Emerging Markets

Highlights Evergrande has not only crossed regulatory gridlines but also regulators’ bottom lines; the government will use the example of Evergrande to impose discipline on real estate developers. The policy response will likely prioritize domestic homebuyers and suppliers to minimize systemic risks and damage to the real economy. However, a bigger risk stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a significant spillover to other segments in the economy. The existing policy restrictions on China’s housing sector will not be reversed; the sector is on a structural downshift and will face risks of further consolidation and profit growth compression. Feature China Evergrande Group continues to stir up the global markets. Last Thursday the company missed a deadline to pay USD $83.5m in bond interest. The firm has now entered a 30-day grace period; it will default if that deadline also passes without payment. Chart 1Roller-Coaster Ride Continues... Evergrande has not remarked on the potential default nor have China’s authorities or state media offered any clues about a potential rescue package. Meanwhile, the PBoC injected large amounts of liquidity into the banking system of late, a clear sign of support for the markets. Evergrande share prices continued their roller-coaster ride (Chart 1). Evergrande’s tumult is indicative of an industry-wide problem.  Real estate developers have expanded their businesses and profits through high-debt growth models. China’s policymakers have been trying to crack down on this business practice since 2017 and their clampdown has significantly intensified since August 2020. In this report, we follow up on last week’s Special Alert and share our thoughts on the potential market implications and policy response to the evolving Evergrande situation. The “Three Red Lines” Versus The “Bottom Lines” Evergrande has not only crossed the “three red lines” – three debt metrics China’s authorities laid out a year ago to reduce the housing sector’s leverage – but it has also crossed the bottom lines of policymakers. Therefore, we do not expect the government to lend a financial hand to bail out the corporation and its shareholders. Meanwhile, as discussed in our Special Alert, we expect that there will be some kind of a rescue plan to help onshore homebuyers and suppliers recover their losses. The authorities’ silence in the past three months as investors’ concerns about Evergrande’s debt situation escalated speaks volumes about plans for the overleveraged company. The Evergrande episode is not idiosyncratic; it represents an industry-wide problem linked to the sector’s high-debt growth model.  However, Evergrande has become China’s and the world’s most indebted property developer; the “three red lines” policy last year has pushed the company into a severe liquidity crunch.  Evergrande not only borrowed heavily to pursue an aggressive expansion strategy (“disorderly expansion of capitals”), but did so as President Xi Jinping famously remarked “houses are for living, not for speculation” in late 2016. Between 2016 and 2020, Evergrande’s total liabilities almost doubled and its stock prices jumped by 460%. Evergrande’s founder was ranked the richest man in China in 2017, building his company’s fortune on excessive leverage. The way that the company accumulated wealth conflicts with the government’s new mantra of building “common prosperity”, a policy shift to reduce income and wealth inequality. Furthermore, Evergrande paid its offshore investors in June this year while it continued to borrow from onshore banks and offload its onshore assets. This move did not bode well for China’s domestic stake- and shareholders, along with policymakers. Chart 2Housing Price Inflation Has Been Subdued Outside Of Top-Tier Cities In contrast with policymakers’ silence about the future of Evergrande and its shareholders, the authorities have reportedly urged the company to finish and deliver its housing projects.  Evergrande’s projects are mostly in tier-three cities where post-pandemic home price inflation has been subdued compared with top-tier cities (Chart 2). As such, policymakers will be less concerned about fueling home prices in these cities and more willing to work out a plan to finish and deliver those housing projects. Bottom Line: Beijing may rescue the stakeholders of Evergrande rather than its shareholders. Contagion Risks We discussed our baseline scenario for Evergrande’s bankruptcy and restructuring in last week’s Special Alert. Our message has been that the well-telegraphed Evergrande default might not create an imminent systemic crisis or crash in China’s financial markets. However, it will likely reinforce the credit tightening that has been underway in China over the past 12 months.  This will delay and weaken the transmission of liquidity easing into the real economy. So far things are not bad enough for policymakers to reflate the economy in any meaningful way. Since the contagion risks from Evergrande’s debt crisis to China’s onshore financial markets seem to be contained, policy easing in the coming months will likely be gradual. Regulators have shown no sign of reversing the existing policy restrictions. Therefore, a bigger risk to China’s financial markets stems from the possibility that policymakers overestimate the resilience of the economy and ignore signs of a spillover to other segments in the economy. Real estate activity and investment in China are set to slow structurally (discussed in the section below). If policymakers allow a disruptive deceleration in the sector's growth while being reluctant to ramp up support in other industries, China’s economic growth could downshift much more than policymakers would like to see. A rapid deceleration in the real economic activity and jitters in the financial markets could reinforce each other and spiral out of control. The facts below explain why risks of an imminent systemic crisis in China’s and global financial markets are limited (Table 1): The exposure of China’s banks to real estate developers is small relative to the banks’ total lending.  Although about 40% of total bank loans are property-related, only 6% are in loans to real estate developers. The majority of the 40% is in mortgage loans, construction loans and other loans collateralized by land and property. Evergrande’s outstanding bank debt accounts for less than 0.1% of China’s total onshore loan balances. The company owes about 1% of China’s existing trust loans and 0.04% of domestic bonds. The company has quality assets, as we discussed in last week’s report, that could cover most of its onshore outstanding debt. Widespread mortgage loan defaults are unlikely to happen, even if Evergrande does not strike a debt restructuring deal with the government. Strict housing and home-sale regulations cap the upside and limit the downside in home prices. Moreover, conservative loan-to-value ratio requirements have contributed to China’s low default rates on mortgage loans.1 Evergrande’s overseas liabilities are more significant, with its USD $20 billion bonds accounting for about 10% of China's corporate USD bonds issued by real estate developers. On the other hand, major US financial institutions have minimal direct exposure to China and Hong Kong SAR. Table 1Evergrande Debt, An Overview* Despite limited systemic risks to the financial markets, a lack of government intervention could result in a disruptive bankruptcy of the company, risking substantial ripple effects on other parts of the economy. Evergrande’s accounts payable and bills amount to nearly RMB 700 billion, owed to companies in the upstream and downstream industry supply chains.  