Emerging Markets

Bank Credit Analyst

Highlights The decline in the US and UK July services PMIs underscores that pandemic control measures are not the only manner by which COVID-19 impacts the services sector of the economy. A slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. The fact that highly-vaccinated advanced economies have experienced a sharp rise in new cases due to the Delta variant underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. The vaccination rate is the most obvious indicator of progress towards NAHRI, but immunity from previous infections is also an important contributor. Reasonable estimates of unreported COVID-19 infections suggest that investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Extremely easy monetary policy, pent up savings, and robust revenue growth will support economic growth and the trend in stock prices – despite the fact that analyst earnings expectations are clearly too high. The recent underperformance of China-sensitive assets has been driven by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts. Chinese stocks are now oversold and could bounce in the near-term, but we would still recommend favoring developed market equities within a global ex-US equity allocation until Chinese policy turns reflationary. Investors should continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from the Delta variant is likely to cause a near-term growth disappointment. High single-digit earnings growth, coupled with some pressure on multiples, continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks, whose outperformance is not dependent on that of EM. Value versus growth, and small caps versus large, will likely benefit from an uptrend in long-maturity bond yields. We recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Feature Chart I-1Meaningful Vaccination Progress Continues Everywhere Except Africa Over the past month, the Delta variant-driven phase of the pandemic has continued to worsen in several advanced economies, arrayed against a continual improvement in the immunity of the world’s population. Chart I-1 highlights that, outside of Africa, the share of the population that is fully vaccinated against COVID-19 is rising at a robust pace of roughly 10 percentage points per month. But in advanced economies with elevated rates of vaccination compared to the rest of the world, new confirmed cases of COVID-19 accelerated in August, driven in most cases by the Delta variant. Chart I-2 highlights that in the UK, the epicenter of the Delta surge, new cases have begun to rise again after having peaked in late July. UK hospitalizations remain low relative to what has occurred since the onset of the pandemic (panel 2 of Chart I-2), but the US has experienced a more significant rise due to its comparatively low vaccination rate. In addition, reflecting a disparity in vaccination rates within the US that we have highlighted, has a strong political dimension.1 Chart I-3 illustrates that ICU capacity utilization (relative to peak staffed ICU beds) has risen sharply in red states, back above its all-time high. ICU usage in blue states is also rising, but it remains 10 percentage points below its prior peak. Chart I-2UK Hospitalizations Remain Stable, Despite Elevated Case Counts Chart I-3Lowly Vaccinated US States Are Suffering The Most From Delta   When discussing the pandemic and its economic impact in past Bank Credit Analyst reports, we have emphasized the importance of hospitalizations as the core driver of policymaker decisions about pandemic control measures. In turn, we have focused on control measures as an important driver of economic activity because these measures clearly impede households’ ability to consume many services. Chart I-4Surging Cases Impact Services Activity, Even Without Pandemic Control Measures But Chart I-4 underscores that control measures are not the only manner by which the pandemic impacts the services sector of the economy. The chart highlights that the Markit services PMI has fallen sharply in July and August in both the US and UK economies, two countries that have few or no pandemic control measures still in place. This is strong evidence that fear and general risk aversion among some consumers is affecting services spending. Given that hospitalizations have remained relatively well controlled in the UK, this also suggests that the impact on consumer sentiment is emerging mostly from new case counts rather than from published hospitalization rates. Chart I-5 highlights that the University of Michigan's Index of Consumer Sentiment fell sharply in August to essentially a 10-year low, providing further evidence that a slowdown in Q3 growth in advanced economies from the Delta surge is now all but inevitable. Chart I-6 highlights that this has not yet been reflected in consensus expectations for growth, suggesting that near-term growth disappointments are likely. Chart I-5A Q3 Growth Slowdown Is Now All But Inevitable... Chart I-6...Which Is Not Currently Reflected In Consensus Expectations For Growth   Shifting Focus From Herd Immunity To NAHRI The fact that highly vaccinated advanced economies have experienced a sharp rise in new cases due to Delta underscores that true herd immunity, as envisioned for most of the pandemic, will likely prove elusive. This point was underscored earlier this month in public comments by the head of the Oxford Vaccine Group,2 who noted that even relatively small rates of transmission from “breakthrough cases” of vaccinated individuals means that anyone who is unvaccinated will likely be exposed to COVID-19 at some point over the coming months or years. From an economic standpoint, this may not be problematic if the spread of the disease among the unvaccinated is slow, as it would allow hospitals time to process COVID patients without risking an overrun of the system (and thus would likely not necessitate a response from policymakers). But the lack of an achievable herd immunity is clearly a risk if community transmission of the Delta variant is high among unvaccinated individuals, even in a scenario where overall vaccination rates are elevated. Consequently, investors need to shift their framework from the idea of herd immunity to that of “NAHRI”: the non-accelerating hospitalization rate of immunity. This concept is borrowed from the idea of NAIRU (the non-accelerating inflation rate of unemployment), and signifies the point at which sufficient immunity has been reached in a country – either through vaccination or past infection – that results in a stable pace of COVID-19 hospitalizations in the absence of any pandemic control measures or precautionary behavior on the part of consumers. Once NAHRI is reached with no control measures and a pre-pandemic rate of interpersonal contact, the pandemic will be effectively over. Chart I-7The US Vaccination Rate Has Picked Up Modestly One clear difficulty with this perspective is that NAHRI is unknown, making it challenging to determine how close a given economy is to a stable pace of COVID-related hospitalization. The experience of the UK over the past month, with an elevated case count yet stable hospitalizations, may suggest that they are close or approaching a stable-hospitalization immunity rate, although investors will still need to watch the UK closely over the coming weeks to confirm if this is the case. The vaccination rate is the most obvious indicator of progress toward NAHRI, and on this front the US has further to go. Chart I-7 highlights that while the pace of first doses administered in the US has risen over the past two months in response to the Delta wave, it will still take until the end of October or early November for the US to reach levels that have been attained by other advanced economies. The introduction of widespread vaccination mandates, as well as the incentive effects of vaccination passports, might raise this rate over the coming weeks. This is even more likely given the FDA's full approval of the Pfizer/BioNTech vaccine this week. But; immunity from previous infections will also contribute to reaching NAHRI, which raises the question of how many unreported COVID-19 infections have occurred since the onset of the pandemic. This is especially important given recent evidence that a previous COVID-19 infection among those who are unvaccinated appears to provide as much protection against the Delta variant as double-dose vaccination does for those without a previous infection (Chart I-8). Chart I-8A Previous COVID-19 Infection Appears To Offer Strong Protection Against The Delta Variant In the US, the Center for Disease Control estimates that from February 2020 to May 2021 only 1 in 4.2 COVID-19 infections were reported, suggesting that there were approximately 120 million total infections during that period. That would be quite positive for the economic outlook if accurate, as it would imply that the true immunity rate in the US is probably much closer to NAHRI than the vaccination rate would imply. However, it is also possible that the Center's estimate is too high, which is what some surveys of Americans seem to suggest. In mid-to-late February, a Pew Research survey reported that 25% of US adults had either tested positive for COVID-19, tested positive for antibodies against the SARS-COV-2 virus, or were confident that they already contracted the virus. This compares with 8.5% of the US population with a confirmed case of COVID-19 at that time, suggesting that the true ratio of reported cases to total infections is closer to 1:3. Chart I-9 highlights what the true US immunity rate might look like compared with the published vaccination rate based on different estimates of unreported infections. The chart highlights that a 1:3 ratio of reported cases to total infections implies an additional 10 percentage points of immunity, which would bring US first-dose vaccination rates in line with those of other DM countries. When combined with a slow but still ongoing rise in first doses administered, as well as emergency use eligibility of children under 12 years old targeted by the end of September, investors have good reason to believe that the US and most other major advanced economies will be above NAHRI, or at least very close to it, at some point in Q4. Chart I-9The True US Immunity Rate May Be A Lot Higher Than The Vaccination Rate Would Suggest A Permanent Shift In Consumer Behavior? The inability to reach true herd immunity, combined with the recent slowdown in services activity in response to a surge in cases from the Delta variant, raises the issue of whether altered consumer behavior will persist beyond the next few months. Chart I-10A Positive Sign That The Delta Wave May Be Abating In our view, the answer is: probably not. First, Chart I-10 makes the simple point that the transmission rate is already falling in advanced economies, suggesting that fears of a complete explosion in new cases beyond previous highs are unfounded. Second, the behavior of consumers over the past two months has been reasonable, but is unlikely to continue once nations begin to approach NAHRI. The Delta variant is still relatively new, and its higher transmissibility, as well as its seemingly higher hospitalization rate for those who are unvaccinated, has understandably given some consumers pause over the past few months (even those who are vaccinated). This is likely especially true among adults with young children in their household, given that they are not currently able to receive a vaccine and given a significant rise in pediatric cases that has occurred in some countries. But the reality is that the world will have to live with the existence of COVID-19 permanently, which consumers, investors, and policymakers will all soon come to accept and normalize. It will become endemic, and receiving annual booster shots against the disease may become a permanent ritual for people around the world. In advanced economies, once most or all individuals who wish to be vaccinated have had the chance to receive their shot, it seems unlikely that periodic waves of rising cases among the unvaccinated will be seen as a threat to individual health, especially if the increase in hospitalizations is limited and