China

Executive Summary China: Can The Economy Recover Without Housing Revival The rebound in China’s business activity in June reflects the release of pent-up demand from the economic reopening after lockdowns in April and May. China’s credit growth recovered meaningfully in June due to large local government (LG) bond issuance. Private sector sentiment and credit demand remain sluggish. Home sales relapsed in the first two weeks of July after a one-off improvement in June, corroborating that the housing market’s fundamentals remain gloomy. Despite posting strong growth in June, Chinese exports are facing strong headwinds from weakening external demand. A contraction in exports is very likely in the second half of this year. Chinese domestic demand remains weak. Renewed rolling lockdowns are likely in view of the escalating Covid-19 cases related to a more infectious Omicron subvariant. The RMB will probably continue to depreciate relative to the US dollar in the next few months. Bottom Line: Investors should maintain a neutral stance on Chinese onshore stocks and an underweight stance on investable stocks in a global equity portfolio. The risk-reward profile of Chinese onshore and offshore stocks in absolute terms is not yet attractive.   Chart 1High-Frequancy(Daily) Economic Indicators The recent recovery in economic activity in June mainly reflects the release of pent-up demand after reopening from lockdowns in April and May. Odds are that this rebound will fade. The relapse in house sales and slowdown in steel production during the first two weeks of July suggest that China’s economy is still struggling to gain traction (Chart 1). China’s business cycle recovery will be more U shaped rather than a repeat of the V-shaped resurgence experienced following the early 2020 lockdown. At that time, a quick and strong revival in the property market and exports shored up China’s recovery in 2H20. In contrast, the economy’s progress in the second half of this year will be dragged down by shrinking exports, weak consumption and depressed demand for housing. China’s recovery will be more U shaped than V shaped for the following reasons: New financing schemes for infrastructure investment recently announced by authorities will not lead to a surge in infrastructure investments in 2H22. The basis is that these new funding sources will largely offset a shortfall in local government (LG) revenues from this year’s land sales, as we discussed in last week’s report. Thus, there will be little new stimulus for infrastructure beyond what was already approved in the budget plan earlier this year. Rolling lockdowns will persist as long as China’s stringent dynamic zero-Covid policy remains in place. The recent flare-up of the more infectious Omicron BA.5 subvariant cases in a few cities raise the likelihood of more lockdowns. The number of cities under mobility restrictions or some form of lockdown climbed during the second week of July (Chart 2). These cities account for around 11% of China’s GDP. The rolling lockdowns will continue to disrupt the economy. Private sector sentiment remains in the doldrums. The willingness to spend or invest among households and enterprises remains very depressed (Chart 3). This will ensure that the multiplier effect of fiscal and credit stimulus will be small. Chart 2The Odds Of Renewed Lockdowns Are Rising Chart 3Sluggish Sentiment Among Chinese Households And Enterprises Chart 4China: Can The Economy Recover Without Housing Revival Since 2008 there has been no recovery in the mainland economy without buoyant real estate construction and surging property prices (Chart 4).  Chinese exports are set to contract as the demand for goods from US and European consumers continues to shrink. ​​​​​ Bottom Line: In absolute terms, the risk-reward profile of Chinese stocks is not yet attractive. We continue to recommend that investors maintain a neutral stance on China’s onshore stocks and underweight allocation on Chinese investable stocks within a global equity portfolio.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com   Peeling Off Credit Data Chart 5June's Credit Growth Was Largely Driven By LG Bond Issuance June’s strong credit growth was again driven by large LG bond issuance (Chart 5, top panel). Consequently, the credit impulse – calculated as a 12-month change in the flow of total social financing (TSF) as a percentage of nominal GDP – is much more muted when LG bond issuance is excluded (Chart 5, bottom panel). Medium- to long-term corporate loan growth only ticked up in June, but short-term bill financing has dropped dramatically (Chart 6). While it is difficult to quantify, it is highly likely that the modest upturn in corporate credit flow was due to (1) corporates’ pent-up demand for financing after the spring lockdowns and (2) the PBoC’s moral suasion used to boost the banks’ credit origination. Meanwhile, a PBoC survey released on June 29-30, showed that loan demand for all types of industrial enterprises plunged