In addition, Evergrande’s contract liabilities are as high as RMB 170 billion and are associated with the pre-sold but unfinished residential units in more than 200 cities. We think policymakers and Evergrande will ultimately agree on a debt restructuring plan. Evergrande could transfer some of its hard assets to state-owned banks or enterprises and the banks could either extend or restructure Evergrande’s existing loans to help finish and deliver the company’s housing projects. Regardless of how the debt is restructured, a government-led rescue will likely prioritize domestic homebuyers and suppliers. Evergrande shareholders and investors in offshore, USD-denominated corporate bonds will suffer large losses. Bottom Line: Our base case scenario is that the government will restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. Will Policymakers Reverse Restrictive Housing Policies? Even though China’s monetary and fiscal policies have eased at margin, policy restrictions on the property market remain in place. The bar for regulators to significantly ease or to reverse policy tightening in the real estate industry is much higher than in past cycles. Furthermore, the government’s efforts to contain the sector’s leverage and home price inflation are structural rather than cyclical. Our view is based on the following observations: Chart 3China's Housing Demand Is On A Structural Downshift China’s housing demand is on a structural downshift due to China’s falling birthrate and working-age population.  The decline in demand will likely accelerate in the next four to five years (Chart 3). Therefore, it is unreasonable to expect that the growth in real estate investment in the coming years will continue growing at the same rate as in the past cycles.  The government is determined to improve housing affordability by capping home prices in the coming years while increasing lower-income household wage growth. Previous “big bang” stimulus and soaring home prices have widened rather than narrowed income and wealth inequality. Beijing’s current primary focus is “common prosperity,” which aims to reduce inequality. This overarching policy initiative will prevent policymakers from backtracking on reforms in the property sector. Things are not bad enough for a major shift in policy direction. Demand for housing is down, but from a very elevated level (Chart 4). The growth of home sales is now reverting to its pre-pandemic rate. In a previous report we pointed out that the current policy backdrop resembles that of 2H2018 and 2019, when the stimulus was very measured despite a slowing economy and an escalating trade war with the US. Demand for housing in the first eight months of this year is stronger than in 2018/19, thus policymakers may not feel pressure to loosen restrictions in the housing sector.  Chart 4Post-Pandemic Housing Demand Stronger Than 2018/19 Chart 5Real Estate Investment Relatively Steady Despite Contracting Housing Starts Growth in real estate investment has been steady despite contracting housing starts (Chart 5).  The government’s deleveraging pressure on the sector since August last year has forced developers to hurry and finish their existing projects (Chart 5, bottom panel). This has helped to reduce developers’ project inventories and discourage them from hoarding land reserves, and the policy intention is unlikely to change (Chart 6). Additionally, the government has prioritized home price stability by capping prices and fine-tuning the supply of land (Chart 7). In other words, housing starts have become less market-driven and weaker readings may reflect regulators’ policy intentions to rein in land supplies.2 Local governments may increase the supply of land when real estate investment softens too fast, but home sales and project completions will have to decelerate more significantly. Chart 6Developers Have Been Rushing To Finish Existing Projects Chart 7Government Prioritizes Home Price Stability By Capping Prices And Fine-Tuning Land Supply Funding constraints will not be removed soon and restrictive policies apply to both developers and banks. Banks need to meet the “two red lines” while developers must bring their leverage ratios below the “three red lines” by end-2023. The “two red lines”, which the PBoC unveiled in January this year, set the upper limit on the portion of household mortgages and real estate loans in banks’ total lending.  Despite aggressively scaling back lending to the housing sector, the lending ratio in many banks – including China’s six large banks and various medium-sized banks – still exceeded the upper limit. These banks will have to continue to reduce their property-related lending while the other banks will maintain a lower percentage of loans to the housing sector than in the past. Consequently, binding constraints on developers and banks will continue to weigh on the housing market in the coming years, suggesting that the property market downturn will last longer than in previous cycles. Chinese policymakers are unlikely to have much appetite for more robust construction activity in the current environment with supply-side constraints for both raw materials and energy. More than 10 provinces in China are currently under power rationing and have cut factory production amid electricity supply issues and a push to enforce environmental regulations. We expect supply shortages and production decreases to continue through the winter, limiting the upside potential of the country’s economic activity. Bottom Line: China’s reforms in the property sector are structural and the leadership is much less likely to use housing as counter-cyclical policy support to the economy than in previous cycles. Investment Implications China’s growth and its ever-important property market activity have slowed. Given the policymakers’ higher pain threshold for a slower economy and lower appetite for leverage, policy easing will likely be gradual and piecemeal in the near term. The current monetary, fiscal, and industry policy backdrops resemble China’s response in H2 2018 and early 2019. Chinese stock prices rose briefly in early 2019 on the expectation of a sizable stimulus, but the rally was short-lived (Chart 8). Furthermore, we do not rule out the possibility that policymakers will be overconfident in their capability to stabilize the economy as they balance structural reforms against growth volatility. They may choose to wait until there are signs of a significant spillover to other segments in the economy before backtracking the deleveraging campaign in the property sector and lending more support to the