be enhanced by adding some exposure to Chinese onshore bonds on an unhedged basis. Part 3. Chinese Onshore Assets For Global Multi-Asset Portfolios Chinese onshore stocks on their own are not suitable for long-term, buy-and-hold strategic investments due to extremely high volatility, and the positive and rising correlation with global stocks and with CNY crosses. Chinese bonds, on the other hand, have an attractive risk-return profile with very low volatility, low correlation with global bonds, and negative correlation with CNY crosses. The negative correlation between Chinese stocks and bonds means that a mixed portfolio of the two assets would provide good diversification (Chart III-1). Chart III-1Chinese Onshore Assets Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-2Chinese Multi-Asset Portfolio Correlation With Global Multi-Asset Portfolios Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Investors may have different stock-bond allocations based on their return-risk objectives and constraints. For illustration, we constructed a stand-alone Chinese multi-asset portfolio by equally weighting onshore stocks and bonds. The correlations of this portfolio with six DM domestic 70-30 stock-bond portfolios have varied over time and by different countries, as shown in Chart III-2. Our Chinese-asset portfolio has a relatively high correlation with US and Japanese assets, but a low correlation with European assets, and almost no correlation with Australian and Canadian assets. Accordingly, the diversification effects are much stronger for GBP-, euro-, AUD- and CAD-based investors than for USD- and JPY-based investors, as shown in Chart III-3. Chart III-3Chinese Multi-Asset Portfolio Should Be Treated As A Standalone Asset By Non-US Asset Allocators Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart III-3 shows how the risk-return profile of a standard 70-30 stock-bond portfolio in the US, UK, Japan, euro area, Australia and Canada may be improved by adding some exposure to a 50-50 Chinese stock-bond portfolio. Even though this equally weighted Chinese onshore asset portfolio has unimpressive returns, when added to a domestic stock-bond portfolio there is an improvement in the return-risk profile of all non-USD-based portfolios. The optimal allocation to the stand-alone Chinese onshore portfolio varies with different home currencies, objectives and time periods, as shown in Table 3. Table 3Chinese Assets Improve Global Multi-Asset Portolios' Return-Risk Profiles Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Bottom Line: Unhedged Chinese onshore stocks and bonds may be treated as a stand-alone asset for global asset allocators, especially non-US ones. Adding a simple 50-50 Chinese stock-bond portfolio may boost the return/risk profile of global multi-asset portfolios. Part 4. Operational Q&A Many foreign investors believe that China’s onshore markets are hard to access. However, regulatory changes in the past 10 years, partially since Stock Connect was launched in 2014, have made it simpler from an operational point-of-view to buy and sell Chinese onshore equities and bonds. Below we answer some questions that international investors may have about market access. Q: Are there any access or quota restrictions for offshore investors to invest in China A-shares via Stock Connect? Historically, access to China’s mainland equity market by offshore investors was restricted through investment quotas and local currency controls. Since 2014, with the launch of Stock Connect, offshore investors no longer have access or repatriation restrictions. Stock Connect allows offshore investors to trade selected A-share stocks listed on the Shanghai (SSE) and Shenzhen (SZSE) Stock Exchanges through offshore brokers. Although not all A-shares listed on the SSE or SZSE can be invested in through Stock Connect, eligible stocks include almost all large- and medium-cap A-shares.1 Note that the Shanghai-Hong Kong (SH-HK) Stock Connect and the Shenzhen-Hong Kong (SZ-HK) Stock Connect complement each other, but they have a dual-channel, independent operation mechanism with two distinct Connect operations. Therefore, their shares cannot be cross-traded. Q: How to purchase China’s A-Shares via Stock Connect? Offshore investors need a Hong Kong or international broker (see MMA strong="">< strong="">GO strong="">> on Bloomberg for a list of Offshore brokers for Stock Connect northbound trading), through whom they buy A-shares. Brokers instruct Hong Kong Exchange’s (HKEX) participants to conduct northbound trades on the SSE or SZSE. Hong Kong Exchange’s subsidiary (a SSE or SZSE participant) also takes instructions to conduct trades on the SSE or SZSE stock exchanges. Clearing and settlement services of A-shares executed through Stock Connect are provided by the Hong Kong Securities Clearing Company (HKSCC), a solely-owned subsidiary of the HKEX, through clearing links established with the China Securities Depository and Clearing Corporation Limited (ChinaClear). The shares of offshore investors are held in an onshore omnibus securities account registered under the HKSCC. Q: Is margin trading or short selling allowed for Stock Connect northbound trading stocks? Yes, most eligible Stock Connect northbound trading A-shares are permitted for margin trading or short selling. Nowadays, more than 80% of the total eligible Stock Connect northbound trading stocks in the SSE and more than 70% of that in the SZSE are permitted for margin trading and short selling. HKEX provides a list of eligible equities for margin trading and short selling in a timely manner.2 Q: Are there other ways to tactically manage exposure to China’s A-shares? There are offshore ETFs that investors can use to hedge their exposure to Chinese equities (Table 4). For example, Direxion Daily CSI 300 China A Share Bear 1X ETF listed on the New York Stock Exchange (NYEX) provides 100% of the inverse exposure of the performance for the CSI 300 index. This ETF may be used to hedge offshore investors’ exposure to domestic China A- shares. Table 4ETFs That Can Be Used To Hedge Investors’ Exposure To Chinese Equities Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Q: Describe the main differences between Bond Connect and CIBM Direct. How do overseas investors hedge their currency exposure when investing in China’s onshore bond market? Bond Connect and China Interbank Bond Market (CIBM) Direct are the official channels for offshore investors to invest in China's onshore bond market except for Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII). Around 680 foreign institutional investors have entered China’s interbank bond market since