Technology

Special Report

Executive Summary Dollar Still The Largest Global Reserve Currency The rise of cryptocurrencies like stablecoins theoretically pose risks to fiat currencies and their general use. In the US, the Federal Reserve will look to adopt a Central Bank Digital Currency (CBDC) – a digital dollar – this decade, to stave off these risks and usher in a new era of central bank money. A digital dollar would likely be integrated as seamlessly as possible into the current monetary regime, thereby maintaining an intermediated role played by existing financial sector actors as well as operating alongside existing circulating currency. The US dollar will eventually face rising competition from digital currencies, both at home and abroad. While other central banks make headway into developing their own CBDCs, China is by far the most advanced. China’s digital yuan will not resolve all of China’s problems with internationalizing its currency but it will create new opportunities. Public and political pushback will occur and will slow adoption of a digital dollar. Gridlock in 2023 may prove to be another headwind. To adopt a digital dollar, politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation, especially as foreign competition on CBDCs rises. Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 10.7% Bottom Line: Policymakers will adopt a CBDC – a digital dollar – this decade. Political pushback may slow adoption, but foreign competition will overcome domestic constraints. Feature Technological innovation over the past decade has given rise to a new asset class – digital assets. Investors are most familiar with cryptocurrencies, and to a lesser extent, non-fungible tokens and decentralized finance-based lending, among others. These assets have witnessed a boom and bust over the past few years (Chart 1). Chart 1Manias: Then And Now Cryptocurrencies have been touted to have money-like characteristics, the most popular being Bitcoin, and others like stablecoins. Stablecoins are mostly used as a medium of exchange between fiat money and cryptocurrencies and vice versa. They are pegged to fiat money and often backed by highly liquid traditional assets1 to maintain their pegs. But cryptocurrencies do not exhibit the traits of durable money today. However, the technological innovation of digital currency represents a natural evolution of money that is irreversible and could someday possess the main characteristics of money: a medium of exchange, a unit of account, and store of value. Cryptocurrencies with money-like qualities theoretically pose a challenge to fiat currencies, i.e. those issued by governments that are not backed by any underlying real asset but rather by trust in government institutions, including the treasury and central bank. Not that trust is a poor basis for a currency. But that trust could fail and new trust could be placed in cryptocurrencies. Governments could eventually lose control of the money supply and payments system, suffer from financial instability, fail to provide regulatory oversight, or fail to prevent the illicit use of digital assets for criminal gain. The same technology driving growth in digital assets has led central banks the world around to research and in some cases develop CBDCs. For an introductory guide to CBDCs, see BCA’s “The Investor’s Guide To Central Bank Digital Currencies.” CBDC research and development are at varying stages across the world’s central banks.2 In the US, the Federal Reserve (Fed) continues to research a CBDC (digital dollar) and its use-case, or justification for being. The Fed has made no commitment to designing a digital dollar anytime soon. But we bet that the Fed’s position will change in coming years. Introducing a digital dollar will reduce the various risks associated with cryptocurrencies whilst also creating efficiencies in the US economy. These efficiencies will also transverse into cross-border efficiencies. Globally, central banks are showing increasing activity in developing CBDCs and introducing a digital dollar would help the Fed maintain monetary dominance across the world while staving off cryptocurrencies, especially stablecoins. The Fed won’t sit idle as a global monetary revolution unfolds. But the policy front is fraught with challenges. Policy makers in the US have expressed mixed views on adopting a digital dollar. Some suggest the Fed would exercise even more control over monetary policy than it does today. Others note risks to consumer data privacy, which could be exploited by government. Public opinion is also mixed with no clear understanding of or need for a digital dollar. Commercial bank business interests may come under attack too, with a digital dollar scalping profit margins from banks, depending on the type and extent of the CBDC operating model employed. Ultimately, the US will want to maintain its position as the global monetary leader. Continued dollar dominance in the global economy is strategically advantageous for the US, especially in a hypo-globalizing world (Chart 2). Ensuring ongoing monetary dominance while rooting out domestic competition from stablecoins will be aided by adopting a digital dollar. Chart 2Dollar Still Dominating Global Reserves Bottom Line: The Fed will most likely adopt a digital dollar within the decade. The Fed And A Digital Dollar The Fed has been actively researching a digital dollar for several years with growing research on design, implementation, and necessity. As it stands, the Fed has not committed to introducing a digital dollar in the foreseeable future. But what would a digital dollar look like and what role would it play in the economy if the Fed decided to introduce one? CBDC Model Briefly, the Fed could choose from three different CBDC operating models: unilateral, synthetic, or intermediated (Diagram 1). A unilateral model would mean the Fed performs all CBDC related functions including direct interaction with end-users. A synthetic model would mean non-Fed actors issuing money backed by Fed assets. Diagram 1Three CBDC Operating Models Realistically, a unilateral and synthetic digital dollar are unlikely. The former would crowd out traditional banking services, while the latter would let actors other than the Fed issue money, violating the Federal Reserve Act. Hence the Fed will most likely pursue an intermediated CBDC model. This model entails digital dollar issuance by the Fed but includes a role for private sector firms to interact with end-users. The intermediary role would be filled by financial firms but also other types of companies such as payment service providers and mobile phone operators. This means the Fed would not totally crowd out existing players across the payment and financial services space. An intermediated model would require the central bank to regulate and oversee other actors, which adds an extra layer of legal and operational complexity to implementation. But it is the model most consistent with the US’s combination of federal government and liberal capitalism, and the model cited by the Fed to most likely be adopted.3 The intermediated model will align with the current two-tier system currently in place (Diagram 2). Digital dollars will feature in both wholesale and retail transactions. Wholesale involves commercial banks and regulated financial intermediaries, while retail involves individuals and non-financial businesses. The model would also operate alongside existing paper money. A digital dollar would be a liability on the Fed, denominated in dollars, and would form an integral part of base money supply (M0). It would be distributed like, and act as a complement to, dollar bills and could be used in transactions conducted in currency and reserves. It would be legal tender just like the paper dollar. Diagram 2Two-Tier Monetary Regime System Digital Dollar Needs The Fed has stated that a digital dollar should, among other things, meet certain criteria before adoption (Table 1). Some of these criteria are already met. Others will be met with adoption. A digital dollar will benefit households, businesses, and the economy at large. For example, a digital dollar would enhance payment transparency, thereby supporting the Fed’s objective to promote safe and efficient payments. And depending on design choices, digital transactions could offer degrees of traceability and aggregate payment data could be analyzed in real time to provide insights into economic health and activity. Table 1Fed Criteria For CBDC Adoption Further, a digital dollar would promote diversification of the payments system, thereby increasing the safety and efficiency of US payment infrastructure. It may also attract new actors offering services related to the digital dollar, spurring financial innovation and fostering financial integration. The payments system is already broadly efficient but adding another layer of digitization with a digital dollar would mean that the US economy would be better positioned for the evolution of the digital economy over the next decade and beyond. The need for broad stakeholder support will be a difficult criterion to meet, however. There would need to be more engagement with the public, inter-government agencies, and Congress. For now, these “needs” outlined by the Fed are more than half met, signaling that a digital dollar could come to fruition within the decade from a policy perspective. International advances on this front will spur US policy makers into action even if they are disinclined. Bottom Line: The needs outlined by the Fed to adopt a digital dollar have been mostly met which ticks off one of the policy implementation checkboxes. There are gains to be had across the economy by introducing a digital dollar, ranging from a more efficient payments system to financial inclusion and decreasing transactions costs. Domestic Competition The proliferation of stablecoins has been noted by government agencies around the world. The Fed too has been keeping note. By the end of 2021, stablecoins had a relatively small market capitalization compared to the broader cryptocurrency market, approximately 6%. Now, stablecoins account for almost 16% of cryptocurrency market capitalization. But trading volumes point to stablecoins having a much larger role in transactions (Chart 3). Stablecoins resolve some of the problems of faith and trust that bedevil cryptocurrencies not backed by traditional assets. Chart 3Stablecoins Rise In Popularity Stablecoins pose two key threats that a digital dollar will essentially nullify: Systemic risk: A growing stablecoin market that is increasingly backed by traditional, high liquid assets could create systemic risk in traditional asset markets. An excessive rise or fall in demand for stablecoins would cause volatility in the liquid assets that back them. Moreover, for example, a fire sale in the stablecoin market would cause demand to fall excessively relative to the backing asset. Prices between stablecoins and the backing asset would diverge, potentially breaking the peg and resulting in further price divergence. And more broadly, high volatility from crypto markets can penetrate traditional or risk-free markets. A digital dollar would render stablecoins unnecessary, allowing cryptocurrency users to transact and convert digital dollars to cryptocurrency while enjoying the backing of the Fed on the value of digital dollars. Cross-border transactions: Stablecoins are also increasingly used for cross-border transactions. According to Fed data, the US pays 5.4% in fees on average per cross-border transaction, which also takes several days to settle. Stablecoins settle almost instantaneously and have much lower transaction fees. So too can a digital dollar. It would settle just as quickly as a stablecoin, if not quicker, and reduce transaction costs for cross-border payments. And because stablecoins are designed to maintain their pegs, they have more potential than cryptocurrencies to act as mediums of exchange outside of the crypto market and economy, potentially threatening the ongoing use of fiat money. Bottom Line: The Fed will design a CBDC around its existing monetary and payments system to allow for seamless integration. There are not many reasons holding back digital dollar adoption from a point of need and benefit. By adopting a digital dollar, the Fed will also fight off the growing risk of stablecoins, which could pose a threat to the use-case of fiat money in everyday life. Other Central Banks On The March The authority to issue money is an important element of economic power. History is replete with examples of currency competition both within countries and between them. CBDC research and development are picking up speed across central banks (Charts 4A and 4B). China is the world leader with its digital yuan, as we discuss below. Design and implementation of CBDCs will follow in coming years just like in the case of the digital yuan. If the theoretical payoffs to adopting a CBDC are met by real-world green shoots, then foreign CBDCs could pose a threat to continued dollar dominance in the global monetary and economic system, namely if countries can draw down their dependence on dollar reserves. Chart 4ACentral Banks Paying More Attention To CBDCs Chart 4BCentral Banks Paying More Attention To CBDCs Central Bank Competition Treasury Secretary Janet Yellen has noted this challenge in recent remarks explaining that any implementation of a “US central bank digital currency must support the prominent role the dollar plays in the global financial system.”4 The Fed is on the same page as the Treasury noting that any CBDC should be used to preserve the dominant international role of the dollar. The dollar is the world’s most widely used currency for payments and investments and serves as the world’s premier reserve currency. The dollar’s international role allows the US to influence the practices and standards of the global monetary and economic system. Basically, when the US constricts the supply of dollars in response to domestic conditions, the rest of the world suffers tighter monetary conditions, and when the US expands the supply, the rest of the world enjoys looser conditions, almost regardless of what other nations want or need. Central banks have made their policy goals clear in respect to developing a CBDC. Some central banks look to expand financial inclusion, market access, and their payments system while others are looking to compete with one another (Table 2). Canada, China, and Sweden want to gain a local and international market advantage for their currencies by introducing CBDCs. Table 2CBDC Policy Goals Of Central Banks China Leading CBDC Race, But… At this early stage, China’s digital yuan poses the largest threat to a digital dollar on the international stage. It is the most prominent CBDC project at this current juncture. The digital yuan entered beta testing at the end of 2020 in parts of the country. Wider testing across provinces is being phased in. China’s monetary endeavors began with the Cross-Border Inter-Bank Payment Service in 2015. The digital yuan will be positioned as an extension of this system to promote the national currency and fight global dollar dominance. But how big of a challenge could a digital yuan mount? The answer is not much, not now. China is the world’s largest trading partner but the renminbi accounts for less than 3% of the world’s reserve currency (Chart 5). The disparity between trade and currency status in the global economy reflects a lack of global trust in the renminbi and is a cause for concern for China. China is structurally invested in the dollar-dominated financial system and hence vulnerable to American influence by means of that system. Chart 5Global Renminbi Reserves Are Low The digital yuan would support more debt issuance based on cost and payment incentives to debt holders when financing BRI projects. This will help drive the use of the digital yuan going forward. For example, China can assert its influence over countries with Chinese debt by having them accumulate digital yuan reserves to pay back loans. China can even provide countries with concessions on loans to promote its digital yuan. Concessions on Chinese debt may lead to easier uptake, therefore promoting issuance. If the cost of switching to the digital yuan is low, countries will see no benefit in continuing their trade transactions with China in US dollars. Using the digital yuan as the currency of invoice to disburse loans can make these transactions more transparent and manageable. This could also allow for more state control over funds, an attractive scenario for China. However, China’s monetary ambitions face serious constraints. Lack of trust in the currency is the most critical challenge for internationalization of the yuan, digital or otherwise. Even if the digital yuan project is five to ten years ahead of the curve, countries still opt to hold the dollar over the yuan in any type of crisis, as has been amply demonstrated in history, and over a range of global shocks since 2019. Hence digital yuan adoption will require guarantees from Chinese institutions. But these same institutions have struggled to internationalize the paper renminbi. Lack of openness, transparency, and convertibility are persistent problems. Bottom Line: Central banks around the world are gearing up to introduce CBDCs in coming years. Some are looking to promote financial inclusivity. Others like China’s digital yuan want to chip away at the dollar’s global dominance. Digital versions of fiat currencies will have to demonstrate substantial economic and trade efficiencies in order to encourage diversification away from the US dollar, since there is no inherent reason a digital version of a nation’s currency would increase trust beyond what is already established. But those efficiencies could take shape, which would put pressure on the US to respond. The US faces significant monetary challenges over the long run, including from CBDCs. But the US is a technological power and will eventually respond by developing its