market/economy. In this scenario, the near-term response in the equity market will likely be very negative. China-related asset prices will not stabilize until policymakers decisively and significantly dial-up their reflationary response. Property sector stocks in China’s on- and offshore markets have been beaten down by policy tightening and lately the Evergrande saga (Chart 9). We maintain our view that these stocks have not reached their bottom. The property downturn in China is a structural change and authorities are unlikely to reverse current restrictions on the sector to support the economy. Chart 8Chinese Stock Price Rally In 2019 Was Short-Lived Chart 9Chinese Real Estate Stocks Have Not Reached Their Bottom The real estate sector’s contribution to China’s economic growth is expected to gradually decline in the medium to long term. The industry will be further reformed and consolidated, and more developers will be forced to abandon their high-leverage, high-growth business expansion model. The outlook for the real estate industry’s profit growth will become less certain.  Investors will require higher risk premiums for real estate sector stocks, which means that these stocks’ valuations will be further compressed.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1 Chinese homeowners’ down payment ratios on a first property is 30% and 50% on a second property. 2Land auctions were delayed in July and August due to overwhelming demand from developers in the first half of the year. Market/Sector Recommendations Cyclical Investment Stance

Highlights Monetary Policy: It’s all but certain that tapering will begin next month and conclude by the middle of next year, but the FOMC is currently split right down the middle on whether it will be appropriate to lift rates in H2 2022. We present five factors to track to decide when the Fed will hike rates. Yield Curve: A bear-flattening of the nominal yield curve remains the most likely scenario for the next 6-12 months. Maintain a position short the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Investors should enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. The 2-year real yield, in particular, has a lot of upside during the next 6-12 months. EM Bonds: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling. Feature This past week was quite eventful for US bond investors. First, the Fed presented its September update on Wednesday, offering some hints about the timing and pace of asset purchase tapering alongside its updated economic and interest rate forecasts. Then, bonds sold off sharply on Thursday, Friday and Monday with the 10-year Treasury yield rising all the way to 1.49%. The first section of this week’s report looks at what we learned from last week’s FOMC meeting and opines on some monetary policy questions that remain unanswered. The second section updates our views on portfolio duration, the yield curve and TIPS in light of last week’s large market moves. Finally, we conclude with an update on the outlook for USD-denominated Emerging Market bonds. Powell Answers Some Small Questions, Avoids The Big One The Small Questions The start date for asset purchase tapering is the first small question that the Fed answered last week. A new sentence was added to the post-meeting statement saying that “a moderation in the pace of asset purchases may soon be warranted” and, in his press conference, Chair Powell clarified that the purpose of the new language is “to put notice out there that [tapering] could come as soon as the next meeting”. After this statement from the Fed, we expect asset purchase tapering to be announced at the next FOMC meeting on November 3rd. A delay until December is possible if September’s employment report is a massive disappointment, but the bar for delaying tapering beyond November appears high. Chair Powell also shed some light on a second small question related to the Fed’s balance sheet. Specifically, the pace of asset purchase tapering. In his press conference the Chair said that “participants generally view that, so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate.” The information about the pace of tapering is slightly more interesting than the start date, if only because Fed policymakers have expressed a desire for net purchases to reach zero before the first interest rate increase. The fact that the Fed is planning to reach net zero purchases by the middle of next year suggests that it wants to leave the door open for a possible rate hike in the second half of 2022. This message was confirmed by the Fed’s updated interest rate projections (Chart 1). The projections revealed an even split (9 vs. 9) on the Committee between those that expect at least one 25 basis point rate increase before the end of 2022 and those that do not expect to lift rates next year. It’s also notable that, out of the 9 participants that don’t expect a rate hike in 2022, 8 anticipate lifting rates in 2023. Chart 1Rate Expectations Of course, as Chair Powell often points out, the Fed’s interest rate projections are contingent on the future state of the economy and will almost certainly be revised as the outlook evolves. What’s more important from a forecasting perspective is knowing how the Fed will react to different economic conditions. The Big Question With that in mind, we know that the Fed has promised not to lift rates until the labor market reaches “maximum employment”. However, as we noted in a recent report, the Fed hasn’t provided much detail on what “maximum employment” actually means.1 Powell’s comments last week didn’t add much clarity, but we can hunt for clues in the Summary of Economic Projections (SEP). In the SEP, we first notice that 13 FOMC participants expect the unemployment rate to be 3.8% - 3.9% or lower by the end of 2022 (Chart 2A). It is logical to assume that this group includes the 9 participants who expect to lift rates in 2022 and 4 additional ones. We also observe that 17 out of 18 participants anticipate an unemployment rate of 3.8% - 3.9% or lower by the end of 2023 (Chart 2B), exactly matching the number of participants who expect to lift rates by then. We can therefore infer that the Fed views an unemployment rate of roughly 3.8% as consistent with “maximum employment”. That is, FOMC participants tend to have rate hikes penciled into their forecasts once the unemployment rate is below 3.8%. Chart 2AFOMC 2022 Unemployment Rate Projection Distribution Chart 2BFOMC 2023 Unemployment Rate Projection Distribution The SEP’s inflation forecasts are less illuminating than the unemployment ones. All but 4 participants expect core PCE inflation to be above the Fed’s 2% target at the end of 2022 (Chart 3A) and no FOMC participant is forecasting below-2% core PCE at the end of 2023 (Chart 3B).2 The most we can take away from these forecasts is that 14 FOMC participants expect inflation to be above target in 2022, but five of those participants don’t see the labor market as being tight enough to lift rates by then. Chart 3AFOMC 2022 Core PCE Inflation Rate Projection Distribution Chart 3BFOMC 2023 Core PCE Inflation Rate Projection Distribution The revelation that FOMC