sharply in Q2, suggesting that sentiment is very weak among corporates (Chart 7). Chart 6Corporate Loan Growth Improved In June... Chart 7… But Corporate Loan Demand Remains Very Weak Household loan demand, which is highly correlated with home sales, remains shaky too (Chart 8, top panel). Medium- to long-term consumer loans continued to plunge, and the annual change in household loan origination remains negative (Chart 8, bottom panel). Chart 8Household Loan Demand Is Still Depressed Chart 9The Credit And Fiscal Impulse Will Be Moderate Overall, our projections for the combined credit and fiscal spending impulse for the rest of this year suggest that the aggregate fiscal and credit impulse will be improving but will be smaller than in 2020, 2016, 2013 and 2009 (Chart 9). Property Market: A Vicious Cycle Unfolding Home sales relapsed in the first two weeks of July after a one-off rebound in June. The weakness was broad-based across all city tiers. This implies that June’s bounce was driven by pent-up demand after lockdowns and does not represent a sustained revival (Chart 10). Sentiment among home buyers remains downbeat. The percentage of households planning to buy homes slipped further according to the PBoC’s urban household survey released on June 29 (Chart 11, top panel). Moreover, the percentage of households expecting home prices to rise has dived to the lowest level since early 2015 according to the same survey (Chart 11, bottom panel). Chart 10No Snapback In Housing Sales Chart 11Downbeat Sentiment Among Home Buyers Chart 12Real Estate Developers' Deteriorating Funding Will Further Dampen Housing Construction Property developers are caught in a vicious cycle.  Financing has not strengthened because the “three red lines” policy remains in place, and developers’ borrowing from banks shows no signs of amelioration (Chart 12, top panel). Critically, the plunge in the sector’s financing is resulting in shrinking housing completions (Chart 12, bottom panel). As property developers are suffering from liquidity shortages, they are dragging on existing construction projects. The upshot is that many Chinese cities are seeing delays in the completion of new homes. The latter is depressing buyers’ sentiment, generating a reluctance to buy properties, and curtailing deposits and advances to developers. In recent years, deposits and advances accounted for 50% of property developers’ financing. Without a substantial improvement in their financing, developers will not be in a position to service their excessive debts and deliver houses they have presold in the recent years. The latter will undermine their financing, closing the vicious cycle. In short, real estate developers’ liquidity shortfalls are evolving into solvency problems. These will continue dampening construction activity. An Export Contraction Ahead China’s exports were robust in June as supply chain and logistic disruptions faded. This was corroborated by last month’s advance in suppliers’ delivery times and production subindexes of China’s official Purchasing Managers’ Index (PMI) (Chart 13). Chart 13Chinese Logistics And Backlog Orders Pressures Have Eased In June Yet, China’s new exports orders remain in contractionary territory (Chart 14). Moreover, the softness of Shanghai’s export container freight index is also signaling weakness in China’s exports (Chart 15).   Chart 14External Demand For Chinese Export Goods Will Be Dwindling Chart 15Signs Of Moderation In China's Exports The shift in consumer spending in developed economies from manufactured goods to services has created headwinds for Chinese exports. US and European consumption of goods (ex-autos) is set to decline below its long-term trend (Chart 16). Given that retail inventories in the US have skyrocketed well above their pre-pandemic trend, US demand for consumer goods and, hence, Chinese exports will dwindle significantly when US retailers start to destock (Chart 17). Falling real household disposable income in the US and Europe will also fortify the downward trend in demand for consumer goods that China is a major producer of. Therefore, we expect shrinking Asian and Chinese exports in the second half of this year. Chart 16Developed Economies’ Household Demand For Goods ex-Autos Will Shrink Chart 17Well-Stocked Shelves In The US Bode Poorly For Chinese Exports Very Sluggish Domestic Demand Both consumer spending and capital expenditure remain in the doldrums. Traditional infrastructure investments picked up strongly in June, while investments in the real estate sector weakened further (Chart 18). Contracting exports will weigh on investments in manufacturing. Even as infrastructure investment recovers modestly, the downtrend in manufacturing and property fixed-asset investments will cap China’s capital spending in 2H22. Capital spending in traditional infrastructure, real estate and manufacturing account for 24%, 19% and 31% of fixed-asset investment, respectively. Chart 18Shrinking Real Estate Investment Will Remain A Drag