Manufacturing

While there is much variability in company profitability, earnings contractions have commenced and appear to be broad-based. We expect earnings growth to deteriorate further into year-end. Companies are reporting concerns about the trajectory of future economic growth and the uncertainty that it brings. Consumer spending on goods has slowed sharply, while spending on discretionary services has surprised on the upside. Business-to-business spending is still strong.

Special Report

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Chart 1Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West​​​​​ Chart 3Turkish Energy Ties With Russia Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.     Executive Summary Euro Bulls Are Evaporating The euro is likely to undershoot in the near term, as the winter months approach and economic volatility in Europe rises. However, much of the euro’s troubles are well understood and discounted by financial markets. This suggests a floor closer to parity for the EUR/USD. Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year. The forces pressuring equilibrium rates lower in the periphery are slowly dissipating. That should lift the neutral rate of interest in the entire eurozone. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro, but that could change. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN Long EUR/GBP 0.846 2021-10-15 -0.13 Short EUR/JPY 141.20 2022-07-07 2.46 Bottom Line: The euro tends to be largely driven by pro-cyclical flows, which will be a positive when risk sentiment picks up. Meanwhile, making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond. Our current stance is more measured because investors could see capitulation selling in the coming months. Feature Chart 1Two Decades After The Creation Of The Euro The creation of the euro was an ambitious project. It began with a simple idea – let’s create the biggest monetary union and everything else will follow, not least, economic might. Over the last two decades, the euro has survived, but its ambitions have been jolted by various crises. Today, the euro is sitting around where it was at the initiation of the project (Chart 1). That has been a tremendous loss in real purchasing power for many of its citizens. Given that we are back to square one, this report examines the prospects for the euro from the lens of its original ambitions, while navigating the economic and geopolitical landscape today. Surviving The Winter Chart 2A European Recession Is Well Priced In Winter will be tough for eurozone citizens. But how tough? In our view, less than what the euro is pricing in. According to the ZEW sentiment index, the eurozone manufacturing PMI should be around 45 today, but sits at 49.8. The euro, which has been tracking the ZEW index tick-for-tick has already priced in a deep recession, worse than the 2020 episode (Chart 2). Bloomberg GDP growth consensus forecasts for the eurozone are still penciling in 2.8% growth for 2022, down from a high of 4%. For 2023, forecasts have hit a low of 0.8%. It is certainly possible that euro area growth undershoots this level, which will cause a knee jerk sell off in the euro. However, much of the euro’s troubles are well understood and discounted by financial markets. Natural gas storage is already close to 80%, the EU’s target, to help the eurozone navigate the winter. Coal plants are firing on all cylinders, and Germany has decided to delay the closure of its nuclear power plants. It is true that electricity prices are soaring, but part of the story has been weather-related, notably a heat wave across Europe, falling water levels along the Rhine that has delayed coal shipments, and lower wind speeds that have affected renewable energy generation. France is also having problems with nuclear power generation, due to little availability of water for cooling reactors. Looking ahead, energy markets are already discounting a steep fall in prices from the winter energy cliff (Chart 3). If that turns out to be true, it will be a welcome fillip for eurozone growth. First, it will ease the need for the ECB to tighten policy aggressively, and second, it will boost real incomes, which will support spending. This is not being discussed in financial markets today. Chart 3AFutures Markets Suggest The Energy Crunch Will Ebb Chart 3CFutures Markets Suggest The Energy Crunch Will Ebb Chart 3BFutures Markets Suggest The Energy Crunch Will Ebb Fiscal Policy To The Rescue? Unlike many other developed economies, the fiscal drag in the eurozone is likely to be minimal for the rest of this year and early next year (Chart 4). As funds from the next generation EU plan are being disbursed into strategic sectors, including renewable energy, Europe’s productive capital base will also improve. This is likely to have a huge multiplier effect on European growth. Chart 4AThe Fiscal Drag In The Eurozone Could Be Minimal Chart 4BThe Fiscal Drag In The Eurozone Could Be Minimal Taking a bigger-picture view, what has become evident in recent years is stronger solidarity among eurozone countries, both economically and politically. Related Report  Foreign Exchange StrategyMonth In Review: Inflation Is Still Accelerating Globally Economically, the standard dilemma for the eurozone was that interest rates were too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. As such, the euro was often caught in a tug of war between a rising equilibrium rate of interest for Germany, but a very low neutral rate for the peripheral countries. The good news is that for the eurozone, a lot of this internal rupture has been partly resolved. Labor market reforms have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract since 2008. This has effectively eliminated the competitiveness gap with Germany, accumulated over the last two decades (Chart 5). Italy remains saddled with a rigid and less productive workforce, but the overall adjustments have still come a long way to close a key fissure plaguing the common currency area. The result has been a collapse in peripheral borrowing spreads, relative to Germany (Chart 6). Ergo, interest payments as a share of GDP are now manageable. It is true that Italy remains a basket case but the ECB’s Transmission Protection Instrument (TPI) will ensure that peripheral spreads remain well contained and a liquidity crisis (in Italy) does not morph into a solvency one. Chart 5The Periphery Is Now Competitive Chart 6Peripheral Spreads Are Still Contained In Real Terms Beyond the adjustment in competitiveness, productivity among eurozone countries might also converge. Our European Investment Strategy colleagues suggest that the neutral rate is still wide between Germany and the periphery. That said, gross fixed capital formation in the periphery has been surging relative to core eurozone members (Chart 7). If this capital is deployed in the right sectors, it will have two profound impacts. First, the neutral rate of interest in the eurozone will be lifted from artificially low levels. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates lower in the periphery are slowly dissipating, that should lift the neutral rate of interest in the entire eurozone. Over a cyclical horizon, this should be unequivocally bullish for the euro. Second, and more importantly, economic solidarity among eurozone members will help ensure the survival of the euro, over the next decade and beyond. Chart 7The Periphery Could Become More Productive Trading The Euro The above analysis suggests long-term investors should be buying the euro today. However, the long run can be a very long time to be offside. Our trading strategy is as follows: Over the next 6 months, stay neutral to short the euro. The economic landscape for the eurozone remains fraught with risk. This is a typical recipe for a currency to undershoot. Eurozone banks are very sensitive to economic conditions in the eurozone, and ultimately the performance of the euro, and the signal from bank shares remains negative (Chart 8). Chart 8European Banks Are Not Part Of The Agenda Watch Eurozone Banks Investors have been cutting their forecasts for the euro but have not yet capitulated. Bets are that the euro will be at 1.10 by the end of next year, and 14% higher in two years. A bottom will be established when investors cut their forecasts below current spot prices (Chart 9). This corroborates with data from net speculative positions that have yet to hit rock bottom.  