participants view a 3.8% unemployment rate as consistent with “maximum employment” is illuminating, but it doesn’t tell the entire story. We don’t know, for example, what assumptions about labor force participation the different Fed officials are using. Our sense is that the following five criteria will ultimately determine when the Fed starts to lift interest rates: An unemployment rate in the neighborhood of 3.8%. Prime-age (25-54) labor force participation close to its pre-pandemic level (Chart 4, top panel). Accelerating wage growth (Chart 4, bottom 2 panels). Long-dated inflation expectations at or above target levels (Chart 5, top 2 panels). Non-transitory inflation at or above target levels (Chart 5, bottom panel). Bottom Line: The FOMC is currently split right down the middle on whether it will be appropriate to lift rates in 2022, but these forecasts aren’t set in stone and next year’s economic data – particularly the five factors listed above – will determine which group is correct. Chart 4Part Rate & Wage Growth Chart 5Inflation & Inflation Expectations Our own view is that the labor market will be sufficiently tight for the Fed to deliver its first rate hike in December 2022, and that rate hikes will proceed more quickly than what is currently priced in the yield curve. US bond investors should maintain below-benchmark portfolio duration. The Fallout In Bond Markets Bonds sold off sharply last Thursday and again yesterday morning. At the time of publication, the 30-year Treasury yield had risen from 1.81% on Wednesday to 2.02% (Chart 6). The 10-year Treasury yield had risen from 1.30% to 1.49% (Chart 6, panel 2). The 5-year yield is up to 0.98% from 0.85% on Wednesday (Chart 6, panel 3), and the 2-year yield is up to 0.28% from 0.24% (Chart 6, panel 4). The yield curve has also steepened since Wednesday, though the 2/10 slope remains well below its March peak (Chart 7). The trend during the past few months has been one of curve steepening out to the 5-year maturity point (Chart 7, panel 2) and flattening beyond that point (Chart 7, bottom 2 panels). Recent market action has led to some steepening beyond the 5-year maturity, but so far that steepening is minor compared to the flattening move we’ve witnessed since the spring. Chart 6Treasury Yield Trends Chart 7Treasury Curve Trends Nominal Curve We have been recommending a position short the 5-year bullet and long a duration-matched barbell consisting of the 2-year and 10-year notes, and we think this trade will continue to outperform. First, the 5-year/5-year forward Treasury yield is back above 2%, consistent with median estimates of the long-run neutral fed funds rate from the New York Fed’s Surveys of Market Participants (2%) and Primary Dealers (2.25%) (Chart 6, bottom panel). We think it will be difficult for the 5-year/5-year forward yield to rise much above these levels, which makes curve flattening more likely than steepening going forward.3 Second, we updated our work on yield curve scenarios to incorporate recent market action and some new information gleaned from last week’s SEP. In this analysis we estimate fair value levels for different parts of the yield curve as of the end of 2022 based on a scenario for the path of the fed funds rate. For example, if we assume that Fed liftoff occurs in December 2022 and rate hikes proceed at a pace of 75 bps per year (the median pace in the SEP) until the fed funds rate levels-off at 2.08% (consistent with a 2%-2.25% range for the long-run neutral fed funds rate), we calculate that the 2-year yield has 74 bps of upside between now and the end of 2022. This is slightly more than the 65 bps of upside in the 5-year yield and much more than the 37 bps of upside in the 10-year yield (Table 1). Comparing this expected change to what is already discounted in the forward curve, we see that both the 2-year and 10-year yields are expected to exceed their forwards by 6 bps. The 5-year yield is expected to exceed its forward by 16 bps. Table 1Treasury Curve Scenario Analysis To us, the message is clear. We want to remain short the 5-year note versus a duration-matched 2/10 barbell. Real & Inflation Curves Chart 8Real & Inflation Curves The increase in the 10-year nominal yield since last Wednesday was roughly evenly split between the real and inflation compensation components. Interestingly, inflation drove a greater proportion of the increase at the front-end of the curve, and the 2-year real yield actually fell. We maintain a neutral recommendation on TIPS versus nominal Treasuries, but this week we recommend taking advantage of recent market action by implementing some curve trades across the real and inflation curves. Specifically, we note that the cost of short-maturity inflation compensation remains well above the cost of long-maturity inflation compensation (Chart 8). Going forward, the cost of front-end inflation compensation will fall as inflation moderates from its current extremely high level. Meanwhile, the cost of long-maturity inflation compensation will remain sticky near the Fed’s target levels. This will lead to a steepening of the inflation curve (Chart 8, panel 2). The combination of a steeper inflation curve and a flatter nominal curve will lead to a much flatter real yield curve (Chart 8, bottom 2 panels). The 2-year real yield, in particular, has a lot of upside if inflation moderates, as we expect, and the 2-year nominal yield rises in line with the projections shown in Table 1. Bottom Line: Investors should remain short the 5-year bullet versus a duration-matched 2/10 barbell on the nominal Treasury curve. Investors should also enter 2/10 steepeners on the inflation compensation curve and/or 2/10 flatteners on the real (TIPS) curve. A Quick Update On Emerging Market Bonds The collapse of Chinese real estate behemoth Evergrande dominated headlines for most of the past week, though so far there has been little contagion into USD-denominated credit markets. Unsurprisingly, the spread on Chinese corporate and quasi-sovereign bonds has widened, and there has been some passthrough into both the High-Yield EM USD Corporate & Quasi-Sovereign Index and the High-Yield EM USD Sovereign Index (Chart 9). However, investment grade EM credit spreads have been relatively unaffected by the turmoil, as have US corporate bond spreads (both IG and HY) (Chart 9, bottom 2 panels). While the Evergrande drama – and weakening Chinese economic growth in general – could weigh on USD-denominated EM bond performance in the near-term, we see an excellent buying opportunity in investment grade EM bonds on a 6-12 month horizon. Investment grade EM Sovereigns outperformed credit rating and duration-matched US corporate bonds in the early months of the recovery but have lagged during the past few months (Chart 10). The same is true for the investment grade EM Corporate and Quasi-Sovereign index (Chart 10, panel 3). This is not to say that EM bond performance has been poor – the EM Sovereign index is still up 97 bps versus duration-matched Treasuries on the year – it has simply failed to keep pace with the stellar performance of US corporate bonds. Chart 9No Contagion Chart 10EM Bonds Versus US Corporates But that recent stellar performance of US investment grade corporate bonds has left spreads in the sector near historically tight levels. In last week’s report we ran some scenarios for US investment grade corporate bond returns during the next 12 months and concluded that excess returns versus Treasuries are probably capped at 85 bps.4 This makes the current spread advantage in EM Sovereigns (Chart 10, panel 2) and EM Corporates & Quasi-Sovereigns (Chart 10, bottom panel) very compelling. This will be especially true if Emerging Market growth accelerates in 2022 on the back of increased Chinese stimulus and a COVID vaccination campaign that is already picking up steam.5 Bottom Line: US bond investors should shift some allocation out of expensive US investment grade corporate bonds and into USD-denominated investment grade EM Sovereigns and Corporates where valuation is more compelling.