On Chinese Investment Growth In 2H Chart 19Contracting Import Volume Reflects China's Sluggish Domestic Demand Imports for domestic consumption (excluding imports for processing and re-exports) are a good proxy for domestic demand trajectory. In June, import volumes contracted deeply at 12% on a year-on-year basis, reflecting sluggish domestic demand (Chart 19). Worryingly, import volume contraction is widespread from key commodities to semiconductors and capital goods (Chart 20A and 20B). Chart 20ABroad-Based Contraction In Imports Chart 20BBroad-Based Contraction In Imports Chart 21Rising New Covid Cases In China Will Constrain Domestic Consumption Recovery Moreover, the recent increase in Covid-19 cases and ensuing lockdowns in China will curb household consumption and the service sector’s activities in the next few months (Chart 21). Newly released labor market data show a mixed picture. The nationwide urban survey-based unemployment rate fell in June, but the unemployment rate among younger workers surged to the highest point since data collection began in 2018 (Chart 22, top panel). Reflecting weak employment conditions, new urban job creation in the first half of the year withered compared with the same period last year (Chart 22, bottom panel). Rapidly deteriorating income prospects are reinforcing households’ downbeat sentiment. A PBoC survey released on June 29 shows that confidence of future income in Q2 plummeted to its lowest level during the past two decades, while the preference for more saving deposits soared to the highest level since data collection began in 2002 (Chart 23). The latter entails that households’ consumption recovery will be gradual and halting, at best, in the second half of this year.  Chart 22Skyrocketed Unemployment Rate Among Young Workers Is A Big Problem Of Chinese Labor Market Chart 23Low Confidence In Future Income Contributes To Households' Unwillingness To Consume The RMB Is Facing Downside Risks In The Near Term Chart 24RMB Is Still Vulnerable The RMB has depreciated by about 6% against the US dollar since March, and we believe this trend will continue in the next few months. China’s interest rate differential versus the US dollar has fallen deeper into negative territory, and the gap may widen even more given that the inflation and monetary policy cycles in China and the US will continue to diverge (Chart 24, top panel). Thus, Chinese fixed-income market outflow pressures could endure this year (Chart 24, bottom panel). Moreover, as discussed in the section above, Chinese exports are set to shrink in the second half of the year. This will also weigh on the RMB. Notably, Chinese companies have started to increase their demand for USD. The net FX settlement rate by banks on behalf of clients has fallen below zero, albeit only marginally (Chart 25). This means more non-financial enterprises (such as exporters and investors) bought from than sold foreign currency to banks (Chart 25, bottom panel). Furthermore, foreign outflows from the onshore equity market have resumed and will likely be sustained, at least through the next few months (Chart 26). Foreign investors will likely flee from Chinese onshore stocks as global stocks continue selling off and China’s economic recovery disappoints in the second half of this year. Chart 25Contracting Exports Will Weigh On The RMB Chart 26Onshore Equity Market Foreign Outflow Pressures Remain, At Least In The Near Term Chinese Equity Market Technicals: Tell-Tale Signs Chart 27A-Shares Has Not Broken Above 200-Day Moving Average The rebound in China’s onshore CSI 300 stock index had been obstructed at its 200-day moving average (Chart 27). A failure to break above this technical resistance would imply non-trivial downside – a retest of its recent lows, at least. The relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – versus the global equity index has petered off at its previous troughs (Chart 28). This is a tell-tale sign of a major relapse. Chart 28A Tell-Sign Of Major Downtrend Chart 29Chinese Tech Stocks Still Appear Fragile The Hang Seng Tech index – which tracks Chinese offshore tech stocks/platform companies – has also failed to break above its 200-day moving average (Chart 29). This entails that the bear market in these share prices might not be yet over. Chart 30Two Large-Cap Chinese Stocks China’s two largest stocks (by market capitalization) – Tencent and Alibaba – may not be out of the woods:  Alibaba has failed at its 200-day moving average (Chart 30, top panel). Tencent has failed to rebound at all (Chart 30, bottom panel). Odds are it will likely drop more.   Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Strategic Themes Cyclical Recommendations

Executive Summary China's Unemployment Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices​​​​​​ Chart 3China's Property Crisis​​​​​​ Chart 4China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

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