Chart 9Euro Bulls Are Evaporating Real interest rates in the euro area are still plunging across the curve, relative to the US. The two-year real yield has hit a cyclical low. Five-year, 10-year and 30-year real yields are also falling. Historically, the euro tends to trend higher when interest rate differentials are moving in favor of the eurozone (Chart 10). Chart 10AReal Rates Are Dropping In The Euro Area Chart 10BReal Rates Are Dropping In The Euro Area Hedging costs have risen tremendously, as the forward market (like investors) is already pricing in an appreciation in the euro. The embedded two-year return for EUR investors is circa 4%, in line with the carry costs (Chart 11). In real terms, the returns are closer to 9% to compensate for much higher inflation expectations in the eurozone. Higher hedging costs will dissuade foreign investors from gobbling up European assets on a hedged basis. Chart 11A 5% Rally In The Euro Is Already Anticipated In short, the euro is likely to enter a capitulation phase. Our sense is that that it will push EUR/USD below parity, towards 0.98. Below that level, we believe the risk/reward profile will become much more attractive for both short- and longer-term investors. Signals From External Demand Chart 12The Euro Is Increasingly Dependant On Chinese Data The eurozone is a very open economy. Exports of goods and services represented 51% of euro area GDP in 2021. This means that what happens with external demand, especially in the US, the UK and China, matters for European growth (Chart 12). Of all its major export partners, China is the biggest question mark. China’s zero Covid-19 policy along with property market troubles has weighed heavily on the euro. Historically, the Chinese credit impulse has been a good coincident indicator for EUR/USD. Lately, that relationship has decoupled (Chart 13A). We favor the view that the credit transmission mechanism in China is merely delayed, rather than broken. For one, a rising Chinese credit impulse usually leads European exports, and this time should be no different. Chinese bond markets are also becoming more liberalized, and as such are a key signal for financial conditions in China. For over a decade, easing financial conditions have usually been a good signal that import demand is about to improve (Chart 13B). This is good news for European export demand. The bottom line is that investors are currently too pessimistic on Europe’s growth prospects at a time when a few green shoots are emerging for external demand. That may not save the euro in the near term but will be a welcome fillip for euro bulls when it does undershoot. Chart 13AThe Muse For The Euro Is Chinese Data Chart 13BThe Muse For The Euro Is Chinese Data Concluding Thoughts Chart 14The Goldilocks Case For The Euro The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts are aggressively revising up their earnings estimates for eurozone equities, relative to the US. They might be wrong in the near term, but over a 9-to-12-month horizon, this has been a good leading indicator for the euro.  Making a structural case for the euro is easy when it comes to valuation. According to our in-house PPP models, an investor who buys the euro today can expect to make 6% a year over the next decade, should the euro mean revert to fair value and beyond (Chart 14). Meanwhile, beyond the winter months, inflation could come crashing back to earth in the eurozone, which will provide underlying support for the fair value of the currency. Our near-term stance is more measured because investors are only neutral the euro, and risk reversals are not yet at a nadir. This is particularly relevant given that Europe still has a war in its backyard, with the potential of generating more market volatility ahead. Given this confluence of factors, we have chosen to play euro via two channels: Long EUR/GBP: As we argued last week, the UK has a bigger stagflation problem compared to the eurozone. This trade is also a bet on improving economic fundamentals between the eurozone and the UK, as well as a bet on policy convergence between the two economies. Short EUR/JPY: The yen is even cheaper than the euro. In a risk-off environment, EUR/JPY will sell off. In a risk-on environment, the yen can still benefit since it is oversold. Meanwhile, investors remain bullish EUR/JPY. Long EUR/USD: We will go long the euro if it breaks below 0.98.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

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Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (August 16 at 10:00 AM EDT, 15:00 PM BST, 16:00 PM CEST). 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. Best regards, Ryan Swift, US Bond Strategist Treasury Index Returns Spread Product Returns

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Executive Summary Iron Ore & Steel Prices: Facing Downward Pressure Global iron ore and steel supply is likely to grow faster than demand over the next six months. As a result, the prices of both metals will likely fall. Chinese steel output will likely rebound moderately in the absence of government-mandated steel production cutbacks. In the meantime, mainland steel demand will continue to contract because of its crumbling property sector. Global steel output excluding China will contract over the next six months on the back of weakening industrial demand for steel. Even though Chinese iron ore consumption may rise moderately over the next six months, its imports will not improve much because of robust growth in domestic iron ore production. Furthermore, global iron ore demand excluding China will decline as steel demand and output contract. In the intervening six months, global iron ore production growth will rise. This will lead to an oversupplied iron ore market.  Bottom Line: Both iron ore and steel prices will likely deflate over the next several months. Therefore, Chinese steel share prices as well as global mining and steel stocks have more downside.   China’s demand for iron ore and steel are key to their respective price outlooks because these metals account for about 70% of global iron ore imports and over 50% of global steel consumption. Considerable reduction in Chinese steel output (hence, demand for iron ore) and rising domestic iron ore supply have resulted in a contraction in Chinese iron ore imports since last June. In the meantime, domestic steel demand weakened sharply, primarily because of plunging property construction. The upshot has been lower domestic steel prices (Chart 1). This report evaluates the direction of iron ore and steel prices over the next six months. Chart 1Crumbling Property Sector: Lower Steel Demand Ahead Chart 2Iron Ore & Steel Prices: Facing Downward Pressure We expect Chinese steel output to rise in the absence of government-mandated production cuts and on positive profit margins. This will lift Chinese iron ore imports. In the meantime, Chinese steel demand will likely continue to contract. Thus, steel prices will continue falling over the next several months (Chart 2, top panel). For iron ore, an increase in Chinese imports will not be enough to offset contracting global demand. As a result, the price of iron ore will face downward pressure over the coming months (Chart 2, bottom panel). From The Chinese Steel Market… The Chinese steel market may experience an increasing oversupply over the next six months. Chinese Steel Supply Chinese steel production is likely to rise moderately in the next six months.  First, there are no government-mandated cuts in steel production currently in place. Chart 3Mandated Steel Output Cuts In 2021: Unlikely Repeat In 2022H2 Last June, Chinese authorities ordered steel mills to cut output from record levels in a bid to restrain carbon emissions. This resulted in a 15% year-on-year drop in Chinese crude steel1 output and a 10% year-on-year decline in Chinese steel products production during 2021H2 (Chart 3). In 2022Q1, to ensure smog-free skies in February as China hosted the 2022 Winter Olympic Games, some steel producers were again ordered to cut their production. As a result, the year-on-year decline of Chinese steel output and steel product output for 2022Q1 were at 10% and 5%, respectively. In 2022Q2, however, the picture is more of a mixed bad. While many small firms increased volumes, medium and large sized steel producers voluntarily chose to reduce their output. As a result, China’s steel output is remains in contraction. Further, tightness in electricity supply over the summer curbed any potential recovery in steel output. Over the next six months, we expect decreasing voluntary cuts and easing electricity supply will lift steel output moderately. Chart 4Steelmakers' Profit Margins: Low, Albeit Still Positive Second, overall profit margins for Chinese steel producers are still positive, albeit at a low level (Chart 4). Even at a very low profit margin, steel producers in China still tend to produce steel as much as they can to cover their very large fixed costs. In other words, if they do not produce, they will experience greater losses.  