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “2022 Will Be All About Inflation”, dated September 14, 2021. 2 Chart 3B shows that 4 participants expect core PCE inflation of 1.9%-2.0% in 2023, but the SEP also reveals that the minimum forecast for core PCE in 2023 is 2.0%. In other words, all 4 participants in that range are forecasting 2.0%, not 1.9%. 3 For more details on the relationship between our 5-year/5-year forward yield target and the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 4  Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 For a recent debate about the outlook for Emerging Market assets please see last Friday’s Webcast: https://www.bcaresearch.com/webcasts/detail/458 Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights The Evergrande crisis is not China’s Lehman moment. Nonetheless, Chinese construction activity will decelerate further in response to this shock. Global equities are frothy enough that a weaker-than-expected Chinese construction sector will remain a near-term risk to stocks prices. European markets are more exposed to this risk than US ones. Tactically, this creates a dangerous environment for cyclicals in general and materials in particular. Healthcare and Swiss stocks would be the winners. Despite these near-term hurdles, we maintain a pro-cyclical portfolio stance, which we will protect with some temporary hedges. We will lift these hedges if the EURO STOXX corrects into the 430-420 zone. A busy week for European central banks confirms our negative stance on EUR/GBP, EUR/SEK, and EUR/NOK. While EUR/CHF has upside, Swiss stocks should outperform Euro Area defensives. Stay underweight UK Gilts in fixed-income portfolios. Feature The collapse of property developer Evergrande creates an important risk for European markets. It threatens to slow Chinese construction activity further, which affects European assets that are heavily exposed to the Chinese real estate sector, directly and indirectly. This risk is mostly frontloaded, as Chinese authorities cannot afford a complete meltdown of the domestic property sector. Moreover, this economy has slowed significantly and more policy support is bound to take place. Additionally, forces outside China create important counterweights that will allow Europe to thrive despite the near-term clouds. While we see more short-term risk for European stocks and cyclical sectors, the 18-month cyclical outlook remains bright. Similarly, European stocks will not outperform US ones when Chinese real estate activity remains a source of downside surprise; but they will afterward. China’s Construction Slowdown Is Not Over The Evergrande crisis is not China’s Lehman moment. Beijing has the resources to prevent a systemic meltdown and understands full well what is at stake. At 160% of GDP, China’s nonfinancial corporate debt towers well above that of other major emerging markets and even that of Japan in the 1980s (Chart 1). If an Evergrande bankruptcy were allowed to topple this debt mountain, China would experience the kind of debt-deflation trap that proved so disastrous in the 1930s. A further deterioration of conditions in Chinese real estate activity is nonetheless in the cards, even if the country avoids a global systemic financial shock. First, the inevitable restructuring of Evergrande will result in losses for bond holders, especially foreign ones. Consequently, risk premia in the Chinese off-shore corporate bonds market will remain wide following the resolution of the Evergrande debacle. While Chinese banks are likely to recover a large proportion of the funds they lent to the real estate giant, they too will face higher risk premia. At the margin, the rising cost of capital will curtail the number of projects real estate developers take on over the coming two to three years. Second, the eventual liquidation of Evergrande will hurt confidence among real estate developers. This process may take many forms, but, as we go to press, the most discussed outcome is a breakup and restructuring where state-owned enterprises and large local governments absorb Evergrande’s operations. Evergrande’s employees, suppliers, and clients who have deposited funds while pre-ordering properties will be made whole one way or the other. However, shareholders and management will not. Wiping out shareholders and senior management will send a message to the operators of other developers, which will negatively affect their risk taking (Chart 2). Chart 1China Cannot Afford A Lehman Moment Chart 2Downside To Chinese Construction Activity   Third, one of President Xi Jinping’s key policy objectives is to tame rampant income inequality in the Chinese economy. Rapidly rising real estate prices and elevated unaffordability only worsen this problem. Hence, Beijing wants to avoid blind stimulus that mostly pushes house prices higher but that would have also boosted construction activity. Thus, if credit growth is pushed through the system, the regulatory tightening in real estate will not end. This process is likely to result in further contraction in floor space sold and started. Bottom Line: The Evergrande crisis is unlikely to morph into China’s Lehman moment. However, its fallout on the real estate industry means that Chinese construction activity will continue to contract in the coming six to twelve months or so. Chinese Construction Matters For European Equities The risk of further contraction in Chinese construction activity implies a significant near-term risk for European equities, especially relative to US ones. Even after the volatility of the past three weeks, global equities remain vulnerable to more corrective action. Speculative activity continues to grip the bellwether US market. Our BCA Equity Speculation Index is still around two sigma. Previous instances of high readings did not necessarily herald the end of bull markets; however, they often resulted in sideways and volatile trading, until the speculative excesses dissipated (Chart 3). The case for such volatile trading is strong. The Fed is set to begin its taper at its November meeting. Moreover, an end of the QE program by the middle of next year and the upcoming rotation of regional Fed heads on the FOMC will likely result