Executive Summary Caught In Risk-Off Selling Weak Chinese and European economies are suppressing copper demand and helping to temper prices in a market that remains fundamentally tight. Weaker US GDP growth could put the three largest economies in the world in or close to recession in 2H22/1H23, which would contribute to demand-side weakness in copper markets. The odds manufacturing and base-metals refining will be curtailed in Europe are rising. Although a strike in Norway has been averted by government intervention, maintenance on Russia’s Nord Stream 1 pipeline scheduled to begin next week likely will serve as a pretext for longer and deeper natgas supply cuts to the EU. Bottom Line: Despite fundamental tightness in global copper markets, prices are being restrained by fears weaker Chinese and European economic performance will lead to a global recession. Early reads of US GDP pointing to negative growth in 2Q22 stoke these fears. Heightened economic policy uncertainty globally exacerbates them. We remain fundamentally bullish copper and will re-establish our long SPDR S&P Metals & Mining ETF (XME) – down ~ 40% from its highs in April – at tonight’s close. In addition, we went long the XOP oil and gas ETF at Tuesday’s close, after prompt Brent breached the buy-trigger we set last week of $105/bbl during this week’s crude-oil sell-off.   Feature   Lower GDP growth expectations in China and the EU – along with a wobbly US economy being flagged by an Atlanta Fed GDPNow forecast pointing to negative growth in 2Q22 – are stoking fears of a global manufacturing and industrial recession. This prompted a rout in industrial commodities – base metals and oil – this week, which still has markets on edge. This slow-down in the world’s three largest economies – accounting for almost 50% of global GDP expressed in purchasing-power terms – is the only thing keeping the level of global copper demand close to supply at present (Chart 1).1 At least for the time being, this is keeping the threat of sharply higher copper prices, which would be more in line with the low levels of supplies and inventories globally, at bay (Chart 2). As of the week ended May 27th, global copper stocks stood at just above 562k tons, which is ~ 31% lower y/y. Chart 1World’s Biggest Economies Slowing Chart 2Copper Prices Disconnect From Fundamentals   Uncertainty Weakens Copper Prices Energy and metals markets remain extremely tight on a fundamental supply-demand basis.2 The sharp sell-off this week in oil and metals prices is, in our view, evidence industrial-commodity prices have decoupled from fundamentals.  This makes traders – hedgers and speculators – extremely risk-averse, which reduces liquidity and increases volatility. On the back of these concerns, markets exhibit the sort of volatility associated with economic collapse, despite still-strong underlying fundamentals. Chart 3Rising Global Policy Uncertainty Volatility is on the rise due to increasing economic uncertainty in these markets. This makes it extremely difficult to assign probabilities to different price outcomes (i.e., true uncertainty). The BBD Global Economic Policy Uncertainty is approaching levels seen during the early pandemic (Chart 3).  We put this rising uncertainty down to poor policy and communication from central banks and governments; a pig’s breakfast of energy policy globally that increasingly adds nothing but confusion to markets; and a muddled public-health policy in China, which produces random shut-downs in global supply chains as covid infections randomly crop up in important port cities.  Lastly, the East and West are moving toward a new Cold War, which already is having profound effects on all markets, trade flows and capital availability in the short- and medium-term. This keeps markets on edge and forces them to parse every geopolitical development that hits the tape.3 Re-forging supply chains, re-building basic industrial infrastructure as the West moves away from outsourcing to China and other EM states will be costly and volatile, especially as embargoes and sanctions increase between these blocs.    This political and economic evolution will require increased investment in base metals production and exploration, along with similar commitments to oil and gas. Low and volatile prices will not support this, as they disincentivize investment, and set markets up for continued shortage and scarcity going forward. In the metals markets, years of underinvestment by major mining companies will keep copper supplies and inventories tight going forward (Chart 4). This will hinder and delay the global renewable-energy transition, which cannot be realized without higher base-metals supplies.  Chart 4Structural Underinvestment In Mining Fundamentally Bullish Copper Recession Fears Haunt Metals Globally … The proximate causes of the persistent weakening of copper prices is the demand destruction arising from the lockdown in China, and an increasing concern over the economic prospects of the EU as it prepares for a possible shut-off of Russian natgas exports. Should Russian supplies be cut off, the EU will be pushed into recession as natural-gas rationing – and the attendant prioritization of human needs going into winter – will constrict economic activity, particularly in manufacturing.  