In addition, given deteriorating employment conditions in the broader economy, maintaining employment has become a major focus of local governments. The latter will guide state-owned enterprises (SOEs) – many steel mills are SOEs or government-affiliated – to raise output and employment. For now, the government has simply asked steel producers to cut their production voluntarily, rather than mandating cuts as authorities did last year and earlier this year. In brief, in the absence of government-mandated steel output reduction, some producers will opt to increase their output to cover their fixed costs and maintain/increase employment. Will the Chinese government demand mandated cuts again later this year? We believe the odds are low. Last year, the mandated cuts were the result of more aggressive emissions reduction targets, with a deadline at the end of 2025 for the Chinese steel sector. In February of this year, the authorities extended this deadline to 2030 to grant its steel sector the ability to reach peak emissions. This will allow a gradual output reduction instead of a sharp reduction in mills with high-emission steel-producing capacity. With such a deadline extension already in place, the government is unlikely to implement mandated steel output cuts again. Chinese Steel Demand Chinese steel consumption will likely continue to contract over the next six months. Chart 5 shows that 58% of Chinese steel consumption is from building and construction, which mainly comprises the property sector and the infrastructure sector. Based on our estimate, Chinese steel demand will decline about 3.8% over the next six months, mainly dragged down by the shattered property market (Table 1). Chart 5Chinese Steel Consumption Composition Table 1Chinese Steel Demand Growth Estimates Chart 6Property Market is in a Crisis The property sector is the largest steel consumer, accounting for about 35% of Chinese steel consumption. This sector is going through a crisis, and there are no signs of improvement yet. Property sales, new construction, and completion are all in a deep and unprecedented contraction (Chart 6, panels 1, 2, and 3). Even the commodity building floor space under construction entered contraction for the first time in at least the past two decades (Chart 6, bottom panel). Both central and local governments have implemented policies to revive the property sector since late last year. Following a wave of mortgage boycotts, the July 28 Central Politburo meeting demanded local governments to ensure those sold-but-unfinished housing projects to be completed. However, due to the extreme shortage of funding faced by real estate developers and the fragmented nature of this industry in China, it will take time to get the current property sector crisis resolved. Nonetheless, we expect supportive policies will work to some extent. We expect the year-on-year contraction in property construction to narrow to 10% over the next six months from about 13% in the past six months. Chart 7Infrastructure Sector: The Main Supportive Force for Chinese Steel Demand The infrastructure sector is another major source for Chinese steel demand (Chart 7). The sector contributes about 23% of Chinese steel consumption. Although the traditional infrastructure investment shows a solid 10% growth, we only assume 7% of growth in the sector’s steel demand. This is because, within the traditional infrastructure sector, two heavy steel consuming subsectors –railway and highway constructions – will register slower growth in their respective investments than overall infrastructure. Chart 8Steel Demand In the Machinery Sector: Likely to Remain In Contraction The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High... Machinery production, the third largest steel consuming sector, will remain in contraction because of the depressed property market. Sales of major construction equipment – excavators, loaders, and cranes – have declined 36%, 23%, and 50% year-on-year in 2022H1 (Chart 8). With continuing weakness in the property market, we expect steel demand from machinery producers to be in a similar contraction (10%) over the next six months. Autos and electric appliances together account for about 7.3% of Chinese steel consumption. Weekly data shows Chinese auto sales are in a recovery phase (Chart 9). We expect the sector’s steel use to increase by 8% year-on-year over the next six months based on our projections from our research on the auto industry. Affected by the faltering domestic property market, the outlook for electric appliances is also dismal. The output of air conditioners, freezers, refrigerators, and washing machines is contracting (Chart 10). The expected contraction in global demand for consumer goods will ensure a continuous drop in their production in China, the largest world producer of white goods. We expect these sectors' steel consumption growth to improve from a 9% contraction in 2022H1 to a 5% contraction over the next six months. Chart 9Steel Demand From Auto Sales is Recovering Chart 10Steel Demand by Electric Appliances: Smaller Contraction Ahead Chart 11Steel Demand in Other Sectors: Will Likely Stay in Contraction Other sectors that consume steel include many industrial goods, such as civil steel ships and containers. The shipping industry has boomed during the past two years because of a global increase in goods demand. This also significantly increased demand for metal containers, and to a lesser extent, civil steel ships between 2020 and 2021 (Chart 11). As global trade volumes contract over the next six months, we expect steel consumption in these other sectors to contract by 3% over the same period. What about external demand for Chinese steel? Chinese steel products exports, which account for about 5% of the country’s steel products output, will grow moderately in the next six months. Historically, the Chinese government had provided a VAT rebate of around 13% to encourage steel exports. Last year, it removed such export tax rebates on various steel products in a bid to slow domestic carbon emissions. Chart 12Chinese Steel Exports: Moderate Growth Ahead However, this has not considerably reduced Chinese steel exports. Chinese exports of steel products only had a year-on-year contraction from January to April 2022, largely because of COVID-related shutdowns, and then experienced considerable growth during May-July of the same year (Chart 12). At the same time, Chinese imports of steel products have been contracting since last May. This pattern shows the strong global competitiveness of Chinese steel products. We expect moderate growth in Chinese steel products exports over the next six months, which will be much lower than last year’s growth. In 2021, Chinese steel products exports surged by 25% year-on-year, as steel exporters rushed to export their products to take advantage of the rebates before its removal. Bottom Line: Chinese steel supply is likely to exceed demand over the next six months. This will result in an oversupplied steel market in China, exerting downward pressure on steel prices. …To The Global Iron Ore Market Chart 13Chinese Steel Production: Largely Determines the Country's Iron Ore Imports Iron ore is mainly used in the steel-making process. Limited iron ore supplies within China mean that about 80% of the country’s iron ore demand are satisfied by imports. As a result, variations in Chinese steel production largely determine swings in Chinese iron ore imports (Chart 13). Based on our expectations of the Chinese steel market, we can provide our supply-demand analysis for the global iron ore market. Global Iron Ore Demand While rebounding Chinese steel output will lift the nation’s iron ore consumption, iron ore demand from the rest of the world will shrink materially. Net-net, global iron ore demand will weaken, albeit only marginally over the next six months. Steel production is declining in the world outside