in a first rate hike by the end of 2022. Already, the growth rate of the global money supply has declined, and the real yield impulse is not as supportive as it once was. Therefore, the deterioration in our BCA Monetary Indicator should perdure (Chart 4), which will heighten the sensitivity of global stocks to bad news out of China. Chart 3Rife With Speculation Chart 4Liquidity Deterioration At The Margin Chart 5Still Too Happy Investor sentiment is also not as washed out as many news stories ascertain. The AAII survey shows that the number of equity bulls has fallen sharply, but BCA’s Complacency-Anxiety Index, Equity Capitulation Indicator and Sentiment composite are still inconsistent with durable market bottoms. Moreover, the National Association of Active Investment Managers’ Exposure Index is still very elevated. When this gauge is combined with the AAII bulls minus bears indicator, it often detects floors in the US dollar-price of the European MSCI index (Chart 5). For now, this composite sentiment measure is flashing further vulnerability for European equities, especially if China remains a source of potential bad news in the coming months. Economic linkages reinforce the tactical risk to European stocks. Chinese construction activity affects the Euro Area industrial production because machinery and transportation goods represent 50% of Europe’s export to China (Chart 6). This category is very sensitive to Chinese real estate activity. Moreover, Europe’s exports to other nations are also indirectly affected by the demand from Chinese construction. Financial markets bear this footprint. Excavator sales in China are a leading indicator of construction activity. Historically, they correlate well with both the fluctuations of EUR/USD and the performance of Eurozone stocks relative to those of the US (Chart 7). Hence, if we anticipate that the problems Evergrande faces will weigh on excavator sales in the coming months, then the euro will suffer and Euro Area stocks could continue to underperform. Chart 6Europe's Exports To China Are Sensitive To Construction Activity Chart 7A Near-Term Risk To European Assets   Similarly, the fallout from Evergrande’s problem will extend to the performance of European equity sectors. The sideways corrective episode in cyclical relative to defensive shares is likely to continue in the near term. This sector twist remains frothy, and often declines when Chinese credit origination is soft (Chart 8). Materials stocks are the most likely to suffer due to their tight correlation with Chinese excavator sales (Chart 9); meanwhile, healthcare equities will reap the greatest benefit as a result of their appealing structural growth profile and their strong defensive property. Geographically, Swiss stocks should perform best (Chart 9, bottom panel), because they strongly overweigh healthcare and consumer staple names. Moreover, as we recently argued, the SNB’s monetary policy is an advantage for Swiss stocks compared to Eurozone defensives.1 Additionally, Dutch equities, with their 50% weighting in tech and their small 12% combined allocation to industrials and materials, could also enjoy a near-term outperformance as investors digest the sectoral impact of weaker Chinese construction activity. Chart 8The Vulnerability Of Cyclicals/Defensives Remains Chart 9Responses To Weaker Construction   Bottom Line: No matter how the Evergrande story unfolds, its consequence on Chinese construction activity may still cause market tremors. Global equity benchmarks may be rebounding right now, but, ultimately, they remain vulnerable to this slowdown. Any negative surprise out of China is likely to cause Europe to underperform because of its greater exposure to Chinese construction activity. Investment Conclusion: This Too Shall Pass The risks to the European equity market and its cyclicals sectors will prove transitory and will finish by the end of the year. Beijing will tolerate some pain to the real estate sector, but the stakes are too high to let the situation fester for long. The main problem is China’s large debt. Already sequential GDP growth in the first half of 2021 was worse than the same period in 2020, and credit accumulation is just as weak as in early 2018 (Chart 10). In this context, if real estate activity deteriorates too much, aggregate profits will contract and, in turn, will hurt the corporate sector’s ability to service its debt. Employment and social tensions create another stress point that will force Beijing’s hand. At 47, the non-manufacturing PMI employment index is already well into the contraction zone (Chart 11). Weakness in construction activity will hurt the labor market further. In an environment where protests have been springing up all over China, the Communist Party does not want to see more stress applied to workers. Chart 10In The End, Stimulus Will Come Chart 11Worsening Chinese Employment Conditions   These two constraints will force Beijing to alleviate the pain caused by a weaker construction sector. As a result, we still expect the Chinese credit and fiscal impulse to re-accelerate by Q2 2022. Developments outside of China will create another important offset that will allow risk assets to thrive once their immediate froth has receded. Strong DM capex will be an important driver of global activity next year. As Chart 12 shows, capex intentions in the US and the Euro Area are rapidly expanding, which augurs well for global investments. Moreover, re-building depleted inventories (Chart 13) will be a crucial component of the solution to global supply bottlenecks. Both activities will add to global demand. As an example, ship orders are already surging. Chart 12DM Capex Intentions Are Firming Chart 13Don't Forget About Inventories     We maintain a pro-cyclical stance in European markets after weighing the near-term negatives against the underlying positive forces. For now, hedging the tactical risk still makes sense and our long telecommunication / short consumer discretionary equities remain the appropriate vehicle – so does being long Swiss stocks versus Euro Area defensives. However, we will use any correction in the EURO STOXX (Bloomberg: SXXE Index) to the 430-420 zone to unload this protection. Bottom Line: The potential market stress created by a slowdown in Chinese construction activity will be a temporary force. Beijing will not tolerate a much larger hit to the economy, especially as tensions are rising across the country. Thus, even if the stimulus response to the Evergrande crisis will not be immediate, it will eventually come, which will support Chinese economic activity. Additionally, the capex upside and inventory rebuilding in advanced economies will create an offset for slowing Chinese growth. Consequently, while we maintain a pro-cyclical bias over the medium term, we are also keeping in place our hedges in the near term, looking to shed them if SXXE hits the 430-420 zone. A Big Week For Central Banks Chart 14The BoE's Is Listening To The UK's Economic Conditions... Last week, four European central banks held their policy meetings: The Riksbank, the Swiss National Bank, the Norges Bank, and the