Bond Connect’s launch in July 2017.3 Here are some differences between CIBM Direct and Bond Connect: Bond Connect is based offshore, which gives overseas investors easy and quota-free access to China’s onshore interbank bond market through offshore trade platforms. Bond Connect permits investors to open accounts, trade, and settle transactions in the offshore market whereas CIBM Direct stipulates the process must be completed in the onshore market. CIBM Direct offers greater access to opportunities in the onshore market because it has access to a wider range of products and hedge tools, such as repos, interest rate swaps, bond lending and bond forwards. In comparison, the only Bond Connect products are bonds traded in China’s inter-bank bond market, and hedge tools are limited. In terms of currency hedging, both CIBM Direct and Bond Connect allow FX hedge tools such as forwards, swaps and options to help investors hedge their exposure to CNY (Chinese yuan traded in the onshore market). CIBM Direct trades in CNY rather than CNH (CNH is Chinese yuan traded in the offshore market) and allows investors to hold onshore balances in CNY. Bond Connect, however, does not allow investors to hold CNY balances. Under Bond Connect, investors are required to exchange CNY into CNH for any excess cash from trading or coupon payments, which can be a currency risk when funds are repatriated. However, offshore investors can hedge their FX exposure with FX Settlement Banks by engaging in various FX trades and FX hedge tools that match their bond position. FX Settlement Banks are banks in Hong Kong approved by the China Foreign Exchange Trade System (CFETS) to access the FX market of CIBM as RMB participation banks. Offshore FX Settlement Banks may square positions in either offshore or onshore FX markets. Investors should contact their Hong Kong custodians, which will appoint an FX Settlement Bank for FX conversion and hedging. Q: Is there another currency hedge mechanism for investors’ CNY exposure?  CNY exposure can be hedged using the usual instruments, such as CNH-forwards or CNY-non deliverable forwards (NDF). However, the CNH-forward has CNH basis risk, which arises from the differences between CNY and CNH spot rates. Investors may consider short CNY currency ETFs listed on the offshore market, such as the WisdomTree Chinese Yuan Strategy Fund (CYB) on the NYEX. CYB offers exposure to the overnight Chinese yuan and uses both short- and long-forward currency contracts for both CNH and CNY to manage its expectations for the currency. It seeks to achieve total returns reflective of money market rates in China available to foreign investors and of changes in the value of the yuan versus the dollar. Xiaoli Tang Associate Vice President, Global Asset Allocation xiaoliT@bcaresearch.com Qingyun Xu, CFA Associate Editor, China Investment Strategy qingyunx@bcaresearch.com   Appendix 1: The Evolution of The Chinese Onshore Markets China’s onshore equity and bond markets have grown dramatically in the past two decades. The equity market is the second largest in the world with more than 4,400 listed companies; the combined market capitalization of the Shanghai and Shenzhen stock exchanges has reached USD12.2 trillion (Chart A1). China’s bond market also is ranked second globally, after the US, with amounts outstanding at USD18.6 trillion (Chart A2). Chart A1China’s Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades China's Stock Market Has Grown Sharply In The Past Two Decades Chart A2China’s Onshore Bond Market Is Second Largest In World Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Thanks to China’s financial market liberalization since the early 2000s, foreign investors can now access China's onshore stock and bond markets to include China A-shares and onshore bonds in portfolios. Various tools are available, including QFII, RQFII, Stock Connect, CIBM Direct and Bond Connect (Diagram 1). Since the launch of Stock Connect in late 2014, the cumulative net northbound flows to the Shanghai and Shenzhen exchanges have been more than RMB1.2 trillion (Chart A3, top panel). The cumulative net capital inflows through CIBM Direct and Bond Connect have reached more than RMB3.5 trillion since these mechanisms were introduced in 2016 and 2017, respectively (Chart A4, bottom panel).  Diagram 1China’s Financial Market Liberalization Roadmap Can Global Investors Afford To Ignore China’s Onshore Markets? Can Global Investors Afford To Ignore China’s Onshore Markets? Chart A3Net Inflows To China’s Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Net Inflows To China's Onshore Markets Through Stock And Bond Connect Chart A4Growing Foreign Holdings Of China’s Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Growing Foreign Holdings Of China's Onshore Equities And Bonds Although foreign investors’ holding of RMB-denominated assets increased significantly in recent years, their share of the total onshore market is still small, highlighting the potential for more capital inflows to China’s onshore market (Chart A4). Following the inclusion of China A-shares in global equity indexes, bond indexes have followed suit and Chinese government bonds are now offered in the world’s three major bond indices. Bloomberg Barclays Global Aggregate Index (BBGA) was the first to include Chinese government bonds in April 2019, followed by the JP Morgan Government Bond-Emerging Market Index (GBI-EM) in February 2020 and finally FTSE Russell’s World Government Bond Index (WGBI) in October 2021.   Footnotes 1The list of eligible A-shares for Shanghai and Shenzhen Connect can be accessed via the HK Exchange 2List of eligible equities for margin trading and short selling 3List of approved investors under Bond Connect Market/Sector Recommendations Cyclical Investment Stance

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 17 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST and August 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Scheduling Note: There will be no US Bond Strategy report next week. The following week (August 31), clients will receive a report written by our Global Fixed Income Strategist Rob Robis. The regular US Bond Strategy publication schedule will resume on September 8 with the publication of September’s Portfolio Allocation Summary. Best regards, Ryan Swift, US Bond Strategist

Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years.   Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Afghanistan? Watch Iran And China Afghanistan? Watch Iran And China Chart 6US Not Shrinking From Global Role US Not Shrinking From Global Role US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.