China. We expect such contraction will continue into early 2023, as the pandemic-triggered overspending on goods ex-autos reverses (Chart 14). In addition, in Europe, energy rationing and sky-high energy prices will likely lead to defunct mills as a response to reducing their output; hence, their iron ore consumption will tank. Given that Europe accounts for about 10% of world steel production and nearly 50% of its steel production is using electric furnaces,2 this will reduce global iron ore demand. Last year, global steel production excluding China increased by 13% year-on-year, the highest growth since 2011 (Chart 15). This is much higher than the average 2% growth during 2017-2019, reflecting the overconsumption of goods by advanced economies in 2021. Indeed, steel production has already declined for four consecutive months. We expect a year-on-year contraction of about 5% global steel production in the world excluding China over the next six months. Chart 14The World Outside China: Steel Output Will Continue Declining Chart 15Falling DM PMI Signals Weaker Steel Output in the World Outside China Scrap steel is one substitute for iron ore in the steel-making process, but, this time, there will be limited replacement from scrap steel in China. Tight supply of scrap steel and relatively high scrap steel prices will make iron ore more appealing than scrap steel as feedstock for Chinese steel producers over the next several months. Scrap prices are currently high relative to both steel product prices and imported iron ore prices (Chart 16). Chart 16Iron Ore Substitute in China: Limited Scrap Steel Demand in 2022H2 Chart 17China: Domestic Iron Ore Output is Rising Global Iron Ore Supply Global iron ore supply will rise slightly over the next six months. Chinese iron ore output is set to continue increasing as well (Chart 17, top panel). The authorities plan to boost domestic iron ore output by 6.5% per year until 2025. Profit margins for Chinese producers are currently at a multi-year high (Chart 17, bottom panel). This will encourage domestic iron ore production over the next six months.  Currencies in global major iron ore producing countries (Brazil, Australia and South Africa) have depreciated considerably. As a result, iron ore prices in these countries in local currency terms are currently still elevated. This will incentivize more iron ore production and exports by producers in these countries. Bottom Line: Global iron ore supply will increase slightly, while demand will contract slightly over the next six months. This will be negative for iron ore prices. Investment Implications Chart 18Global Mining Stocks and Steelmaker Stock Prices: More Downside Ahead Avoid Global Steel And Mining Stocks For Now Both iron ore and steel prices will likely deflate over the next six months. Hence, global mining stocks and steelmakers stock prices will experience more downside in the coming months (Chart 18). Global ex-China steel producers have benefited from strong steel demand in DM and from surging steel prices (Chart 15 above). As we expect that DM demand for consumer goods will contract over the next six months, steel prices will drop, weighing on global steelmakers’ share prices.  Concerning equity valuations, global mining and steel stocks trade at very low trailing P/E ratios. However, for highly cyclical stocks, such a low trailing P/E ratio is often a sign of peak profits. At peaks of cycles, share prices drop first, while EPS remains elevated, as it is a backward-looking variable. In fact, more often than not, buying these stocks when the P/E ratio is very high and selling them when the P/E ratio is very low has been a very profitable strategy. In short, a low P/E ratio for mining share prices and steel producers is not a reason to be long these stocks. The direction of both the global industrial cycle and steel and iron ore prices is what matters. On both counts, the outlook remains downbeat for now.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1     According to the World Steel Association, crude steel is defined as steel in its first solid (or usable) form, including ingots, semi-finished products (billets, blooms, slabs), and liquid steel for castings. 2     The electric furnace is using electricity and scrap steel to produce crude steel. As Europe is facing energy constraint, this will likely affect European steel output greatly. Strategic Themes Cyclical Recommendations

S&P 500 Chart 1Macroeconomic Backdrop Chart 2Profitability Chart 3Valuations And Technicals Chart 4Uses Of Cash Cyclicals Vs Defensives Chart 5Macroeconomic Backdrop Chart 6Profitability Chart 7Valuation And Technicals Chart 8Uses Of Cash Growth Vs Value  Chart 9Macroeconomic Backdrop Chart 10Profitability Chart 11Valuations And Technicals Chart 12Uses Of Cash Small Vs Large Chart 13Macroeconomic Backdrop Chart 14Profitability Chart 15Valuations and Technicals Chart 16Uses Of Cash Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation  

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Executive Summary Non-Commodity Enterprises: No Profit Expansion For 12 Years The past decade has seen a deterioration in the financial performance metrics of industrial Chinese companies. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long-term profitability of China’s industrial sector. Potential deleveraging by local governments, companies and households will cap revenue growth for enterprises and, hence, weigh on their profitability. High commodity prices in the past 18 months have improved profitability and financial metrics for commodity producers. These strengths will reverse as commodity prices sink in the coming months. Corporate earnings are set to disappoint in 2H. Bottom Line: We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. In absolute terms, risks to Chinese shares prices are to the downside. ​​​​Among Chinese industrial companies, underweight commodity producers and overweight food & beverage, autos and utilities.   The data for this report for industrial enterprises, which are sourced from China’s National Bureau of Statistics (NBS), encompass state-owned and holding enterprises (SOEs) and other forms of ownership, including private ones. It covers both listed and non-listed companies. The sectors included are construction materials, steel, non-ferrous metals, energy, coal, machinery, auto, tech hardware, food & beverage and utilities. An analysis based on this dataset shows that China’s corporate profitability and efficiency ratios have experienced a prolonged structural downturn since the early 2010s (Chart 1 and 2). Chart 1Chinese Industrial Companies: Structural Deterioration in Productivity... Chart 2… And Operational Efficiency Chart 3Cyclical Improvements Within Structural Downtrend In the past 10 years, these measures improved only modestly during recovery periods and stumbled during downturns (Chart 3). The structural deterioration in corporate profitability from 2011 onward has followed structural improvements from the late 1990s to 2010. Beyond cyclical upswings, China's corporate profitability will likely continue to face structural headwinds. Declining efficiency of investments, rising labor compensation and slowing productivity growth will constitute formidable headwinds to the long run profitability of China’s industrial sector. Furthermore, potential deleveraging by local governments, companies and households will curtail revenue growth for enterprises and, hence, weigh on profitability. Investigating The Financial Performance Of Industrial Enterprises Our analysis of corporates’ financial ratios shows the following: Corporate leverage: The total liabilities (debt)-to-sales ratio rose sharply from 2011 until 2021. However, the leverage ratio has declined in the past 18 months. A close examination suggests that the descent in the debt-to-sales ratio has been due to surging revenues of resource producing companies propelled by rising commodity prices. Chart 4 illustrates that the debt-to-sales ratio has dropped substantially for commodity producers, but much less so for other industrial companies. In the case of non-commodity industrial enterprises, the leverage ratio has not declined much because nominal sales have been lackluster. As resource prices continue to drop, revenues of commodity companies will be devastated, and their debt-to-sales ratios will spike. The thesis that corporate leverage has not yet dropped in China is corroborated by data on all companies. The country’s corporate leverage remains the highest worldwide (Chart 5). Chart 4The Decline In Debt-To-Sales Ratio For Commodity Producers Was Largely Due to Surging Commodity Prices Chart 5China's Corporate Leverage Remains The Highest In the World Chart 6Corporates' Debt servicing Ability Has Been propelled by falling interest rates Debt servicing: Even though debt levels of industrial companies remain elevated, their interest coverage ratios – operating profits-to-interest expense – have improved since late 2020. For all industries, interest expenses have dropped substantially because of falling interest rates (Chart 6). On the margin, this has also helped industrials’ profit margins.   