own CBDC. Pushback Against A Digital Dollar The Fed has stated that it would only pursue a digital dollar in the context of broad public and cross-governmental support. However, neither the public nor congress broadly support one at present. Public opinion is uneducated on the issue and therefore highly malleable depending on leadership and events. Public Opinion Is Non-Supportive Across age groups, people do not know enough about digital currencies and think it is a bad idea to introduce a digital dollar (Chart 6). A 2020 poll found that only 13% of respondents approved of a digital dollar.5 Low approval is becoming a trend. However, the same poll showed that 38% of respondents think the US dollar is backed by gold, bonds, or oil. Addressing poor monetary literacy among the public would help to improve public support of a digital dollar. US households say they are more likely to trust traditional financial institutions than government agencies to safeguard their personal data (Chart 7). A digital dollar will grant the Fed and federal government far-reaching information regarding the everyday financial transactions of households. Trust in government has been declining and a digital dollar underpinned by a central ledger system would provoke consumer privacy lobby groups and government activists to fight and protest adoption (Chart 8). Chart 6Popular Support For A Digital Dollar Is Lacking Chart 7Households Trust Government Less Than Financial Institutions Chart 8Trust In Government Has Been Waning Chart 9Inflation Outbreak Will Limit Big Government About half of the US public already view the government as “doing too much” (Chart 9). The explosive inflation of 2020-22 will slow the underlying ideological shift to the political left, potentially limiting support for a digital dollar. Public opinion has been shifting for decades in favor of more government involvement in people’s day-to-day lives (Chart 10), but that trend may well stall now that excess of government creates tangible negatives for household pocketbooks (inflation). The bigger of a problem the Fed has in taming inflation in 2022-23, the bigger the political backlash will be. Federal solutions will suffer as a result. This is our theme of “Limited Big Government,” since the role of the state will increase relative to the past 40 years but still within an American context of checks and balances. Chart 10People Have Favored Government Involvement Bottom Line: There is no clear public demand for the digitization of the dollar at present. A major financial or economic disruption stemming from the monetary system or digital assets may be necessary to call public attention to the question. Meanwhile the private sector will drive innovation and the federal government will react to try to maintain domestic stability and international competitiveness. These data support the Fed taking an intermediated approach to cbdc when forced to take action. Policymakers Will Resist Policymakers are divided over the idea of a digital dollar. Senator Ted Cruz introduced a bill in March 2022 to “prohibit the Federal Reserve from offering products or services directly to individuals, maintaining accounts on behalf of individuals, or issuing a central bank digital currency directly to an individual.”6 Cruz has yet to receive widespread party support on the bill but he could get the backing from more GOP members if Republicans take over Congress, as expected, this November. Some Republicans and Democrats have favored cryptocurrencies while others have not, advocating for crypto-mining and crypto start-ups in progressive-left and libertarian right states. But the center-left and center-right might lean more toward cryptocurrency regulation and digital dollar adoption. Coalitions may need to be formed on the topic of a digital dollar, in parties and between parties. A digital dollar will cause a level of disruption, which will affect both the Democrats and Republicans. Government gridlock will create challenges to digital dollar adoption too. The upcoming mid-term elections favor the GOP. Both the House and the Senate are expected to flip in favor of the GOP in 2023. The “Blue Sweep” policy setting will end and only the White House will remain in Democrat control. Republicans have a shot at flipping the White House in 2024, which could see a “Red Sweep.” This scenario may slow adoption of a digital dollar but it will only preclude the unilateral cbdc model, not the intermediated model. The period of 2023-24 is too soon for adoption of a digital dollar anyway but the fact is that gridlock will delay the process until external factors force US action. Bottom Line: Public and political pushback will slow the adoption of a digital dollar. Politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation but this will be difficult in a highly polarized country and will likely depend on foreign competition. Investment Takeaways We avoided cryptocurrencies during the irrational exuberance over the past two years. We expect governments to regulate the sector in order to preserve a monopoly over money supply and hence geopolitical interests. With monetary conditions tightening, we expect continued volatility in the crypto space. The US dollar remains strong tactically but is nearing its peak cyclically. We remain long but have put the currency on downgrade watch as the market more fully prices a range of bad news this year. On the global stage, the US dollar will remain the premier reserve currency despite cyclical ups and downs. The current macroeconomic backdrop is negative for the US financial sector (Chart 11). Mergers and acquisitions are drying up while regulatory risks loom. Initial public offerings are also slowing, while trading volume is low. Consumers had already accumulated debt earlier in the cycle and with rising interest rates amid a more challenging job environment, growth in loans and ultimately bank profits will slow. The commercial banking sector faces challenges during the upcoming transitional period of disruptive innovation and regulatory uncertainty. We believe the Fed and policymakers in general will want to cause as little disruption as possible, by integrating any digital dollar with the traditional finance sector as seamlessly as possible. However, transitions, especially those digital in nature, bring with them high uncertainty in the financial sector and elsewhere. Chart 11Financial Sector Facing Macro Headwinds     Guy Russell Senior Analyst guyr@bcaresearch.com     Footnotes 1     Stablecoins are backed by various assets and means. Fiat money, commodities, other cryptocurrencies and by algorithmic means are some examples. 2     See The Bank For International Settlements, Central Bank Digital Currencies: Executive Summary, September 2021, bis.org. 3    See The Board of Governors of the Federal Reserve System, Money and Payments: The U.S.Dollar in the Age of Digital Transformation, January 2022, federalreserve.gov. 4    See U.S. Department Of The Treasury, Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets, April 2022, treasury.gov. 5    See Cointelegraph, Most Americans are against a digital dollar CBDC, survey reveals,september 25, 2020, cointelegraph.com 6    See Ted Cruz’s Proposed Bill to amend the Federal Reserve Act to prohibit the Federal reserve banks from offering certain products or services directly to an individual, and for other purposes, March 2022, cruz.senate.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary Buying a home is now more expensive than renting in many parts of the world. In the US and UK, disappearing homebuyers combined with a flood of home-sellers will weigh on home prices over the next 6-12 months. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. A collapse in Chinese property development and construction activity will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, stay structurally overweight the China 30-year government bond. Fractal trading watchlist: US Biotech versus Utilities. Buying A Home Is Now More Expensive Than Renting! Bottom Line: The decade-long global housing boom is over. Feature For the first time since 2018, the number of Brits wanting to buy a home is less than the number of Brits wanting to sell their home. The balance of homebuyers versus homes for sale is the main driver of any housing market. When multiple homebuyers are competing for a home for sale, the subsequent bidding war puts upward pressure on house prices. But when, multiple homes for sale are competing for a homebuyer, the subsequent discounting war puts downward pressure on house prices. The balance of homebuyers versus homes for sale is the main driver of any housing market. This makes the number of homebuyers versus homes for sale the best leading indicator of house prices. The recent collapse of this leading indicator in the UK warns that UK house prices are likely to soften through the remainder of 2022 and into 2023 (Chart I-1). Chart I-1With Fewer UK Homebuyers Than UK Home-Sellers, UK House Prices Are Set To Drop Homebuyers Are Disappearing While Home-Sellers Are Flooding The Market Disappearing homebuyers combined with a flood of home-sellers is also evident in the US. According to Realtor.com: “Weary US homebuyers face not only sky-high home prices but also rising mortgage rates, and that financial double whammy is hitting homebuyers hard: Compared with just a year ago, the cost of financing 80 percent of a typical home rose 57.6 percent, amounting to an extra $745 per month.” Compared with just a year ago, the cost of financing 80 percent of a typical US home rose 57.6 percent, amounting to an extra $745 per month. Unsurprisingly, US mortgage applications for home purchase have recently plunged by a third (Chart I-2) and homebuyer demand has declined by 16 percent since last June.1 Meanwhile, the inventory of homes actively for sale on a typical day in June has increased by 19 percent, the largest increase in the data history. Chart I-2With The Cost Of Financing A US Home Purchase Surging, Mortgage Applications Have Collapsed The flood of new homes on the market means that the dwindling pool of homebuyers will have more negotiating leverage on the asking price (Chart I-3 and Chart I-4). This will balance the highly lopsided negotiating dynamics in the raging seller’s market of the past two years. The shape of things to come can be seen in Austin, Texas, which was one of the hottest markets during the early pandemic real estate frenzy. Chart I-3US Homebuyers Are Disappearing... Chart I-4...While US Home-Sellers Are Flooding The Market “Prices are definitely starting to go down again… last Friday, an Austin home was listed at $825,000. The next day, at the open house, no one came. A few months ago, there would have been 20 or more buyers showing up. The sellers didn’t want to test the market, so on Sunday, they dropped it to $790,000. It sold for $760,000.” Buying A Home Is Now More Expensive Than Renting The nub of the problem for homebuyers is that the mortgage rate is higher than the rental yield. In simple terms, buying a home is now more expensive than renting (Chart I-5). The housing bulls counter that the high mortgage rate will force rental yields to adjust upwards by rents going up, but this argument is flawed. Chart I-5Buying A Home Is Now More Expensive Than Renting! The most important driver of rent inflation is the unemployment rate (inversely). Because, to put it bluntly, you need a steady job to pay the rent! Today, the Federal Reserve’s inflation problem, in a nutshell, is that rent inflation is too high even versus the tight jobs market (Chart I-6). Chart I-6The Fed Needs To Push Up Unemployment To Pull Down Rent Inflation Although the Fed cannot say this explicitly, its mechanism to bring down inflation is to push up unemployment, and thereby to pull down rent inflation, which constitutes almost half of the core inflation basket. In this case, the rental yield (rent divided by house price) would adjust upwards by the denominator – house prices – going down. The most important driver of rent inflation is the unemployment rate (inversely). Yet the housing bulls also argue that the housing boom is the result of a structural undersupply of homes. They claim that as this structural undersupply persists, it will underpin house prices. But this ‘housing shortage’ narrative is another myth, which we can debunk with two simple observations. Through the past decade, home prices have risen simultaneously and exponentially everywhere in the world. Now ask yourself, is it plausible that there could be a structural undersupply of homes everywhere in the world at the precisely the same time? If this doesn’t debunk the housing shortage narrative, then try this second observation. Through the past decade, gross rents have tracked nominal GDP. Theory says that gross rents should track nominal GDP, because the quality of the housing stock improves broadly in line with GDP, and therefore so too should rents. If there really was a structural undersupply of housing, then gross rents would be structurally outperforming nominal GDP. But that hasn’t happened in any major economy (Chart I-7). Chart I-7Rents Have Tracked GDP, So There Is No 'Structural Undersupply' Of Homes As an aside, if rents track GDP, then why do they constitute almost half of the core inflation basket?  The answer is that the rents included in inflation are ‘hedonically adjusted’, meaning that are supposedly deflated for quality improvements – though there is always a niggling doubt whether the statisticians do this adjustment correctly! Pulling all of this together, the synchronized global housing boom of the past decade was not the result of a structural undersupply. Instead, it was the result of a valuation boom – meaning, plummeting rental yields, which in turn were the result of plummeting mortgage rates, which in turn were the result of plummeting bond yields. But now that mortgage rates are much higher than rental yields, this ‘virtuous’ cycle risks turning vicious. Falling employment and falling house prices risk becoming a self-reinforcing negative feedback loop that turns a mild recession into a severe recession. To stop such a vicious cycle running out of control, policymakers will eventually have no other choice than to bring down mortgage rates. For this reason, on a time horizon of 6-12 months, overweight bonds. But The Prize For The Biggest Housing Boom Goes To… China The housing booms in the UK, US and other Western economies, extreme as they are, are small fry compared to the housing boom in China. Chinese real estate, now worth $100 trillion, is by far the largest asset-class in the world. And Chinese rental yields, at around 1 percent, are well below the yield on cash. Begging the question, how can Chinese real estate valuations be in such stratospheric territory, with a yield even less than that on ‘risk-free’ cash? The simple answer is that investors have been led to believe that Chinese real estate is a risk-free investment! 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 (Chart I-8). Chart I-8Chinese Real Estate Is Perceived To Be A 'Risk Free' Investment With the bulk of Chinese households’ 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. In turn, the ensuing ‘negative wealth effect’ would be catastrophic for household spending in the world’s second largest economy. Therefore, in contrast to the US housing debacle in 2008, the Chinese government will ensure that its property market adjustment does not come from a collapse in home prices. Rather, it will come from a collapse in property development and construction activity, combined with keeping interest rates structurally low. This will have negative long-term implications for commodities, emerging Asia, and developing countries that produce raw materials. Structurally underweight. On the other hand, Chinese bonds are an excellent investment for those investors who can accept the capital control risks. Stay structurally overweight the China 30-year government bond. Fractal Trading Watchlist Biotech and Utilities are both defensive sectors, based on the insensitivity of theirs profits to economic fluctuations. But whereas Biotech is ‘long duration’, Utilities is ‘shorter duration’. Over the coming months, as the economy falters and bond yields back down, long duration defensives, such as Biotech, are likely to be the winners. This is supported by the recent underperformance reaching the point of fractal fragility that has indicated previous major turning points (Chart I-9). The recommended trade is long US Biotech versus Utilities, setting a profit target and symmetrical stop-loss at 20 percent. This replaces our long US Biotech versus Tech position, which achieved its 17.5 percent profit target, and is now closed. Chart I-9Biotech Is Set To Be A Big Winner Chart 1CNY/USD Has Reversed Chart 2US REITS Are Oversold Versus Utilities Chart 3CAD/SEK Reversal Has Started Chart 4Financials Versus Industrials To Reverse Chart 5The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 6The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 7FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 8Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 9The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 10The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 11Food And Beverage Outperformance Has Been Exhausted Chart 12AT REVERSAL Chart 13AT REVERSAL Chart 14The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 15The Strong Trend In The 3 Year T-Bond Is Fragile Chart 16A Potential Switching Point From Tobacco Into Cannabis Chart 17Biotech Is A Major Buy Chart 18Norway's Outperformance Could End Chart 19Cotton's Outperformance Is Vulnerable To Reversal Chart 20Fractal Trading Watch List Chart 21The Rally In USD/EUR Could End Chart 22The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 23A Potential New Entry Point Into Petcare Chart 24GBP/USD At A Turning Point Chart 25Fractal Trading Watch List Chart 26Fractal Trading Watch List Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Realtor.com gauge homebuyer demand by so-called ‘pending listings’, the number of listings that are at various stages of the selling process that are not yet sold. Fractal Trading System Fractal Trades 6-12 Month Recommendations Structural Recommendations Closed Fractal Trades 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  