the viability of the health care system is not under threat. Beyond Delta: The Economy And Financial Markets In A Year’s Time On a 6-12 month time horizon, economic growth in advanced economies, as well as the trend in financial markets, is not likely to be driven by the Delta variant of COVID-19. Instead, the cyclical investment outlook will continue to depend on the factors that we have discussed in several previous reports: Extremely Easy Monetary Policy: Chart I-11 illustrates the 10-year US Treasury yield relative to trend nominal GDP growth. The chart highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s, which will continue to support domestic demand even if growth moderates over the coming year. Excess Savings: A waning growth impulse from fiscal policy will likely weigh on real goods spending, which is roughly 10 percent higher than its pre-pandemic trend (Chart I-12). But services spending, which accounts for about 70% of overall consumer spending, is still 5% below its pre-COVID trend and will be supported by the deployment of a significant amount of excess savings that have accumulated over the course of the pandemic. Some of these excess savings have probably been deployed to pay down debt, but a sizeable portion likely remains to support services spending. Chart I-13 highlights that the gap in spending is fairly broad-based across different services categories, underscoring that a recovery in services spending is not overly-dependent on the return of a particular type of consumer spending behavior. Chart I-11US Monetary Policy Is Extraordinarily Easy Chart I-12Pent-Up Savings Will Support Services Spending   Robust Revenue Growth: The equity market is likely to be supported by strong revenue growth over the coming year, even if it modestly disappoints current expectations. Chart I-14 presents bottom-up analysts’ expectations for S&P 500 sales per share growth over the coming year, alongside a proxy for nominal growth expectations (12-month forward expectations for real GDP growth plus 2 percentage points). The chart highlights that, while expectations for sales growth are modestly above what our proxy would suggest, nominal growth expectations are the strongest they have been in over a decade. Chart I-13Missing Services Spending Is Broad- Based Across Spending Categories Chart I-14S&P 500 Revenue Growth Is Likely To Be Strong Over The Coming Year...   On the latter point, while revenue growth will likely support the equity market, expectations for earnings are now clearly too high. Chart I-15 highlights that bottom-up analysts are calling for 18% earnings growth over the coming year – after what has already been a very impressive earnings recovery – and for profit margins to expand by a full percentage point from what is already a new high. Chart I-16 presents a long-term perspective on corporate profit margins, highlighting how stretched they have become even relative to the uptrend of the past three decades. Chart I-15...Even Though Earnings Expectations Are Clearly Too High Chart I-16US Profit Margins Are Very Elevated, Even Given The Past Three Decade's Uptrend     Chart I-17 highlights that earnings expectations usually disappoint, given the perennial optimism of bottom-up analyst expectations. The chart shows that they historically disappoint on the order of 5 percentage points, but that a 10 percentage point miss would not be so uncommon. Thus, EPS growth that is in line with the revenue growth proxy shown in Chart I-14 will not likely weigh on investor sentiment. China And EM Stocks As a final point about the macro and cyclical investment outlook, Chart I-18 highlights that our Market-Based China Growth Indicator has fallen below the boom/bust line for the first time since the middle of last year. We highlighted in last month’s report that China would not likely provide the global economy with a growth impulse until Chinese policy turns reflationary, and financial assets that are sensitive to Chinese economic growth are now flashing a warning sign. We therefore continue to believe that a normalization in services spending in advanced economies remains the likely impulse for global growth over the coming year. Chart I-17A 10% Earnings Miss Over The Coming Year Would Not Be Unprecedented Chart I-18Chinese Growth Proxies Are Performing Poorly   However, at least a part of the recent underperformance of China-sensitive assets has been driven by the spectacular underperformance of broadly-defined tech stocks in China since late-May (Chart I-19). The selloff in Chinese tech stocks has been triggered by a regulatory crackdown by Chinese authorities on new economy companies, which reflects new socio-political and economic shifts in China – which are thus not likely to be transitory. Still, Chinese stocks are now oversold even in absolute terms (Chart I-20), raising the question of whether EM stocks overall are due for a bounce. Chart I-19Some Of The Recent EM Underperformance Reflects The Chinese Regulatory Crackdown Chart I-20Chinese Stocks Are Oversold In Absolute Terms     In the short term, the answer is yes, but over a 6-12 month time horizon we would still recommend favoring developed market equities within a global ex-US equity allocation. First, while policy from China may eventually act as a catalyst for EM equities, BCA’s China strategists do not believe that Chinese policymakers have yet reached the “pain point” that would signal regulatory and monetary policy easing. Second, China and EM more generally is comparatively tech heavy, and thus will face headwinds on a relative basis if value outperforms growth over the coming year (as we expect). Chart I-21EM Stocks Do Not Offer A Compelling Value Catalyst Versus DM Ex-US Third, Chart I-21 highlights that EM stocks offer no compelling value proposition relative to DM ex-US equities. EM stocks are modestly cheap on a 12-month forward P/E basis (trading at a 13% discount), but this has been true historically – with the exception of a brief period from mid-2007 to mid-2008. Relative to the past decade, EM valuation is at roughly average levels versus global ex-US stocks, suggesting that Chinese policy and sector performance trends are likely to be the key drivers for EM performance relative to non-US equities. Investment Conclusions Chart I-22Favor DM Ex-US Vs. US, And Value Vs. Growth, Over The Coming Year In Section 2 of this month’s report, we explain why the Fed’s maximum employment criterion is likely to be reached earlier than investors and the Fed itself expects. This suggests that equity multiples may come under pressure over the coming year as long-maturity government bond yields rise. However, we noted above that earnings are likely to grow at a high single-digit pace, and that this is likely to support the uptrend in US stock prices as developed economies approach or surpass the non-accelerating hospitalization rate of immunity from COVID-19 and the world continues to move toward to a post-pandemic state. In combination with our expectation of rising government bond yields, investors should thus continue to favor stocks versus bonds in a multi-asset portfolio over the coming year, with the proviso that the impact from Delta is likely to cause a near-term growth disappointment. On a 12-month time horizon, high single-digit earnings growth coupled with some pressure on multiples continues to point to mid-single-digit returns from US equities. Within a global equity allocation, we would recommend that investors favor global ex-US stocks. The outperformance of the latter is not dependent on the outperformance of emerging markets, as Chart I-22 highlights that DM ex-US equities now trade at close to a 30% discount relative to their US counterparts – an extreme reading that partially reflects the extraordinary discount of global value versus growth stocks (panel 2). The trend in value versus growth is strongly correlated with the trend in financials versus broadly-defined technology stocks, and rising long-maturity bond yields favor the earnings of the former and weigh on the multiples of latter. Chart I-23 highlights that global small cap stocks may also outperform over the coming year, given their fairly strong correlation with long-maturity bond yields since the start of the pandemic. Finally, as we have noted in previous reports, the US dollar is a reliably counter-cyclical currency over 12-month periods. The recent bounce in the US dollar in the face of rising stock prices has deviated from this relationship, but only modestly so (Chart I-24). A similar deviation occurred in Q1 of this year, and was resolved with the dollar, not stock prices, moving lower. Consequently, we recommend that investors favor short USD positions, in response to a likely downtrend in the dollar over the coming year. Chart I-23Small Cap Stocks Will Likely Outperform If Long-Maturity Bond Yields Rise Chart I-24A Pro-Risk Investment Stance Argues For A Dollar Downtrend   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst August 26, 2021 Next Report: September 30, 2021 II. The Return To Maximum Employment: It May Be Faster Than You Think When defining maximum employment, many investors focus on the state of the labor market that prevailed as of February 2020. However, the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic, suggesting that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%. This assumes that the Fed deems the ongoing recovery in the labor market to be “broad-based and inclusive,” given revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August. The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects already have or are likely to be reversed as the overall unemployment rate continues to fall. A permanent decline in the participation rate, relative to pre-pandemic levels, is likely given ongoing demographic trends. Even if the recent behavioral impact of retirements is overdone, the demographic impact of retirement on the participation rate suggests that the Federal Reserve may hit its maximum employment objective by next summer, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. In a 2H 2022 rate hike scenario, the fair value of the 10-year Treasury yield will be 2.2%-2.3% next year, which the market is not priced for. This underscores that investors should maintain a short duration position within a fixed-income portfolio, and that equity investors should favor value over growth stocks on a 12-month time horizon. The cyclical outlook for monetary policy in the US rests heavily, if not exclusively, on the length of time needed to return to maximum employment. In this report, we argue that a complete return to the state of the labor market as of February 2020 is probably not required for the Fed’s maximum employment objective to be met, because the jobs market was likely beyond maximum employment at that time. In addition, we highlight that the broad-based and inclusive nature of the Fed's maximum employment objective is objective will not delay the first Fed rate hike beyond what the trajectory of the unemployment rate would suggest, as the odds of a persistent negative impact on demographic segments of the labor market no longer seem meaningful. In fact, the one partial exception that we can identify – retirement – argues for an earlier return to maximum employment. We conclude by noting that a first Fed rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19 or if the Fed’s inflation liftoff criteria are no longer met. Normalized levels of inflation expectations, as well as reasonable estimates of a closed output gap over the coming year, suggest that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. A 2022 rate hike is not currently reflected in market pricing, underscoring that investors should remain short duration within a fixed-income portfolio. Equity investors should expect a meaningful rise in stock market volatility as long-maturity yields rise over the coming year, and should favor value over growth stocks once fears of the likely impact of the Delta variant on near-term economic growth abate. Defining “Maximum Employment” Chart II-1Last Cycle, Rates Began To Rise Before Maximum Employment Was Reached Last September, the Fed’s official shift to an average