Efficiency: Asset turnover (sales/assets), inventory turnover (sales/inventory) and receivables turnover (sales/receivables), have all have sunk in the past 10 years, as shown in Chart 2. Lower turnover indicates falling efficiency. Coal, steel and non-ferrous metals have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign. Meanwhile, there has been no improvement in inventory turnover for non-commodity enterprises.   Profit margins: Net profit margins for industrial corporates have recently risen slightly. However, the entire improvement in industrial profit margins is attributable to commodity producers. With the exception of commodity producing sectors, there has not been any upturn in operating profit margins and/or net profit margins (Chart 7). Rising corporate income taxes from 2011 to 2020 were one of the reasons worsening profitability (Chart 8). Chart 7Improvement In Industrial Profit Margins Is Attributable To Commodity Producers Chart 8Rising Corporate Income Taxes Have Contributed The Divergency Between GPM And Net Profit Margin Profitability: The return on assets (RoA) and the return on equity (RoE) for industrial corporates have dwindled during the past decade (Chart 1 above). The spike in commodity prices in the past two years has helped profitability of commodity producers, but this is about to reverse. A DuPont analysis1 illustrates that the downturn in corporate profitability was driven by poor operating efficiency and a lack of improvement in net profit margins. Chart 9 shows that the profitability of non-commodity producers has worsened dramatically during the past 10 years. After more than a decade-long structural downturn, the RoA and RoE for commodity producers have recently strengthened along with asset turnovers and net profit margins (Chart 10). However, the commodity bonanza is over for now and profitability measures of resource companies are set to worsen significantly.2 Chart 9A DuPont Analysis: Non-Commodity Enterprises Chart 10A DuPont Analysis: Commodity Enterprises Bottom Line: The past decade has seen a deterioration in the financial performance metrics of industrial companies. The profitability of corporates has undergone a structural decline along with a prolonged slump in operating efficiency.  High commodity prices in the past 18 months have ameliorated profitability and efficiency parameters for commodity producers. Nevertheless, these improvements will vanish as commodity prices fall materially in the coming months. Structural Headwinds To Corporate Profitability The following factors will weigh on China’s corporate profitability in the long term: 1. Demographics and rising labor costs: A shrinking workforce since mid-2010s has led to higher wages that have weighed on the corporate sector’s profitability (Chart 11). This dynamic is also confirmed by rising labor compensation as a share of non-financial corporates’ value added, as illustrated in Chart 12. Chart 11China: Shrinking Labor Force Chart 12Labor Compensation As A Share Of Corporate Revenues In China, blue-collar labor shortages and upward pressures on wages will likely intensify in the coming decade. A rapid decline in the population’s natural growth rate with the third lowest fertility rate in the world (below Japan) foreshadows a decline in China’s working age population which started in 2015.  2. Common prosperity policies: The share of labor compensation in GDP has risen since 2011 at the expense of the share of corporate profits (Chart 13). China’s common prosperity policies will only reinforce this trend. These policies will encourage enterprises to assume more social duties, distributing a larger share of profits to society at the expense of shareholders. Chart 13Labor's Share Will Continue Rising In China's National Income Chart 14Output Per Unit Of Capex Is Falling 3. Declining efficiency of investments: A deteriorating output-to-capital ratio  indicates capital misallocation or falling efficiency (Chart 14). When a nation attempts to invest substantially for a long time, capital will likely be misallocated and the return on new investment will be low. This will drag down the overall return on capital. Falling efficiency ultimately entails lower productivity. 4. Slowing productivity growth: China’s productivity growth has downshifted, and total factor productivity growth slipped again recently. Notably, total factor productivity – a measure of productivity calculated by dividing economy-wide total production by the weighted average of inputs – has contributed less and less to China’s real GDP growth in the past decade. It is unrealistic to expect that China will reverse the downward trend in productivity growth in the next few years. 5. Deleveraging by companies and households: China’s corporate sector continues to face deleveraging pressures. Although some industrial enterprises underwent deleveraging in recent years, the country’s overall corporate debt is still very elevated. Remarkably, Chinese corporate debt as a share of nominal GDP is the highest in the world, as shown in Chart 5. China’s households are reducing debt. Depressed household income growth and deflating home prices have curbed borrowing. Deleveraging by households heralds weaker consumption, which is negative for corporates revenues. Bottom Line: Rising labor compensation and declining efficiency of investments constitute formidable headwinds to the profitability of China’s industrial sector. Moreover, the secular outlook of corporates’ profitability is also vulnerable to lower productivity growth and weaker top-line growth due deleveraging among companies and households. The Cyclical Outlook In our report two weeks ago, we discussed how China’s business cycle recovery in the second half of this year will be more U rather than V shaped. Both sluggish domestic demand and contracting external demand for Chinese exports will curb the rebound of the industrial sector in 2H. Industrial earnings are set to disappoint.  Chart 15Non-Commodity Enterprises: No Profit Expansion For 12 Years Manufacturing producers have not been able to fully pass on higher input prices to consumers given weak demand. This weakness together with elevated commodity prices has led to a substantial profit divergence between upstream and mid- and downstream industries since late 2020 (Chart 15).  However, upstream commodity producers face the headwind of commodity price deflation. At the margin, weakening resource prices will benefit mid- and downstream industries that use commodities. However, their revenue growth will remain fragile due to subdued domestic and external demand and a lack of pricing power. The tight correlation between industrial profits and raw material prices reinforces the importance of commodity prices as a driver of China’s industrial profit cycles Therefore, if commodity prices drop meaningfully in the second half of this year, then overall industrial profits in China will suffer markedly. Chart 16The share of loss-making industrial enterprise ventures has Rocketed Furthermore, overcapacity and operational inefficiencies persist despite supply-side reforms and a capacity reduction campaign implemented by China’s authorities. Chart 16 demonstrates that the share of loss-making industrial enterprise ventures has soared to 24%, implying capital misallocation.  