Executive Summary Analysts Have Little Confidence In Their Forecasts In the front section of the sector chart pack, we conduct cross-sectional comparisons. Profitability: Earnings expectations for the cyclical sectors are too high and will come down since analysts have little confidence in their forecasts. But despite their bullishness, analysts also expect margins of the most cyclical sectors to contract over the next 12 months. Balance sheet quality: Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors, which they used to repair their balance sheets. Tech, Materials, and Financials have improved the most. Valuations and technicals: Cyclical sectors appear inexpensive (both in absolute terms and relative to history) because multiples have contracted. Technicals signal that the market is oversold.  Much of the bad news is priced in, but “new” bad news is likely on the way: We are still in the early stages of the monetary tightening cycle, there is talk about earnings and economic recessions, rates have not stabilized yet, and inflation has not peaked. Bottom Line: We continue to recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.     This week we are sending you a Sector Chart Pack, which offers macro, fundamentals, valuations, technicals, and uses of cash charts for each sector. In the front section of this publication, we will focus on cross-sectional comparisons.  As investors are starting to shift their attention away from worries about intransigent inflation toward concerns about slowing growth, they will seek out companies and sectors that offer the strongest and most resilient earnings growth, pristine balance sheets, and strong cash yield. In other words, companies that have the highest chance of surviving the downturn unscathed and of outperforming the market. Performance vs. Our Portfolio Positioning Chart 1Looking Under The Hood... The S&P 500 is down roughly 20% off its January 2022 peak. However, 11 industry groups have performed even worse, with Automobiles and Components down as much as 39% off peak. The rest of this inglorious list is dominated by Consumer Cyclicals, Technology, and Financials (Chart 1). We were foreseeing headwinds, and have preempted some of the damage by shifting our portfolio positioning away from the most cyclical areas of the market: We underweighted Semiconductors back in January, observing that Semis are both highly economically sensitive and “growthy” and will be hit by a double whammy of slowing growth and rising rates.  We have been underweight Hardware and Equipment since last summer, moving to this trade a bit too early.  We downgraded Consumer Durables And Retailing in February, observing that demand for goods, pulled forward by the pandemic, is waning and consumption is shifting away from goods to services. More recently, we downgraded Media and Entertainment. The sector has fallen significantly, but we reasoned that if an economic downturn is indeed on the way, advertisement expense is one of the first that companies curtail when they are tightening their belts. Last week, we downgraded Travel to underweight: Even well-heeled consumers are starting to feel the pinch of surging prices. And while most will take that long-awaited post-COVID vacation, the outlook beyond summer is bleak with surging costs of fuel and labor. As for Autos, we were complacent in our thinking that car shortages will eventually translate into strong earnings growth. Despite the disappointing performance, the EV Revolution remains a long-term investment theme for us. Also having opened the position in June 2021, we are still in the green at +7% in relative terms. We have also upgraded our position in Staples to overweight on a premise that many Americans are reeling from surging prices of food, fuel, and shelter. Consumer Staples is the only likely beneficiary, and its pricing power is on the rise. Bottom Line: We have been able to contain some of the damage incurred by market rotation away from cyclicals. Profitability Earnings Growth Expectations As we have written extensively in the past (e.g., “Is Earnings Recession In The Cards”,) the analysts' earnings growth forecast for the S&P 500 of 10% is too high, especially considering the number of adverse events that have taken place since the beginning of the year, and the overall trajectory of monetary policy and economic growth. The analysts are yet again missing the turning point, just as they did back in 2008, and even in 2020. Chart 2Earnings Forecasts For Cyclicals Are Still Way Too High We have noticed that the cyclical industries with the highest EPS growth forecasts, such as Consumer Services, Transportation, and Auto, are most prone to earnings disappointment. To be fair, EPS growth expectations for Consumer Services and Transportation are down from December when they stood at 550% and 143% respectively (Chart 2).  Earnings Uncertainty So how certain are analysts about their projections? A short answer is – not particularly.  We gauge earnings uncertainty by looking at the dispersion of analyst EPS expectations scaled by the magnitude of EPS. In a way, this is a measure of analyst consensus, with estimates clustered around a certain number indicating extreme certainty of forecasts. We notice that the advent of COVID-19 rendered panic among analysts with the rate of uncertainty surging. More recently, uncertainty has decreased but remains elevated by historical standards (Chart 3). Looking at earnings projections by industry group (Chart 4), we notice that earnings uncertainty is the highest in the cyclical pockets of the market where the highest EPS growth is still expected: Consumer Services, Transportation, and Retailing. Chart 3Analysts Have Little Confidence In Their Forecasts... Chart 4... Especially For Cyclical Industry Groups   Implications? Analysts as a group have little confidence in cyclical sector growth, and downward revisions are imminent. Margins In the “Marginally Worse” and subsequent “Sector Margin Scorecard” reports in October, we called for margins to roll over as early as 2022.  Curiously, despite their bullishness, analysts expect the margins of most cyclical sectors to contract over the next 12 months (Chart 5). Chart 5Despite Their Bullishness, Analysts Expect Margins To Contract Chart 6Pricing Power Is Declining But There Are Exceptions Pricing Power As we observed early on, one of the key reasons for margin contraction is a decline in companies’ pricing power, i.e., their ability to pass costs on to their customers (Chart 6).  The Materials sector experienced the most significant decline in pricing power, likely a positive as this may be an early sign that inflation is abating.  It is also important to note that three sectors – Consumer Staples, Utilities, and Tech–are still growing their pricing power. Consumer Staples and Utilities are necessities, demand for which is fairly inelastic, while Tech is offering services that are still in high demand, as they help improve productivity and substitute labor, which is in short supply, for capital, which is still abundant. Degree of Operating Leverage Chart 7Low Operating Leverage Helps In Case Of Downturn If pricing power is waning, what else can come to the rescue? After all, with inflation in the high single digits, nominal sales growth is to remain robust. The crucial piece of the puzzle is the ability of companies to convert sales into profits, i.e., operating leverage (Chart 7). Companies with high fixed costs enjoy higher operating leverage, and a small increase in sales translates into significant earnings growth (and vice versa). However, in case of an outright sales contraction, we are better off holding industries and sectors with low operating leverage, such as Staples and Healthcare. Earnings Stability Chart 8Defensives Have The Most Resilient Earnings What sectors have the most resilient earnings, that won’t let investors down in a downturn? To answer this question empirically, we looked at a historical variation in EPS-realized growth rates by sector1 (Chart 8).  We found that Staples, Healthcare, and Technology have had the most stable earnings growth rates. However, the last 12 years or so, characterized by low yields and nearly non-existent inflation, were a boon for long-duration technology stocks – so our experiment may not be pure. Bottom Line: Earnings expectations for the cyclical sectors are too high and will come down as analysts have little confidence in their forecasts.  Balance Sheet Quality Free Cash Flow Chart 9Post-pandemic Surge In Demand Resulted In Free Cash Flow Windfall... Post-pandemic demand has resulted in a free cash flow windfall for companies in multiple sectors. Technology benefited from the transition to remote working. Energy and Materials have not been able to meet the “reopening” demand after years of underinvestment, which resulted in constrained supply, and soaring prices (Chart 9). Chart 10...Which Companies Used To Repair Their Balance Sheets Interest Coverage The companies used this profits windfall to repair their balance sheets and reduce their levels of debt. As a result, the interest coverage ratio has picked up across the board (Chart 10). Bottom Line: Corporate balance sheets across most sectors look strong. Tech, Materials, and Financials have improved the most. Cash Yield Companies that pay dividends and buy back their stocks not only enhance the returns of their shareholders but also signal their confidence in future earnings and the strength of their balance sheets (Chart 11). That is one of the reasons income funds were strong performers over the past few months as investors were seeking out quality investments (Chart 12). Chart 11Cash Yield Has Not Been This Attractive In Years... Chart 12High Dividend Yield Signals Corporate Confidence Valuations A corollary to our conclusion that earnings estimates are hardly trustworthy, is that forward multiples are not a great valuation metric on the verge of an earnings contraction. Trailing multiples are a better measure of value at this point in the cycle. We sorted PE multiples by their Z-score to 10 years of history (Chart 13) and notice the most cyclical sectors are rather inexpensive, both in absolute terms and relative to history as markets are forward looking.  Chart 13High Dividend Yield Signals Corporate Confidence Technicals Chart 14US Equities Appear Oversold   And last, but not least: The US equity market is oversold, and most industry groups are several standard deviations below the neutral reading (Chart 14).  Bottom Line: Technicals signal that the market is oversold. Yet, a sustainable rebound may still be months away. Investment Conclusion Is it finally time for bottom fishing? We believe that oversold conditions and sectors trading at 30-40 percent of their peak are “necessary but insufficient conditions.” For the equity market to rebound, all the bad news needs to be fully priced in – however, we are still in the early stages of the monetary tightening cycle, and there is talk about earnings and economic recessions, the severity of which is impossible to gauge at this point. Rates have not stabilized yet, and inflation has not peaked. Much of the bad news is priced in, but “new” bad news is likely on the way.   Bottom Line We recommend that investors remain patient and pad the more defensive and quality allocations in their portfolios at the expense of cyclical sectors that are geared to a slowdown. Companies with strong and resilient earnings and quality balance sheets will be able to better weather the storm, if it arrives.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash   Communication Services Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuations And Technicals Chart II-8Uses Of Cash Consumer Discretionary Chart II-9Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Consumer Staples Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations And Technicals Chart II-16Uses Of Cash Energy Chart II-17Macroeconomic Backdrop Chart II-18Profitability Chart II-19Valuations And Technicals Chart II-20Uses Of Cash Financials Chart II-21Macroeconomic Backdrop Chart II-22Profitability Chart II-23Valuations And Technicals Chart II-24Uses Of Cash Health Care Chart II-25Sector vs Industry Groups Chart II-26Profitability Chart II-27Valuations And Technicals Chart II-28Uses Of Cash Industrials Chart II-29Macroeconomic Backdrop Chart II-30Profitability Chart II-31Valuations And Technicals Chart II-32Uses Of Cash Information Technology Chart II-33Macroeconomic Backdrop Chart II-34Profitability Chart II-35Valuations And Technicals Chart II-36Uses Of Cash Materials Chart II-37Macroeconomic Backdrop Chart II-38Profitability Chart II-39Valuations And Technicals Chart II-40Uses Of Cash Real Estate Chart II-41Macroeconomic Backdrop Chart II-42Profitability Chart II-43Valuations And Technicals Chart II-44Uses Of Cash Utilities Chart II-45Macroeconomic Backdrop Chart II-46Profitability Chart II-47Valuations And Technicals Chart II-48Uses Of Cash   Table II-1Performance Table II-2Valuations And Forward Earnings Growth Footnotes 1           Scaled and inverted Recommended Allocation

Special Report

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

Special Report

Executive Summary Chinese Infrastructure Investment Growth: A Slowdown Ahead Despite the authorities’ push, China’s infrastructure1  investment nominal growth2 will likely slow from the current rate of 8% to 1-3% in 2022H2, on a year-over-year basis.   Funding shortages will limit local governments’ capability to invest in traditional infrastructure fixed-asset investment (FAI), which will likely grow by only 1-2% in 2022H2. We expect China’s cheap green loans to support a 10-15% growth in tech infrastructure spending in the second half of this year. However, the scale of China’s tech infrastructure investment is too small in absolute terms to offset the weakness in traditional infrastructure spending.  Tech infrastructure plays will likely outperform traditional infrastructure plays in the long term as China continues its efforts to peak carbon emissions before 2030 and reach carbon neutrality before 2060. As new infrastructure investment will accelerate in the coming years, we are positive on the sectors of NEV and NEV charging poles. Given the still-high valuation of the sector and mounting downward pressure that the Chinese economy is currently facing, we look to buy these sectors at a better price entry point. Bottom Line: China’s infrastructure investment growth will likely slow from the current 8% rate to 1-3% in 2022H2 due to funding constraints and a shrinking pool of profitable infrastructure projects. Feature Infrastructure investment growth in China accelerated to 8% (nominal) in the first four months of this year (Chart 1, top panel). The authorities demanded that local governments execute infrastructure projects sooner and faster to offset the strong headwinds to the economy from COVID restrictions and continued property downturn. Nonetheless, China’s infrastructure investment growth will likely slow from the current annual rate (YoY) of 8% to 1-3% in 2022H2 due to funding constraints and a lack of financially feasible projects, bringing the whole year’s growth to slightly below 4%.  Although a 4% YoY growth in infrastructure investment this year would be an improvement from the 0.4% YoY contraction in 2021, it is far below the 12% average rate of infrastructure spending growth over the past decade (Chart 1). Moreover, we estimate that traditional infrastructure investment, which accounts for 95% of China’s total infrastructure spending, will only grow by 1-2% in 2022H2 (Chart 2, top panel). Chart 1Chinese Infrastructure Investment: Moderate Growth In 2022H2 Chart 2Investment Growth In 2022H2: Deceleration In Traditional Infrastructure While Acceleration In Tech Infrastructure For the tech infrastructure, we are more positive as building cutting-edge tech infrastructure– including 5G networks, data centers, artificial intelligence (AI) and Internet of Things (IoT) – has become a top development priority for China. With supportive policies and cheap green loans, we expect a 10-15% YoY growth in Chinese tech infrastructure in 2022H2 (Chart 2, bottom panel). However, the scale of China’s tech infrastructure investment is too small in absolute terms to offset the weakness in traditional infrastructure spending. After all, tech infrastructure currently only accounts for about 5% of the total Chinese nominal infrastructure FAI (Chart 3). Chart 3Breaking Down Chinese Infrastructure Investment Tech infrastructure plays will likely outperform their traditional infrastructure counterparts in the long term as China continues its efforts to peak carbon emissions before 2030 and reach carbon neutrality before 2060. As new infrastructure investment will accelerate in the coming years, we are positive on the sectors of NEV and NEV charging poles. Yet, considering China’s economy is still facing downward pressure and the sector’s valuations are still high, we look to buy these sectors at a better price entry point. Funding Constraints The recent strong rebound in Chinese infrastructure investment was mainly driven by a massive frontload of local government special purpose bond (SPB) sales, as well as funding from last year’s SPB proceeds – both funding resources will not sustain into the second half of this year.   