inflation targeting regime represented a significant break from how the Fed conducted monetary policy in the past. The shift replaced what was previously a “symmetric” 2% inflation target with the goal of achieving inflation that averages 2% over time, meaning that monetary policy is no longer strictly forward-looking. According to the Fed's previous framework, monetary policy should start to tighten before the economy reaches its full employment level, in anticipation that further declines in the unemployment rate will likely lead to accelerating inflation. For example, during the last economic cycle, the Fed began to raise interest rates in December 2015, when the unemployment rate stood at 5% (Chart II-1). But the Fed's new regime implies that the onset of tightening should begin later, the criteria for which was explicitly laid out in the September 2020 FOMC statement: “The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 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.” In addition, while the Fed’s statutory mandate from Congress has always included the pursuit of maximum employment as an objective of monetary policy, revisions to the FOMC’s Statement on Longer-Run Goals and Monetary Policy Strategy last August explicitly noted that the maximum level of employment is a “broad-based and inclusive goal.” This has left many investors questioning when the Fed’s maximum employment criterion will be reached, with some market participants believing that a complete return to the state of the labor market that prevailed as of February 2020 will be required before the Fed lifts interest rates. But there are three arguments suggesting that the US labor market was beyond maximum employment levels at the onset of the COVID-19 pandemic: 1. Chart II-2 highlights that the February 2020 unemployment rate ranked at the 5th percentile of its post-WWII history, and was at its lowest level since the late-1960s. While it is true that the unemployment rate would have been higher for most of the last economic expansion based on December 2007 age-adjusted participation rates, Chart II-3 highlights that this effect had waned by the end of 2019. This underscores that the pre-pandemic unemployment rate likely reflected very low labor market slack. Chart II-2The US Labor Market Was Likely Beyond Maximum Employment Levels Prior To The Pandemic 2. The February 2020 unemployment rate stood at 3.5%, which is at the very low end of the Fed’s NAIRU estimates, and meaningfully below the CBO’S long- and short-term NAIRU projections (Chart II-4). Given that NAIRU estimates signify the level of unemployment that is consistent with a steady inflation rate, this implies that 3.5% is likely below the “maximum employment” unemployment rate. Chart II-3The Part Rate Had Mostly Normalized Just Prior To COVID-19 Chart II-4A 3.5% Unemployment Rate Is Likely Below NAIRU Chart II-5Wage Growth Accelerated In Response To A Sub-4% Unemployment Rate 3. The pre-pandemic trend in wage growth also supports the notion that the labor market was past maximum employment levels at that time. Chart II-5 highlights that average hourly earnings and the Atlanta Fed’s median wage growth tracker were both accelerating in 2018/2019, and Chart II-6 highlights that real average hourly earnings growth of production and nonsupervisory employees was close to its 90th percentile historically at the end of 2019. This underscores that the Fed is likely to raise interest rates before the unemployment rate falls back to 3.5%, assuming that the ongoing recovery in the labor market is deemed by the Fed to be “broad-based and inclusive.”   Chart II-6Real Average Hourly Earnings Growth Was At Its 90th Percentile Historically Prior To COVID-19 Breadth, Inclusivity, And Participation Chart II-7The "She-cession" Is Over The extraordinary nature of the COVID-19 pandemic has indeed had an outsized impact on some demographic segments of the labor market, but most of these effects have already reversed or are likely to as the overall unemployment rate continues to fall. And as we highlight below, the one partial exception that we can identify – retirement – in fact argues for an earlier return to maximum employment. We focus our demographic segment analysis on four main categories: 1. employment by gender; 2. race; 3. wage level and education; and 4. the impact on labor force participation from retirement. Gender Chart II-7 highlights the impact of the pandemic on the US labor market by gender. In 2020, the impact of the pandemic fell disproportionately on women. The unemployment rate rose close to 13 percentage points for women from February to April of last year, versus a 10 percentage point rise for men. In addition, the recovery in the participation rate last year was less robust for women, who disproportionately cited family responsibilities as the basis for not participating in the labor force. However, Chart II-7 also highlights that the disproportionate labor market impact of the pandemic on women is now over, with the female unemployment rate closer to its pre-pandemic level than for men, with a similar recovery in the participation rate. The difference in wage growth, relative to February 2020 levels, is also now smaller for women than for men. Thus, barring the development of a new divergence over the coming year, there is no longer any basis for the Federal Reserve to distinguish between men and women in the labor market recovery. Chart II-8Black Unemployment And Labor Force Participation Has Mostly Normalized Race Chart II-8 highlights the impact of the pandemic on the US labor market by race. In this case, it is clear that a disproportionately negative effect on Black employment persisted for longer than it did for women. But it is also clear that the Black unemployment rate is now roughly the same magnitude above its February 2020 level as is the case for the overall unemployment rate. In June, the Black labor force participation rate had actually recovered more than the overall participation rate, although it did decline meaningfully in July. The Black labor force participation rate has shown itself to be highly volatile since the onset of the pandemic, and we doubt that the July reading marks a decoupling from the overall participation rate. It is also true that median non-white wage growth has decelerated significantly more than median white wage growth during the pandemic, but this has occurred from a very elevated starting point. Median non-white wage growth was growing a full percentage point above median white wage growth just prior to the pandemic, compared with a half a percentage point below today. This deceleration has likely occurred as a lagged impact from the larger rise in Black unemployment noted above, which has now dissipated – suggesting that nonwhite wage growth is not likely to meaningfully lag over the coming year. Two additional points highlight that Black unemployment, labor force participation, and wages are likely to be highly correlated with overall labor market trends over the coming year. First, Chart II-9 highlights that in 2019 Black workers were underrepresented in management / professional and natural resources / construction / maintenance occupations, and overrepresented in service and production / transportation / material moving occupations. Given that services spending remains below its pre-pandemic trend, it is likely that the Black unemployment rate will continue to decline as the gap in leisure and hospitality and other services employment closes further relative to pre-pandemic levels. Chart II-9Black Unemployment Will Fall As Services Spending Recovers Second, Table II-1 highlights that Black survey respondents to the Census Bureau’s Household Pulse Survey located in New York and California are reporting lower and only modestly higher levels, respectively, of lost employment income than is the case for Black workers in the US overall. Given that services employment in these two states, particularly New York, are the most likely to be negatively impacted by persistent “work-from-home” effects, Table II-1 suggests that Black services employment is not likely to lag gains in overall services employment. Wage Level And Education Chart II-10 highlights wage growth for those with a high school diploma or less, for low-skilled workers, and for those in the lowest average wage quartile, and Charts II-11A & II-11B highlight the impact of the pandemic on the unemployment and participation rates by education. Table II-1No Evidence Of A Negative “Work-From- Home” Effect On Black Unemployment Chart II-10Wage Growth By Education And Skill Level Is Largely Unchanged Chart II-11AThe Least Educated Workers Still Need To See More Job Gains… Chart II-11B…But This Will Occur As Services Spending Improves     On the wage front, Chart II-10 makes it clear that there are no major negative differences between those with limited education, limited skills, or limited pay and the overall trend in wage growth relative to pre-pandemic levels. Reflecting a shortage of workers in some services industries, wages for 1st quartile wage earners and low-skilled workers are accelerating, and are poised to reach their highest level since 2008. On the employment and participation front, Charts II-11A & B show that the job market recovery has been less pronounced for high school graduates and those with less than a high school diploma. But, we believe – with high conviction – that this reflects the industry composition of the existing employment gap, which skews heavily towards service and leisure & hospitality. These jobs tend to require less formal education and training, and to offer less pay. Given this, and similar to the case for Black employment, low education employment growth is unlikely to meaningfully diverge from the trend in overall services employment over the coming year. The Impact Of Retirement On Labor Force Participation Chart II-12Most Of The Pandemic Decline In Labor Force Participation Has Occurred Due To Retirement Chart II-12 presents a breakdown of the change in overall labor force participation from Q4 2019 to Q2 2021 by nonparticipation category. The chart is based off the Atlanta Fed’s Labor Force Participation Dynamics dataset, and employs some Bank Credit Analyst estimates to seasonally adjust the impact of some categories in the first half of this year and to align it with the actual change in the published monthly seasonally-adjusted participation rate. The chart underscores that, while family responsibilities and those who are not in the labor force but who want a job (the shadow labor force) have been important contributors to the decline in labor force participation since the onset of the pandemic, retirement has been the single most important factor driving the participation rate lower. This sharp drop in labor force participation from retirement likely reflects the decision of some older workers to bring forward their retirement date by a year or two, although a recent study from the Kansas City Fed suggests that the non-demographic component of the recent surge in retirements has mainly been driven by a decline in the number of retirees rejoining the labor force.3 But demographic effects are important, and Chart II-13 highlights that the participation rate has fallen at a rate of roughly 30 basis points per year on average since 2008, reflecting the aging of the population. Chart II-13 is consistent with the age-adjusted participation rate that we showed in Chart II-3 above, and underscores that, even though the recent decline in the participation rate due to retirement is overdone, a permanent decline relative to pre-pandemic levels is likely the result of ongoing demographic trends. In our view, the Federal Reserve is unlikely to regard a demographically-driven decline in the overall participation rate as evidence that the labor market recovery has fallen short of the Fed’s maximum employment objective. It is possible that a return of the working age participation rate to its pre-pandemic level will be viewed as a condition for maximum employment, but Chart II-14 highlights that progress on this front is already more advanced. Chart II-13A Full Recovery To The Pre-Pandemic Labor