Bank of England. No major surprises came out of these meetings, with central banks discourses and policy evolving in line with their respective economies. The BoE veered on the hawkish side, highlighting that rates could rise before its QE program is over. This implies a small possibility of a rate hike by the end of 2021. However, our base case remains that the initial hike will be in the first half of 2022. The BoE is behaving in line with the message from our UK Central Bank Monitor (Chart 14). Moreover, the combination of rapid inflation and strong house price appreciation is incentivizing the BoE to remove monetary accommodation, especially because UK financial conditions are extremely easy (Chart 14, bottom panel). One caution advanced by the MPC is the uncertainty surrounding the impact of the end of the job furlough scheme this month. However, the global economy will be strong enough next spring to mitigate the risks to the UK. The results of last week’s MPC meeting and our view on the global and UK business cycles support the short EUR/GBP recommendation of BCA’s foreign exchange strategist,2 as well as the underweight allocation to UK Gilts of our Global Fixed Income Strategy group.3 The Norges Bank is the first central bank in the G-10 to hike rates and is likely to do so again later this year. While Norwegian core inflation remains low, house prices are strong, monetary conditions are extremely accommodative, and our Norway Central Bank Monitor is surging (Chart 15). The Norwegian central bank will continue to focus on these positives, especially in light of our Commodity and Energy team’s view that Brent will average more than $80/bbl by 2023.4 In this context, we anticipate the NOK to outperform the euro over the coming 24 months. Nonetheless, the near-term outlook for Norwegian stocks remains fraught with danger. Materials account for 17% of the MSCI Norway index and are the sector most vulnerable to a deterioration in Chinese construction activity. The Riksbank continues to disregard the strength of the Swedish economy. Relative to economic conditions, it is one of the most dovish central banks in the world. The Swedish central bank is completely ignoring the message from our Sweden Central Bank Monitor, which has never been as elevated as it is today (Chart 16). Moreover, the inexpensiveness of the SEK means that Swedish financial conditions are exceptionally accommodative. At first glance, this picture is bearish for the SEK. However, easy monetary conditions will cause Sweden’s real estate bubble to expand. Expanding real estate prices and transaction volumes will boost the profits of Swedish financials, which account for 27% of the MSCI Sweden index. Moreover, Swedish industrials remain one of our favorite sectors in Europe, and they represent 38% of the same index. As a result, equity flows into Sweden should still hurt the EUR/SEK cross. Chart 15...And The Norges Bank, To Norway's Chart 16The Riksbank Is Blowing Real Estate Bubbles Chart 17The CHF Still Worries The SNB Finally, the SNB proved reliably dovish. Our Switzerland Central Bank Monitor is rising fast as inflation and house prices improve (Chart 17). However, the SNB is rightfully worried about the expensiveness of the CHF, which generates tight Swiss financial conditions (Chart 17, bottom panel). Consequently, the SNB will keep fighting off any depreciation in EUR/CHF. Thus, the SNB will be forced to expand its balance sheet because the ECB is likely to remain active in asset markets longer than many of its peers. This process will be key to the outperformance of Swiss stocks relative to other European defensive equities.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1 Please see European Investment Strategy “The ECB’s New Groove,” dated July 19, 2021, available at eis.bcarsearch.com 2 Please see Foreign Exchange Strategy “Why Are UK Interest Rates Still So Low?,” dated March 10, 2021, available at fes.bcarsearch.com 3 Please see European Investment Strategy “The UK Leads The Way,” dated August 11, 2021, available at eis.bcarsearch.com 4 Please see Commodity & Energy Strategy “Upside Price Risk Rises For Crude,” dated September 16, 2021, available at fes.bcarsearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Chart 2Natgas Storage Remains Tight US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 Chart 6       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights Evergrande is just a canary in the coalmine warning of the vulnerability of global real estate, which is now trading on its highest valuation ever. US house prices are now more extended versus rents than at the peak of the credit boom. US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). We reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. New structural recommendation: buy the China 30-year government bond Stay structurally long real estate. Even though valuations are high, they will get even higher when 30-year bond yields reach their ultimate low.  Fractal analysis: Uranium and Palm Oil. Feature Chart of the WeekThe $300 Trillion Global Real Estate Market Dwarfs The $90 Trillion Global Economy The recent woes of China’s systemically important real estate developer Evergrande confirm the concern we voiced in our October 29, 2020 Special Report: The Real Risk Is Real Estate. To be clear, we do not expect any Evergrande default to topple the global financial dominoes á la 2008. The Chinese government is able and almost certainly willing to prevent its own Lehman moment. A more realistic concern is that the rich valuation of real estate, both in China and globally, is vulnerable to the slightest of shocks, and Evergrande is just a canary in the coalmine. Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock According to global real estate specialist Savills, four of the top six world cities for real estate inflation in 2021 are in China. Through just the first half of the year, prime real estate prices have surged by 14 percent in Shanghai, 13 percent in Hangzhou, 9 percent in Shenzhen, and 8 percent in Guangzhou.1 This surge in Chinese property prices has lifted Chinese valuations to nosebleed levels. Today, prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. From such nosebleed valuations, a fire sale of Evergrande’s inventory – as creditors tried to recover debts – could weigh down real estate prices. And the repercussions would extend beyond China’s property sector. Prime real estate yields in China’s major cities are barely above 1 percent, just a third of the global average of 3 percent. Without a social safety net and with limited places to park their money, Chinese savers have for years been encouraged to buy homes, in the widespread belief that property is the safest investment, whose price is only supposed to go up. With the bulk of people’s wealth in property acting as a perceived economic safety net, even a 10 percent decline in house prices would constitute a major shock to the household sector’s hopes and expectations of what property is (Chart I-2). Chart I-2Even A 10 Percent Decline In Chinese House Prices Would Constitute A Major Shock In turn, the ensuing ‘negative wealth