According to the data from the Ministry of Finance, in the first five months of 2022, special bond issuance has already reached 2.03 trillion RMB, significantly higher than the 1.2 trillion RMB issued during the same period last year. In addition, there has been an estimated 1.2 trillion unused SPB proceeds from 2021 that have been carried over to 2022 to fund infrastructure spending. However, such a boost in local government funding of infrastructure investment is unsustainable. We expect Chinese infrastructure investment growth to fall back to the 1-3% range in 2022H2 due to limited financial availability and a shrinking pool of infrastructure projects. Chart 4 shows the breakdown of the major funding sources of Chinese infrastructure investment. Most of them are likely to face considerable constraints over the next six months. Chart 4Major Funding Sources Of Chinese Infrastructure Investment (1) Less Revenues Chinese local governments face tremendous shortfalls of cash, which will impede their ability to meet their nearly 30% contribution to overall infrastructure funding: Land sales by local governments contribute nearly 90% of government-managed funds (GMF3). The latter's revenues, excluding proceeds from SPB issuance, account for 16% of overall infrastructure funding. The deep contraction in home sales has depressed real estate developers’ land purchases, which has considerably reduced local government revenues (Chart 5). This will curb the ability of local governments to finance their infrastructure projects through GMFs. Although we expect a moderate rebound in property sales over the next six months from very depressed levels in recent months, the improvement in local government land sales will likely be very limited as real estate developers are still overleveraged and under severe funding constraints.   In addition to the slump in land sales, tax cuts for corporates and low-income households are also eroding local government revenues, and COVID-related expenses add to spending needs. Shrinking corporate profits will also pose downward risks to the tax revenues of local governments (Chart 6). Chart 5Government-Managed Funds: Headwinds From Falling Land Sales Chart 6Declining Government Tax##br## Revenues   The general budget of local governments,4 which contributes to about 14% of overall infrastructure financing, is extremely tight this year. In the first four months of the year,  revenues of local governments fell by about 18% from the same period last year, while their expenditures increased by 5%. As a result, the general government’s fiscal deficit will likely exceed both the 2.8% target set for this year and the 3.2% fiscal deficit of last year (Chart 7).   Chart 7Government General Budget: Large Deficit (2) Less SPB Available In H2 Chart 8Local Government Special Bond Issuance Will Decrease In 2022H2 Local government SPB issuance, which is used exclusively to fund infrastructure projects, has been another major source of financing for domestic infrastructure projects since 2016 (Chart 8).    As local governments frontloaded 56% of their 2022 SPB quota in the first five months of this year, they will have less fiscal support from SPBs in 2022H2. As net local government SPB issuance made up about 16% of overall infrastructure FAI on average in the past three years, there is quite a financing gap to be filled in 2022H2. (3) Contracting Domestic Loan Demand Domestic loans contribute to about 20% of overall infrastructure financing, with 14% from regular non-household medium-long-term (MLT) lending, and another 6% from domestic green loans. Infrastructure projects are generally long-term investments in nature and hence often require MTL loans. Presently, the impulse of non-household MLT lending is contracting (Chart 9). While not all MLT loans are used for infrastructure, sluggish MLT lending also reflects corporates’ reluctance to borrow for and invest in infrastructure projects. Strong economic headwinds due to COVID-induced lockdowns and the slumping property market, mounting local government debt, and low returns on infrastructure projects will continue to curb corporates’ demand for bank loans to fund infrastructure projects, particularly from the private sector. The “green loans”,5 which are used for but not limited to new energy infrastructure projects, will continue to grow strongly in 2022H2. In 2021, the increase in green loans for infrastructure was 1.64 trillion RMB, or a 62% increase from the previous year. In 2022, we expect new green loans could rise 50%-80% to 2.5-3 trillion RMB, with an increase of 0.6-1.1 trillion RMB in new green loans in the second half of the year. While green loans will help support the overall infrastructure investment, given their small size (green loans accounted for about 8% of China’s total infrastructure investment in 2021), they will unlikely fully offset the shortfall from other financing sources this year (Chart 10). Chart 9Sluggish Medium/Long-Term Bank##br## Lending Chart 10Green Loans: Strong Growth In 2022H2 But Still Small Amount Relative To Overall Infrastructure Investment In the long run, though, to reach peak carbon emissions by 2030 and carbon neutrality by 2060, China will continue to lean heavily on its banking system to accelerate green projects and infrastructure investment. (4) Public-Private Partnerships (PPP) Since 2014, PPPs have become an important financing model for Chinese local governments to fund infrastructure investments. However, to control rising local government leverage, the central government has tightened regulations on PPP projects since early 2018. Heightened scrutiny has resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPP contributions to total infrastructure FAI have been consistently declining, from over 30% in 2017 to about 4% currently (Chart 11). So far this year, the amount of signed and implemented PPP investments has been falling. While the private sector’s propensity to invest has been extremely weak, a shrinking pool of profitable infrastructure projects could be another contributing factor. The number of projects – which are in the preparation stage in the national total project entries – has been falling from its peak of 2,550 in June 2017 to only 465 in March 2022 (Chart 12). Chart 11Public-Private Partnerships Funding: Limited Growth In 2022H2 Chart 12A Shrinking Pool Of Public-Private Partnership##br## Projects (5) Other Funding Sources Local government financing vehicles (LGFV) and shadow bank borrowing were major financing sources prior to 2018. However, following the 2017/2018 financial de-risking and anticorruption campaign, local governments have scaled back their shadow bank activities significantly. Shadow banking remains in deep contraction (Chart 13). We expect only a modest pick-up in LGFV leveraging during the rest of the year, given that both the anticorruption campaign and a reshuffling of local government officials are ongoing. Chart 13Shadow Banking Will Remain In Deep Contraction In addition, policy banks could sell special sovereign bonds to help fund domestic infrastructure projects. For example, in a recent State Council meeting, Premier Li Keqiang requested policy banks to provide 800 billion RMB ($120 billion) in funding for infrastructure projects. An 800-billion-RMB additional funding, if fully invested, would only add about 0.4% growth to this year’s infrastructure spending. Bottom line: Due to funding constraints and a shrinking pool of profitable infrastructure projects, China’s infrastructure investment growth rate will likely slow from the current 8% pace to 1-3% in 2022H2. Infrastructure Investment Focus: Shifting From Traditional To New Chart 14China Is Shifting Its Focus Away From Traditional Infrastructure Development… The pace of new infrastructure (including but not limited to tech infrastructure) is set to accelerate both cyclically (in the next 6 to 12 months) and structurally (in the next 3 to 5 years), while traditional infrastructure investment growth will slow. However, over a cyclical time horizon, infrastructure investment in new economy sectors is too small to offset the weakness in spending in traditional sectors. Decelerating Investment In Traditional Infrastructure In 2022H2 And Beyond Chart 14 shows the real growth rate of railways, highways and airports has all dropped to below 3% last year. Correspondingly, investment in transport infrastructure only grew 1.4% in 2020 and 1.6% in 2021, a distinctly slower pace from 3.9% in 2018 and 3.4% in 2019. Similar growth deceleration has also occurred in the Water Conservancy, Environment & Utility Management sector. Investment growth in nominal terms this sector fell from 3.3% in 2018 and 2.9% in 2019 to 0.2% in 2020 and saw a 1.2% contraction in 2021. Most Chinese cities with large populations and/or high population density have already upgraded their sewer system in recent years and, therefore, localities have only been maintaining rather than upgrading these systems. The Water Conservancy, Environment & Utility Management sector and the Transport, Storage and Postal Service sector together account for the lion’s share (78%) of total infrastructure investment. A growth deceleration in these two sectors will likely lead to slower growth in overall infrastructure investment, compared with the first four months of this year, when both sectors grew by 7.2% and 7.4%, respectively, in nominal terms. Accelerating Investment In New Infrastructure In 2022H2 And Beyond Chart 15...To New Infrastructure Development Investment in new economy sectors–such as Electricity, Gas & Water Production and Supply, which currently accounts for about 18% of overall infrastructure investment–will remain strong in 2022H2. Investment in the subsector of ultra-high-voltage electricity transmission (UHV electricity transmission) and smart grid, as well as new electricity infrastructure, such as wind and solar power, will also continue to accelerate. The construction of 5G base stations will grow strongly in the coming years but may see a moderation in growth this year. Network operators such as China Mobile, China Unicom and China Telecom plan to build about 600,000 5G base stations, slightly lower than last year’s 650,000. The construction of new electric vehicle (NEV) charging poles accelerated because of a significant increase in NEV sales (Chart 15). Elevated oil prices and technology improvement in NEV performance have boosted NEV sales in China. As such, investment growth in NEV charging infrastructure is set to rise in the coming years. Bottom line: China’s investment focus is shifting from traditional infrastructure to new economy infrastructure. As such, we expect new infrastructure investment in tech and green energy to rise at the expense of traditional infrastructure (Chart 16). Chart 16"Green Investment" Is Rising, “Dirty Thermal” Investment Is Falling Investment Implications The infrastructure sector accounts for about 10-15% of China’s total steel consumption and about 30-40% of cement consumption (Chart 17). Chart 17A Slowdown In Chinese Infrastructure Spending Will Weigh On Steel And Cement Prices We expect China’s infrastructure investment, particularly in traditional sectors like highway construction, to slow in the second half of the year. As such, steel prices are at risk of falling further. Moreover, sluggish construction activity in property markets will be a drag on steel prices (Chart 18). Slower growth in traditional infrastructure investment in the next six months, as well as structurally will pose downward pressures on the performance of both global and Chinese onshore machinery stocks (Chart 19). Chart 18Dismal Property Markets Will Be A Drag On##br## Steel Prices Chart 19Slower Growth In Traditional Infrastructure Investment Will Weigh On Global/Chinese Machinery Stocks Chart 20Look To Buy NEV Stocks We are positive on China’s NEV sector’s structural outlook and stock performance, based on an acceleration in new economy infrastructure investment in the coming years. However, the near-term outlook on the sector’s stock performance is neutral at best. The sector’s valuations are high, considering China’s economy is still facing downward pressure due to a faltering property market, sluggish household income growth and consumption, falling export demand, as well as heightened risks of further COVID-induced lockdowns. NEV stocks will likely have more shakeouts in the coming six months before any sustainable uptrend. Hence, we look to buy these sectors at a better price entry point (Chart 20).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1  Including both traditional infrastructure and tech infrastructure. For the purposes of this report, the composition of “infrastructure” includes “traditional infrastructure” and “tech infrastructure.” The “traditional infrastructure” comprises three categories – (1) Transport, Storage and Postal Service; (2) Water Conservancy, Environment & Utility Management; and (3) Electricity, Gas & Water Production and Supply. 2 Please note that all growth rates in this report are nominal growth rates. 3 According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures for the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. 4 The general budget of local governments covers local governments’ day-to-day operation as well as local infrastructure development (mainly in four categories: Environment Protection,  Urban & Rural Community Affairs, and Affairs of Agriculture, Forest  & Irrigation and Transportation). In contrast, the government-managed funds (GMF) excluding proceeds from SPB issuance finances the big ang national-level important infrastructure projects. 5 Last November, the People’s Bank of China (PBoC) launched a carbon emission reduction facility (CERF) to offer low interest loans to financial institutions that help firms cut carbon emissions. The targeted green lending program will provide 60% of loan principals made by financial institutions for carbon emission cuts at a one-year lending rate of 1.75%. The funding will be available retroactively after the loans are made, and can be rolled over twice. Strategic Themes Cyclical Recommendations

Special Report

Executive Summary Indian Voter’s Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Chart 11India’s Debt Levels Are High And Rising It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Listen to a short summary of this report.         Executive Summary The US Inflation Surprise Index Has Rolled Over Global equities are nearing a bottom and will rally over the coming months as inflation declines and growth reaccelerates. While equity valuations are not at bombed-out levels, they have cheapened significantly. Global stocks trade at 15.3-times forward earnings. We are upgrading tech stocks from underweight to neutral. The NASDAQ Composite now trades at a forward P/E of 22.6, down from 32.9 at its peak last year. The 10-year Treasury yield should decline to 2.5% by the end of the year, which will help tech stocks at the margin. The US dollar has peaked. A weakening dollar will provide a tailwind to stocks, especially overseas bourses. US high-yield spreads are pricing in a default rate of 6.2% over the next 12 months, well above the trailing default rate of 1.2%. Favor high-yield credit over government bonds within a fixed-income portfolio.   Bottom Line: The recent sell-off in stocks provides a good opportunity to increase equity allocations. We expect global stocks to rise 15%-to-20% over the next 12 months. Back to Bullish We wrote a report on April 22nd arguing that global equities were heading towards a “last hurrah” in the second half of the year as a Goldilocks environment of falling inflation and supply-side led growth emerges. Last week, we operationalized this view by tactically upgrading stocks to overweight after having downgraded them in late February. This highly out-of-consensus view change, coming at a time when surveys by the American Association of Individual Investors and other outfits show extreme levels of bearishness, has garnered a lot of attention. In this week’s report, we answer some of the most common questions from the perspective of a skeptical reader.   Q: Inflation is at multi-decade highs, global growth is faltering, and central banks are about to hike rates faster than we have seen in years. Isn’t it too early to turn bullish? A: We need to focus on how the world will look like in six months, not how it looks like now. Inflation has likely peaked and many of the forces that have slowed growth, such as China’s Covid lockdown and the war in Ukraine, could abate.   Q: What is the evidence that inflation has peaked? And may I remind you, even if inflation does decline later this year, this is something that most investors and central banks are already banking on. Inflation would need to fall by more than expected for your bullish scenario to play out. A: That’s true, but there is good reason to think that this is precisely what will happen.  Overall spending in the US is close to its pre-pandemic trend. However, spending on goods remains above trend while spending on services is below trend (Chart 1). Services prices tend to be stickier than goods prices. Thus, the shift in spending patterns caused goods inflation to rise markedly with little offsetting decline in services inflation. To cite one of many examples, fitness equipment prices rose dramatically, but gym membership fees barely fell (Chart 2). Chart 1Total US Consumer Spending Is Almost Exactly At Its Pre-Pandemic Trend, But The Composition Of Spending Remains Skewed Chart 2Asymmetries Matter: Firms Manufacturing Sports Equipment Jacked Up Prices, But Gyms Barely Cut Prices As goods demand normalizes, goods inflation will come down. Meanwhile, the supply of goods should increase as the pandemic winds down, and hopefully, a detente is reached in Ukraine. There are already indications that some supply-chain bottlenecks have eased (Chart 3). Q: Even if supply shocks abate, which seems like a BIG IF to me, wouldn’t the shift in spending towards services supercharge what has been only a modest acceleration in services inflation so far? A: Wages are the most important driver of services inflation. Although the evidence is still tentative, it does appear as though wage inflation is peaking. The 3-month annualized growth rate in average hourly earnings for production and nonsupervisory workers slowed from 7.2% in the second half of 2021 to 3.8% in April (Chart 4). Assuming productivity growth of 1.5%, this is consistent with unit labor cost inflation of only slightly more than 2%, which is broadly consistent with the Fed’s CPI inflation target.1 Chart 4Wage Pressures May Be Starting To Ease Moreover, a smaller proportion of firms expect to raise wages over the next six months than was the case late last year according to a variety of regional Fed surveys (Chart 5). The same message is echoed by the NFIB small business survey (Chart 6). Consistent with all this, the US Citi Inflation Surprise Index has rolled over (Chart 7).   