Force Participation Rate Is Unlikely Chart II-14The Working Age Participation Rate Has Recovered More Than The Overall Part Rate   A lower overall participation rate results in a faster decline in the unemployment rate for any given level of employment growth. Given that there are minimal-to-no remaining labor market divergences along other demographic dimensions of the labor market that aren’t simply correlated with the overall unemployment rate, the implication of a permanently lower participation rate is that the Federal Reserve is likely to hit its maximum employment objective earlier than market participants, and the Fed itself, are currently expecting. Timing The Return To Maximum Employment, And The First Fed Rate Hike Table II-2 presents the average monthly nonfarm payroll growth that will be required to reach a 3.8% unemployment rate, a level that Fed Vice Chair Richard Clarida recently affirmed would in his view likely constitute maximum employment.4 The values shown in the table assume the trend participation rate shown in Chart II-13 above, as well as a recent average of monthly population growth. Table II-2The Return To Maximum Employment May Be Faster Than You Think The table highlights that the unemployment rate is likely to fall to 3.8% following the creation of roughly 4.3 million additional jobs. If the monthly change in nonfarm payrolls continues to grow at its average over the past 3 months, this threshold will be met in January 2022 – essentially a full year before the Fed and market participants expect interest rates to begin to rise. Based instead on a simple linear trend of nonfarm payrolls since late last year, the unemployment rate is likely to fall to 3.8% by sometime next summer. As we highlighted above, the Fed has been explicit that its conditions for raising the funds rate are the following: Labor market conditions have reached levels consistent with the Committee's assessments of maximum employment Inflation has risen to 2 percent Inflation is on track to moderately exceed 2 percent for some time. Currently, the second and third conditions for liftoff are present, suggesting that a first rate hike is possible by the middle of next year, barring a long-lasting impact on US economic activity from the Delta variant of COVID-19. We agree that inflation will slow significantly from its current pace over the coming year as pandemic-induced supply-side factors wane, which some investors have noted may put the Fed’s inflation criteria back into play. But we doubt that the Fed will narrowly focus on the year-over-year growth rate in the core PCE deflator – which will be strongly influenced by base effects next year from this year’s comparatively elevated price level – when judging its second and third liftoff criteria. Instead, the Fed is likely to focus on the prevailing “run rate” of inflation that excludes prices experiencing any disinflationary effects of supply-chain normalization. Chart II-15 illustrates one important reason that the Fed’s inflation criteria will remain “checked” over the coming year. The chart shows that the pandemic, especially last year’s fiscal response to it, has “normalized” important measures of inflation expectations (based on an interval of 2004 to today). We noted in a report earlier this year that inflation is determined by both the degree of economic slack and inflation expectations, a framework that the Fed and many economists refer to as the “modern-day Phillips Curve.”5 Chart II-15The Fed’s Inflation Liftoff Criteria Are Likely To Stay “Checked” Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade, but we noted in our report that this perception is due to a singular focus on the economic slack component of the modern-day version of the curve – to the exclusion of inflation expectations – and a failure to consider the lasting impact of sustained periods of a negative output gap on those expectations. Chart II-16A Closed Output Gap Will Support Liftoff-Consistent Inflation Chart II-16 highlights that both market and Fed economic projections imply a positive output gap within the next 12 months, suggesting that inflation itself will remain liftoff-consistent barring a significant shock to growth or a major disinflationary/deflationary supply-side event. Declines in the prices of goods that have surged as a result of the disruption of global supply chains could potentially lower inflation expectations over the coming year, but our sense is that this is only likely in a scenario in which the prices of these goods fall below their pre-pandemic levels (which we do not currently expect). Investment Implications      There are three key investment implications of a potentially faster return to maximum employment than is currently anticipated by investors and the Fed. First, Chart II-17 highlights that the market is not priced for a first Fed rate hike by next summer, and Table II-3 highlights that a sizeable majority of respondents to the New York Fed’s Survey of Primary Dealers do not expect a single rate hike in 2022. Chart II-18 highlights that the fair value of the 10-year Treasury yield a year from today is 2.2%-2.3% in a 2H 2022 rate hike scenario, underscoring that a short duration stance is warranted within a fixed-income portfolio over the coming year – barring a long-lasting impact on economic activity from the Delta variant of COVID-19. Chart II-17The Market Is Not Fully Priced For A Quick Return To Maximum Employment Table II-3Market Participant Surveys Show No Hike Expectations Next Year Chart II-18Investors Should Maintain A Short-Duration Fixed-Income Stance Second, while a 2.2%-2.3% 10-year Treasury yield would not necessarily be negative for stock prices on a sustained basis, Chart II-19 shows that it would bring the equity risk premium (ERP) within its 2002-2007 range. The level of the 10-year yield that is consistent with that range has fallen relative to pre-pandemic levels and is now clearly below the trend rate of economic growth, due to a significant run-up in equity market multiples. This underscores that stocks are the most dependent on T.I.N.A., “There Is No Alternative,” than at any other point since the global financial crisis. It is unclear what ERP investors will require to contend with the myriad risks to the longer-term economic outlook, many of which are political or geopolitical in nature and which did not exist in the early 2000s. Chart II-19Now, Stocks Are Increasingly Dependent On Low Bond Yields Consequently, there are meaningful odds that equities will experience a “digestion phase” at some point over the coming year as long-maturity bond yields rise – potentially trading flat-to-down in absolute terms for several weeks or months. It is also possible that stocks will experience a more malicious sell-off, if it turns out that equity investors require a structurally higher risk premium than what prevailed prior to the global financial crisis. This is not our base case view. We continue to recommend an overweight stance toward equities in a multi-asset portfolio. But it is a risk that warrants monitoring over the coming year. Finally, rising bond yields clearly favor value over growth stocks on a 12-month time horizon. In the US, the sizeable recent bounce in growth stocks has occurred alongside a renewed decline in the 10-year Treasury yield, which itself has been driven by renewed fears about the economic impact of the Delta variant. Thus, growth stocks may remain well bid relative to value in the very near term. But on a 12-month time horizon, value stocks are likely to outperform their growth peers, as long duration tech sector valuation comes under pressure and financial sector earnings benefit from higher interest rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator over the past year highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum. Bottom-up analyst earnings expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. But investors more focused on the near term, we would note the potential for further underperformance of cyclical sectors, value stocks, international equities, and most global ex-US currencies versus the US dollar. The US 10-Year Treasury yield has fallen sharply since mid-March, but may be in the process of bottoming. This decline was initially caused by waning growth momentum, but has since morphed into concern about the impact of the delta variant of SARS-COV-2 and the implications for US monetary policy. 10-year Treasury yields are well below the fair value implied by a late-2022 rate hike scenario, underscoring that the recent decline in long-maturity yields is overdone. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the 3-month rate of change in industrial metals prices is now close to zero. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization and the absence of a significant reflationary impulse from Chinese policy, will likely weigh on commodity prices at some point over the coming 6-12 months. US and global LEIs remain very elevated, but are starting to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 2 “Herd immunity a ‘mythical’ goal that will never be reached, says Oxford vaccine head”, The Telegraph, August 10, 2021. 3 What Has Driven the Recent Increase in Retirements? by Jun Nie and Shu-Kuei X. Yang, Federal Reserve Bank of Kansas City Economic Bulletin, August 11, 2021. 4 Outlooks, Outcomes, and Prospects for U.S. Monetary Policy, by Fed Vice Chair Richard H. Clarida, At the Peterson Institute for International Economics, Washington, D.C. (via webcast), August 4, 2021 5 Please see The Bank Credit Analyst Special Report "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated 18 December, 2020, available at bca.bcaresearch.com

Highlights The post-pandemic investment phase is just a continuation of the post-credit boom investment phase. This is because the pandemic has just accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends will structurally weigh on the profits of old economy sectors, consumer prices, and bond yields. At the same time, these trends are a continuing structural tailwind for the profits in those sectors that facilitate the shift to a more digital and cleaner world. Our high-conviction recommendation is to stay structurally overweight growth sectors versus old economy sectors… …and to stay structurally overweight the US stock market versus the non-US stock market. Fractal analysis: PLN/USD, Hungary versus Emerging Markets, and sugar versus soybeans. Feature Chart of the WeekUS And Non-US Profits Go Their Starkly Separate Ways Many people use the US stock market as a proxy for the world stock market. Intuitively, this makes sense, because the US stock market is the largest in the world, and the S&P 500 and Dow Jones Industrials are well-known indexes that we can monitor in real time. In contrast, world equity indexes such as the MSCI All Country World are less familiar and do not move in real time. Yet to use the US stock market as a proxy for the world stock market is a mistake. Although the US comprises makes up half of the world stock market capitalisation, the other half is so different – the non-US yan to the US yin – that the US cannot represent the world. As we will now illustrate. US Profits Have Doubled While Non-US Profits Have Shrunk Over the past ten years, US and non-US stock market profits have gone their starkly separate ways. While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011! (Chart of the Week) While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011. Of course, in any comparison of this sort, a key issue is the starting point. In this first part of our analysis, we are defining the starting point as the point at which profits had recouped all their global financial crisis losses. For both US and non-US profits this point was in March 2011 (Chart I-2 and Chart I-3). Chart I-2Comparing Profit Growth Since The Full Recovery From The Financial Crisis Chart I-3Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Because the issue of the starting point of the analysis is contentious, we will look at a much earlier starting point later in the report. But first, here are the decompositions of the US and non-US stock market moves from March 2011. US stock