This leaves two of the three largest economies in the world either in recession or not growing at all. Added to this is the fear of a wobbly US economy, which has been slowed by higher energy prices and the Fed’s hawkish tightening of monetary policy. The Atlanta Fed’s GDPNow forecast for 2Q22 estimates a 2.1% contraction in US GDP. This would be the second consecutive quarter of negative growth and would meet a widely held rule-of-thumb indicator or recession.4  In our modelling, we estimate the income elasticity of copper demand in DM economies like the EU and US (1.39) and EM-ex-China (0.87) states is higher than that of China (0.37). This means that a 1% contraction in p.a. Chinese real GDP would translate to a 0.37% p.a. fall in copper demand, all else equal. A contraction of real incomes – i.e., real GDP – in the EU and EM-ex-China will cause a larger relative adjustment in copper demand than in China, even though the level of copper demand in China is far greater in absolute terms (Chart 5).  A recession in the EU will reduce import demand for China’s manufactured output in these markets (Chart 6). As China’s trade volumes fall, Chinese manufacturing PMIs will contract. Similarly, exports to China from the EU will weaken as manufacturing weakens and real GDP moves lower. We believe this will put more pressure on the Chinese government to provide fiscal and monetary stimulus to counter such a downdraft.  Chart 5Copper Demand Sensitive to Real GDP (Income) Chart 6Trade Channel Effects Follow GDP Weakness … But China Worries Dominate The Chinese economy is showing signs of further slowing.5 Weakness in credit levels, infrastructure investment, manufacturing, the property sector, and exports all indicate the covid-policy lockdowns, high commodity prices, and parsimonious credit and fiscal policies have produced a dramatic slowing in economic activity. In our modelling, we find evidence that each of these components exhibits a long-run inverse relationship with Chinese copper inventories, which in turn exhibits a long-run inverse relationship with COMEX copper prices.  Roughly 10 days after the initial Shanghai lockdown, copper prices went into contango (Chart 7). This occurred despite continuous declines in Chinese copper inventories during the lockdown months (Chart 8). Such anomalous behavior – i.e., as inventories fall markets become more backwardated – makes it difficult to connect prices and supply-demand-inventory fundamentals. Chart 7Copper In Contango For Most Of China’s Lockdown Chart 8Chinese Copper Inventories Continue To Draw In Lockdown BCA’s China Investment Strategy expects a muted 2H22 recovery for the Chinese economy. Rolling lockdowns due to China’s COVID policy will reduce the potency of fiscal and monetary stimulus. The stop-start nature of economic activity will stymie growth in disposable income and job creation, which in turn will translate to weaker aggregate demand. The knock-on effect of weaker business activity due to the lockdown earlier this year has been a higher propensity to save by households (Chart 9). Household surveys conducted by the PBoC show that, since 2017, household savings have been increasing, suggesting a precautionary sentiment (Chart 10). Chart 9Chinese Economic Slowdown Reduced Credit Demand Chart 10Rising Precautionary Savings... Chart 11...Will Impact Domestic Property Market We do not expect the property market to recover in a manner similar to what occurred following China’s re-opening after the first wave of the COVID-19 pandemic. Depressed household purchasing power will keep housing demand subdued, while the “three red lines” policy, which limits the amount property developers can borrow, will keep supply low (Chart 11).6 Housing accounts for ~ 30% of copper consumption in China, which means weak property markets will remain a drag on copper demand. Investment Implications Continued weakness in China’s economy and a potentially deep recession in the EU will continue to restrain demand for copper globally. In addition, with the US economy looking wobbly, the third global pillar of economic strength also will be weakening going into 2H22. These fundamental demand-side effects will lower pressure on tight copper inventories and keep prices subdued, in our view. This does not, however, signal an all-clear for copper supply or inventory tightness. Weaker demand is the only thing keeping prices from rising sharply, given the tight supply and inventory position of global copper markets. On the supply side, governance issues in copper-rich Latin American states, which are in the process of revising their social contracts with copper producers and consumers, will increase mining costs for companies, disincentivizing long-term and large-scale investments in new mines.7 These costs ultimately will be borne by consumers as supply shortages mount and the need to increase capex grows. Ultimately, this will feed into longer-term inflation and inflation expectations. Chart 12Caught In Risk-Off Selling We remain long-term bullish copper, as fundamentals remain tight and will get tighter. That said, over the short term, aggregate-demand weakness in the three major economic pillars in the world makes us leery of getting long copper futures, particularly as prompt COMEX prices test support (Chart 12).  