Chart 6... Small Business Owners Included Chart 7The US Inflation Surprise Index Has Rolled Over   Q: What about the “too cold” risk to your Goldilocks scenario? The risks of recession seem to be rising. A: The market is certainly worried about this outcome, and that has been the main reason stocks have fallen of late. However, we do not think this fear is justified, certainly not in the US (Chart 8). US households are sitting on $2.3 trillion excess savings, equal to about 14% of annual consumption. The ratio of household debt-to-disposable income is down 36 percentage points from its highs in early 2008, giving households the wherewithal to spend more. Core capital goods orders, a good leading indicator for capex, have surged. The homeowner vacancy rate is at a record low, suggesting that homebuilding will be fairly resilient in the face of higher mortgage rates.   Q: It seems like the Fed has a nearly impossible task on its hands: Increase labor market slack by enough to cool the economy but not so much as to trigger a recession. You yourself have pointed out that the Fed has never achieved this in its history. A: It is correct that the unemployment rate has never risen by more than one-third of a percentage point in the US without a recession occurring (Chart 9). That said, there are three reasons to think that a soft landing can be achieved this time. Chart 9When Unemployment Starts Rising, It Usually Keeps Rising First, increasing labor market slack is easier if one can raise labor supply rather than reducing labor demand. Right now, the participation rate is nearly a percentage point below where it was in 2019, even if one adjusts for increased early retirement during the pandemic (Chart 10). Wages have risen relatively more at the bottom end of the income distribution. This should draw more low-wage workers into the labor force. Furthermore, according to the Federal Reserve, accumulated bank savings for the lowest-paid 20% of workers have been shrinking since last summer, which should incentivize job seeking (Chart 11). Chart 10Labor Participation Has Further Scope To Recover Chart 11Depleted Savings Will Force More Lower-Wage Workers Into The Labor Market Second, long-term inflation expectations remain well contained, which makes a soft landing more likely. Median expected inflation 5-to-10 years out in the University of Michigan survey stood at 3% in May, roughly where it was between 2005 and 2013 (Chart 12). Median expected earnings growth in the New York Fed Survey of Consumer Expectations was only slightly higher in April than it was prior to the pandemic (Chart 13). Chart 12Consumer Long-Term Inflation Expectations Have Risen But Remain Relatively Low Chart 13US Consumers Do Not Expect Wages To Grow At A Much Higher Rate Than In The Pre-Pandemic Period A third reason for thinking that a soft landing may be easier to achieve this time around is that the US private-sector financial balance – the difference between what the private sector earns and spends – is still in surplus (Chart 14). This stands in contrast to the lead-up to both the 2001 and 2008-09 recessions, when the private sector was living beyond its means.   Q: You have spoken a lot about the US, but the situation seems dire elsewhere. Europe may already be in recession as we speak! A: The near-term outlook for Europe is indeed challenging. The euro area economy grew by only 0.8% annualized in the first quarter. Mathieu Savary, BCA’s Chief European Strategist, expects an outright decline in output in Q2. To no one’s surprise, the war in Ukraine is weighing on European growth. The Bundesbank estimates that a full embargo of Russian oil and gas would reduce German real GDP by an additional 5% on top of the damage already inflicted by the war (Chart 15). Chart 14The US Private-Sector Financial Balance Remains In Surplus Chart 15Germany’s Economy Will Sink Without Russian Energy While such a full embargo is possible, it is not our base case. In a remarkable about-face, Putin now says he has “no problems” with Finland and Sweden joining NATO, provided that they do not place military infrastructure in their countries. He had previous threatened a military response at the mere suggestion of NATO membership. In any case, there are few signs that Putin’s increasingly insular and dictatorial regime would respond to an oil embargo or other economic incentives. The wealthy oligarchs who were supposed to rein him in are cowering in fear. It is also not clear if Europe would gain any political leverage over Russia by adopting policies that push its own economy into a recession. It is worth noting that the price of the December 2022 European natural gas futures contract is down 39% from its peak at the start of the war (Chart 16). It is also noteworthy that European EPS estimates have been trending higher this year even as GDP growth estimates have been cut (Chart 17). This suggests that the analyst earnings projections were too conservative going into the year. Chart 16European Natural Gas Futures Are High But Below Their Peak Chart 17European And US EPS Estimates Have Been Trending Higher This Year Chart 18Chinese Property Sector: Signs Of Contraction Q: What about China? The lockdowns are crippling growth and the property market is in shambles. A: There is truth to both those claims. The government has all but said that it will not abandon its zero-Covid policy anytime soon, even going as far as to withdraw from hosting the 2023 AFC Asian Cup. While the number of new cases has declined sharply in Shanghai, future outbreaks are probable. On the bright side, China is likely to ramp up domestic production of Pfizer’s Paxlovid drug. Increased availability of the drug will reduce the burden of the disease once social distancing restrictions are relaxed. As far as the property market is concerned, sales, starts, completions, as well as home prices are all contracting (Chart 18). BCA’s China Investment Strategy expects accelerated policy easing to put the housing sector on a recovery path in the second half of this year. Nevertheless, they expect the “three red lines” policy to remain in place, suggesting that the rebound in housing activity will be more muted than in past recoveries.2  Ironically, the slowdown in the Chinese housing market may not be such a bad thing for the rest of the world. Remember, the main problem these days is inflation. To the extent that a sluggish Chinese housing market curbs the demand for commodities, this could provide some relief on the inflation front.   Q: So bad news is good news. Interesting take. Let’s turn to markets. You mentioned earlier that equity sentiment was very bearish. Fair enough, but I would note the very same American Association of Individual Investors survey that you cited also shows that investors’ allocation to stocks is near record highs (Chart 19). Shouldn’t we look at what investors are doing rather than what they’re saying? A: The discrepancy may not be as large as it seems. As Chart 20 illustrates, investors may not like stocks, but they like bonds even less. Chart 19Individual Investors Still Hold A Lot Of Stock   Chart 20B... But They Like Bonds Even Less Chart 21Global Equities Are More Attractively Valued After The Recent Sell-Off Global equities currently trade at 15.3-times forward earnings; a mere 12.5-times outside the US. The global forward earnings yield is 6.7 percentage points higher than the global real bond yield. In 2000, the spread between the earnings yield and the real bond yield was close to zero (Chart 21). It should also be mentioned that institutional data already show a sharp shift out of equities. The latest Bank of America survey revealed that fund managers cut equity allocations to a net 13% underweight in May from a 6% overweight in April and a net 55% overweight in January. Strikingly, fund managers were even more underweight bonds than stocks. Cash registered the biggest overweight in two decades.   Q: Your bullish equity bias notwithstanding, you were negative on tech stocks last year, arguing that the NASDAQ would turn into the NASDOG. Given that the NASDAQ Composite is down 29% from its highs, is it time to increase exposure to some beaten down tech names? A: Both the cyclical and structural headwinds facing tech stocks that we discussed in These Three High-Flying Equity Sectors Could Come Crashing Back Down To Earth and The Disruptor Delusion remain in place. Nevertheless, with the NASDAQ Composite now trading at 22.6-times forward earnings, down from 32.9 at its peak last year, an underweight in tech is no longer appropriate (Chart 22). A neutral stance is now preferable.   Chart 22Tech Stock Valuations Have Returned To Earth Q: I guess if bond yields come down a bit more, that would help tech stocks? A: Yes. Tech stocks tend to be growth-oriented. Falling bond yields raise the present value of expected cash flows more for growth companies than for other firms. While we do expect global bond yields to eventually rise above current levels, yields are likely to decline modestly over the next 12 months as inflation temporarily falls. We expect the US 10-year yield to end the year at around 2.5%.   Q: A decline in US bond yields would undermine the high-flying dollar, would it not? A: It depends on how bond yields abroad evolve. US Treasuries tend to be relatively high beta, implying that US yields usually fall more when global yields are declining (Chart 23). Thus, it would not surprise us if interest rate differentials moved against the dollar later this year. Chart 23US Treasuries Have A Higher Beta Than Most Other Government Bond Markets It is also important to remember that the US dollar is a countercyclical currency (Chart 24). If global growth picks up as pandemic dislocations fade and the Ukraine war winds down, the dollar is likely to weaken. Chart 24The Dollar Is A Countercyclical Currency A wider trade deficit could also imperil the greenback. The US trade deficit has increased from US$45 billion in December 2019 to US$110 billion. Equity inflows have helped finance the trade deficit, but net flows have turned negative of late (Chart 25). Finally, the dollar is quite expensive – 27% overvalued based on Purchasing Power Parity exchange rates.   Q: Let’s sum up. Please review your asset allocation recommendations both for the next 12 months and beyond. A: To summarize, global inflation has peaked. Growth should pick up later this year as supply-chain bottlenecks abate. The combination of falling inflation and supply-side led growth will provide a springboard for equities. We expect global stocks to rise 15%-to-20% over the next 12 months. Historically, non-US stocks have outperformed their US peers when the dollar has been weakening (Chart 26). EM stocks, in particular, have done well in a weak dollar environment Chart 26Non-US Stocks Will Benefit From A Weaker US Dollar Chart 27The Market Is Too Pessimistic On Default Risk Within fixed-income portfolios, we recommend a modest long duration stance over the next 12 months. We favor high-yield credit over safer government bonds. US high-yield spreads imply a default rate of 6.2% over the next 12 months compared to a trailing 12-month default rate of only 1.2% (Chart 27). Chart 28Falling Inflation Will Buoy Consumer Sentiment Our guess is that this Goldilocks environment will end towards the end of next year. As inflation comes down, real wage growth will turn positive. Consumer confidence, which is now quite depressed, will improve (Chart 28). Stronger demand will cause inflation to reaccelerate in 2024, setting the stage for another round of central bank rate hikes.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on           LinkedIn Twitter       Footnotes 1    The Federal Reserve targets an average inflation rate of 2% for the Personal Consumption Expenditures (PCE) index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of 2.3%-to-2.5%. 2    The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary Allies Still Have Faith In USD The Biden administration’s use of sanctions has prompted market speculation about the longevity of the dollar. Yet the DXY has hit 100 and could break out, in the context of rising interest rates and safe-haven demand. The US’s increasingly frequent recourse to economic sanctions is a sign of growing foreign policy challenges. US rivals will continue to diversify away from dollar-denominated reserves. However, from a big picture point of view, there is no clear case that the dollar suffers from US sanctions. When global growth reaccelerates, the dollar can weaken. But until then it will remain resilient. Recommendation (Tactical) Inception Level Inception Date Return Long DXY 96.19 23-FEB-22 5.8% Bottom Line: Tactically stay long DXY and defensives over cyclicals. Feature The US’s aggressive use of sanctions against Russia, in response to its invasion of Ukraine, has prompted market speculation about the future of the global financial and monetary system. Related Report  US Political StrategyBiden's Foreign Policy And The Midterms               It is helpful to begin with facts – what we really know – before launching into grandiose predictions for the future. For example, while some analysts are predicting the demise of the US dollar’s position as the leading reserve currency, so far global investors have bid up the dollar in the face of rising policy uncertainty (Chart 1). In this report we conduct a short overview of US sanctions policy and draw a few simple investment conclusions. Chart 1US Political Risk And The Dollar US Extra-Territorialism Not Yet Hurting The USD The DXY is now trading at 101.2, above the psychological threshold of 100, suggesting that it could break out above its 2016 102.2 peak. The drivers are an expected sharp rise in real interest rates, in both absolute and relative terms, as the Federal Reserve starts on a rate hike cycle that is expected to add 225 basis points to the Fed funds rate this year alone to combat core inflation of 6.5%. This monetary backdrop must be combined with extreme global political and economic instability to explain the dollar’s potential breakout. The global situation is growing less stable, as EU-Russia energy trade breaks down while China imposes lockdowns to stop the spread of Covid-19. Over the past twenty years, the US has struggled to maintain its global leadership. Washington became distracted by wars in the Middle East and South Asia, a national property market crash and financial crisis, and a spike in political polarization and populism. The US public grew war-weary, while the US faced growing challenges from large and powerful nations that it could not confront militarily. Therefore US policymakers turned to economic tools to try to achieve their objectives: namely sanctions but also tariffs and export controls. Many economists and political scientists have warned that the US’s expanding use of economic sanctions – and broader trend of international, extra-territorial, law enforcement – would drive other countries to sell the US dollar and buy other assets, so as to reduce their vulnerability to US tools. This reasoning is sound, as we can see with Russia, which has reduced its dollar-denominated foreign exchange reserves from 41% to 16% since 2016, while increasing its gold holdings from 15% to 22% over the same period. Other major countries vulnerable to US sanctions could follow in Russia’s footsteps. However, so far, the dollar is not suffering excessively from such moves. On the contrary it is rising. The US started using sanctions aggressively with North Korea in 2005, Iran in 2010, and Russia since 2012. The dollar has fluctuated based on other factors, namely rising when the global commodity and industrial cycle was falling (Chart 2). Chart 2TWUSD And DXY Since 2000 Sanctions are a limited prism through which to examine the dollar. But if there is any observable effect of the US’s turn toward sanctions against major players like Russia in 2012 and China in 2018, it is that it has boosted the dollar rather than hurt it. Obviously that trend could change someday. But for now, as the Ukraine war dramatically heightens the US struggle with its rivals, investors should observe that the dollar is on the verge of a breakout. If the dollar continues to rise, it suggests that the US’s structural turn toward more aggressive economic and financial sanctions is not negative for the dollar. It may be neutral or positive. Cyclically the trade-weighted dollar is nowhere near its 2020 peak and could still fall short of that peak, especially if global tensions subside. But the collapse in the euro has caused the DXY to break above its 2020 peak already. Bottom Line: Stay tactically long DXY while watching whether it can break sustainably above 100 to determine whether our cyclically neutral view should be upgraded. US Sanctions On North Korea In this century, the US began to turn more aggressive in its use of sanctions when it confronted the “Axis of Evil” following the terrorist attacks on September 11, 2001. North Korea withdrew from the Nuclear Non-Proliferation Treaty in 2003 and began to pursue a nuclear and ballistic missile program more intently. The US responded by levying serious sanctions on that state beginning in 2005. Gradually tougher US sanctions never caused a change in the North Korean regime or foreign policy. On the contrary North Korea achieved nuclear weaponization and is today outlining an expansive nuclear doctrine.  