market profits are up 93 percent, while the multiple paid for those profits (valuation) is up 75 percent. Compounding to a total price gain of 235 percent (Chart I-4). Chart I-4US Profits Up 93 Percent, Valuation Up 75 Percent Non-US stock market profits are down -9 percent, while the multiple paid for those profits is up 38 percent. Compounding to a total price gain of a measly 25 percent (Chart I-5). Chart I-5Non-US Profits Down -9 Percent, Valuation Up 38 Percent The aggregate world stock market profits are up 24 percent, while the multiple paid for those profits is up 57 percent. Compounding to a total price gain of 94 percent (Chart I-6). Chart I-6World Profits Up 24 Percent, Valuation Up 57 Percent The Post-Credit Boom Phase Favours The US Over The Non-US Stock Market In the post-credit boom phase, several important features of stock market performance are worth highlighting. In absolute terms, valuation expansion has lifted US stocks by twice as much as non-US stocks, 75 percent versus 38 percent. Yet even the 75 percent expansion in the US stock market valuation has played second fiddle to the 93 percent expansion in US stock market profits. Absent valuation expansion, non-US stocks would stand lower today than in 2011. But for non-US stocks, whose structural profit growth has been non-existent, valuation expansion has been the only instrument for structural gains. Indeed, absent valuation expansion, non-US stocks would stand lower today than in 2011. And absent valuation expansion at a world level, the world stock market would lose three quarters of its ten-year gain. What can explain the startling performance differential between US and non-US stocks on both profit and valuation expansions? As we have argued before, most of the difference does not come from the underlying (US versus non-US) economies, but instead comes from the company and sector compositions of the stock markets. The US stock market is heavily over-weighted to global growth companies and sectors – such as technology and healthcare (Chart I-7) – which, by definition, have experienced structural growth in their profits. In contrast, the non-US stock market is heavily over-weighted to global old economy companies and sectors – such as financials, energy, and resources (Chart I-8) – whose profits have stagnated, or entered structural downtrends (Chart I-9). Chart I-7The US Stock Market Is Heavily Over-Weighted To Growth Sectors Chart I-8The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors   Chart I-9Old Economy Sector Profits Have Gone Nowhere At the same time, when bond yields decline, companies whose profits are growing (and time-weighted into the distant future) see a greater increase in their net present values. Hence, companies in the global growth sectors have experienced a larger valuation expansion than those in the old economy sectors. In this way, the US stock market has outperformed the non-US stock market on both profit growth and valuation expansion. The key question is, will these post-credit boom trends continue? The answer depends on whether the post-pandemic world marks a new phase for investment, or whether it is just a continuation of the post-credit boom phase. The Post-Pandemic Phase Is A Continuation Of The Post-Credit Boom Phase Let’s now address the issue of the starting point of our analysis by panning out to 1990. This bigger picture from 1990 shows three distinct phases for investors (Chart I-10 and Chart I-11). Chart I-10Since 1990, There Have Been Three Distinct Investment Phases Chart I-11The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The first phase was the 1990s build-up to the dot com boom. This phase clearly favoured growth sectors, and thereby the US stock market versus the non-US stock market. The second phase was the early 2000s credit boom. This phase clearly favoured sectors that facilitated the credit boom or benefited from its spending – notably, the old economy sectors of financials, energy, and resources. Thereby it favoured the non-US stock market versus the US stock market. The third and most recent phase is the post-credit boom phase. This phase has flipped the leadership back to growth sectors as the absence of structural credit growth has stifled financials as well as the capital-intensive old economy sectors that had previously benefited from the credit boom. Additionally, the structural disinflation that has comes from weak credit growth has dragged down bond yields and – as already discussed – given a much bigger boost to growth sector valuations. Since 1990, there have been three distinct phases for investors: the dot com boom; the credit boom; and the post-credit boom. Now we come to the key question. Did 2020 mark the end of the post-credit boom phase and the start of a new ‘post-pandemic’ phase? On the evidence so far, the answer is an emphatic no. Crucially, there is no new credit boom. A still highly indebted private sector is neither willing nor able to borrow. And although public sector debt surged during the pandemic, governments are now keen to temper or rein in deficits. In any case, Japan teaches us that government borrowing – which is bond rather than bank financed – does nothing for the banks or the broader financial sector. An equally important question is, has the pandemic reversed the societal and economic trends of the post-credit boom phase? The answer is no. Quite the contrary, the pandemic has accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends are structurally disinflationary for the profits of old economy sectors as well as for consumer prices. Thereby, they will continue to weigh on bond yields. At the same time, the trends are a continuing structural tailwind for the profits in those sectors that facilitate and enable the shift to a more digital and cleaner world. While we are open to the evolving evidence, the post-pandemic investment phase seems an extension of the post-credit boom phase. This means that structurally, there is no reason to flip out of growth sectors back to old economy sectors. It also means that structurally, there is no reason to switch from US to non-US stocks. Fractal Analysis Update This week’s fractal analysis highlights three potential countertrend moves based on fragile fractal structures. First, the recent rally in the US dollar could meet near-term resistance given its weakening 65-day fractal structure. A good way of playing this would be long PLN/USD (Chart I-12). Chart I-12PLN/USD Could Rebound Second, the strong outperformance of Hungary versus Emerging Markets – largely driven by one stock, OTP Bank – has become a crowded trade based on its 130-day fractal structure. This would suggest underweighting Hungary versus the Emerging Markets index (Chart I-13). Chart I-13Underweight Hungary Versus EM Finally, the sugar price has skyrocketed as extreme weather has disrupted output in the world’s top producer, Brazil. Given that supply bottlenecks ultimately ease, a recommended trade would be to short sugar versus soybeans, using ICE versus CBOT futures contracts (Chart I-14). Set the profit target and symmetrical stop-loss at 8 percent. Chart I-14Short Sugar Versus Soybeans Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights US crude oil output will continue its sharp recovery before leveling off by mid-2022, in our latest forecast (Chart of the Week). The recovery in US production is led by higher Permian shale-oil production, which is quietly pushing toward pre-COVID-19 highs while other basins languish. Permian output in July was ~ 143k b/d below the basin's peak in Mar20, and likely will surpass its all-time high output in 4Q21. Overall US shale-oil output remains ~ 1.1mm b/d below Nov19's peak of 9.04mm b/d, but we expect it to end the year at 7.90mm b/d and to average 8.10mm b/d for 2022. We do not expect US crude oil production to surpass its all-time high of 12.9mm b/d of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means larger shares of free cashflow will go to shareholders, and not to drilling for the sake of increasing output. While our overall balances estimates remain largely unchanged from last month, we have taken down our expectation for demand growth this year by close to 360k b/d and moved it into 2022, due to continuing difficulties containing the COVID-19 Delta variant. Our Brent crude oil forecasts for 2H21, 2022 and 2023 remain largely unchanged at $70, $73 (down $1) and $80/bbl. WTI will trade $2-$3/bbl lower. Feature Chart 1US Crude Recovery Continues Global crude oil markets are at a transition point. The dominant producer – OPEC 2.0 – begins retuning 400k b/d every month to the market from the massive 5.8mm b/d of spare capacity accumulated during the COVID-19 pandemic. For modeling purposes, it is not unreasonable to assume this will be a monthly increment returned to the market until the accumulated reserves are fully restored. This would take the program into 2H22, per OPEC's 18 July 2021 communique issued following the meeting that produced this return of supply. Thereafter, the core group of the coalition able to increase and sustain higher production – Kuwait, the UAE, Iraq, KSA and Russia – is expected to meet higher demand from their capacity.1 There is room for maneuver in the OPEC 2.0 agreement up and down. We continue to expect the coalition to make supply available as demand dictates – a data-dependent strategy, not unlike that of central banks navigating through the pandemic. This could stretch the return of that 5.8mm b/d of accumulated spare capacity further into 2H22 than we now expect. The pace largely depends on how quickly effective vaccines are distributed globally, particularly to EM economies over the course of this year and next. US Shale Recovery Led By Permian Output While OPEC 2.0 continues to manage member-state output – keeping the level of supply below that of demand to reduce global inventories – US crude oil output is quietly recovering. We expect this to continue into 1H22 (Chart 2). Chart 2Permian Output Recovers Strongly The higher American output in the Lower 48 states primarily is due to the continued growth of tight-oil shale production in the low-cost Permian Basin (Chart 3). This has been aided in no small part by the completion of drilled-but-uncompleted (DUC) wells in the Permian and elsewhere. Chart 3E&Ps Favor Permian Assets Since last year’s slump, the rig count has increased; however, compared to pre-pandemic levels, the number of rigs presently deployed are not sufficient to sustain current production. The finishing of DUC wells means that, despite the low rig count during the pandemic, shale oil supply has not dipped by a commensurate amount. This is a major feat, considering shale wells’ high decline rates. Chart 4US Producers Remain Focused On Shareholder Priorities DUCS have played a large role in sustaining overall US crude oil production. According to the EIA, since its peak in June 2020, DUCs in the shale basins have fallen by approximately 33%. As hedges well below the current market price for shale producers roll off, and DUC inventories are further depleted, we expect to see more drilling activity and the return of more rigs to oil fields. We do not expect US crude oil output to surpass its all-time high of 12.9mm b/ of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means only profitable drilling supporting the free cashflow that allows E&Ps to return capital to shareholders will receive funding. US oil and gas companies have a long road back before they regain investors' trust (Chart 4).   Demand Growth To Slow We expect global demand to increase 5.04mm b/d y/y in 2021, down from last month's growth estimate of 5.4mm b/d. We have taken down our expectation for demand growth this year by ~ 360k b/d and moved it into 2022, because of reduced mobility and local lockdowns due to continuing difficulties in containing the COVID-19 Delta variant, particularly in Asia (Chart 5).2 We continue to expect the global rollout of vaccines to increase, which will allow mobility restrictions to ease, and will support demand. This has been the case in the US, EU and is expected to continue as Latin America and other EM economies receive more efficacious vaccines. Thus, as DM growth slows, EM oil demand should pick up (Chart 6). Chart 5COVID-19 Delta Variant's Spread Remains Public Health Challenge Chart 6EM Demand Growth Will Offset DM Slowdown Net, we continue to expect demand for crude oil and refined products to grind higher, and to be maintained into 2023, as mobility rises, and economic growth continues to be supported by accommodative monetary policy and fiscal support. If anything, the rapid spread of the Delta variant likely will predispose central banks to continue to slow-walk normalizing monetary policy and interest rates. Global Balances Mostly Unchanged Chart 7Oil Markets To Remain Balanced Although we have shifted part of the demand recovery into next year, at more than 5mm b/d of growth, our 2021 expectation is still strong. This is expected to continue next year and into 2023 although not at 2021-22 rates. Continued production restraint by OPEC 2.0 and the price-taking cohort outside the coalition will keep the market balanced (Chart 7). We expect OPEC 2.0's core group of producers – Kuwait, the UAE, Iraq, KSA and Russia – will continue to abide by the reference production levels laid out in 18 July 2021 OPEC communique. Capital markets can be expected to continue constraining the price-taking cohort's misallocation of resources. These factors underpin our call for balanced markets (Table 1), and our view inventories will continue to draw (Chart 8). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23Our balances assessment leaves our price expectations unchanged from last month, with Brent's price trajectory to end-2023 intact (Chart 9). We expect Brent crude oil to average $70, $73 and $80/bbl in 2H21, 2022 and 2023, respectively. WTI is expected to trade $2-$3/bbl lower over this interval. Chart 8Inventories Will Continue To Draw Chart 9Brent Prices Trajectory Intact   Investment Implications Balanced oil markets and continued inventory draws support our view Brent and refined-product forward curves will continue to backwardate, even if the evolution of this process is volatile. As a result, we remain long the S&P GSCI and the COMT ETF, which is optimized for backwardation. We continue to wait for a sell-off to get long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ETF).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish The US EIA expects natural gas inventories at the end of the storage-injection season in October to be 4% below the 2016-2020 five-year average, at 3.6 TCF. At end-July, inventories were 6% below the five-year average (Chart 10). Colder-than-normal weather this past winter – particularly through the US Midwest and Texas natural gas fields – affected production and drove consumption higher this past winter, which forced inventories lower. Continued strength in LNG exports also are keeping gas prices well bid, as Asian and European markets buy fuel for power generation and to accumulate inventories ahead of the coming winter. Base Metals: Bullish The main worker’s union at Chile's Escondida mine, the largest in the world, and BHP reached an agreement on Friday to avoid a strike. The mine is expected to constitute 5% of total mined global copper supply for 2021. China's refined copper imports have been falling for the last three months (Chart 11). Weak economic data – China reported slower than expected growth in retail sales and manufacturing output for July – contributed to lower import levels.  Precious Metals: Bullish Gold has been correcting following its recent decline, ending most days higher since the ‘flash crash’ last Monday, facilitated by a drop in real interest rates. The Jackson Hole Symposium next week will provide insights to market participants regarding the Fed’s future course of action and if it is in fact nearing an agreement to taper asset purchases. According to the Wall Street Journal, some officials believe the program could end by mid-2022 on the back of strong hiring reports. This was corroborated by minutes of the FOMC meeting which took place in July, which suggested a possibility to begin tapering the program by year-end. While the Fed stressed there was no mechanical relationship between the tapering and interest rate hikes, this could be bearish for gold, as real interest rates and the bullion move inversely. On the other hand, political uncertainty and a potential economic slowdown in China will support gold prices. Ags/Softs: Neutral Grain and bean crops are in slightly worse shape this year vs the same period in 2020, according to the USDA. The Department reported 62% of the US corn crop was in good to excellent condition for the week ended 15 August 2021, compared to 69% for the same period last year. 57% of the soybean crop was in good-to-excellent shape for the week ending on the 15th vs 72% a year ago. Chart 10 Chart 11 Footnotes 1 Please see our report of 22 July 2021, OPEC 2.0's Forward Guidance In New Baselines, which discusses the longer-term implications of this meeting and the subsequent communique containing the OPEC 2.0 core group's higher reference production levels. It is available at ces.bcareserch.com. 2 S&P Global Platts notes China's most recent mobility restrictions throughout the country will show up in oil demand figures in the near future. We expect similar reduced mobility as public health officials scramble to get more vaccines distributed. Please see Asia crude oil: Key market indicators for Aug 16-20 published 16 August 2021 by spglobal.com. Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Closed Trades

Special Report

Dear Client, This week we are sending you a joint Special Report written by my colleagues Xiaoli Tang, Associate Vice President at BCA Research’s Global Asset Allocation, and Qingyun Xu, Associate Editor at China Investment Strategy. In the Special Report Xiaoli and Qing investigate the impact on global portfolios when adding onshore Chinese assets. Their findings confirm our view that Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. However, they conclude that to improve both the absolute and risk-adjusted returns of the onshore equity market, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. More importantly, they find that both hedged and unhedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, and Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios. I trust you will find it insightful. Next week the China Investment Strategy team will take our second of the two-week summer break. We will resume our publication on Wednesday, September 1st. Best regards, Jing Sima, China Strategist Highlights Global investors have become increasingly interested in Chinese onshore equities and bonds as part of their multi-asset portfolios as Chinese onshore equities and bonds have been included in major global stock and bond indexes. In this report, we investigate the impact on global portfolios when adding onshore Chinese assets. Three assets (stocks, bonds and stock-bond combinations) and six home currencies (the USD, JPY, EUR, GBP, CAD and AUD) are included in our portfolio analysis. Chinese onshore equities have not been a good long-term, buy-and-hold asset for global equity investors due to extremely high volatility. To improve both the absolute and risk-adjusted returns of the onshore equity market, however, investors can apply an equal-weighted, five-factor smart-beta strategy or active sector/industry allocation strategies. Hedged Chinese onshore bonds are excellent risk diversifiers for DM bond investors, but higher absolute and risk-adjusted returns may be derived from unhedged bonds, thanks to the positive carry and negative correlation between the onshore Chinese bond index and CNY crosses. Chinese onshore bonds are also a good risk-diversifier and complementary to Chinese equity-centric portfolios, given the negative correlation between the performance of Chinese bonds and equities. Adding a stand-alone Chinese portfolio with equally weighted onshore bonds and equities to a typical 70-30 domestic equity-bond portfolio would significantly improve a non-USD investor’s risk-adjusted return. Global investors may access China’s onshore equity and bond markets through Stock Connect(s), Bond Connect and CIBM Direct. Risk management tools are also available via both onshore and offshore instruments. Feature In the past three decades, China’s financial markets have become the second largest in the world both in terms of equity capitalization and bonds outstanding. Pro-market financial reforms have made the onshore markets increasingly accessible to foreign investors (Appendix 1). As China’s domestic equities and bonds are gradually added to major global equity and bond indexes, the onshore markets have become too sizeable to be ignored by global investors. Chart 1China A Onshore Shares: Highly Volatile Driven By Policy Swings Gyrations in China’s equity market in July in response to regulatory changes imposed on various industries (internet, property, education, healthcare and capital markets), however, should be a reminder that volatility in this market is an ever-present aspect. The instability is driven by China’s profound cyclicality in credit, money and macroeconomic policies (Chart 1). Moreover, the unpredictability is exacerbated by periods of geopolitical tensions and domestic political events. We focus on the portfolio impact of adding onshore equities and bonds to global investors’ domestic portfolios with six different home currencies: the USD, euro (EUR), Japanese yen (JPY), British pound (GBP), Australian dollar (AUD) and Canadian dollar (CAD). We also address how to access the onshore markets and what risk management tools are available. Many global investors already have a significant home bias in their portfolios, therefore this report will look at replacing part of a domestic portfolio with Chinese onshore assets. Part 1. Are Chinese Onshore Equities A Good Alternative For Global Equity Investors? 1.1: Chinese Equities Have A Poor Long-Term Return-Risk Profile Chart I-1How Does China A Compare With Global Equities The extremely volatile nature of the MSCI China A onshore equity index (referred to as ‘China A’ in this report) is not a recent phenomenon. Although the volatility in China A has moderated since 2015, the stocks in the index remain highly cyclical and closely correlated with China’s credit growth. China A has gone through two full boom-bust cycles since December 2000 and the third up-cycle started in 2019 is being challenged, as shown in Chart I-1 panel 1. On a rolling three-year basis, China A’s volatility has steadily declined since its peak in early 2015 and is currently comparable to other markets. Meanwhile, its correlation with the rest of the world has steadily risen, standing at around 60% with major equity markets (Chart I-1, bottom 3 panels). The change in correlation with global equity markets could be linked to the launch of the Shanghai Stock Connect and Shenzhen Stock Connect as well as a more market-based RMB exchange rate in the past six years.  Compared with domestic equities for investors in the US, euro area, Japan, UK, Canada and Australia, however, China’s A-shares’ unhedged return-risk profile did not become more attractive after the launch of the Shanghai Stock Connect. As illustrated in Table 1, China A’s underperformance has spanned the entire upcycle in global equities starting in March 2009. It was only in the early years following China’s entrance into the WTO in 2001 that China A-shares performed better than their peers in Japan and the euro area. Table 1Return-Risk Profiles: China A Onshore Index vs Global Equity Indexes and CNY Crosses USD/CNY exchange rate volatility has increased since the 2015 de-pegging from the US dollar, but remains at very low level compared with other CNY crosses. The People’s Bank of China (PBoC) primarily manages the RMB against the dollar by targeting a daily USD/CNY fixing rate, while allowing market forces to drive the RMB value against a basket of currencies in the China Foreign Exchange Trade System (CFETS) index. Chart I-2Correlations Between China A And DM Currencies Interestingly, even though CNY crosses with the euro, GBP, JPY, AUD and CAD have much higher volatility, the volatility in unhedged China A-shares in each of those currencies is similar to or lower than that in USD. For example, from December 2014 to July 2021, AUD/CNY had an annualized volatility of 8.8%, much higher than the 4.5% of the USD/CNY, yet the unhedged China A-share's volatility in AUD was 21%, lower than the 24% in USD. The reason lies in correlation, as shown Chart I-2. While China A-shares in CNY have a positive correlation with USD/CNY and JPY/CNY (i.e. China A-share prices tend to rise when China’s currency appreciates against the US dollar and Japanese yen), they have falling and negative correlations with the other four currencies. For equity investors in the US and Japan, exposure to the CNY would increase potential volatility to their home-currency portfolios, but the opposite would be true for investors in the euro area, the UK, Australia and Canada. In addition, Chinese onshore equity correlations with DM equities and EM-ex China equities were low, but have increased since 2015, making onshore shares less attractive for global equity investors looking to diversify. Bottom Line: Chinese onshore shares are a poor long-term asset for global equity investors. 