With a further rising share of enterprises making losses as commodity prices plunge, the ability of companies to service debt will deteriorate and hence banks will experience climbing non-performing loans. Bottom Line: China’s recovery in the second half of this year will be more U than V shaped. Corporate earnings are set to disappoint in 2H. Investment Strategy The gloomy outlook for corporate profitability does not bode well for the performance of Chinese stocks. Chinese A-shares are struggling to bottom on the back of shaky economic fundamentals, while investable stocks are cheap for a reason. We maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. Lower profitability and return on equity have ramifications for the valuations of China’s industrial companies. Remarkably, China’s industrial profits have been flat in the past 12 years (Chart 15 above). That is a reason why many Chinese stocks have been de-rated. Among A-share industrial companies, sectors with higher profitability are coal, non-ferrous metals, auto, construction materials and food & beverage. However, coal, non-ferrous metals and construction materials are pro-cyclical sectors, and their profit growth is positively correlated with economic growth, which is facing downward pressure at least through the end of this year. In addition, resources and commodity plays are vulnerable in the next 6 to 12 months. We recommend to underweight these sectors.  Within the Chinese equity universe, we recommend overweighting autos, food & beverage, and utilities sectors. Food & beverage and utilities are interest rate-sensitive sectors, which will continue to benefit from lower onshore bond yields. In addition, utilities sector’s profit margin and earnings will improve as coal prices decline. The auto sector will gain an advantage from China’s stimulus for auto purchases, especially for new energy vehicles.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The DuPont analysis breaks down return on equity in three distinct elements: net profit margin, operational efficiency, and leverage. This analysis enables to identify how various drivers impact return on equity. 2Please see China Investment Strategy Special Report "Global Copper Market: No Bottom Yet," dated July 27, 2022, and Emerging Markets Strategy Report "A Cocktail Of Falling Oil Prices And Surging US Wages," dated July 21, 2022, available at bcaresearch.com Strategic Themes Cyclical Recommendations

Special Report

Executive Summary Rebounding Chinese Auto Sales China’s stimulus for auto purchases and an easing global auto chip shortage will lead to about a 10% recovery in domestic auto sales in 2022H2 from a year ago. Next year, we expect Chinese auto sales to grow only modestly (under 5%).  The share of new energy vehicles (NEVs) in auto sales is rising rapidly in China, crowding out internal combustion engine vehicles (ICEVs) at a fast rate. China is becoming more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Production of NEVs and the installation of NEV charging poles will expand rapidly. Yet, given the still-high valuation of these stocks, we will look to buy into these sectors at a better price entry point. Bottom Line: Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months on the expectation of improving car sales. Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. Feature Chinese total auto sales contracted by 12% year on year in the first five months of this year due to a deep 24% contraction in non-NEV sales. In stark contrast, Chinese NEV sales have more than doubled during the same period. However, the 1-million-unit increase in NEV sales failed to counteract the 2.4-million-unit loss in non-NEV demand. This raises two questions. Why have NEV sales skyrocketed at a time when non-NEV sales have tanked? Will Chinese auto sales recover in 2022H2 and 2023? If so, then how strongly will the recovery be? The answer to the first question lies in a major auto chip allocation strategy that many Chinese auto producers adopted last year. Under limited semiconductor supplies, auto producers in China prioritized the use of chips in their production of NEV models – which have higher profit margins –over traditional vehicles. The greater availability of NEVs than ICEVs has meant an increase in sales of the former and a deep contraction in the latter in 2022H1. Chart 1Chinese Auto Sales: A Recovery Ahead? For the second question, we believe that China’s stimulus package to boost auto sales and an easing global auto chip shortage will lead to about a 10% recovery in auto sales in 2022H2 from a year ago. On the other hand, growth in 2023 will be very modest (under 5%). Accordingly, the daily data of Chinese retail auto sales have already shown a strong rebound in the total sales of NEVs and ICEVs in the last three weeks of June (Chart 1). Auto Sales In China: A Gradual Recovery     China’s auto sales are set to have a gradual recovery in 2022H2. We expect auto sales to reach 26.2-26.8 million units by the end of this year, with NEV and non-NEVs rising to 5-5.3 million units and 21.2-21.5 million units, respectively1 (Chart 2). The reasons for our positive estimates include policy stimulus, improving technological advancement of NEVs, as well as an easing in the global auto chip shortage. First, the government has issued a flurry of policies since late May attempting to boost domestic auto demand. As Chart 1 shows, these policies have proved effective, at least for now. In previous episodes of stimulus aimed at boosting auto sales in 2009-2010, 2016-2017, and 2019-2021, authorities had implemented similar supportive measures. While the stimulus worked well in the first two episodes, it was not effective in 2019-2021 (Chart 3).   Chart 2Auto Demand In China: A Gradual And Moderate Rebound Chart 3Policy Stimulus Will Help Lift Chinese Auto Demand Box 1 shows our summary of those auto stimulus and a comparison of these episodes. Of all these policies, we believe that a sales tax reduction2 on certain vehicles has proved to be the most effective policy as it directly reduced the prices of these vehicles. In 2022H2, this policy will mainly benefit ICEVs sales as NEVs will continue to enjoy a full exemption from the 10% vehicle purchase tax. The government is also considering an extension of the exemption for NEVs to the end of next year.  Box 1China’s Stimulus Package For The Domestic Auto Industry​​​​​​​ This year’s stimulus is more comparable to the 2009 and 2016 episodes as they share the same reduction in the sales tax rate from 10% to 5%. The main difference is that this time the policy targets cars with 2-liter engines or smaller, while back in 2009 and 2016 this policy only applied to vehicles with capacity no bigger than 1.6-liters. This means a larger range of vehicles will benefit from the reduction. In short, the current policy will allow an additional 23% share of total vehicles sold to benefit from the stimulus. Please note that for the period of 2019-2021 there was no sales tax reduction. This may be one of the reasons for the lack of recovery in vehicle sales in this episode; Chinese auto sales contracted in both 2019 and 2020. Second, Chinese NEVs buyers have been enjoying government subsidies, albeit on a sliding scale since 2019. The amount of subsidy has been dropping by 10%, 20% and 30% in 2020, 2021 and 2022, respectively (Table 1). We expect NEV sales to rise as the subsidy is set to expire by the end of this year. This may induce some buyers to buy NEVs before the subsidy ends. Table 1Government Subsidy For NEV Purchase in China Chart 4NEVs Become More Appealing To Chinese Consumers In addition, NEVs are becoming increasingly appealing for auto buyers. This is due to longer travel mileage per battery charge, constant improvement in NEV related technologies, and an expanded charging/battery swap framework (Chart 4). Further, in comparison to traditional ICEVs, NEVs have become increasingly more equipped with functions such as autonomous driving, intelligent interconnection, and other software application-based services. NEVs will also become more integrated with intelligent and interactive networks. All these features will make NEVs more attractive to automobile buyers as well.  According to the McKinsey China Auto Consumer Insights 2021 report, Chinese consumers are more interested than ever in smart vehicle technologies, and they are willing to pay a premium for innovative features. 