US sanctions on North Korea were never going to drive global macro trends. However, they could have had an impact on South Korean trends. Initially none of the US sanctions reversed the dollar’s decline against the Korean won. After the global financial crisis in 2008, when the dollar began an uptrend against the won, we observe periods of significant new sanctions in which the won rises and the dollar falls (Chart 3, top panel). The same can be said for the outperformance of US equities relative to South Korean equities – if sanctions had any impact, they simply reinforced the flight to US assets in a globally disinflationary context. The trend was mirrored within the US equity market by the rise of tech versus industrials (Chart 3, bottom panel). Chart 3US Sanctions On North Korea Since Covid-19, the outperformance of US tech is now being overturned by high inflation, which has triggered a vicious selloff in tech. In 2022, global growth is slowing, stagflation is taking shape, and the odds of a recession are rising. Stagflation is negative for both industrials and tech, but more so tech. However, South Korea is still suffering from a deteriorating global macro and geopolitical backdrop, as globalization falters, US-China competition rises, and the US fails to contain North Korean ambitions. Sanctions are a symptom rather than a cause.  Bottom Line: US sanctions on North Korea pose no threat to the US dollar. Tactically US industrials can continue to outperform tech but both sectors will suffer in a stagflationary context. US Sanctions On Venezuela The US has slapped sanctions on Venezuela since the early 2000s but these sanctions kicked into high gear in 2015 after President Nicolas Maduro took power and eliminated the last vestiges of democratic and constitutional order. The US recognized the opposition as the legitimate government so sanctions relief will not be easy or convenient. Sanctions have not changed the regime’s behavior, but the regime has all but collapsed and major changes could happen sooner than people expect. Moreover any short-term sanction relief prompted by high oil prices will not be sustainable: the Republican Party will oppose it, hence private US corporations will doubt its durability, and Venezuela’s failing oil industry cannot be revived quickly anyway (Chart 4, top panel).    The US has strong relations with Venezuela’s neighbor Colombia. Yet Colombia faces the greatest economic and security risks from Venezuelan instability. The US dollar vastly outstripped the Colombian peso over the past decade, consistent with the US energy sector’s underperformance (Chart 4, bottom panel). Chart 4US Sanctions On Venezuela With Covid-19, this trend reversed because of the global energy squeeze and inflationary environment. The implication was positive for the Colombian peso as well as global (and US) energy sector relative performance. But the peso only marginally improved against the dollar, while US energy outperformance is now stretched.  Bottom Line: Energy sector still enjoys macro tailwinds but it is no longer clear that US energy stocks will outperform the broad market for much longer. Favor energy by staying long US energy small caps versus large caps. Also stay long oil and gas transportation and storage sub-sector relative to the broad market. The Biden administration is unlikely to give sanction relief to Venezuela. If it does, it will be ineffective at reducing oil prices in the short term. Either way, there will be little impact on the US dollar. US Sanctions On Iran US policy toward Iran is critical to global stability and energy prices in 2022 and the coming years. US sanctions did not change Iran’s behavior alone, but in league with the P5+1 (the UK, France, China, Russia, plus Germany) sanctions forced Iran to accept limit on its nuclear program in 2015. However, the Trump administration withdrew from that agreement and imposed “maximum pressure” sanctions on Iran in 2018, leading to a sharp depreciation in the market exchange rate of the Iranian toman (Chart 5, top panel). The Saudi Arabian riyal, by contrast, is pegged to the dollar and remains steady except when oil prices collapse (Chart 5, middle panel). The Saudis still rely on the Americans for national security so they are unlikely to abandon the dollar, though they may marginally diversify their foreign exchange reserves. The Biden administration wants to rejoin the 2015 deal but first is trying to extract concessions from Iran. Iran feels limited pressure: while its currency is still weak and inflation high, Iran has not succumbed to social unrest. Iranian oil production and exports are rising amid global high prices (Chart 5, bottom panel). Ultimately Iran wants to continue to advance its nuclear program in line with the North Korean strategy. Hence Biden can rejoin the deal unilaterally if he wants to avoid Middle Eastern instability ahead of the midterm elections. But it would be a short-term, stop-gap agreement and the reduction in oil prices would be fleeting. By contrast, if Biden fails to lift Iran’s sanctions, then the risk of oil disruptions from the Middle East goes way up. Tactically investors should expect upside risks to the oil price, but that would kill more demand and weigh on global growth. Over the past decade the outperformance of US equities relative to Saudi and Emirati equities falls in line with the outperformance of US tech relative to energy sectors. As mentioned, this trend has largely run its course, although it can go further in the short run. But there is a broader trend related to growth versus value styles. The UAE’s stock market is heavily weighted toward financials, while the US is heavily weighted toward tech. The US tech sector has collapsed relative to financials (Chart 6).  Chart 5US Sanctions On Iran Chart 6US Sanctions On Iran Bottom Line: US energy and financials sectors can fare reasonably well in a stagflationary context but their outperformance relative to tech is largely priced from a cyclical point of view. US maximum pressure sanctions on Iran never hurt the US dollar. US Sanctions On Russia The US’s extraordinary sanctions against Russia in 2022 – including freezing its dollar-denominated foreign exchange reserves – have sparked market fears that countries will divest from US dollars to protect themselves from any future US sanctions. To be clear, the US has confiscated foreign enemies’ property and foreign exchange reserves in the past. True, Russia is qualitatively different from other countries, such as Iran, because it is one of the world’s great powers. Yet the US closed off all economic and financial linkages with Russia from 1949-1991 because of the Cold War, the very period when the US dollar rose to prominence as the global reserve currency. In 2022, sanctions on Russia have primarily hurt the Russian ruble, not the US dollar (Chart 7). The Russians divested from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. But they were not able to divest fast enough to prevent the 2022 sanctions from pummeling their financial system and economy. Chart 7US Sanctions On Russia Going forward Russia will be much more insulated from the US dollar but at a terrible cost to long-term productivity. The lesson for other US rivals may be to diversify away from the dollar – but that will be a secondary lesson. The primary lesson will be to take economic stability into account when making strategic security decisions. Economic stability requires ongoing engagement in the global financial system and US dollar system. US sanctions on Russia have benefited US equities and dollar relative to Russian assets as one would expect. Russia’s invasion of Ukraine exacerbated the trend. The takeaway for US investors is that the energy sector’s outperformance sector’s outperformance can continue in the short run but is becoming stretched from a cyclical perspective. Bottom Line: Investors should expect oil and the energy sector to remain strong in the short run, while tech will suffer in an inflationary and stagflationary environment. But energy may not outperform tech for much longer. US Sanctions On China US policy toward China is the critical question today. China holds $1 trillion in dollar-denominated exchange reserves and must recycle around $200 billion in current account surpluses every year into global assets. The US has imposed sweeping sanctions on Iran since 2010, Russia since 2012, and China since 2018. China began diversifying away from dollar-denominated foreign exchange reserves in 2011 in the wake of the Great Recession. The US-initiated trade war in 2018 solidified the change in China’s foreign reserve strategy. The US sanctions against Russia will further solidify it. There are some signs that US punitive measures affected the USD-CNY exchange rate but global economic cycles are far more powerful. The yuan appreciated from 2005 until the global financial crisis, during the height of US-China economic and diplomatic engagement. It depreciated through the manufacturing slowdown of 2015 and the US-China trade war. It appreciated again with the pandemic stimulus and global trade rebound. The yuan was affected by US sanctions and tariffs on the margin amid these larger macro swings (Chart 8, top panel). Still, the overarching trend since 2014 points to a rising dollar and falling yuan. Globalization is in retreat and US-China strategic competition is heating up. As with South Korea, these trends are negative for Chinese assets. US sanctions are a symptom rather than a cause of the underlying macro and geopolitical dynamics. The same point can be made with regard to US equity performance relative to Chinese – and hence US tech outperformance relative to US industrial stocks (Chart 8, bottom panel). However, as with Korea, the cyclical takeaway is to favor industrials over technology in a stagflationary environment. Chart 8US Sanctions On China Bottom Line: Tactically favor US industrials over tech until the world’s stagflationary trajectory is corrected. US-China relations are one area where US sanction policy can hurt the dollar, as China will seek to diversify over time. But so far the evidence is scant. US Sanctions And Foreign Holdings Of Treasuries Having examined US sanctions on a country-by-country basis, we should now turn toward holdings of US dollars and Treasury securities. Are US economic sanctions jeopardizing the willingness of states to hold US assets? First, Americans hold 74% of outstanding treasuries. Foreigners hold the remaining 26% (Chart 9, top panel). This is a large degree of foreign ownership that reflects the US’s openness as an economy, as well as the size of the treasury market, which makes it attractive to foreign savers who need a place to store their wealth. Of this 26%, defense allies hold about 36%. Theoretically up to 17% of treasuries stand at risk of rapid liquidation by non-allied states afraid of US sanctions. But a conservative estimate would be 6%. Notably the share of foreign-held treasuries held by non-allies has fallen from 40% in 2009 to 23% today. Non-allies are reducing their share fairly rapidly (Chart 9, middle panel). What this really means is that China and Hong Kong are reducing their share – from 26% in 2008 to 16% today. Brazil and India have maintained a steady 6% of foreign-held treasuries. Notably the offshore financial centers see a growing share, suggesting that trust in the dollar remains strong even among states and entities that wish to hide their identity. Some of the divestment that has occurred from non-allied states may be overstated due to rerouting through these third parties. Looking at the data in absolute terms, only China – and arguably Brazil – can be said with any certainty to be pursuing a dedicated policy of divesting from US dollar reserves (Chart 10). This makes sense, as China, like Russia, is engaged in geopolitical competition with the US and therefore must take precautions against future US punitive measures. But these measures are not so far generating a worldwide flight from the dollar, either at the micro level or the macro level. Chart 9Foreign Purchases Of US Treasuries Chart 10Foreigners With Large Treasury Holdings In fact, the biggest competitor to the US dollar is the euro. This is clear from looking at the share of global currency reserves – the two are inversely proportional (Chart 11). And yet it is the European Union, not the US, that could suffer a long-term loss of security, productivity, and stability as a result of Russia’s invasion of Ukraine. The euro is losing status as a reserve currency and the war could exacerbate that trend. Chart 11Global Reserve Currency Basket Europe does not provide protection from US sanctions. The EU, like the US, utilizes economic sanctions and the two entities share many similar foreign policy objectives. Europe is also allied with the US through NATO. When the US withdrew from the Iran nuclear deal, the EU did not withdraw, yet EU entities enforced the sanctions, as their economic linkages with the US were much more valuable than those with Iran. In the case of Russia, the two have imposed sanctions in league, as they will likely do toward other small or great powers that attempt to reshape the global order through military force. The next competitors to the dollar and euro are grouped together in Chart 11 above because they are the US’s “maritime allies,” such as Japan, the United Kingdom, and Australia. These countries will pursue a similar foreign policy to the United States and they do not offer protection from US sanctions during times of conflict or war.  The true competitor is the Chinese renminbi. The renminbi will grow as a share of global reserves. But it faces serious obstacles from China’s economic policy, currency controls, closed capital account, and geopolitical competition with the United States. Washington’s sanctions have already targeted China yet the US dollar has remained resilient.  Bottom Line: The US’s erratic foreign policy in recent decades has potentially weighed on the US’s commanding position as a global reserve currency, with its share of reserves falling from 71% in 2000 to 59% today. But US allies have mostly picked up the slack. And the dollar’s top competitor, the euro, is likely to suffer more than the dollar from the Ukraine war. Still it is true that US sanctions are alienating China, which will continue to diversify away from the dollar.  Investment Takeaways Tactically stay long the US dollar (DXY). The combination of monetary policy tightening and foreign policy challenges is driving a dollar rally that could result in a breakout.  US sanctions policy is not a convincing reason to sell the dollar in today’s context. Over the medium term dollar diversification poses a risk, although the dollar will still remain the single largest reserve currency over a long-term, strategic horizon. For further discussion see the Special Report by our Foreign Exchange Strategy and Geopolitical Strategy, “Is The Dollar’s Reserve Status Under Threat?” Given US domestic policy uncertainty in an election year, and foreign policy challenges, stay long defensive sectors, namely health care, over cyclical sectors.   Tactically our renewable energy trade has dropped sharply. But cyclically it remains attractive, as our recent Special Report with our US Equity Strategy team demonstrates. If Congress fails to succeed in promoting its new climate and energy bill, then this trade could suffer bad news in the near term. Tactically US industrials can continue to outperform the tech sector, given the stagflationary context that is developing. Energy’s outperformance, especially relative to tech, is becoming stretched, at least from a cyclical point of view. But geopolitical trends suggest oil risks are still to the upside tactically. For now, maintain exposure to high energy prices by staying long energy small caps versus large caps and O&G transportation and storage.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Special Report