1.2: Factor Strategies Work Well In The Onshore Market Despite Chinese equities’ poor long-term performance, applying a factor strategy to Chinese onshore stocks can create impressive results. In a GAA Special Report on smart-beta strategies for MSCI DM and EM markets, we concluded that a simple, equally weighted five-factor strategy would smooth out the cyclicality of individual factors and outperform the broad market. These five factors are value, equal weight (i.e. size), quality, momentum and minimum volatility, as defined and calculated by MSCI (see Box 1). When we apply the same methodology to the MSCI China A onshore market, the result is even more impressive as shown in Chart I-3. Box 1MSCI Factor Indices Chart I-3Factor Performance: China A Vs Global Since December 2004, the value and small cap factors  have outperformed the broad  benchmark by about 11%  and 47%, respectively, in the China A universe, despite sharp corrections since December 2016  for small cap  and Oct 2018 for value. In contrast, in the global universe, value and small cap have underperformed the global benchmark by 24% and 7%, respectively, in the same time frame (Chart I-3, panels 2 and 6.) This confirms anecdotal evidence that the onshore equity market was less efficient than its global peer, although efficiency has improved. Momentum is a consistent factor for global markets. A GAA Special Report on momentum strategy shows that momentum works better in markets with higher individuality where self-attribution and self-confidence are more pervasive, according to Hofstede’s Cultural Dimension theory. This behavioral aspect is confirmed by the performance of momentum in China’s onshore market: in the early years, momentum did not work well, but strengthened after both Shanghai and Shenzhen shares were accessible to foreign investors via the two Stock Connects and mainland institutional investors became more prevalent (Chart I-3, panel 4) Quality is the most consistent factor for global markets because investors reward companies with solid fundamentals. As shown in (Chart I-3, panel 3), this factor has worked even better in the China A market than in the global universe. The fact that good fundamentals have generated superior equity return repels the “myth” that the China A market is a “casino” driven by individual investors, who totally ignore company fundamentals. The minimum volatility factor works in a similar fashion in the onshore Chinese market as in the global markets. Chart I-4Onshore Equity Market Can Be Improved By Smart-Beta Strategies Factor timing can hardly generate consistent outperformance. BCA’s GAA team advocates equally weighting the five time-tested factors for the MSCI global universe. This approach also applies to China’s onshore market (Chart I-3, panel 1). Since all the factor indexes became available in August 2013, the equally weighted, five-factor portfolio has outperformed the benchmark by about 20% in total with similar volatility. On a rolling one- and three-year basis, this strategy also performs better than the benchmark (Chart I-4). Some investors may prefer a more active and quantitative approach; they should refer to CIS’s Special Report on factor investing in the A-share market. The CIS report recommends that global investors should opt for industry groups with above-median return on equity (ROE) and below-median ex-post beta when investing in the onshore market. ROE is a quality factor in MSCI (see Box 1 above) and below-median beta is a variation of low volatility. Bottom Line: Factor strategies can improve the return and risk profiles of China’s onshore equity market. Part 2. Chinese Onshore Bonds Chinese onshore bonds have attracted global investors because they offer much higher yields than DM government bonds (Chart II-1). At the same time, as shown in Chart II-2, Chinese onshore bond yields have low to negative correlations with major government bond yields. Thus, the onshore bonds offer potential risk diversification for global bond portfolios. Chart II-1Chinese Bonds Offer Higher Yields Chart II-2Chinese Yields Have Low Correlation With DM Bond Yields For foreign DM government bonds, the conventional wisdom is to hedge foreign currency exposure because currency fluctuations outweigh bond volatility. A GAA Special Report shows that hedged foreign bonds have favorable return-risk profiles compared with domestic bonds in major DM countries. For EM local currency debt (based on the JP Morgan GBI-EM Global Diversified Local Currency Debt Index), USD investors should hedge their EM FX exposure while non-USD DM investors should not hedge. However, non-USD investors should avoid EM local currency debt if their objective is to maximize risk-adjusted return on the long-term horizon. Do Chinese bonds share the same traits as the EM aggregate? Our analysis suggests that Chinese bonds have historically provided better risk-adjusted returns to USD-based bond investors, hedged and unhedged. Thus, allocating a portion of the US Treasury portfolio to Chinese onshore bonds would improve a US bond portfolio’s return-risk profile. The Bloomberg Barclays (BB) China Treasury and Policy Bank Bond Index is used for the analysis. The index has a history starting in January 2004, even though it was included in BB's three flagship bond indexes only in April 2019.  On a hedged basis, Chinese onshore bonds deliver similar returns to global bonds as shown in Chart II-3. This is not surprising because interest-rate parity implies that the expected return on domestic assets equals the exchange-rate adjusted return on foreign currency assets, given foreign exchange market equilibrium. Unhedged returns, however, have outperformed both local and foreign government bonds for bond investors in the US, Japan, UK and the euro area since 2004 (Chart II-4). Carry was negative for USD-, GBP- and euro-based investors before the Global Financial Crisis, but has become positive since that time. The CNY has appreciated in general, albeit with greater movement against the non-USD crosses.  Chart II-3Chinese Bond Performance In A Global Context Chart II-4Carry And Spot CNY Exchange Rate Unhedged Chinese bonds have much higher absolute returns and also much higher volatility when compared with hedged bonds. How do Chinese onshore bonds fare on a risk-adjusted return basis? Table 2 compares the risk-return profiles of hedged and unhedged Chinese bonds with local and hedged foreign DM bonds in two periods: one from January 2004 and the other from July 2017 when the Bond Connect was launched. Table 2Return-Risk Profiles: Chinese Onshore Bond Index Vs DM Local Bond Indexes Several observations from Table 2: In local currency terms, Chinese bonds have the best risk-adjusted return and the second lowest volatility – only higher than Japanese government bonds (JGBs) – both from January 2004 and from July 2017. Since the start of Bond Connect, the risk-adjusted return of Chinese bonds in CNY has strengthened significantly with higher return and lower volatility. In contrast, there has been a deterioration in DM local bonds and their corresponding hedged foreign government bonds’ return/risk profiles.   In the past four years, Chinese bonds have outperformed all DM local bonds when unhedged, both in terms of absolute return and risk-adjusted return. When compared with a hedged foreign government bond, however, the absolute return advantage has been offset by much higher FX volatility. Still, euro- and JPY-based bond investors enjoy higher risk-adjusted returns from unhedged Chinese bonds than their respective hedged foreign DM government bonds. However, GBP-based investors would be better off with hedged non-UK government bonds. For USD-based bond investors, unhedged Chinese bonds would only be slightly inferior to hedged non-US government bonds. On a hedged basis, Chinese bonds have lower returns and less volatility than local bonds (with the exception of Japan), but they have higher risk-adjusted returns than local bonds in all but the euro area. When compared with hedged foreign bonds, euro- and USD-based investors would do slightly better with the Chinese bonds while JPY- and GBP-based investors would earn slightly more with other DM government bonds. How much should a bond investor replace local bonds with Chinese ones? For illustration, Chart II-5 plots the efficient frontiers for bond investors in the US, euro area, Japan and the UK when hedged Chinese bonds are added to their respective domestic bond portfolios. This addition would reduce portfolio volatility for all domestic bond portfolios, regardless of time frame. This is especially impressive for JGB investors because JGBs already have the lowest volatility among DM bonds. Moreover, returns would be improved for USD- and JPY-based investors when Chinese bonds are gradually included in domestic bond portfolios up to the risk-minimizing point.  Chart II-5Adding Hedged Chinese Bonds Reduces Volatility For All DM Domestic Bond Portfolios* For GBP- and euro-based investors, however, adding hedged Chinese bonds would reduce absolute returns, but significantly improve risk-adjusted returns for GBP-based bond investors. Interestingly, even though euro zone local bonds have had superior risk-adjusted returns to hedged Chinese bonds since 2017, their risk-adjusted returns would still increase by about 18% when 50% of their local-bond portfolio is allocated to Chinese bonds. What is more striking is how unhedged Chinese bonds impact the return/risk profiles of global investors’ domestic bond portfolios. Unlike DM foreign bonds, which have inferior risk-adjusted returns when foreign currency exposure is not hedged, unhedged Chinese onshore bonds actually enhance a domestic bond investor’s absolute and risk-adjusted returns, as shown in Chart II-6. This is because of Chinese bonds’ superior risk-adjusted return measured in CNY (Table 2), negative correlations with CNY crosses (Chart II-7) and low to negative correlations with DM government bonds (Chart II-2). Chart II-6Adding Unhedged Chinese Bonds Enhances Absolute and Risk-Adjusted Returns For All DM Domestic Bond Portfolios* For US bond investors who seek to maximize risk-adjusted return, the domestic Treasury portfolio would be improved significantly if about 40-50% of their holding were allocated to unhedged Chinese bonds. In comparison, the ratios would be lower for bond investors in the euro area, Japan and the UK. The key message is that global investors do not need to hedge the RMB exposure when investing in the Chinese onshore bond market. Chart II-7Chinese Bond Correlation With DM Currencies Chart II-8Chinese Yuan Still Has Upside Potential We still have a favorable cyclical outlook for the CNY against the US dollar, supporting the case not to hedge the currency. The CNY is at about one standard deviation below fair value even though the gap has been narrowing since mid-2020 (Chart II-8). We expect the CNY to keep appreciating in the coming years barring major disruptive geopolitical/political events. China’s relatively strong productivity growth should continue to support the currency’s rising fair value. On a cyclical basis, given that the US Fed is firmly staying behind the curve (capping the upside in real bond yields in the US), the differential in real interest rates between China and other major economies should remain favorable for the RMB.  