80% of consumers report that autonomous driving will be a key factor in their decision-making when they buy their next car. Meanwhile, 69% of consumers consider that over-the-air update technology (OTA) is an important feature, and 62% of those are willing to pay for it. Chart 5NEV Sales In China Are Not Very Sensitive To Gasoline Prices Rising oil and gasoline prices have also encouraged NEV sales in the past six-to-nine months. But we believe high fuel prices are relatively less important factors to NEV demand in China than in the US and EU. For example, in 2020H2, when oil prices were only around US$40-50 and domestic gasoline price were low, Chinese NEV sales still rose strongly during the same period (Chart 5). Third, the deep contraction in non-NEV sales in China in 2021 was partially caused by the global auto chip shortage. Global semiconductor chip shortages are likely to continue easing in 2022H2 as demand-supply gaps decrease across most components. Demand for consumer electronics is set to contract in the US and the EU in the next six-to-nine months. Hence, some capacity for PC and smartphone chips could be used to produce auto chips in the months ahead. Bottom Line: Government initiatives to boost auto sales, improving technological advancement of NEVs, and an easing of the global auto chip shortage will lift Chinese auto sales to some extent. Structural Auto Demand: A New Normal? Auto sales peaked in 2017 and are since down by 13%. Even if auto sales registered a modest recovery as we expect in 2022 and 2023, they will still be about 6% below their 2017 peak. The reasons why we do not expect a brisk auto sales recovery are as follows: Household (HH) income growth is very weak and the unemployment rate has been rising (Chart 6). HHs have considerable debt (Chart 7). With house prices not rising, and potentially deflating, HH willingness to take on more debt has declined. Chart 6Falling HH Income Growth And Rising Unemployment Chart 7HH Debt Burden Is Already High​​​​​​ Wage/income growth has downshifted and narrowed its gap with interest rates on consumer loans. The cost HH debt has therefore risen relative to their income growth, making consumers less willing to take on more debt.   Reflecting downbeat consumer sentiment, the HH marginal propensity to consume has fallen to very low levels and has not shown signs of improvement (Chart 8). With the mediocre structural auto demand outlook in China, NEV sales will rapidly gain market share from non-NEVs (Chart 9). NEVs currently account for about 18% of total auto sales in China, still much lower than the country’s goal of 40% in 2030. Chart 8HH Willingness To Spend Is Low Chinese Consumers: Falling Willingness To Consume Chart 9Accelerating NEV Penetration In China Last week the EU passed a plan of a 2035 phase-out of new fossil fuel car sales. This is also a trend for China. Chinese auto makers such as Changan, BAIC Motor and Haima have already announced that they will stop ICEV production in 2025. Chart 10Decelerating Growth In Chinese Oil Demand Declining ICEV sales will lead to lower growth of these vehicles on the road (Chart 10). Consequently, gasoline and diesel demand growth from passenger and commercial autos will be decelerating in China in the coming years. Bottom Line: Passenger car demand in China will be settled in low single digit growth rates. The market share of NEVs will rise very fast at the expense of ICEVs. In turn, falling ICEV sales will result in slower growth in domestic petroleum demand.  China: Increasing Competitiveness Chart 11Increasing Competitiveness Of Chinese Auto Manufacturers China has become increasingly competitive in global auto manufacturing. This is a strong tailwind for the country’s auto exports. In fact, the country’s net exports of autos have been rising (Chart 11). China is the world’s largest auto producer and consumer, accounting for 32.5% and 32% of global auto production and sales, respectively. The country is also the world’s largest NEV producer. Chart 12China: The World’s Leading And Largest EV Battery Producer ​​​​​​​​​​​​​​The battery is the most important component of an NEV, and its technological progress holds the key to the speed of NEV penetration. China is the world leader in this battery technology. China’s CATL is currently the world's largest battery manufacturer, with a market share of 32.5%. CATL ranked first in the world for five consecutive years from 2017 to 2021. In addition, four out of the top ten global EV battery players are Chinese companies, with a total market share of 44%, up from 41% last year (Chart 12). Moreover, in late June, CATL launched its cell-to-pack (CTP 3.0) battery. With a record-breaking volume utilization efficiency of 72% and an energy density of up to 255 Wh/kg, it achieves the highest integration level worldwide so far, capable of delivering a range of over 1,000 km on a single charge. The CTP 3.0 batteries are expected to be mass produced and come onto the market in 2023. The development of charging/battery-swapping infrastructure will continue to be faster in China than in other countries/regions due to the country’s competitive advantage in NEV production, including batteries, as well as related policy support. For example, the number of total public & private charging poles rose at a compound annual growth rate of 50% in the past five years. This allows China to collect more NEV charging-related data, which could be used to improve the country’s NEV manufacturing process, charging pole production, and the country’s charging infrastructure development. This will help reduce the charging anxiety of Chinese NEV users. In terms of autonomous driving, five Chinese companies have been included in the world’s 10 best autonomous driving companies based on their technological edge, according to the global autonomous driving report released by the California Department of Motor Vehicles (DMV). In addition to test drives in the US, major Chinese NEV makers have also carried out test drives in China with long distances and more complicated driving conditions. For example, as of mid-March, Baidu Apollo’s autonomous driving has already exceeded 25 million kilometers. In comparison, the total test distance of autonomous driving of all autonomous driving test cars in California were only 6.4 million kilometers. Chart 13China: Faster NEV Penetration Versus Other Countries At 13.4%, the share of NEVs in total auto sales in China was high last year compared with other countries (Chart 13). The ratio has already risen to 21% in the first five months of this year. Bottom Line: China will become more competitive in global auto manufacturing given its edge in NEV battery technologies and autonomous driving. Investment Implications Chinese onshore and offshore automobile stock prices have risen sharply in the past couple of months, expecting improving car sales in the short-to-medium term (Chart 14). Our bias is that the rally has been too fast and gone too far. Investors should wait for a pullback before they buy. A shakeout in broader Chinese offshore and onshore stocks is likely due to the following (Chart 15): Chart 14Chinese Automobile Stock Prices: A Lot Of Good News Already Priced In... Chart 15...A Pullback Is Due Chart 16Look To Buy Chinese NEV-related Stocks China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. Global equities have probably not completed their downtrend. It will be hard for Chinese stocks to continue rallying if global share prices continue to fall. That said, we have a bullish bias towards Chinese NEV producers. China’s NEV sector enjoys tailwinds from structurally strong demand and its technological edge, especially in batteries. Hence, we will look to buy Chinese NEV and battery stocks at a better price entry point (Chart 16).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1     China Association of Automobile Manufacturers (CAAM) predicted Chinese auto sales to rise to 27.5 million units for the full year. We are a little bit less optimistic on that front. 2     The State Council of China is enacting 60-billion-yuan (US$9 billion) worth of tax cuts between June and December. The purchase tax on certain passenger vehicles will be reduced by half to 5% of the sticker price. The tax cuts target cars with 2-liter engines or smaller, priced at 300,000 yuan (US$ 44,800) or less. Strategic Themes Cyclical Recommendations

Special Report

Executive Summary Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Chart 3BCyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Chart 6China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Listen to a short summary of this report.       Executive Summary Chinese Stocks Are Relatively Cheap The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. A much better option would be to adopt measures that boost disposable income. Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. With the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales. A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. Go long the iShares MSCI China ETF ($MCHI) as a tactical trade. Bottom Line: China faces a number of economic woes, but these are fully discounted by the market. What has not been discounted is a broad-based stimulus program focused on income-support measures.   Dear Client, I will be visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi next week. No doubt, the outlook for oil prices will feature heavily in my discussions. I will brief you on any insights I learn in my report on June 17. In the meantime, I am pleased to announce that Matt Gertken, BCA’s Chief Geopolitical Strategist, will be the guest author of next week’s Global Investment Strategy report. Best regards, Peter Berezin Chief Global Strategist Triple Threat The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Let us discuss each problem in turn.   Problem #1: China’s Zero-Covid Policy in the Age of Omicron Chart 1China’s Lockdown Index Remains Elevated China was able to successfully suppress the virus in the first two years of the pandemic. However, the emergence of the Omicron strain is challenging the government’s commitment to its zero-Covid policy. The BA.2 subvariant of Omicron is 50% more contagious than the original Omicron strain and about 4-times more contagious than the Delta strain. While 89% of China’s population has been fully vaccinated, the number drops off to 82% for those above the age of 60. And those who are vaccinated have been inoculated with vaccines that appear to be largely ineffective against Omicron. Keeping a virus as contagious as measles at bay in a population with little natural or artificial immunity is exceedingly difficult. While the authorities are starting to relax restrictions in Shanghai, China’s Effective Lockdown Index remains at elevated levels (Chart 1). A number of domestically designed mRNA vaccines are in phase 3 trials. However, it is not clear how effective they will be. Shanghai-based Fosun Pharma has inked a deal to distribute 100 million doses of Pfizer’s vaccine, but so far neither it nor Moderna’s vaccine have been approved for use. Our working assumption is that China will authorize the distribution of western-made mRNA vaccines later this year if its own offerings prove ineffectual. The Chinese government has already signed a deal to manufacture a generic version of Pfizer’s Paxlovid, which has been shown to cut the risk of hospitalization by 90% if taken within five days of the onset of symptoms. In the meantime, the authorities will continue to play whack-a-mole with Covid. Investors should expect more lockdowns during the remainder of the year.   Problem #2: Weaker Export Growth China’s export growth slowed sharply in April, with manufacturing production contracting at the fastest rate since data collection began. Activity appears to have rebounded somewhat in May, but the new export orders components of both the official and private-sector manufacturing PMIs still remain below 50 (Chart 2). Part of the export slowdown is attributable to lockdown restrictions. However, weaker external demand is also a culprit, as evidenced by the fact that Korean export growth — a bellwether for global trade — has decelerated (Chart 3).  Chart 2China’s Export Growth Has Rolled Over Chart 3Softer Export Growth Is Not A China-Specific Phenomenon Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are now well above their pre-pandemic trend, suggesting that the demand for Chinese-made goods will remain subdued over the coming months (Chart 4). The surge in commodity prices is only adding to Chinese manufacturer woes. Input prices rose 10% faster than manufacturing output prices over the past 12 months. This is squeezing profit margins (Chart 5). Chart 4Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 5Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users A modest depreciation in the currency would help the Chinese export sector. However, after weakening from 6.37 in April to 6.79 in mid-May, USD/CNY has moved back to 6.66 on the back of the recent selloff in the US dollar. Chart 6The RMB Tends To Weaken When EUR/USD Is Rising We expect the dollar to weaken further over the next 12 months as the Fed tempers its hawkish rhetoric in response to falling inflation. Chart 6 shows that the trade-weighted RMB typically strengthens when EUR/USD is rising. Chester Ntonifor, BCA’s Chief Currency Strategist, expects EUR/USD to reach 1.16 by the end of the year.   Problem #3: Flagging Property Market Chinese housing sales, starts, and completions all contracted in April (Chart 7). New home prices dipped 0.2% on a month-over-month basis, and are up just 0.7% from a year earlier, the smallest gain since 2015. The percentage of households planning to buy a home is near record lows (Chart 8). Chart 7The Chinese Property Market Has Been Cooling Chart 8Intentions To Buy A House Have Declined China’s property developers are in dire straits. Corporate bonds for the sector are, on average, trading at 48 cents on the dollar (Chart 9). Goldman Sachs estimates that the default rate for property developers will reach 32% in 2022, up from their earlier estimate of 19%. The government is trying to prop up housing demand. The PBoC lowered the 5-year loan prime rate by 15 bps on May 20th, the largest such cut since 2019. The authorities have dropped the floor mortgage rate to a 14-year low of 4.25%. They have also taken steps to make it easier for property developers to issue domestic bonds. BCA’s China strategists believe these measures will foster a modest rebound in the property market in the second half of this year. However, they do not anticipate a robust recovery – of the sort experienced following the initial wave of the pandemic – due to the government’s continued adherence to the “three red lines” policy.1 China is building too many homes. While residential investment as a share GDP has been trending lower, it is still very high in relation to other countries. China’s working-age population is now shrinking, which suggests that housing demand will contract over the coming years (Chart 10). Chart 9Chinese Property Developer Bonds Are Trading At Distressed Levels Chart 10Shrinking Working-Age Population Implies Less Demand For Housing Chinese real estate prices are amongst the highest anywhere. The five biggest cities in the world with the lowest rental yields are all in China (Chart 11). The entire Chinese housing stock is worth nearly $100 trillion, making it the largest asset class in the world. As such, a decline in Chinese home prices would generate a sizable negative wealth effect. Chart 11Chinese Real Estate Is Expensive A Silver Bullet? Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. Luckily, one does not need to fill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. China needs to reorient its economy away from its historic reliance on investment and exports towards consumption. The easiest way to do that is to adopt measures that boost disposable income, which has slowed of late (Chart 12). Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. The authorities have not talked much about pursuing large-scale income-support measures of the kind adopted by many developed economies during the pandemic. As a result, market participants have largely dismissed this possibility. Yet, with the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales (Chart 13). A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. As we saw in the US and elsewhere, stimulus cash has a habit of flowing into the stock market; and with real estate in the doldrums, equities may become the asset class of choice for many Chinese investors. With that in mind, we are going long the iShares MSCI China ETF ($MCHI) as a tactical trade. Chart 12Disposable Income Growth Has Been Trending Lower Chart 13Chinese Stocks Are Relatively Cheap At a global level, a floundering Chinese property market would have been a cause for grave concern in the past, as it would have represented a major deflationary shock. Times have changed, however. The problem now is too much inflation, rather than too little. To the extent that reduced Chinese investment injects more savings into the global economy and knocks down commodity prices, this would be welcomed by most investors. China’s economy may be heading for a “beautiful slowdown.” Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter   Footnotes   1      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. View Matrix Special Trade Recommendations Current MacroQuant Model Scores