effect’ would unleash a major headwind to household spending in the world’s second largest economy. Nosebleed Property Valuations Everywhere The precarious valuation of real estate is not just a Chinese concern. US house prices are now more extended versus rents than at the peak of the credit boom (Chart I-3). Chart I-3US House Prices Are Now More Extended Versus Rents Than At The Peak Of The Credit Boom Yet the phenomenon extends globally. Through the past ten years, world prime residential prices are up by 70 percent while rents are up by just 25 percent.2 As a mathematical identity, this means that the bulk of the increase in global real estate prices is due to valuation expansion (Chart I-4). Savills confirms this by pointing out that its global prime residential yield has fallen below 3 percent for the first time, and constitutes the lowest global rental yield since the firm began tracking the data in 2005. Chart I-4The Bulk Of The Increase In Global Real Estate Prices Is Due To Valuation Expansion The culprit for the richest ever valuation of global real estate is the structural collapse in global bond yields. And the culprit for the structural collapse in bond yields is persistently ultra-low policy interest rates combined with trillions of dollars of quantitative easing (Chart I-5). Chart I-5The Culprit For The Richest Ever Valuation Of Global Real Estate Is The Structural Collapse In Global Bond Yields But now, policy makers risk being hoisted by their own petard. The tight relationship between bond yields and real estate yields means that bond yields have very limited scope to rise before pulling the bottom out of the $300 trillion global real estate market. Given that this dwarfs the $90 trillion global economy, even a 10 percent correction amounting to $30 trillion would constitute a devastating negative wealth effect (Chart of the Week). Nosebleed Property Valuations Reinforce The Structural Case For 30-Year Bonds Some people counter that in an inflationary shock, property – as the ultimate real asset – ought to perform well even as bond yields rise. However, when valuations start off in nosebleed territory as now, the initial intense headwind from deflating valuations obliterates the tailwind from inflating incomes. An easy way to understand this intense headwind is through the concept of affordability. In the US the 15-year mortgage rate tracks the 10-year T-bond yield plus a usually consistent spread of around 1 percent. Hence, if the 10-year T-bond yield rose from 1.3 to 2 percent, the mortgage rate would rise from 2.3 to 3 percent, a proportionate increase of 30 percent. For the marginal buyer using an interest-only mortgage, this means that already stretched affordability versus income would worsen by 30 percent.3 Therefore, for the marginal buyer to keep his bid on the property the same, his income would have to inflate by 30 percent. But in an inflationary shock that pushed up the bond yield by 0.7 percent, it is implausible that wages would rise by 30 percent. Let’s say, at a push, that wages rose by 10 percent. To keep affordability and mortgage demand the same, property prices would have to plunge by 20 percent. In fact, earlier this year we saw the extreme vulnerability of US mortgage demand to higher bond yields. When the bond yield collapsed at the start of the pandemic in 2020, the mortgage rate declined more sedately. Hence, in the early stage of bond yield rebound, the US mortgage rate did not increase (Chart I-6). Chart I-6In 2020, The US Mortgage Rate Briefly Decoupled From Its Usual Relationship With The Bond Yield But by early 2021, the mortgage rate had normalised its relationship with the bond yield, so the snap-up in yields earlier this year lifted mortgage rates point for point. The worrying result was that US mortgage applications for house purchases collapsed by one third (Chart I-7). Chart I-7As Bond Yields Rose Earlier This Year, US Mortgage Applications Collapsed By One Third Fortunately, the negative feedback from markets and the economy meant that the snap-up in bond yields was brief. As yields have subsequently fallen back, mortgage demand has stabilised. Yet the crucial lesson is that US bond yields cannot move up very far before severely choking mortgage demand and hence the housing market (not to mention the stock market). To repeat, US house prices are more stretched versus rents than at the peak of the credit boom in 2007. With this precarious dynamic, we reiterate our structural recommendation to own the US 30-year T-bond, whose ultimate low in yield will come in the next deflationary shock. As bond yields rose earlier this year, US mortgage applications collapsed by one third. But today we are adding a new structural recommendation. Given that Chinese real estate valuations are even more precariously balanced than those in the US, and that purchases have been lending-fuelled, Chinese long-dated bonds are an excellent structural investment for those investors who can accept the capital control risks. As a structural holding, buy the China 30-year government bond (Chart I-8). Chart I-8The Ultimate Low In The US And China 30-Year Bond Yield Is Still To Come As for the highly-valued real estate asset-class, the paradox is that valuations will reach their ultimate high when 30-year bond yields reach their ultimate low. Until then, stay structurally long real estate. Uranium Is The Latest ‘Meme Theme’ The recent near-vertical ascent in uranium plays have left many investors scratching their heads and wondering: what’s going on? The answer, in large part, is that uranium plays have become the latest ‘meme theme’. On Reddit’s Wall Street Bets forum, the Canadian uranium miner Cameco has become the second most discussed stock, with one post likening the current opportunity to that in Gamestop, the original meme stock. Of course, as in all meme themes, there must be a loose narrative to latch on to. In this case, it is that as a zero carbon-emitting source of energy, uranium demand should rise while supply remains tight. Still, fractal analysis suggests that meme investors have moved prices too far too fast. Elsewhere, fractal analysis suggests that the spectacular rally in palm oil is also susceptible to a reversal. In this case, the rally has been due to supply bottlenecks in Indonesia and Malaysia, which we expect ultimately to ease (Chart I-9) Chart I-9The Spectacular Rally In Palm Oil Is Susceptible To Reversal Nevertheless, this week our favoured trade is to short the meme theme rally in uranium plays (Chart I-10). A good expression is to short the UK stock Yellow Cake, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-10Short The Meme Theme Rally In Uranium Plays   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The other two cities in the top six are Los Angeles and Miami. 2 Based on Savills Prime Index: World Cities – Capital Values, and World Cities – Rents and Yields, June 2011 through June 2021. 3 This calculation assumes an interest only mortgage. The increase would be less for a capital repayment mortgage, but it would still be substantial. Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations