Emerging Markets

Highlights Monetary Policy: The Fed will keep rates at the zero bound at least until inflation is above 2% and it will maintain an accommodative policy stance until long-dated TIPS breakeven inflation rates move above 2.3%. Remain overweight spread product versus Treasuries and stay in nominal yield curve steepeners. Bond Yields & The Dollar: US dollar weakness will be bearish for bonds during the next 6-12 months. As long as the global economic recovery is maintained, the dollar will weaken further and bond yields have room to rise. EM Sovereigns: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio, with the exception of Mexico. Economy: August’s poor retail sales figures strengthen our conviction that further fiscal stimulus is required to sustain the economic recovery. Our base case outlook is that Congress will deliver that stimulus in the coming weeks, and that yields will be higher in 6-12 months. But the risk of no deal is too great to ignore. Keep portfolio duration close to benchmark for now. Fed Adopts Explicit Forward Guidance, But Leaves Many Questions Unanswered Chart 1Fed And Markets Agree: No Rate Hike Until 2024 Following last month’s adoption of an average inflation targeting regime, the next logical step was for the Fed to translate its new policy framework into more explicit forward rate guidance.1 The Fed took that step at last week’s FOMC meeting by adding the following language to its post-meeting statement: The Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.2 Chart 2A Long Way From 2% The new guidance says that the funds rate will not rise off the zero bound until three criteria are met: The labor market must be at “maximum employment” Inflation must be at or above 2% Inflation must be “on track to moderately exceed 2%” Notice that the criteria of “maximum employment” and inflation that “moderately exceeds 2%” are quite vague. In fact, Fed Chair Powell stated in his post-meeting press conference that “maximum employment” refers to a range of different labor market indicators, not just the unemployment rate. He also refused to provide more detail on how much of an inflation overshoot would qualify as “moderate”. This means that, practically, the only actionable information that the Fed gave investors is the promise that the funds rate won’t rise at least until inflation is at or above 2%. This is important info that can be easily visualized on a chart (Chart 2). We can plainly see that core inflation has a long way to go before it reaches the Fed’s target, and also that the Fed will not be making the same hawkish policy mistake it made in 2015, when it lifted rates with year-over-year core PCE inflation at 1.2%. Monetary policy will remain accommodative and supportive for risk assets until TIPS breakeven inflation rates return to well-anchored levels. For their part, FOMC participants don’t expect inflation to reach the 2% target for quite a while. The median participant doesn’t see core inflation reaching 2% until sometime in 2023, and only 4 out of 17 participants expect to lift rates before 2024. This is consistent with market pricing. The overnight index swap curve doesn’t price-in a full 25 basis point rate hike until September 2024 (Chart 1). Investment Implications We know that the Fed wants inflation to overshoot 2% for some period of time. Now, based on last week’s new guidance, we also know that no rate hikes will occur until inflation is above 2%. However, we still don’t know how much or how long of an inflation overshoot the Fed is targeting. For this reason, we think investors would be wise to keep in mind that the goal of the Fed’s new framework is to ensure that inflation expectations return to well-anchored levels. Our sense is that “well anchored” can be defined as a range of 2.3% to 2.5% for long-maturity TIPS breakeven inflation rates (Chart 3). Chart 3Inflation Expectations: The Fed's Real Target We see monetary policy staying accommodative and supportive for risk assets until TIPS breakeven inflation rates reach those levels. This argues for maintaining an overweight 6-12 month allocation to spread product versus Treasuries. This also argues for staying overweight TIPS versus nominal Treasuries, and for positioning in nominal yield curve steepeners. The Fed will maintain its firm grip on the front-end of the curve for a long time yet, but the market will eventually start to price-in liftoff at the long end. A Weaker Dollar Will Be Bearish For Bonds, Bullish For EM Sovereign Spreads The broad trade-weighted US dollar is 8% off its 2020 peak, and the BCA house view is that the dollar will weaken further during the next 12 months. This section explores what that will mean for Treasury yields and for USD-denominated Emerging Market Sovereign debt. The Dollar And Treasury Yields Bond yields and the dollar are intimately related, but the relationship is more complex than a simple coincident correlation. We like to think of the relationship as a feedback loop between the exchange rate, bond yields and global economic growth (Chart 4). Chart 4The Dollar/Bond Feedback Loop Since the dollar is currently falling, let’s start at the left-hand side of the feedback loop shown in Chart 4. The dollar’s current weakness is both a reflection of improving global economic growth and a catalyst for even stronger global economic growth. It is reflective because, compared to the rest of the world, the US is a large and stable economy. Firms and investors will respond to a positive global growth environment by sending capital overseas in search of higher returns. This puts downward pressure on the dollar. Dollar weakness also boosts global economic growth by making US dollars cheaper to acquire in global markets. This is particularly important for emerging markets, where a weaker dollar gives policymakers leeway to boost domestic growth via easier monetary and fiscal policies, without sacrificing the purchasing power of their currencies. Higher yielding countries tend to have less economic slack than low yielders. Moving to the top of the loop, stronger global economic growth (aka global reflation) will obviously impart upward pressure to bond yields. What’s less obvious is that US yields will rise by more than yields in the rest of the world. Chart 5 shows 3-year trailing yield betas for several major developed bond markets. Notice that the highest-yielding countries (US and Canada) also have the highest yield betas. This means that their yields rise the most when global bond yields are rising and fall the most when global bond yields are falling. This pattern holds because higher yielding countries tend to have less economic slack than low yielders. In other words, the high yielders will be quicker to price-in eventual monetary tightening when global growth is on the upswing. The high yielders also have more room to fall when growth ebbs. Chart 5High Yielding Bond Markets Are The Most Cyclical Initially, global reflation sends US bond yields higher. But eventually, US yields will become too high relative to the rest of the world. At that point, the US dollar will respond to wide interest rate differentials and start to appreciate. This dollar appreciation will eventually lead to slower economic growth (“global deflation”), which will cause bond yields to decline. Finally, just as US bond yields rise more than non-US yields during the global growth upswing, they also fall more during the downswing. Eventually, the tightening rate differentials lead to US dollar depreciation and the cycle repeats. Where are we situated in the cycle right now? As of today, we contend that rate differentials between the US and the rest of the world have fallen a lot, and we are at the stage of the loop where the dollar is weakening in response (Chart 6). This means that dollar weakness has further to run, and we should expect that it will eventually lead to global reflation and higher US bond yields. In fact, Chart 7 shows that sentiment toward the dollar has already soured considerably, and that increasingly bearish dollar sentiment has a habit of leading to higher bond yields. Chart 6Rate Differentials Signal More Downside For Dollar Chart 7Bearish Dollar Sentiment Leads To Higher Bond Yields Eventually, US yields will rise too much compared to the rest of the world and the dollar’s depreciation will stop. But for now, dollar weakness is bearish for bonds. The Dollar And USD-Denominated EM Sovereign Spreads USD-denominated Emerging Market Sovereigns are an obvious sector that benefits from a weaker US dollar. Since the debt is denominated in US dollars but the country collects tax revenues in its local currency, any dollar weakness makes the issuer’s debt easier to service, and presumably leads to tighter sovereign spreads. Most of the dollar’s weakness this year has come against other developed market currencies, not against EMs. Despite this relationship, we are reluctant to advocate an overweight allocation to EM Sovereigns. First, most of the dollar’s weakness this year has come against other developed market currencies, not against EMs (Chart 8). Chart 8EM Currencies Have Lagged Second, an environment of US dollar depreciation and global reflation is also a good environment for US corporate bonds and, with a couple exceptions, US corporate spreads are more attractive than EM Sovereign spreads. The vertical axis of Chart 9 shows the spread differential between the USD-denominated bonds of several EMs relative to a position in US corporate bonds with identical duration and credit rating. After differences in duration and credit rating are considered, only Turkey, Colombia, South Africa, Mexico and Russia offer a spread advantage over US corporate credit. The horizontal axis of Chart 9 shows each country’s export coverage of its foreign debt obligations. Greater coverage should make that country’s currency less vulnerable to depreciation, and vice-versa. In our view, the Turkish, Colombian and South African currencies are simply too risky. But Mexico and Russia present more interesting opportunities. Chart 9EM Sovereign Spread Over US Credit Versus Currency Vulnerability We recommend an overweight allocation to Mexican Sovereigns because they offer a spread advantage relative to US corporates, and because the currency has been on an appreciating trend versus the dollar that still has further to run to get back to pre-COVID levels (Chart 8, panel 3). Despite the small spread pick-up, we would avoid Russian Sovereigns, at least until after the US election. The Ruble has been depreciating versus the dollar since mid-year (Chart 8, bottom panel) and a Democratic sweep in November will likely lead to the imposition of fresh US sanctions on Russia.3 Bottom Line: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio. Despite the outlook for US dollar weakness, US corporate bonds offer more value and will deliver better returns. Mexican debt is the sole exception. Mexican spreads are attractive and the peso has room to appreciate. Economic Update: Signs Of Weakness In Consumer Spending  Chart 10A Warning From Retail Sales In last week’s report, we warned that without a fresh round of fiscal stimulus, the 12-month outlook for US consumer spending is dire.4 Then, last Wednesday, we received August’s retail sales figures – the first month of spending data since the expiry of the CARES act’s income support provisions – and learned that spending contracted on the month, after having rebounded sharply in May, June and July when the CARES act was in full force (Chart 10). There had been some hope that US consumers might be able to compensate for the lack of income by deploying some of the savings they had built up in the spring, thus keeping spending at decent levels for at least a few months. But August’s weak retail sales report challenges that narrative, as does the fact that consumer sentiment surveys have not improved very much since April (Chart 10, panel 3). Still low consumer sentiment suggests that households remain cautious and that they will be reluctant to spend with the same abandon they showed prior to COVID. We also note that, while weekly initial jobless claims continue to fall, the pace of improvement has significantly tapered off during the past few weeks and initial claims are still coming in about 4 times higher than they were last year (Chart 10, bottom panel). Bottom Line: While significant strides have been made, the US economy is not out of the woods. Our base case view is that Congress will deliver sufficient household income support in the coming weeks, allowing the economic recovery to continue. But the risk that they won’t is too great to ignore. Keep portfolio duration close to benchmark for now, and position for higher yields on a 6-12 month horizon via less risky duration-neutral yield curve steepeners. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed examination of the Fed’s new average inflation targeting regime please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 3 Please see Geopolitical Strategy / Emerging Markets Strategy Special Report, “US-Russia: No Reverse Kissinger (Yet)”, dated July 3, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Lower-income Chinese households are overly indebted, while higher-income groups hold too much cash.  Apart from real estate and cash, ordinary Chinese people have few choices in allocating their assets. Household consumption has not been stimulated to the same degree as during previous cycles. The recently announced “dual circulation” strategy may not be an imminent solution to China’s chronic high debt, high savings issue. However, an acceleration in policy actions of late may be steps in the right direction in encouraging Chinese households to spend more domestically and to invest in domestic companies. Feature The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably, the pace of consumer spending growth started decelerating almost two years before the pandemic struck the country (Chart 1). Chart 1Chinese Consumers Scaled Back Spending Before COVID-19 Chart 2Chinese Households Save Cash, Lots Of It Furthermore, Chinese households have added a total of 8.3 trillion yuan to their bank deposits so far this year, or about 8% of China’s 2019 national output (Chart 2). Outsized cash savings helped to cushion consumers from the pandemic’s economic impact and will support a consumption rebound as China’s economic and service sector activities continue to normalize. However, an acceleration in cash savings and decline in households' propensity to spend would not bode well for a structurally balanced economic growth model. Chinese policymakers recently announced a new “dual circulation” strategy, and fast-tracked several policy actions to facilitate easier access for households to consume luxury goods and participate in the domestic capital markets. The policies will likely have a small, near-term economic impact. But in the long run they can set up a trend which will benefit domestic consumption growth and better utilize the substantial cash holdings among Chinese domiciles. Too Much Saving Or Too Much Debt? While Chinese households have excessive cash savings, they also carry too much debt. Families hold a total of 55 trillion yuan of debt, or 94% of their aggregate disposable income. The debt-to-income ratio is fast approaching that in the US (Chart 3). At the same time, their debt-to-cash ratio, on an aggregate basis, is extremely low relative to other countries (Chart 4). Chart 3Chinese Households Are Almost As Leveraged As The US Ones Chart 4But They Also Hold Way More Cash Than The US Ones Chinese people are net savers, and only about 30% of Chinese families are in debt, which is less than half of the number in the US (Chart 5 and Table 1). This means approximately two-thirds of households have a positive net worth. On the other hand, Chinese consumers who borrow are deeply indebted. China’s median debt-to-income ratio is around 180%, according to recent surveys, with the lowest income group carrying debt loads that are a whopping 12 times their income (Table 2). Chart 5Two Thirds Of Chinese Households May Be Debt Free Table 1Chinese Household Credit Participation Rate Table 2Chinese Household Debt-To-Income Ratio, By Income Groups Bottom Line: Lower-income groups are heavily indebted, while higher-income families have too much cash on hand.  Too Few Investment Choices Chinese households hold a majority of their assets in real estate investments and cash. The former has seen prices skyrocket, crowding out the discretionary spending capability of lower-income families.1 On the other hand, cash and cash equivalents such as CDs, currently earn a meager 2%. The obsession with holding properties has been reinforced by the astonishing pace of money creation in the past 10 years (Chart 6). Despite sky-high prices, real estate has been the main counter-inflation measure in China. According to the 2019 China Household Finance Survey, nearly 60% of Chinese household debt is in home loans, which is about twice the number compared with the US. Furthermore, the share of second-home loans (as a share of all residential housing loans) escalated from less than 30% in 2011 to 65.9% in 2018, greatly exceeding the share of first home loans. Post-pandemic demand for housing has remained strong and household debt is still expanding faster than nominal disposable income growth (Chart 7). Even though lower-income groups have significantly scaled back on mortgages, given that such a large portion of household assets is tied up in real estate means that any deflation in property prices will have a devastating impact on consumer net worth (Table 2 on Page 4). Consequently, discretionary spending by even middle- and high-income households will be curtailed. Chart 6Helicopter Money In China Chart 7Household Credit Still Expands Faster Than Income Growth In addition to the long-standing issue of a lack of social safety net, Chinese families’ high cash holdings are due to a lack of investment alternatives. Even though the country has the world’s second largest equity market by value, only 11% of Chinese residents participate in the stock market, a dismal number compared with a 50% equity market participation rate in the US.2 The low participation rate is not surprising: over a 10-year time span, returns on cash have more or less matched returns on A-share stocks (Chart 8). The extreme volatility in Chinese equities has curbed citizens’ enthusiasm to participate in the market. Chart 8Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Bottom Line: Chinese household profile is characterized by the heavy concentration of cash among higher-income households and the elevated indebtedness of low-income ones stemming from sky-high real estate prices. Is The New “Dual Circulation” Strategy A Solution? Consumer spending in China has been growing rapidly in the past 20 years, at a rate roughly in line with the increase in disposable incomes. Income and consumption growth peaked in 2007 but since then has been dwindling along with falling productivity (Chart 9). Cyclically, the consumption recovery will bring its growth rate back to the pre-COVID 19 level. Demand for real assets and consumer durable goods has been strong after the pandemic (Chart 10). Even the demand for luxury goods has made a comeback.3   Chart 9Chinese Consumption, Income, And Productivity Growth Chart 10Chinese Consumption Is Recovering However, for consumption to sustain an expansion rate similar to the past decade, China’s productivity growth must accelerate and, in turn, boost per capita income growth. Conversely, the country would need to maintain a high rate of credit expansion to generate enough economic growth and inflation to spur strong nominal income growth (Chart 11). Credit expansion can boost nominal growth but it is productivity growth that generates per capita income growth.  Chart 11Household Credit Impulse Has Been Muted Since 2018 The recently announced “dual circulation” strategy and an acceleration in policy actions by the Chinese leadership may suggest a different path than in previous cycles. Policymakers seem to focus on changing and upgrading the composition of China’s existing consumption base rather than boosting consumption growth through monetary stimulus in the household sector. Moreover, they are looking to change the configuration of family savings and investments. Our colleagues at BCA Research's Emerging Markets Strategy have stated that improvements in the turnover of consumers’ bank deposits and cash, if successful, may allow China to slow its overall credit and money growth but still sustain a steady nominal GDP growth rate.4 Details of the new “dual circulation” strategy are sparse, but we think the following developments in the past couple of months are relevant to investors: Bringing home overseas consumption and reducing the service trade deficit: China fast-tracked policies that target duty-free shopping venues, a strategy designed to lure Chinese consumers back to the domestic market. Beijing made unprecedented moves to invigorate Hainan province’s duty-free shopping and issue new licenses to allow companies to operate duty-free shops both online and offline. In the past five years, Chinese residents have spent an average of 250 billion USD annually shopping overseas. Purchases of duty-free products overseas account for a small share of China’s 12.5 trillion yuan retail industry. Nonetheless, repatriating some overseas consumption would allow China to not only narrow its service trade deficit, but also to create more service businesses and jobs internally (Chart 12).  The move signifies that Chinese policymakers are committed to change domestic consumer spending behavior while upgrading the retail industry. However, we remain cautious on retail stocks in the next 6 to 12 months. Retail growth has not yet rebounded to its pre-pandemic level, and the valuations in retail-sector stocks are overly stretched (Chart 13). Chart 12China Has Been Running A Huge Service Trade Deficit Chart 13Retail Sector Valuations Are Elevated   Increasing households’ equity holdings in domestic companies: Direct financing in the form of equities and corporate bonds only accounts for about 15% of total social financing, compared with 65% in bank lending. Chinese corporations rely mostly on bank loans and retained earnings, whereas US companies are heavily dependent on equity financing. The “dual circulation” strategy encourages more direct financing for SMEs, science and technology companies. It also explicitly calls for a greater household participation in the financial markets, which would guide more savings into domestic capital markets. In the past few months, the government has accelerated financial market reforms aimed at providing easier access for corporations and individuals to domestic equity markets. In the first half of this year, 119 companies went public in Shanghai and Shenzhen; these companies raised about 140 billion yuan, which was more than double the amount from a year ago. New individual investor accounts on the Shanghai exchange rose by 30% (year to date) from a year ago. Notably, both the IPO and household participation rates resemble the onset of the boom-bust cycle in 2015. However, this time Chinese regulators have been much more vigilant and restrictive about over-leveraging, acting early and removing some steam from retail investor rush (Chart 14). Chart 14Chinese Authorities Have Less Tolerance For Equity Market Leverage Chart 15Chinese Stocks Still Have Upside Potentials It remains to be seen whether the authorities will be able to boost and sustain consumer confidence in the domestic equity market. The efforts by the Chinese government will either succeed by securing a gradual and healthy secular bull market, or they will fail by triggering another boom-bust cycle in the domestic market. Either way, investors should stay overweight Chinese stocks on at least a 6-month horizon (Chart 15).   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Households in the bottom 40 percentile in China have no discretionary spending capacity. “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 2投保基金公司《2019年度全国股票市场投资者状况调查报告》and Pew Research Center. 3China ‘Revenge Spending’ Offsets Plunge in Luxury Goods Revenue 4Please see Emerging Markets Strategy Special Report "China’s Rebalancing: Will Consumers Rise To The Challenge?" dated August 29, 2019, available at ems.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights China’s surge in refined copper imports allows it to cover a structural short position it has in this critical commodity – mostly in its unrefined state – and ensures the stimulus being deployed to revive its economy ahead of the 100th anniversary of the founding of the Communist Party in July will not falter due to a lack of basic raw materials (Chart of the Week). We expect continued resilience in commodities generally into 2021 – particularly in base metals, iron ore and crude oil – as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its robust economic growth. As with oil, we expect copper demand will benefit from a weaker USD and stronger global trade. The odds of a COVID-19 vaccine being available by year-end or early 2021 remain favorable, which also will support a revival in demand.1 We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 to finish at $3.15/lb. We would not be surprised by higher prices, and are, therefore, getting long December 2021 COMEX copper at tonight's close. Feature The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. COVID-19 may have derailed the Communist Party’s realization of the “Chinese Dream” this year, wherein the leadership vowed real per-capita GDP would double in the decade ending in 2020, but it is unlikely to diminish the celebration of the Party’s 100th anniversary in July.2 Chart of the WeekVol Falls As Know Unknowns Are Resolved The global commodity-demand destruction caused by the COVID-19 pandemic depressed the prices of commodities generally, particularly those which China is structurally short – e.g., copper, iron ore, oil and natural gas. As terrible as the pandemic has been in human terms, it has allowed Chinese firms and the State Reserve Bureau to sharply increase imports of refined copper, which rose 34% in the January-to-July period to 2.5mm MT amid such low prices, which bottomed at $2.10/lb in late March and now are trading above $3.00/lb.3 China accounts for more than 50% of global refined copper consumption and ~ 40% of refined production (Chart 2).4 Chart 2China Dominates Metals Consumption The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. Global copper ore and concentrate supply fell ~ 3% y/y in 2Q20, led by a 28% decline in Peru’s mine production, according to the World Bureau of Metal Statistics (Chart 3). This was a result of containment policies that limited mining activities to slow the pandemic’s spread in Latin America. In Chile, COVID-19 cases stabilized in recent months at around 100 per million people (Chart 4). In Peru, cases have been declining since August, but from an elevated level. Supply is expected to recover rapidly as these economies reopen, but further mine disruptions remain a risk. Chart 3Peru's Copper Ore Supplies Recovering Chart 4COVID-19 Copper Supply Risks Falling Commodity-Demand Indicators Move Higher we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. Global central banks and government stimulus unleashed in the wake of the COVID-19 pandemic, combined with a depreciating US dollar, pushed our commodity-demand indicators higher over the last few months (Chart 5). This supported copper prices, which are up 42% since their March 23 low. Moreover, the pickup in economic activity in China’s major trading partners provided further support to copper demand, given that ~ 17% of China’s copper consumption comes from exports of products containing copper (Chart 6).5 Chart 5Commodity Demand Is Reviving Chart 6Expect Chinese Employment Gains As Economy Continues To Recover For the balance of 2H20, we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. These are key factors driving our positive view on metal – especially copper – prices. Communist Party’s 100th Anniversary Will Boost Commodity Prices China’s buying spree for commodities it is structurally short – particularly copper, iron ore and oil – minimizes the risk fiscal and monetary stimulus deployed to revive its economy will be derailed this year or next. This is particularly important next year: We expect stimulus will continue and will be hitting the economy full force in time for the Communist Party’s centennial celebrations in July. For the infrastructure and construction spending that will be spurred by the massive stimulus, this is critical to spurring employment – a key goal of the Party’s domestic harmony focus – domestic manufacturing, services, and exports (Chart 6).6 This will keep demand for copper – and commodities generally – strong into 2021, as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its world-beating economic performance. And, because stocks of critical commodities are increasing as stimulus is hitting the domestic economy next year, the risk of massively inflating prices while the county is celebrating the Party’s centennial in July – as happened following the Global Financial Crisis (GFC) – is minimized, but not completely eliminated (Chart 7). Chart 7COMEX Stocks Will Move To China That said, we still expect copper to move higher next year. In our modeling of prices, we note world PMIs, EM FX rates, the USD, also drive copper prices, in addition to those factors discussed above specific to China. We expect COMEX high-grade copper prices to end 2020 at $3.00/lb, and to average $3.11/lb next year (Chart 8). On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close, expecting 2021 to end at $3.15/lb. Chart 8Copper Prices Expected To Increase Risks To Our Copper View Geopolitical risks remain the chief threat to our bullish copper view. The US Presidential election campaign rhetoric, in particular, has turned bellicose vis-à-vis China, with President Donald Trump threatening to “decouple” economically from China if he is reelected.7 These sorts of pronouncement threaten to escalate what could now be considered a trade dispute to an all-out trade war, particularly if it includes sanctions against US firms investing in manufacturing and services in China, as Trump promises. At the limit, this would put a long-term bid under the USD, and reverse the nascent recovery in commodity demand resulting from a weaker dollar. Outright military confrontation between the US and China also is a risk, particularly as tensions in the South China Sea and the Asia-Pacific region continue. The most likely confrontation would be an escalation of hostilities resulting from a naval or aerial face-off, the number of which has been steadily increasing. The threat of a second wave of COVID-19 also remains a risk, particularly if it results in another round of lockdowns globally. That said, we believe the odds of this are very low, as the capacity to absorb another shutdown in economic activity in DM and EM economies likely has been exhausted by measures already implemented this year. It is highly unlikely any economy can afford another round of economic shutdown without triggering an economic depression. Bottom Line: China’s surge in refined copper imports allows it to cover its structural short position in the commodity, and, equally importantly, to ensure an expected revival of economic activity into 2021 – when the Communist Party celebrates its 100th anniversary – will not falter because it lacks basic raw materials. We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 prices to average $3.11/lb. On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices dipped below $40/bbl for the first time since mid-June. Prior to this move, prices had been stable in a narrow range around $43/bbl since mid-June. Pessimism is increasing re the outlook for demand, as Saudi Arabia reduced its official selling prices (OSPs) for crude delivered to Asian buyers by $1.40/bbl. The negative sentiment was exacerbated by the selloff in tech stocks that began last Thursday. WTI net speculative positions are down to 20% of total open interests vs. 22% in July, as hedge funds exit oil markets. Base Metals: Neutral The LMEX index is up 4% over the past four weeks, supported by higher metals’ consumption and imports in China. Moreover, mobility trends in Europe, Japan, and the US have begun to turn up again in recent weeks based on Apple mobility data. The recovery in China’s economic activity remains the main pillar of our base metals outlook. However, Europe, Japan, and the US still represent a non-negligible share of global metal demand (e.g. ~ 24% copper consumption). Hence, the recent uptick in mobility data is constructive for base metal prices.  