Executive Summary The Declining Value Of An Old Friendship India may buy cheap oil from Russia, but oil alone cannot expand this partnership. India needs to maintain a balance of power against China and Pakistan. With Russia’s heft set to decline, India will be compelled to explore a configuration with America. India will slowly yet surely move into America’s sphere of influence. Strong geopolitical as well as economic incentives exist for both sides to develop partnership. The US’s grand strategy will continue to collide with that of Russia and China. China will increasingly align with Russia and is doomed to stay entangled in a strategic conflict with India. With India a promising emerging market set to cleave to America, we reiterate our strategic buy call on India. Tactically however we are bearish on India. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis. Trade Recommendation Inception Date Return LONG INDIAN TECH / CHINESE TECH EQUITIES 2022-04-21   Bottom Line: For reasons of geopolitics as well as macroeconomics, we maintain our constructive view on India and our negative view on China on a strategic time frame. On a tactical timeframe, we remain sellers of India given cyclical political and macro risks. Feature Russia’s invasion of Ukraine has forced all players at the global geopolitical table to show their hand. The one major player at the table who is yet to show her cards is India. Which side India choses matters. Its geopolitical rise is one of the many reasons we live in a brave new multipolar world. India will gain influence in the global economy as a large buyer of oil and guns and as a user of tech platforms and capital. Related Report  Geopolitical StrategyFrom Nixon-Mao To Putin-Xi The situation is complicated by mixed signals. India has played a geopolitically neutral or “non-aligned” role for most of its time since independence in 1947. Those who believe India will stay neutral point to the fact that India has continued buying oil from Russia and has abstained from voting on both anti-Russia and anti-Ukrainian resolutions at the United Nations. Those who predict that India will side with Russia have trouble explaining how India will get along with China, which committed to a “no limits” strategic partnership with Russia prior to the invasion. Those who speculate that India will align with the US have trouble explaining India’s persistent ties with Russia and the Biden administration’s threat of punishment for those who help Russia circumvent US sanctions. In this report we argue that the Indo-Russian friendship is destined to fade over a long-term, strategic horizon. The reason is simple: Russia’s geopolitical power is fading and hence it can no longer help India meet its regional security goals. The growing Russia-China alignment will only alienate India further. Hence, we expect the relationship between India and Russia to be reduced to a transactional status – mainly trade in oil and guns over the next few years, while strategic realities will drive India to tighten relations with the US and its Asian allies. Three geopolitical forces will break down the camaraderie between India and Russia, namely: (1) A collision in the grand strategies of America with that of both China and Russia, (2) India’s need to align with the US to underwrite its own regional security, and (3) China’s rising distrust of India as India aligns with the US and its allies. In fact, we expect China and India to stay embroiled in a strategic conflict over the next few years. Any thaw in their relations will be temporary at best. The rest of this report explains and quantifies these forces. We conclude with actionable investment conclusions. Let’s dive straight in. US Versus China-Russia: A Grand Strategy Collision “For the enemy is the communist system itself – implacable, insatiable, unceasing in its drive for world domination … For this is not a struggle for supremacy of arms alone – it is also a struggle for supremacy between two conflicting ideologies: freedom under God versus ruthless, Godless tyranny. “ – John F. Kennedy, Remarks at Mormon Tabernacle, Utah (September 1960) Chart 1China’s Is An Export-Powered Economic Heavyweight It’s been six decades since these words were spoken and today the quotation is more relevant than at any time since the Cold War ended in 1991. The excerpt captures how the Biden administration has positioned itself with respect to Russia and China, only replacing “communist” with “autocratic” in Russia’s case. The Ukraine war helps America advance its grand strategy with respect to Russia. The Ukraine war is steadily draining Russia’s already limited economic might. Western sanctions aim to weaken Russia further. Russia’s military capabilities are now in greater doubt than before, so that its only remaining geopolitical strengths are nuclear weapons and, significantly, its leverage as an energy supplier. With Russia weakened, yet capable of reinforcing China, America will focus more intensely on China over the coming years and the breakdown in US-China relations will only accelerate. China is a genuine economic competitor to the United States (Chart 1). Its strategic rise worries America. To make matters worse, America poses a unique threat to China. China relies heavily on energy imports (Chart 2) from the Middle East (Chart 3). This is a source of great vulnerability as China’s fuel imports must traverse seas that America controls (Map 1). During peace time, and periods of robust US-China strategic engagement, this vulnerability is not an issue. But China is acutely aware that America has the capability to choke China’s energy access at will in the event of hostilities, just as it did to Japan in World War II. Russia has managed to wage war in Ukraine, against US wishes, since it is a net energy supplier to Europe and the global economy. Chart 2China And India Rely On Imports For Energy​​​​​ Chart 3India And China Both Depend On Middle East For Oil​​​​​​ Map 1US Military Footprint In Middle East Threatens China … Yet US Presence In South Asia Is Weak Atop China’s fuel-supply related insecurities, America has begun a strategic pivot to Asia in recent years. For instance, America has pulled troops out of Iraq and Afghanistan, declared a trade war on China, and strengthening strategic alliances and partnerships with regional geopolitical powers like India and Australia (Table 1). The US has retained its alliance with the Philippines despite an adverse government there, while South Korea has just elected a pro-American president again. With Japan, South Korea and Australia aligned militarily with the US, China’s naval power pales in comparison (Chart 4). Table 1America’s Influence In Asia Is Rising Chart 4China’s Naval Power Pales Versus US Allies In Asia Now China cannot watch America refurbish its grand strategy in Asia silently. Given China’s need for supply security, geopolitical independence, and regional influence, Beijing will double down on building its influence in Asia and in the eastern hemisphere. Against this backdrop of US-China competition, military conflict becomes increasingly likely, especially in the form of “proxy wars” involving China’s neighbors but conceivably even in the form of US-China naval warfare. China’s plans to modernize and enhance its economic prowess will add to America’s worries (Chart 5). A bipartisan consensus of American lawmakers is focused on reviving America’s economic strength but simultaneously limiting China’s benefit by restricting Chinese imports and American high-tech exports (Chart 6). Since Beijing cannot afford to base its national strategy on the hope of lingering American engagement, US-China trade relations will weaken regardless of which party controls the White House. Chart 5China’s Growing Might Worries America​​​​​​ Chart 6US Growth Does Not Equal Growth In Imports From China ​​​​​​ The consensus in global financial media (which we never bought) held that the Biden administration would reduce tensions with China – but the détente never occurred and the remaining window for détente is limited by the uncertainty of the 2024 election. The US is currently occupied with Russia but threatening to impose secondary sanctions on China if it provides military assistance or circumvents sanctions. The Russo-Ukrainian war has led to an energy price shock that hurts an industrial economy like China’s. For the rest of this year China’s leaders will be consumed with managing the energy shock, a nationwide Covid-19 outbreak, and the important political reshuffle this fall. Only in 2023 will Beijing have room for maneuver when it comes to the US. But the US cannot return to engagement, which strengthens China’s economy, while China cannot open up to the US economy and become more exposed to future US sanctions. Bottom Line: A grand strategy collision between the US and China is certain. US dominance of sea routes that China uses for energy imports necessarily intimidates China. America’s pivot to Asia threatens China’s regional influence. This will prompt China to restrict American advances in strategic geographies —and not only the Taiwan Strait but also, as we will see, in South Asia. US-India Strategic Alignment: Only A Matter Of Time “If they [nation states] wish to survive, they must be willing to go to war to preserve a balance against the growing hegemonic power of the period.” – Nicholas J. Spykman, America's Strategy in World Politics (Harcourt, Brace and Co, 1942) For reasons of strategy, China will continue to build its influence in South Asia. South Asia offers prospects of sea access to the Indian Ocean, namely via Pakistan. This factor could ease China’s fuel supply insecurities. Also, penetrating northern India helps China set up a noose around India’s neck, thus neutralizing a potential enemy and US ally. In short China will pursue a two-pronged strategy of Eurasian development and naval expansion, both of which threaten India. Against this backdrop, India needs US support to counter Pakistan to its west, China’s latest intrusions into its eastern flank (Map 2), and China’s maritime challenge. India has historically spent generously on defense, but its military might pales in comparison to that of China. Even partial support from America would help India make some progress toward a balance of power in South Asia (Chart 7). Map 2China’s Newfound Interest In India’s Eastern Flank Chart 7America Can Provide Military Heft To India​​​​​​ Chart 8US Is A Key Trading Partner For India​​​​​​ There’s another reason why US alignment makes sense for India. Much like China, India is highly import-dependent for its fuel needs (Chart 2). Given India’s high reliance on the Middle East for energy, India stands to benefit from America’s solid military footprint in this region (Map 1). The US too has a motive in exploring this alliance. India can provide a strategic foothold on the Eurasian rimland. America will value this new access route to Eurasia because America knows that its military footprint in South Asia is surprisingly weak – a weakness it needs to address against the backdrop of China’s increasing influence in the region (Map 1). Meaningful economic interests also underpin the US-India relationship. India and the US appear like sparring partners from time to time. The US may raise issues of human rights violations in India and the two may bicker over trade. However there exist strong economic incentives for the two countries to keep their differences under check and develop a long-term strategic partnership. The US is a major user of India’s software services and buys nearly a fifth of India’s merchandise exports. The trading relationship that India shares with the US is far more developed than India’s trading relationship with China and Russia (Chart 8). Capital is a factor of production that India desperately needs to finance its high growth. America and its allies are also major suppliers of capital to India (Chart 9). India is averse to granting China the political influence that would go along with major capital infusions and direct investments. Chart 9US And Its Allies Are Major Suppliers Of Capital To India​​​​​​ Chart 10India Offers US Firms Access To High Growth​​​​​​ Chart 11India Is A Key Market For American Big Tech India on its part is a large marketplace which offers high growth prospects (Chart 10) and remains open and accessible to American corporations (unlike say Russia or China). The growth element is something that American firms will value more over time, as the American economy is mature and has a lower potential growth rate. Most importantly if the US imposes sanctions on India, then two key business lobbies are sure to mitigate the damage. In specific: Since India is a key potential market for American tech firms (Chart 11), Big Tech will always desire amicable Indo-US relations. Since India is the third largest buyer of defense goods globally, American defense suppliers will have similar intentions. In both cases, US policy planners will support these industries’ lobbying efforts due to the grand strategic considerations outlined above. Bottom Line: India will slowly yet surely move into America’s sphere of influence. Notwithstanding persistent differences, the Indo-US relationship will strengthen over a strategic timeframe. Strong geopolitical motives as well as notable economic incentives exist for both sides to develop this alignment. Indo-Russian Alignment: Destined To Fade The Indo-Russian friendship can be traced back to the second half of the 20th century. The fulcrum was the fact that Russia was a formidable land-based power and provided an offset against threats from China and Pakistan (Chart 12). The finest hour of this friendship perhaps came in 1971 when Russia sided with India in its war with Pakistan. India’s citizens hold an unusually favorable opinion of Russia (Chart 13). Chart 12The Declining Value Of An Old Friendship​​​​​​ Chart 13Indians Hold A Favorable Opinion Of Russians ​​​​​​ Despite this rich past, the Indo-Russia friendship is doomed to fade over a strategic timeframe. Even if  Russia’s share in Indian oil rises from current low levels of 2%, this glue alone cannot hold the Indo-Russian relationship together for one key reason: Russia’s geopolitical might has been waning and Russia can no longer help India establish a balance of power against China and Pakistan (Table 2). In fact, since 2006, the Russo-Indian partnership has been commanding lower geopolitical power than that of China (Chart 12). Table 2Russia’s Military Heft Is Of Limited Use To India Today Managing regional security is a key strategic concern for India. As Russia’s geopolitical power wanes so will India’s utility of Russia as an effective guarantor of India’s security. Russia’s war in Ukraine is ominous in this regard, as Russian armed forces were forced to retreat from Kyiv, while the country’s already bleak economic prospects have worsened under western sanctions. The solidification of the China-Russia axis will alienate India further (Chart 14). China is essential to Russia’s economy now while Moscow is essential to China’s Eurasian strategy of bypassing American naval dominance to reduce its supply insecurity. Russia holds the keys to Central Asia, from a military-security point of view, and hence also to the Middle East. Furthermore, limited economic bonds exist to prevent India and Russia from falling out. Russia accounts for a smidgen of India’s trade (Chart 8). India is Russia’s largest arms client (accounting for +20% of its arms sales) but this reliance could also decline over time: The Indian government has been pursuing a range of policies to increase the indigenous production of arms. This is a strategic goal that would also reinforce India’s economic need for more effective manufacturing capabilities. Russia’s own defense franchise had been coming under pressure, even before the Ukraine war (Chart 15). On the contrary, Western arms manufacturers’ franchise has been steadily growing. Chart 14China-Russia Axis Will Alienate India ​​​​​ Chart 15The Rise & Rise Of Western Arms Manufacturers ​​​​​​ While the US may look the other way in the short term when India buys arms from Russia, over a period of time the US is bound to pull India away by using a combination of sticks (mild sanctions) and carrots (heavy discounts). Two aforementioned external factors will also work against the Indo-Russia relationship namely (1) The Russo-Chinese alignment and its clash with US grand strategy and (2) The coming-to-life of a US-India strategic alignment. Bottom Line: India’s need for cheap oil will preserve basic Indo-Russian relations for some time. But oil alone cannot drive a deeper strategic alignment. Regional security concerns are paramount for India. Russia’s geopolitical decline will force India to explore an alignment with America, which will offer India security in the Indian Ocean and Persian Gulf in the face of China’s emergence in this region. Is A Realignment In Indo-China Relations Possible? But why should India not join the other Asian giants to balance against America’s threat of global dominance? Would such a bloc not secure India’s interests? And what if the US imposes harsh sanctions for India’s continued trade with Russia and strategic neutrality? Or what if a future US administration grows restless and attempts to force India to choose sides sooner rather than later? Even if the US offends India, it will only lead to a temporary improvement in India’s ties with the China-Russia alliance. This is because America stands to lose if India cleaves towards the Sino-Russian alliance and would thus quickly correct its policy. In specific: Security Interests: America will risk losing all influence in South Asia if India were to cleave towards China. India provides a key foothold for America to control China’s regional ascendance especially given that the US has now withdrawn from Afghanistan and its bilateral relations with Pakistan are weak. Business Interests: India’s movement into the China-Russia sphere of influence can have adverse business implications for American corporations and US allies, given that the US is abandoning the Chinese market over time, while India is a large and fast-growing consumer of American tech exports and services. India could emerge as a major buyer of American defense goods and will import more and more energy provided by the US and its partners in the Persian Gulf. These business groups will lobby for the withdrawal of US sanctions on India given India’s long-term potential. Meanwhile any improvement in Indo-Chinese relations will have a limited basis. In specific: Ascendant Nationalism In China And India: China’s declining potential GDP is motivating a rise in nationalism and an assertive foreign policy. Meanwhile India’s inability to create plentiful jobs for a young and growing population is also fuelling a wave of nationalism. A historic turn toward Sino-Indian economic engagement would require the domestic political ability to embrace and promote each other’s well-being. Pakistan Factor: India’s eastern neighbor Pakistan is controlled by its military. The military’s raison d'être is enforced by maintaining an aggressive stance towards India, while pursuing economic development through whatever other means are available. As long as Pakistan’s military stays influential its stance towards India will be hostile. And as long as Pakistan’s economy remains weak (Chart 16), its reliance on China will remain meaningful (Chart 17). Chart 16Pakistan: High Military Influence, Low Economic Vigor ​​​​​​ Chart 17China & Pakistan: Iron Brothers?​​​​​​ Chart 18Indians View China And Pakistan Negatively   China also benefits from its alliance with Pakistan because it provides an alternative entry point into India and access to the Indian Ocean. Fundamental Distrust: For reasons of history, Indians harbor a negative opinion of both Pakistan and China (Chart 18). This factor reinforces the first point that any Indian administration will see limited political dividends from developing a long-term alignment with China or with Pakistan. Bottom Line: If any Indo-Chinese détente materializes owing to harsh US sanctions, which we do not expect, the result will be temporary. America has limited incentives to push India towards the Sino-Russian camp. More importantly, China and India will stay entangled in a strategic conflict for reasons of both history and geography. Investment Conclusions Chart 19Sell India Tactically But Buy India On A Strategic Horizon The historic Indo-Russia relationship will weaken over the next few years as India and Russia explore new alignments with USA and China respectively. The relationship may not collapse entirely but has limited basis to grow given Russia’s declining geopolitical clout. Indo-American economic interests are set to deepen not just for reasons of security. India may consider looking for alternatives to Russian arms in the American defense industry while American Big Tech will be keen to grow their footprint in India. With India set to cleave to America, a country whose geopolitical power remains unparalleled today, we reiterate our constructive long-term investment view on India (Chart 19). However, tactically we remain worried about near-term geopolitical and macro headwinds that India must confront. China will strengthen relations with Russia over the next few years. It needs Russia’s help to execute its Eurasian strategy and to diversify its sources of fuel supply, over the long run. Given that the US and its allies will be engaged in a conflict with China over a strategic horizon, we reiterate our strategic sell call on China. Tactically we are neutral on Chinese stocks, given that they have already sold off sharply in accordance with our views over the past two years. In view of both these calls, we urge clients with a holding period mandate of more than 12 months to reduce exposure to Chinese assets and increase exposure to Indian assets. We also recommend investors go strategically long Indian tech / short Chinese tech. This pair trade is likely to keep rising on a secular basis.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com 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

Special Report

Executive Summary Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Global semiconductor stock prices are vulnerable to the downside over the next three to six months. The global semiconductor industry has entered a cyclical slump. Demand for semis faces headwinds this year. The pandemic boom in goods (ex-auto) consumption in developed economies is likely over. Plus, households’ disposable income in these economies is contracting in real terms. In China, ongoing lockdowns are depressing household income, which will limit their discretionary spending. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point.      Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will be looking to recommend buying semiconductor stocks when a more material deceleration in semi companies’ revenue and profits are priced in. Feature Chart 1Semi Stocks Have Been Selling off Despite Strong Revenues A small divergence between global semiconductor sales and semi stock prices has opened up (Chart 1). Although global semiconductor sales have been super strong, global semiconductor stock prices peaked in late December and have since declined by 23%. We believe the global semiconductor industry is entering into a cyclical slump. The demand for PCs/tablets/game consoles/electronic gadgets as well as commercial computers and servers – and with them semiconductor sales/shipments – had surged in the last two years.  Behind this boom was the significant increase in online activities stemming from pandemic-related lockdowns. However, these one-off factors have largely run their course. Global semiconductor demand growth currently faces headwinds and is set to slow meaningfully in H2 this year. We expect more downside in global semiconductor stock prices over the next three to six months. The five previous cyclical downturns in the global semiconductor sector resulted in share price declines that were greater than the current 23% drawdown (Table 1). Also, in four of these five cycles, the duration of the peak-to-trough period exceeded the current 3.5 months of decline from the December peak. Nevertheless, the structural outlook for global semiconductor demand remains constructive due to the increasing adoption of the 5G network, electric vehicles, data centers and IoTs. We are waiting for a better entry point later this year. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market Near-Term Demand Headwinds Chart 2Global Semis Sales Have Diverged From Global Manufacturing Cycle There has been a remarkable divergence between world semi sales and the global business cycle (Chart 2). The US ISM manufacturing new order-to-inventory ratio, a barometer of the global business cycle, dropped below 1, signaling a slowdown in US manufacturing in the coming months (Chart 2, top panel). Critically, the volume of China’s semiconductor imports started to contract recently and the growth of Chinese imports from Taiwan also plunged (Chart 3). China is the world’s largest semiconductor consumer, accounting for 35% of global semiconductor demand. The slowdown in the country’s chip demand does not bode well for the global semiconductor market. We expect the growth of semiconductor sales in all regions to decelerate considerably this year (Chart 4). Chart 3China's Semis Import Volumes Are Contracting Chart 4Semiconductor Sales Value Growth Across Regions   First, the one-off boost to demand for goods in general, and electronic devices in particular, due to global pandemic lockdowns has largely run its course. Chart 5The Pandemic Boom In PC Sales Is Largely Over Traditional PCs and tablets: Demand for traditional PCs1 and tablets surged in the past two years. This was due to the significant increase in online activities, such as working from home, business, education, e-commerce, gaming and entertainment. According to the International Data Corporation (IDC), after two consecutive years of strong growth, global traditional PC and tablet shipments experienced a 5% contraction in volume terms in 1Q2022. In addition, computer production in China – the world’s largest computer producer and exporter – also showed a significant growth deceleration (Chart 5). These data indicate that the pandemic boom in PC sales is largely over. Server demand: Another major contributor to the boom in semi demand was from the server sector. The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers to run on. However, demand growth for the server sector is also set to decelerate slightly. According to TrendForce Research, global server shipment growth will slow from over 5% year-on-year in 2021 to 4-5% this year. The global server sector and the traditional PC/tablet sectors together account for about 22% of global chip demand, based on the data from the IDC. Second, automobiles and consumer electronic goods (e.g., smartphones and home appliances), – which together account for about 42% of global semiconductor demand – will weaken this year. Both ongoing lockdowns in China and the surge in commodity prices due to the Russia-Ukraine war will exacerbate inflationary pressures and create major headwinds to household disposable income in real terms and discretionary spending around the world. Hence, global consumers will remain cautious in their spending on discretionary goods. For example, China’s household marginal propensity to consume proxy dropped to a 15-year low (Chart 6, top panel). This will translate to constrained household spending this year, leading to weaker sales in consumer electronic goods and automobiles (Chart 6, middle and bottom panel). Similarly, US real household consumption of goods ex-autos is likely to experience a mean reversion this year (Chart 7, top panel). After having bought the sheer number of goods (ex-autos) in the last two years, US consumers are likely to shift their spending towards services. Chart 6China: Consumer Spending Will Continue Disappointing​​​​​​ Chart 7Beware of A Mean-Reversion In US Real Household Consumption Of Goods ex-Autos   Plus, very high headline inflation is eroding US consumers' purchasing power (Chart 7, bottom panel). The relapse in DM goods demand will hinder the global semiconductor industry. There are already some signs of a slowdown in consumer demand. Apple was reported to have reduced its orders for its recently released iPhone SE by 20% and cut orders for AirPods by about 10 million units due to weaker-than-expected demand.2 Notably, global smartphone sales have been – and will remain – stagnant due to their longer replacement cycle.3 Chart 8Semi Shipments-To-Inventory Ratios Are Falling In Korea And Taiwan Third, inventory stockpiling also contributed to last year’s strong semiconductor sales. The length and intensity of the chip shortage which started in H2 2020 caused a broad range of customers – including the manufacturers of smartphones and other consumer electronics – to order more than they need. This inventory stockpiling caused forward inventory days for customers of semi producers to increase by 28% from last quarter to 50 days, which is near peak inventory levels experienced in the last cycle. Businesses will likely start drawing down their stockpiles, rather than increasing their semiconductors orders this year. This will also reduce semiconductor demand on the margin. The semiconductor shipments-to-inventory ratios from Korea and Taiwan have been falling, corroborating the cyclical downturn in the Asian semi industry (Chart 8). Bottom Line: We believe the global semiconductor sector has entered a cyclical slump. The sector’s sales are facing plenty of headwinds, and its growth will decelerate considerably this year. What About The Supply Shortage? The semiconductor industry has been known for its cyclicality. Periods of shortage have been followed by periods of oversupply. The latter led to declining prices, revenues, and profits for semi producers. Hence, massive expansion plans announced by the major players have indeed raised fears that the supply shortage will turn into a supply glut down the road. The global semiconductor shortage in place since late 2020 has been eased to some extent and is set to diminish considerably later this year and next year. Both a moderation in demand growth and an increase in new capacity will likely mitigate the supply tightness meaningfully. It takes about 18-24 months on average to build a new semiconductor fabrication plan. According to estimates from the Semiconductor Industry Association (SIA), the global semiconductor industry added 4 million wafers per month of manufacturing capacity between January 2020 and January 2022. 75% of this new manufacturing capacity had already come on-line as of October 2021. IC Insights also reported global installed wafer capacity increased 6.7% in 2020 and 8.6% in 2021. It also projected the capacity expansion to be 8.7% in 2022. In comparison, the annual growth rate in global installed wafer capacity was only 3.2% in 2019. Last June, industry organization SEMI estimated that construction on close to 30 new fabs will start by the end of 2022.4 Mainland China and Taiwan added the greatest number of new fabrication plants, followed by the Americas. In addition the world’s top three chip makers (TSMC, Intel and Samsung) all raised their capex plans significantly for this year (Box 1). On the whole, according to IC Insights, worldwide semiconductor capex will likely jump by 24% in 2022 to a new all-time high of $190.4 billion, up 86% from just three years earlier in 2019. BOX 1 Top 3 Chip Makers: Massive Capex Expansion Ahead TSMC doubled capex from nearly US$15bn in 2019 to US$30bn in 2021 and set aside US$40-44bn for 2022, a 33%-47% boost year-on-year. In mid-2021, Samsung’s chip manufacturing unit increased its capex plans until 2030 from US$115bn (about US$12.8 bn annually) to US$151bn (about US$16.8 bn annually), a 31% increase year-on-year. Intel increased its capex from US$14.5 billion in 2020 to $18-19 billion in 2021. This number jumped to US$25-28 billion for 2022, a 39-47% lift year-on-year. In general, massive capex at a collective level will be negative for share prices of semi producers. Announcements of capex expansion, which increase an individual company’s production capacity, could be perceived as a positive for that company. Yet, rapid capacity expansion is typically negative for the overall sector as it often leads to lower prices and profitability down the road. Chart 9Aggressive Collective Capex Ultimately Hurts Semis Stocks Given that the collective capex for the global semiconductor sector has expanded substantially, the odds of an oversupplied semiconductor market have increased. This shift will likely weigh on semiconductor stock prices (Chart 9). Bottom Line: The global semiconductor supply-demand balance is likely improving (demand is slowing and supply is rising). Massive capital spending plans will inevitably raise concerns about an eventual supply glut in the global semiconductor industry. This will weigh on global semiconductor share prices in the coming months. Taiwanese And Korean Semi Stocks Odds are that Taiwanese and Korean semi stock prices will continue falling in absolute terms. Interestingly, since early 2021 TSMC and Samsung share prices have exhibited different price patterns vis-a-vis the global semiconductor stock indexes (Chart 10). TSMC had double tops in the past 15 months and has dropped 30% in USD terms from its January peak despite posting substantial revenue growth (Chart 11, top panel). Chart 10TSMC And Samsung Stock Prices: Do Not Catch A Falling Knife Chart 11Semi Stocks in Asia: Share Prices Lead Corporate Revenues Share prices of Korean DRAM producers (Samsung and Hynix) are down over 30% in USD terms from their early 2021 peak, frontrunning the decline in our DRAM revenue proxy (Chart 11, bottom panel). In addition, even though Samsung released better-than-expected business performance for the first quarter last Thursday, it still failed to attract buyers. Both cases –TSMC and Samsung –signal that robust revenue/earnings are no longer enough to trigger a rally in semiconductor share prices. This suggests that the market is forward-looking and foresees a poor outlook. Chart 12Taiwan's New Orders-To-Client Inventories Ratio Suggests The Downturn Is Not Yet Over A slowdown in demand will lead to a deceleration in both companies’ revenue growth and profits. For TSMC, the smartphone sector still accounts for 44% of the company’s revenue. Hence, a risk is that global smartphone sales contract this year due to longer replacement cycles5 and constrained household spending as inflation curbs their purchasing power. In such a case, TSMC’s sales growth will disappoint, and the stock will likely drop toward $80 (Chart 10 on page 9). Taiwan’s new orders-to-client inventories ratio for semiconductors points to lower semi stocks in this bourse (Chart 12). For Samsung, signs of a slowdown in demand are already emerging in memory chips, reflecting slower sales, primarily of PCs. Moreover, TrendForce expects average overall DRAM pricing to drop by approximately 0-5% in 2Q22 due to marginally higher inventories and weakening demand. Equity Valuations And Investment Conclusions Chart 13Multiples Of Global Semis Stocks Are Still Elevated The global semiconductor stock index in USD terms has declined by 23% from its recent peak. The still-elevated multiples of semiconductor stocks suggest that there is more downside ahead in absolute terms (Chart 13).  One of the reasons that semi stocks have fallen could be their de-rating amid rising US bond yields. Having rallied tremendously in the past 10 years, global semis had become one of the most expensive industry groups worldwide. As a result, higher US bond yields are causing multiple compression for global semis (Chart 14). The closest comparison for the current episode is probably the 2016-2018 boom-bust cycle (Chart 15). During this period, the massive stimulus in China and the adoption of 4G smartphones/tablets had pushed up semiconductor share prices. In 2018, after the one-off adoption/replacement cycle ran out of steam, semi stocks dropped by nearly 30% amid slowing demand and rising global bond yields. By comparison, the one-off surge in global semi demand in 2020-2021 was much larger than the one in 2016-2018. Also, global semi stocks have rallied by much more and have become more expensive now compared with the 2016-18 episode. We expect a mean reversion in demand to lead to a slightly larger decline in global semi stocks than in 2018. This means that there is still about 15-20% more downside from the current level. As to allocation to semi stocks within an EM equity portfolio, we recommend maintaining a neutral allocation to Taiwan and reiterate an overweight stance on the KOSPI. These are relative calls, i.e., against the EM benchmark. We remain negative on their absolute performance. Chart 14Higher US Bond Yields = Multiple Compression For Global Semis Stocks Chart 15A Comparison With The 2016-2018 Semi Rally And Selloff Given that Korean stocks in general, and Samsung in particular, have already underperformed, further downside in their relative performance will be limited. As to the Taiwanese overall equity index and TSMC, share prices remain elevated relative to the EM benchmark. Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We will be looking to recommend buying semiconductor stocks after a more material deceleration in semi companies’ revenue and profits gets priced in. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1    Traditional PCs are comprised of desktops, notebooks and workstations. 2     https://asia.nikkei.com/Spotlight/Supply-Chain/TSMC-says-demand-for-sma… 3     https://www.wsj.com/articles/good-chip-results-wont-be-good-enough-1164… 4     https://asia.nikkei.com/Spotlight/Supply-Chain/Chipmakers-nightmare-Wil… 5     https://www.cnet.com/tech/mobile/getting-a-new-iphone-every-2-years-is-…