Bottom line: In a search-for-yield environment, the return-risk profiles of dedicated DM government bond portfolios may be enhanced by adding some exposure to Chinese onshore bonds on an unhedged basis. Part 3. Chinese Onshore Assets For Global Multi-Asset Portfolios Chinese onshore stocks on their own are not suitable for long-term, buy-and-hold strategic investments due to extremely high volatility, and the positive and rising correlation with global stocks and with CNY crosses. Chinese bonds, on the other hand, have an attractive risk-return profile with very low volatility, low correlation with global bonds, and negative correlation with CNY crosses. The negative correlation between Chinese stocks and bonds means that a mixed portfolio of the two assets would provide good diversification (Chart III-1). Chart III-1Chinese Onshore Assets Chart III-2Chinese Multi-Asset Portfolio Correlation With Global Multi-Asset Portfolios Investors may have different stock-bond allocations based on their return-risk objectives and constraints. For illustration, we constructed a stand-alone Chinese multi-asset portfolio by equally weighting onshore stocks and bonds. The correlations of this portfolio with six DM domestic 70-30 stock-bond portfolios have varied over time and by different countries, as shown in Chart III-2. Our Chinese-asset portfolio has a relatively high correlation with US and Japanese assets, but a low correlation with European assets, and almost no correlation with Australian and Canadian assets. Accordingly, the diversification effects are much stronger for GBP-, euro-, AUD- and CAD-based investors than for USD- and JPY-based investors, as shown in Chart III-3. Chart III-3Chinese Multi-Asset Portfolio Should Be Treated As A Standalone Asset By Non-US Asset Allocators Chart III-3 shows how the risk-return profile of a standard 70-30 stock-bond portfolio in the US, UK, Japan, euro area, Australia and Canada may be improved by adding some exposure to a 50-50 Chinese stock-bond portfolio. Even though this equally weighted Chinese onshore asset portfolio has unimpressive returns, when added to a domestic stock-bond portfolio there is an improvement in the return-risk profile of all non-USD-based portfolios. The optimal allocation to the stand-alone Chinese onshore portfolio varies with different home currencies, objectives and time periods, as shown in Table 3. Table 3Chinese Assets Improve Global Multi-Asset Portolios' Return-Risk Profiles Bottom Line: Unhedged Chinese onshore stocks and bonds may be treated as a stand-alone asset for global asset allocators, especially non-US ones. Adding a simple 50-50 Chinese stock-bond portfolio may boost the return/risk profile of global multi-asset portfolios. Part 4. Operational Q&A Many foreign investors believe that China’s onshore markets are hard to access. However, regulatory changes in the past 10 years, partially since Stock Connect was launched in 2014, have made it simpler from an operational point-of-view to buy and sell Chinese onshore equities and bonds. Below we answer some questions that international investors may have about market access. Q: Are there any access or quota restrictions for offshore investors to invest in China A-shares via Stock Connect? Historically, access to China’s mainland equity market by offshore investors was restricted through investment quotas and local currency controls. Since 2014, with the launch of Stock Connect, offshore investors no longer have access or repatriation restrictions. Stock Connect allows offshore investors to trade selected A-share stocks listed on the Shanghai (SSE) and Shenzhen (SZSE) Stock Exchanges through offshore brokers. Although not all A-shares listed on the SSE or SZSE can be invested in through Stock Connect, eligible stocks include almost all large- and medium-cap A-shares.1 Note that the Shanghai-Hong Kong (SH-HK) Stock Connect and the Shenzhen-Hong Kong (SZ-HK) Stock Connect complement each other, but they have a dual-channel, independent operation mechanism with two distinct Connect operations. Therefore, their shares cannot be cross-traded. Q: How to purchase China’s A-Shares via Stock Connect? Offshore investors need a Hong Kong or international broker (see MMA <GO> on Bloomberg for a list of Offshore brokers for Stock Connect northbound trading), through whom they buy A-shares. Brokers instruct Hong Kong Exchange’s (HKEX) participants to conduct northbound trades on the SSE or SZSE. Hong Kong Exchange’s subsidiary (a SSE or SZSE participant) also takes instructions to conduct trades on the SSE or SZSE stock exchanges. Clearing and settlement services of A-shares executed through Stock Connect are provided by the Hong Kong Securities Clearing Company (HKSCC), a solely-owned subsidiary of the HKEX, through clearing links established with the China Securities Depository and Clearing Corporation Limited (ChinaClear). The shares of offshore investors are held in an onshore omnibus securities account registered under the HKSCC. Q: Is margin trading or short selling allowed for Stock Connect northbound trading stocks? Yes, most eligible Stock Connect northbound trading A-shares are permitted for margin trading or short selling. Nowadays, more than 80% of the total eligible Stock Connect northbound trading stocks in the SSE and more than 70% of that in the SZSE are permitted for margin trading and short selling. HKEX provides a list of eligible equities for margin trading and short selling in a timely manner.2 Q: Are there other ways to tactically manage exposure to China’s A-shares? There are offshore ETFs that investors can use to hedge their exposure to Chinese equities (Table 4). For example, Direxion Daily CSI 300 China A Share Bear 1X ETF listed on the New York Stock Exchange (NYEX) provides 100% of the inverse exposure of the performance for the CSI 300 index. This ETF may be used to hedge offshore investors’ exposure to domestic China A- shares. Table 4ETFs That Can Be Used To Hedge Investors’ Exposure To Chinese Equities Q: Describe the main differences between Bond Connect and CIBM Direct. How do overseas investors hedge their currency exposure when investing in China’s onshore bond market? Bond Connect and China Interbank Bond Market (CIBM) Direct are the official channels for offshore investors to invest in China's onshore bond market except for Qualified Foreign Institutional Investors (QFII) and RMB Qualified Foreign Institutional Investors (RQFII). Around 680 foreign institutional investors have entered China’s interbank bond market since Bond Connect’s launch in July 2017.3 Here are some differences between CIBM Direct and Bond Connect: Bond Connect is based offshore, which gives overseas investors easy and quota-free access to China’s onshore interbank bond market through offshore trade platforms. Bond Connect permits investors to open accounts, trade, and settle transactions in the offshore market whereas CIBM Direct stipulates the process must be completed in the onshore market. CIBM Direct offers greater access to opportunities in the onshore market because it has access to a wider range of products and hedge tools, such as repos, interest rate swaps, bond lending and bond forwards. In comparison, the only Bond Connect products are bonds traded in China’s inter-bank bond market, and hedge tools are limited. In terms of currency hedging, both CIBM Direct and Bond Connect allow FX hedge tools such as forwards, swaps and options to help investors hedge their exposure to CNY (Chinese yuan traded in the onshore market). CIBM Direct trades in CNY rather than CNH (CNH is Chinese yuan traded in the offshore market) and allows investors to hold onshore balances in CNY. Bond Connect, however, does not allow investors to hold CNY balances. Under Bond Connect, investors are required to exchange CNY into CNH for any excess cash from trading or coupon payments, which can be a currency risk when funds are repatriated. However, offshore investors can hedge their FX exposure with FX Settlement Banks by engaging in various FX trades and FX hedge tools that match their bond position. FX Settlement Banks are banks in Hong Kong approved by the China Foreign Exchange Trade System (CFETS) to access the FX market of CIBM as RMB participation banks. Offshore FX Settlement Banks may square positions in either offshore or onshore FX markets. Investors should contact their Hong Kong custodians, which will appoint an FX Settlement Bank for FX conversion and hedging. Q: Is there another currency hedge mechanism for investors’ CNY exposure?  CNY exposure can be hedged using the usual instruments, such as CNH-forwards or CNY-non deliverable forwards (NDF). However, the CNH-forward has CNH basis risk, which arises from the differences between CNY and CNH spot rates. Investors may consider short CNY currency ETFs listed on the offshore market, such as the WisdomTree Chinese Yuan Strategy Fund (CYB) on the NYEX. CYB offers exposure to the overnight Chinese yuan and uses both short- and long-forward currency contracts for both CNH and CNY to manage its expectations for the currency. It seeks to achieve total returns reflective of money market rates in China available to foreign investors and of changes in the value of the yuan versus the dollar. Xiaoli Tang Associate Vice President, Global Asset Allocation xiaoliT@bcaresearch.com Qingyun Xu, CFA Associate Editor, China Investment Strategy qingyunx@bcaresearch.com   Appendix 1: The Evolution of The Chinese Onshore Markets China’s onshore equity and bond markets have grown dramatically in the past two decades. The equity market is the second largest in the world with more than 4,400 listed companies; the combined market capitalization of the Shanghai and Shenzhen stock exchanges has reached USD12.2 trillion (Chart A1). China’s bond market also is ranked second globally, after the US, with amounts outstanding at USD18.6 trillion (Chart A2). Chart A1China’s Stock Market Has Grown Sharply In The Past Two Decades Chart A2China’s Onshore Bond Market Is Second Largest In World Thanks to China’s financial market liberalization since the early 2000s, foreign investors can now access China's onshore stock and bond markets to include China A-shares and onshore bonds in portfolios. Various tools are available, including QFII, RQFII, Stock Connect, CIBM Direct and Bond Connect (Diagram 1). Since the launch of Stock Connect in late 2014, the cumulative net northbound flows to the Shanghai and Shenzhen exchanges have been more than RMB1.2 trillion (Chart A3, top panel). The cumulative net capital inflows through CIBM Direct and Bond Connect have reached more than RMB3.5 trillion since these mechanisms were introduced in 2016 and 2017, respectively (Chart A4, bottom panel).  Diagram 1China’s Financial Market Liberalization Roadmap Chart A3Net Inflows To China’s Onshore Markets Through Stock And Bond Connect Chart A4Growing Foreign Holdings Of China’s Onshore Equities And Bonds Although foreign investors’ holding of RMB-denominated assets increased significantly in recent years, their share of the total onshore market is still small, highlighting the potential for more capital inflows to China’s onshore market (Chart A4). Following the inclusion of China A-shares in global equity indexes, bond indexes have followed suit and Chinese government bonds are now offered in the world’s three major bond indices. Bloomberg Barclays Global Aggregate Index (BBGA) was the first to include Chinese government bonds in April 2019, followed by the JP Morgan Government Bond-Emerging Market Index (GBI-EM) in February 2020 and finally FTSE Russell’s World Government Bond Index (WGBI) in October 2021.   Footnotes 1The list of eligible A-shares for Shanghai and Shenzhen Connect can be accessed via the HK Exchange 2List of eligible equities for margin trading and short selling 3List of approved investors under Bond Connect Market/Sector Recommendations Cyclical Investment Stance