Precious Metals: Neutral Gold prices are down 2% since last week, pressured by a slight increase in the US dollar and real rates. The divergence in COVID-19 cases between the US and Europe increases the risk of a short-term bounce higher if this leads to the US economy outperforming that of the EU (Chart 9). Still, mounting geopolitical risks ahead of the US election, lower-for-longer interest rates, and a resumption of the downward trend in the USD over the medium term should support gold later this year. Ags/Softs:  Underweight Soybean prices remain steady, near 2-year highs. The USDA crop progress report listed 55% of soybeans in good or excellent condition for the week ending September 6, 2020. This is a substantial deterioration compared to 66% in those categories last week and 73% at the beginning of August. Corn futures were supported by similar weak supply fundamentals. The USDA reported 55% of corn crops in good or excellent condition against 62% the previous week. Going forward, it will be important to monitor the DXY as it has been strengthening since the beginning of September and could be a headwind to these commodity prices if it breaks to the upside (Chart 10). Chart 9EU Cases Are Rising Chart 10US DXY Strengthening     Footnotes   1     Please see Lower Vol As OPEC 2.0 Gains Control, published September 3, 2020, for additional discussion of vaccine availability. 2     Please see Iron Ore, Steel Poised For Rally, which we published February 13, 2020, for a discussion of the commodity-market implications of China’s dual policy goals of doubling GDP between 2010 and 2020 and preparing for the celebration of the 100th anniversary of the founding of the Chinese Communist Party in 1921. It is available at ces.bcaresearch.com. 3    Please see China's July refined copper imports surge 90% on year boosted by open arbitrage published by S&P Global Platts September 1, 2020. 4    China also accounts for close to 50% of copper ore imports, according to he Observatory of Economic Complexity (OEC). 5    Please see The Impact of the COVID-19 Pandemic on World Copper Supply, published by the International Copper Study Group on May 21, 2020. 6    For an update of the stimulus measures and China’s economic performance, please see China Macro And Market Review published September 9, 2020, by our China Investment Strategy colleagues. It is available at cis.bcaresearch.com. 7     Please see Trump threatens to ‘decouple’ U.S. economy from China, accuses Biden of ‘treachery’ published by marketwatch.com September 7, 2020.       Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights Economic data in August point to a faster recovery in demand than in production. The service-sector recovery is picking up speed; consumption growth remains negative, but will benefit from a steady rebound in the service sector. The strong upward momentum in China’s stock prices, on the other hand, has lost some steam since the second half of July. Policy supports and improving economic fundamentals still warrant a constructive stance on Chinese stocks over the coming 6 to 12 months. Feature Both soft and hard data released over the past couple of weeks indicate that China’s economic recovery remains on track. August’s official PMI new orders sub-index continued to advance, and the official non-manufacturing PMI made the largest month-to-month improvement since March when the Chinese economy reopened. Hard economic data, such as exports and sales of homes, cars and retail goods, show that both external and domestic demand growth is strengthening.   Chart 1Chinese Stocks Taking A Breather From July's Rally, Despite Improving Economic Fundamentals Despite the economic improvement, the July rally in Chinese stocks faltered in August and into the first week of September. Although stock prices are still 12-15% higher than the end of June and continue to outperform global benchmarks, they are slightly below their mid-July peak in absolute terms (Chart 1). The pause in China’s stock market was inevitable because of the stunning pace of acceleration in early July, which saw margin lending rise to explosive levels that invited Chinese policymakers to cool the market. Last week’s corrections in the high-flying US tech stock prices also dragged down some of the Chinese tech sector's top performers. US sanctions targeting China’s tech companies may exacerbate downward pressure on the sector’s performance. Therefore, we continue to recommend that investors hold a neutral position for the next three months on Chinese tech stocks, in both absolute and relative terms. The outlook for China’s economic growth and monetary conditions supports our constructive view on the overall Chinese stocks, over a cyclical (6 -12 months) horizon. In the near term, we prefer offshore stocks outside of the tech sphere, and prefer onshore semiconductor stocks within a global semi equity portfolio. China’s “old economy” sectors, such as industrials and materials, will continue to benefit from the ongoing massive stimulus. Furthermore, the semiconductor sector has become China’s new poster child, as the country ramps up longer-term, earnings-friendly policy supports to develop its domestic semiconductor industry and counter the Trump administration’s restrictions.1  Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Tables 1 and 2 present key developments in China’s economic and financial market performance in the past month, and we highlight several aspects below: China’s