Persistently weak copper prices will disincentivize the needed investment in new supply the world will need to effect a transition to renewable energy in coming decades. For this reason, we are comfortable re-establishing our long XME metals and mining ETF at tonight’s close, as copper prices are down 40% from their April highs. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish. A strike by Norwegian energy-sector workers that would have hit the natural gas market in Europe particularly hard was averted earlier this week.8 This still leaves the EU and UK (Europe) at risk of additional losses of Russian natgas exports beginning next week when Nord Stream 1 (NS1) maintenance is due to start. These threats have pushed Dutch Title Transfer Facility (TTF) natural gas prices up close to 93% since 1 June, and close to 400% y/y as of Tuesday. For the first five months of this year, Europe’s been importing just under 15 Bcf/d of LNG, with ~ 8.5 Bcf/d of those volumes coming from the US, based on EIA data. The EIA expects US LNG exports to average ~ 11.9 Bcf/d this year and 12 Bcf/d in 2023. Europe accounted for just under 75% of US exports in January – April of this year, and we expect that to continue going forward. The IEA expects Russia to supply 25% of EU demand this year, the lowest in 20 years. Last year, Russian imports covered ~ 40% (~ 7 TCF) of EU demand. Base Metals: Zinc stocks are depleted but prices are dropping on recession fears (Chart 13). Smelting operations were hit last year following the power-supply crunches in China and Europe. While China has recovered its energy security, Europe, which accounts for ~15% of global refined zinc supply, has not. Reduced natgas supply from Russia will make the smelting shortage in Europe even more acute, especially if power and fuel rationing occur. In April, China was a net exporter of zinc for the first time since 2014, as low demand in the state and low European zinc supply incentivized Chinese smelters to ship metal to the West despite high outbound tariffs. Precious Metals: Markets switched from inflation to growth fears, as central banks, notably the Fed began hiking interest rates aggressively to curb inflation. Investors have been flocking to the USD, which hit a 20-year high on recession fears this week (Chart 14). This has happened at the expense of the yellow metal, which, since breaking through the USD 1800/oz mark last week, has continued to drop, hitting an 8-month low as of yesterday's close. Chart 13Global Copper Inventories Remain Tight Chart 14   Footnotes 1     Please see China, US and EU are the largest economies in the world, which was published by Eurostat 19 May 2020. 2     For additional discussion of oil-market fundamentals, please see Recession Unlikely To Batter Oil Prices, which covers our expectation for global oil balances and prices. It was published 16 June 2022. 3    Please see Hypo-Globalization (A GeoRisk Update) published by BCA Research’s Geopolitical Strategy 30 July 2021. See also Commodities' Watershed Moment, which we published 22 March 2022.  4    Please see GDPNow, published by the Federal Reserve Bank of Atlanta 1 July 2022. 5    Please see Third Quarter Geopolitical Outlook: Thunder And Lightning, published by BCA’s Geopolitical Strategy 24 June 2022. This report notes, “China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect … . Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively.” 6    In August 2020, the Ministry of Housing and Urban-Rural Development and the People’s Bank of China proposed to implement a policy which kept a ceiling on companies’ asset to liability ratio at 70%, net debt to equity ratio at 100%, and cash to short-term borrowings ratio at 1. Developers whose liabilities are within these requirements may increase their liabilities by less than 15%. These were known as the “three red lines.” Per that policy, if one or more of these ceilings are surpassed, maximum liabilities growth is capped at a lower percentage. 7     Please see Add Local Politics To Copper Supply Risks, which we published 25 November 2021. It is available at ces.bcaresearch.com. See also Chile sticks to plan for new mining profit tax up to 32% linked to copper price, published by reuters.com via mining.com 1 July 2022. 8    Please see Norway’s government halts oil and gas strike published by ft.com 5 July 2022. Investment Views and Themes Strategic Recommendations Tactical Trades Trades Closed In 2022