NBS manufacturing PMI was essentially unchanged in August (51 vs. 51.1 in July), but details of the survey imply that what has underpinned an industrial sector improvement this year remains in place. Although the production sub-index slowed, the new orders component increased, indicating that demand is strengthening relative to supply (Chart 2). The export orders component of the manufacturing PMI and the newly released trade data are both improving, suggesting that external demand is also holding up (Chart 2, bottom panel). The steel industry’s PMI fell to 47 in August from 49.2. As noted in last month’s China Macro And Market Review,2 the consistent outperformance in production recovery relative to demand since Q1 has led to an inventory buildup and a pullback in production. Inventory destocking will likely impede China’s imports of major commodities until the laggard recovery in industrial demand sustainably outpaces production (Chart 3). Chart 2Demands Are Improving On Both Domestic And External Fronts... Chart 3...But Inventory Buildup Is Temporarily Impeding Production And Imports Chart 4Accelerating Service Sector Recovery Should Give A Boost To Consumption Despite a minor drop in the construction PMI sub-index due to heavy rains and floods in China’s central provinces, the acceleration in service activities pushed the non-manufacturing PMI to its highest level since early 2018 (Chart 4). China’s domestic COVID-19 infection rate remains low, giving rise to a rebound in service sector’s activities, such as tourism, catering, sports and entertainment. The resumption rate of theater operations reached 88% by the end of August. While the year-over-year growth rate in total retail sales of consumer goods remains negative, household purchases from larger enterprises registered a 2.2% increase in July (Chart 4, bottom panel). The normalization of activities in the service sector, coupled with the upcoming holiday season in September/October, will further support China’s household consumption recovery. China’s central bank and housing authorities have reportedly rolled out new rules to curb borrowing among overly indebted property developers. We do not expect the new directions to have a significant impact on our near-term outlook for real estate activities. Bank loans account for less than 15% of Chinese property developers’ funds, compared with down payments at 35%. Therefore, strong housing demand should more than offset any potential pullback in bank lending to property developers (Chart 5).  Despite some pullbacks in the prices of Chinese stocks of late, we do not think that the cyclical upturn in Chinese stocks has run its course. Even though the PBoC seems to have normalized its post-COVID 19 monetary policy, monetary conditions remain very accommodative and fiscal stimulus will accelerate the pace of credit expansion through Q3.3 Continued money creation should prop up both China’s economic recovery and stock outperformance, in absolute terms and relative to global benchmarks. In addition, 10-year government bond yields rose 15bps in the past month and are now 66bps above their April low. The mounting bond yields on the back of an improved economic outlook, coupled with the continued outperformance in Chinese cyclical stocks over defensives, also support our constructive view on Chinese stocks on a 6-to-12 month basis (Chart 6). Chart 5Demand Should Continue Driving Property Sector Growth Chart 6Fundamentals Are Supportive Of A Positive Cyclical View On Chinese Stocks Chinese tech company stocks suffered losses last week due to selloffs in the global equity market led by US tech stocks. Technology is at the root of the ongoing US-China struggle, which we discussed in our weekly report on Aug 12.4 Given that the MSCI China index is heavily weighted towards some of China’s tech giants (e.g.: Alibaba, Tencent and Baidu), Chinese investable stocks are more vulnerable to both gyrations in the US tech sector and the escalating tech war between the US and China. As such, we continue to recommend that investors overweight investable stocks that are exposed to China’s “old economy” sectors. An acceleration in China’s demand-side recovery and a normalization of service activities will bode well for the performance of cyclical sectors, such as industrials and materials (Chart 7). In addition, we continue to overweight Chinese onshore semiconductor stocks relative to their global peers. Despite some volatility in recent weeks, we believe the structural upcycle in the Chinese onshore semi sector will continue, driven by Chinese policymakers’ ramped-up policy initiatives to support the nation’s domestic semiconductor research and production (Chart 8). Some of the fiscal and monetary incentives such as multi-year tax exemptions and cheaper bank credits will boost the sector’s longer-term growth prospects, whereas policies like government funding support and prioritized initial public offerings will push up the sector’s near-term multiple expansion. Chart 7Stick To "Old Economy" Chinese Stocks For The Time Being Chart 8Chinese Semis On A Policy-Driven Structural Upturn     Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1, 4Please see China Investment Strategy Weekly Report "Sticking With Chinese “Old Economy” Stocks In A Widening Tech War," dated August 12, 2020, available at cis.bcaresearch.com 2, 3Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated August 5, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations