Corporate

Highlights In this report, we take a close look at corporate margins by analyzing their key drivers: The general level of economic activity, trends in labor costs and productivity, borrowing costs, tax rates, depreciation charges, the exchange rate, and corporate pricing power. The likely contraction of margins next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth and a decline in corporate pricing power.  In the meantime, the tight labor market is putting upward pressure on wage growth despite a peak in productivity improvement. Input costs are also on the rise with PPI soaring, cutting into corporate profitability. Depreciation is already rising on the back of the recent recovery in capex. Interest expense has bottomed in the face of rising rates, and the potential healing of corporate balance sheets is leading to re-leveraging to raise capital for capex and buybacks.  The US corporate tax rate is bound to increase based on news from Capitol Hill.   The model above encapsulates all of these moving parts (Chart 1) and reiterates that the path of least resistance is lower for US corporate margins. S&P 500 operating margins are likely to contract in 2022. Feature Profits Have Rebounded S&P 500 earnings growth has rebounded vigorously from the pandemic low. Operating earnings-per-share stand 32% YoY above the January 2020 pre-pandemic high (Chart 2). Margins have also exceeded pre-pandemic levels of 11.7% reaching 14.4% in September (Chart 3). The basic story behind a rebound in profitability is well understood: Companies have cut costs aggressively, productivity has improved, lower interest rates have reduced debt servicing burdens, a weaker dollar has boosted overseas earnings, and corporate pricing power has strengthened. Gauging the direction of change for each of these various factors will help us assess whether profits can continue growing, and whether operating margins can continue expanding. Chart 1After An Impressive Surge, Margins Are Set To Decline Chart 2Profits Have Rebounded Vigorously Chart 3Margins Are Above Pre-pandemic High Sneak Preview: We expect profit margins to contract in 2022 NIPA Operating Margins vs S&P 500 Operating Margins The market tends to focus on S&P 500 earnings and these can be measured on a reported or operating basis, with the latter removing the effects of one-off charges. In order to better understand the path of S&P 500 margins, we aim to relate profits to the economic cycle; to do so, we analyze the data from the national income and product accounts (NIPA) because they are fully integrated with GDP and any related series. National non-financial after-tax profits without the inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj)1 are conceptually closest to S&P 500 profits as they measure the after-tax worldwide earnings of US corporations. Fortunately, the S&P and equivalent national income measures of operating profits broadly track each other over the long run, although the S&P data display greater volatility. The NIPA profit margin series is 70% correlated with S&P 500 operating profit margins. While this level of correlation indicates that long-term trends in NIPA profits and S&P earnings are broadly similar, short-term annual and quarterly growth rates can differ dramatically. The Key Drivers Of Profitability A number of factors can influence the path of profits: The general level of economic activity, including trends in borrowing costs, tax rates, depreciation charges, the exchange rate, productivity, and corporate pricing power. It clearly would be most bullish if productivity had been the main driver because any future benefits from the other four sources will be limited. Interest rates will normalize at some point, and effective tax rates seem more likely to rise than fall from current levels, and we should hope for faster depreciation in line with increased capital spending. In addition, the downside in the dollar is constrained by the desire of other countries to maintain competitive exchange rates. Corporate pricing power is the sole mitigating factor against these cost pressures. In this report, we will methodically go through and assess the outlook for each of these profit drivers, and their cumulative effect on profit margins for the next year or so. Revenue Growth Is A Key To Margin Expansion The EBITD measure of domestic non-financial profits excludes the impact of changes in taxes, interest rates and depreciation charges and is thus the series that is most directly affected by the underlying economic cycle and by productivity. Moreover, because it covers only domestic profits, it is not overly influenced by exchange-rate movements. GDP growth and NIPA EBITD margin expansion move in tandem. The post-pandemic rebound in economic growth has underpinned margin recovery (Chart 4). However, real GDP forecasts have recently been cut from 6.5%  to just under 6% for 2021, and to 4% in 2022 (Chart 5). Slower growth suggests that the pace of margin expansion will also slow. Chart 4EBITD Margins Usually Track GDP Chart 5GDP Growth Is Expected To Slow Cost Drivers Of Profits Labor Expense As Percentage Of Sales Has Been Falling Looking at the expense side of the NIPA Income Statement, we note that labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items (Chart 6). The NIPA EBITD margin allows us to gauge the effect of changes in labor costs on the bottom line.  Chart 6Labor Costs Are The Largest Expense After the initial spike to 54% of sales at the beginning of the pandemic, explained by rapidly falling sales and an inability of companies to rapidly reduce employee numbers, labor costs as a percentage of sales have been reverting to historical levels.  This is a curious phenomenon as wages have recently been on the rise: The number of open positions has been exceeding the number of job seekers by over a million, indicating that jobs are plentiful.  As a result, the quit rate has exploded (Chart 7). To attract and retain workers, businesses have been raising compensation, leading to average weekly earnings rising by more than 5% year over year. As a result, wages-to-sales have been trending up (Chart 8). Chart 7Quit Rate Exploded Pushing Wages Up Chart 8Wages-to-Sales Have Been Trending Up If companies must pay more for labor, why has the labor expense as percentage of sales fallen? To answer this question, we will look at the selling prices over unit labor costs as a proxy for the EBITD margin (Chart 9) to examine the underlying profitability as a function of labor costs. However, since the beginning of the pandemic, this stable relationship has broken down, with selling prices falling over unit labor costs, while margins have been expanding. Digging deeper, we notice that NIPA sales prices have rebounded (Chart 10) due to a surge in inflation and a rise in a corporate pricing power (Chart 11), while unit labor costs dived. This can be attributed to a pandemic productivity surge (Chart 12), making it cheaper to produce each additional unit.  Chart 9A Proxy For EBITD Margin Chart 10Sales Prices Are Up, Unit Labor Costs Are Down Chart 11US Corporate Power Is Waning Chart 12Productivity Has Peaked However, after rising for months, the ability of companies to raise prices further has been diminished by consumers’ income increasing slower than inflation, reducing their purchasing power.  Improvements in productivity have also peaked and are unlikely to propel margins higher.  Input Costs Are Soaring While cost of goods sold (COGS) is not one of the lines in the NIPA income statement, we would be remiss not to mention that input costs have been on the rise. The most recent reading in PPI was up 8.3% YoY (Chart 13). The price of oil has been surging as well. An increase in the cost of materials definitely has an adverse effect on corporate margins. We will quantify the effects of the year-on-year percentage of PPI on margins later in this report. Chart 13Input Prices Have Soared Other Drivers Of Profitability: Depreciation, Interest And Taxes Switching gears to other costs, interest, taxes, and depreciation expenses are likely to increase going forward. Capex Is Rising, So Will Depreciation Expense Depreciation expense is the second largest expense in the cost structure, constituting some 15% of sales. Between mid-2009 and mid-2012, depreciation charges fell sharply, curtailed by weak investment growth during the Global Financial Crisis (GFC) economic downturn. Similarly, the same story unfolded during the 2015 manufacturing slowdown, and the pandemic-induced recession (Chart 14). Today, growth in US domestic fixed investment has rebounded at rates comparable to the 2000 and 2010 recoveries. The trend will continue: According to the Philly Fed Manufacturing Survey, capex intentions have been rising (Chart 15). As a result, depreciation expense is set to climb, cutting into margins and earnings. Chart 14Capex Surge Will Lead To Higher Depreciation Chart 15More Capex Is Under Way Interest Costs Set To Increase With Rising Rates Interest charges are small compared to other expenses, never rising above 5% of sales. There has been quite a lot of variability in interest charges in recent years, reflecting swings in both interest rates and the level of corporate borrowing (Chart 16). Falling interest costs provided a boost to profits between 2008 and 2010, as well as during the trade war and the pandemic. Also, corporations have been de-leveraging, but this trend is about to turn: As the corporate sector heals, it is likely to re-leverage, whether to finance capex or buybacks. With interest rates set to rise, interest costs are likely to become a drag on profits (Chart 17).   Chart 16Higher Rates And Corporate Re-Leveraging Will Push Interest Costs Up Chart 17Corporate Debt Has Bottomed Effective Tax Rates Are Likely To Increase Effective tax rates have fallen from about 18% in 2014-2017 to 12% in January 2018 because of the Trump Administration’s tax reform and remain low by historical standards (Chart 18). Meanwhile, taxes paid have also been hit by the 2020 downturn thanks to temporary tax breaks, and have not yet rebounded to pre-pandemic levels, thereby aiding margin expansion. However, given the Biden Administration’s push to increase the US corporate tax rate and eliminate loopholes, chances are that tax expenses will rise. Chart 18Effective Tax Rates Are Low By Historical Standards Overseas Profits So far, we have focused on the domestic drivers of changes in margins.  Yet for many US corporations, especially the ones in the S&P 500, overseas profits are a key source of profits. Many industries derive a substantial share of sales from abroad, and for Technology, this number stands as high as 58%.  Historically, overseas profits have been a tremendous source of growth (Chart 19) thanks to rising exposure to fast-growing emerging economies, a weaker dollar, and the transfer of operations to low-tax regimes. However, recently this trend has turned due to closing loopholes allowing companies to locate headquarters in lower tax regime jurisdictions, tax reform, foreign profits amnesty, and unified global pressure to tax US multinationals. Onshoring of manufacturing production is another emerging trend that is likely to improve the efficiency of supply chains but will add to production expenses, chipping away at corporate profitability. The US dollar has been weakening during the pandemic, giving a boost to profits thanks to both lower prices of the American goods and translation effects (Chart 20). Chart 19Overseas Profits Are Trending Down Chart 20USD TRW Is Strengthening Hence, we conclude that the share of overseas profits is unlikely to change and is not going to become an engine for profit growth for US corporations. Where Next For Profits? The clear implication from the above analysis is that profits have ceased to benefit from earlier benign trends in depreciation charges, interest costs, and tax rates. Looking ahead, these factors, are destined to become modest headwinds for profit growth. Sales growth is also likely to slow as GDP growth returns to trend, with overseas profits less of a source of growth. And importantly, productivity growth and pricing power have peaked and turned, depriving the economy of its key drivers of margin expansion. S&P 500 The obvious question is how all the factors affecting NIPA margins translate into the forecast for change in S&P 500 operating margins. S&P 500 margins are subject to the same profit drivers as the NIPA accounts. In order to forecast the effect of these factors on the year-on-year changes in operating margins, we have built a simple regression model that uses year-on-year changes in average hourly earnings (AHE) to capture the cost of labor; high-yield option-adjusted spreads (OAS) to capture the cost of borrowing; year-on-year PPI as a change in cost of input materials; the trade-weighted USD as an indicator capturing change in foreign profits; and, lastly, the BCA pricing power indicator to measure companies’ ability to pass on these costs to their customers (Table 1).   Table 1Regression To Predict Operating Margins YoY% The model forecast of margin growth peaked in August 2021 and is about to slow into the balance of the year (Chart 21). Margins will contract outright in December 2021-January 2022. The growth rate for margins in January 2022 is -65% year on year.  In January 2021, operating margins were 7.2%. Incorporating a negative year-on-year growth rate, we arrive at margins of only 2.6%, which is certainly very low. The caveat here is that our objective is to predict the direction of change as opposed to working out a point estimate of future margins. In other words, there is a wide confidence interval around any forecast of earnings given the unpredictability of movements in the exchange rate, productivity and the general level of economic activity. However, our assumptions are conservative, and the model clearly points to a margin contraction in 2022. Chart 21After An Impressive Surge, Margins Are Set To Decline And lastly, why will margins contract? What is the main culprit that would make things worse? The answer is an increase in input and labor costs (PPI and AHE), both of which are no longer being offset by a corporate pricing power: The ability of corporations to pass on their costs to customers has diminished, and margins are going to take a hit (Chart 22 & Table 2). Chart 22Increase In Costs Is No Longer Offset By Pricing Power Table 2Contributions To Margins Growth Bottom Line Earnings growth and profit margins are of paramount importance to the performance of equities – as we wrote in a report in August, the key driver of returns has shifted from multiple expansion to earnings growth. Despite the recent pullback, the S&P 500, trading at 20.5x forward multiples, is still expensive. Our analysis shows that S&P 500 operating margins are likely to contract in 2022 because of rising wages, a slowdown in productivity, increases in interest and depreciation expenses, and potential tax hikes. On the revenue side, US GDP growth is slowing, and corporate pricing power is waning, making it difficult to pass on rising costs to customers. Impending margin contraction does not bode well for the strong performance of US equities in the year ahead.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com       Footnotes 1     Profits before tax reflect the charges used in tax accounting for inventory withdrawals and depreciation. The inventory valuation adjustment (IVA) and the capital consumption adjustment (CCAdj) are used to adjust before-tax profits to NIPA asset valuation concepts. The IVA adjusts inventories to a current-cost basis, which is similar to valuation of inventory withdrawals on a last-in/first-out basis. The CCAdj adjusts tax-reported depreciation to the NIPA concept of economic depreciation (or “consumption of fixed capital”), which values fixed assets at current cost and uses consistent depreciation profiles based on used asset prices. Recommended Allocation

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

Highlights Economy – A partial undoing of 2017’s Tax Cuts and Jobs Act is in the works as Congress takes up the Biden Administration’s infrastructure agenda: A modest increase in the marginal corporate tax rate to help fund infrastructure investment is being discussed on Capitol Hill. We do not expect the ultimate agreement will meaningfully impact output. Markets – Equities appear to have taken little note of the tax-hike debate, and there are worries that investors are being overly complacent about the potential implications: Earnings estimates do not seem to reflect the impact of higher taxes on companies’ bottom lines. Based on the proposals that are reportedly being discussed, however, we think the impact on S&P 500 earnings will be modest. Strategy – A tax hike alone does not justify broad asset allocation shifts, though adjusting positions within equity portfolios could have promise: The effects from a marginal rate increase will be felt most strongly at the individual stock level, based on differences in effective tax rates. Feature We have shown that bear markets (light red shading) and recessions (gray shading) tend to coincide, while stocks generally march higher during economic expansions (Chart 1). We have also shown that the S&P 500 performs considerably better when monetary policy is easy (the fed funds rate is below our estimate of equilibrium) than when it is tight (fed funds exceeds our equilibrium estimate). While an investor could do a lot worse than mechanically tie his/her equity positioning to the state of the business cycle and/or the monetary policy cycle, it is not easy to recognize the onset of a recession in real time or accurately assess the equilibrium fed funds rate. We are confident, however, that a recession will not occur in time to sour the twelve-month outlook unless a vaccine-resistant strain of COVID emerges and that monetary policy is at least a couple years from turning restrictive. Chart 1Bear Markets Coincide With Recessions There is more to asset allocation than monetary policy settings and the state of the business cycle, but they currently call for a default equity overweight in multi-asset portfolios. Per our process, an investor must have a very good reason for overriding that default. A blow to earnings from a corporate tax hike that has not been discounted could provide that reason, especially when valuations are extremely elevated. Although it is difficult to know exactly what markets are discounting at any given moment, it seems clear that equity analysts have not put a great deal of effort into estimating the impact of a tax hike on the earnings of the companies in their coverage universe. The good news is that our base-case scenario suggests that the tax changes most likely to make it through Congress will deal the bull a glancing blow rather than a knockout punch. We estimate that a statutory increase in the corporate tax rate from 21% to 25% would clip S&P 500 earnings by about 5%. Against a backdrop of unusually conservative four-quarter earnings expectations, the lagged effects of extraordinarily accommodative monetary and fiscal support, and a paucity of alternatives, the equity bull market appears to be capable of weathering a modest tax hike. The Gap Between Marginal And Effective Tax Rates The byzantine nature of the United States tax code creates myriad opportunities for the spectrum of companies subject to its provisions. Tailored tax advice is a thriving cottage industry that employs hundreds of thousands of well-paid accountants, attorneys and specialists in structuring transactions to minimize clients’ outlays. The upshot of the various incentives embedded in the code is that the marginal tax rate – the tax owed on an additional dollar of earnings – may diverge from the effective tax rate – the share of an entity's aggregate earnings that are paid in taxes. Based on the relative favoritism the code bestows upon a particular activity, or the disparate way it treats domestic and foreign operations, effective tax rates can vary widely at the industry level. Of the 392 S&P 500 constituents that owed income tax in their last full year of operations, 60% had an all-in effective tax rate that fell below the 21% statutory federal rate.1 After allowing for state and local income tax levies, the distribution of effective rates shows that a considerable majority of companies manage to pay less than the marginal rate (Chart 2A). The potential for reducing the effective rate is directly related to a company’s size (presumably because the biggest companies are most likely to have multinational activities): the 30 largest tax-paying constituents, accounting for over one-half of the index's tax-paying market-cap, were even more adept at staying below the all-in marginal rate (Chart 2B). Chart 2AS&P 500 Constituents Pay Less Than The Stated Tax Rate ... Chart 2B... Especially If They're Mega-Caps If every S&P 500 constituent’s effective tax rate equaled the marginal tax rate, an increase to 25% from 21% would result in a 5.1% decrease in S&P 500 earnings, as net income would fall from 79 cents of every dollar of pre-tax income to 75 cents. The income decline would be permanent, assuming no further tax-rate changes, and would merit an equivalent decline in the index. Changes in long-run fundamental prospects are not reflected instantaneously in stock prices, however, and it is uncertain just when the market would account for it. There are additionally some near-term buffers to declines in forward four-quarter estimates that might mask any drag from a tax hike. If A Long-Term Tree Falls, Will It Make A Sound? The future is unknowable, but we have at least a puncher’s chance of anticipating what’s to come over short segments like a quarter or a year. The ecosystem of publicly held companies largely operates within that one-to-four-quarter timeframe: companies report quarterly results, as do asset managers, and nearly everyone professionally involved with public equities is subject to compensation structures with annual performance incentives. A share of stock may entitle its owner to a proportional share of earnings in perpetuity, but the next four quarters loom large in the market’s calculus, even to the point of obscuring nearly everything that may come after them. It follows, then, that surprises affecting the outlook for the next year may muffle the market’s reaction to tax negotiations on Capitol Hill. We repeat that consensus analyst expectations for the coming four quarters are modest relative to history and the current macroeconomic backdrop. Now that the second quarter is in the books, analysts are calling for a slight earnings retrenchment, with earnings falling nearly 7% in the third quarter before rising 4% and 1% in the next two quarters, respectively, to settle in the first quarter of 2022 at a level 2% below the quarter just ended. They are not projected to top last quarter’s high-water mark until the second quarter of 2022 (Table 1). Table 1A Low Bar It is possible that earnings will grow that slowly – the pandemic is not over, corporate profit margins may narrow if companies are unable to raise prices enough to cover their rising input costs, fiscal support for the economy is waning, and financial conditions may tighten as the Fed dials back monetary accommodation at the margin – but it would be unlikely on two counts. First, it would counter the empirical record. Earnings have tended to grow, quarter-on-quarter, during expansions (Chart 3). Chart 3That's Why They're Called Expansions Second, it would fly in the face of the red-hot macroeconomic backdrop. The lagged effects of extraordinarily accommodative monetary and fiscal policy settings have real US GDP poised to grow at a pace well above its long-run potential trend through the end of 2022. The equity market is indifferent to quarterly GDP releases, which come out every 63 trading days with a one-month lag and are subject to two revisions that arrive after 21-session intervals, but trailing four-quarter GDP is highly correlated with trailing four-quarter sales (Chart 4, top) and earnings per share (Chart 4, bottom). We of course prefer forward-looking models to backward-looking data but the persistence of economic cycles, especially as they have lengthened across the postwar era, confers some useful predictive properties on trailing data. Chart 4GDP Growth Influences Revenue And Earnings Growth Earnings are a function of revenues (units times price per unit) and margins (per-unit profitability) and robust GDP growth would seem to be tied only loosely to the latter. Over the last three decades, however, growth in S&P 500 earnings per share has been as correlated with GDP growth as growth in revenue per share. Margins are already elevated (Chart 5) and rising cost pressures threaten to squeeze them unless companies can pass on costs to their customers, but the volume pickup embedded in potent real GDP growth will mitigate some of the downward pressure. Chart 5Elevated For Longer? We will have to wait and see how much pricing power companies have, as it will probably take several months before a clear picture begins to emerge. If they can make price hikes stick, margins will hold up, earnings will keep rising and the S&P 500 should power through the meager year-end 2021 and 2022 targets offered by a panel of buy- and sell-side strategists in last week’s Barron’s. We think it is plausible that households, flush with found money from pandemic fiscal transfers and/or financial and housing market appreciation, may prove to be relatively price-insensitive until they work down their windfalls. Vibrant demand could push companies to increase capacity, boosting hiring and capex, stoking more demand in a self-reinforcing post-pandemic honeymoon. The boom would not go on forever, but such a scenario would yield more upside for financial markets and the economy than the increasingly wary consensus projects. Revisiting Lower Fifth Avenue’s Retail Corridor To landlords’ chagrin, businesses’ real estate costs are a source of margin relief. We returned to lower Fifth Avenue to update our retail rental survey and found that little changed between Memorial Day and Labor Day. Two storefronts that were vacant at the end of May have since been rented by pandemic winners Tonal (interactive home gyms) and Hoka (high-performance running shoes), filling two corner locations in the northern half of the corridor (Figure 1). Four storefronts that were occupied by apparel retailers on our last tour – Gap, Gap Kids and Gap Body, and Rigby & Peller, a specialty purveyor of lingerie and swimwear – are vacant now (Figure 2). The net two-store decline has reduced the retail occupancy rate on Fifth Avenue between 14th Street and 23rd Street to 60% from 63%. Figure 1Fifth Avenue Storefronts, 19th Street To 23rd Street Figure 2Fifth Avenue Storefronts, 14th Street To 19th Street According to the Real Estate Board of New York (REBNY), average and median asking rents along the corridor have fallen by 3% and 21%, respectively, since Fall 2020. The excess of storefront supply over demand is a modest inflation corrective in an economy in which the partial release of pent-up demand has exceeded the uneven restoration of supply across several categories. REBNY’s semi-annual rental research survey left no doubt that retail tenants have the upper hand in Gotham and we’d suspect that office tenants do as well. The current market offers tenants ample availability and reduced leasing costs. Some firms recently capitalized on the conditions[,] … includ[ing] [upscale British furniture] retailer … Timothy Oulton [which leased over 7,000 square feet of space across three levels at 20th and Broadway, a block east of Fifth Avenue]. Additionally, an array of smaller service-oriented retailers such as dry cleaners, dance studios and barber shops are locking in favorable terms or shifting to better locations.2 Investment Implications The investment implications of the equity market’s seeming nonchalance regarding looming corporate tax hikes will probably be most keenly felt at the sector, sub-industry or individual stock level. Though we do not see meaningful asset allocation consequences, the disparity in effective tax rates at the sector level (Table 2) hints at disparities across sub-industries and individual stocks. With input from equity analysts, it should be possible to assemble baskets of stocks based on their sensitivity to a higher marginal income tax rate. Table 2One Size Does Not Fit All As Barron’s September 6th Fall Investment Outlook feature highlighted, buy-side CIOs and sell-side strategists have adopted a measured tone. Year-end 2021 S&P 500 targets hover around the index’s current level and top-down 2022 projections offer no more than grudging upside. Tightening margins are a leading fundamental concern, along with rising inflation pressures, and elevated valuations contribute to the sense of unease. A chorus of “This won’t end well” intonations suggests that stocks may have a wall of worry to scale before the spoilsport consensus can claim validation. Regarding inflation concerns, asset allocators should bear in mind that stocks are an inflation hedge relative to cash and bonds. They should also recognize that high inflation does not derail equities; tight monetary policy in response to high inflation, which involves higher interest rates as part of a deliberate effort to throttle an overheating economy, derails equities. Investors conditioned to a predictably rapid Fed response may view this as a distinction without a difference. Per our house view that the fed funds liftoff date is over a year away and the sustained series of rate hikes required to tighten policy is well more than another year out, however, TINA's influence may become even more pronounced before this bull market ends. We remain vigilant, but we think it is too early to head for cover.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The term “all-in” recognizes that US corporations uniformly incur tax liabilities at the state level in addition to their federal obligations. The average marginal 2021 state income tax rate is 6.6%. 2  REBNY_Manhattan_Retail_Spring_2021.pdf

This week I have been holding client calls and roundtables with clients located in the EMEA region. In next week’s report we will share our answers to the most common client questions. In the meantime, this week we are sending you a report about Peru that discusses the political situation and the outlook for the nation’s financial markets. Best regards, Arthur Budaghyan Highlights Do not bottom fish in Peruvian financial markets. Political volatility has not yet reached its apex. Clashes between the government and congress are inevitable. Either president Pedro Castillo will be impeached and massive protest will follow, or his party’s radical leftist agenda will be at least partially legislated. Neither scenario bodes well for Peru’s financial markets. Capital outflows and lower metal prices pose a threat to the exchange rate. Go short the sol versus the US dollar. Dedicated EM equity and fixed-income managers should continue underweighting Peru in their respective portfolios. Feature Chart 1Peru: Absolute And Relative Equity Performance Peru’s financial assets have plummeted due to the election of left-wing president Pedro Castillo. Some investors may be tempted to bottom fish in these markets due to their lower valuations and oversold conditions (Chart 1, top panel). Some may attempt to draw parallels with Brazil’s 2002 election of Lula da Silva which initially triggered a selloff in Brazilian financial markets followed by a substantial rally during the president’s two terms in office. Will that be the case with Peruvian markets? We do not think so. Unlike twenty years ago in Brazil, Peru is currently facing a much worse political and economic outlook. Overall, the political volatility as well as deteriorating macro fundamentals warrant a higher risk premium on Peruvian assets. Thus, we recommend investors underweight Peru within EM equity, local, and sovereign fixed-income portfolios (Chart 1, bottom panel). A Political Showdown Is Looming One could argue that Peruvian financial markets have hit a floor and that much of the bad news has already been priced. Another argument is that Castillo will not be able to pass sweeping socio-economic reforms because of strong opposition from congress. In our opinion, Peru has yet to reach peak political tensions, which may very well end with a bang. Given this heightened political uncertainty, investors should brace themselves for a rocky ride. We identify two main risks plaguing Peruvian politics. First, the unsustainable ideological divide within Castillo’s proposed cabinet between far-left militants and the pragmatic center-left. Second, the looming clash between a government that wants to upend the country’s socioeconomic system and a notoriously harsh congress keen on making the president’s job unbearable. Intra-Government Dichotomy The ideological divide in Castillo’s government is extreme. On one side is the Marxist-Leninist wing, headed by Free Peru’s party leader, Vladimir Cerrón, and prime minister candidate, Guido Bellido. On the other side is the left-to-center members, headed by Pedro Francke, the minister of finance candidate. The more extremist Marxist-Leninist camp constitutes the majority, while moderates are a minority. Critically, the Marxist-Leninist radicals will make few concessions to the moderate ministers, as the former believe they have a mandate from the people to upend the country’s socio-economic system. Nevertheless, the policies supported by the general public are more nuanced than that. According to a national Ipsos survey from August, 85% of respondents believe president Castillo should govern with technocrats in his governments’ key positions. Only 11% support him making the ideology of his party the centerpiece of his policies and promoting (radical) members of his party. This shows how Castillo’s victory was more of a national referendum against Fujimori and the corrupt political elites than support for a radical socialist government. We elaborated on this topic in our previous report on Peru. The wide ideological divide between the party and a few moderate members of the cabinet in key positions will make governing extremely difficult. Cracks are already beginning to form. Bellido and Francke hold different views on the role of the state in the economy. Bellido, on the one hand, has stated he supports state-owned companies in commodity-extracting sectors (particularly natural gas and hydroelectricity) and the drafting of a new constitution to give the state greater ownership of mining contracts. Francke, on the other hand, wants to reinstate fiscal spending caps and is less harsh with multinational companies, favoring an increase only in mining taxes. Furthermore, there is significant uncertainty around the government’s official fiscal plan, as Francke has avoided giving clear figures on fiscal expenditures and social programs. To make matters worse, there is growing concern that it is party leader Cerrón who is de facto in charge, and that he has an enormous influence on Castillo. Cerrón is unpopular among voters as a result of his criminal allegations, close ties to the Cuban regime, and often apologetic stance toward the Maoist terrorist group, Shining Path. Although he intended to run as the presidential candidate for Free Peru, he was banned from the election because of ongoing criminal accusations, which is why he handpicked Castillo as his replacement. Without a doubt, he intends to be heavily involved in government decision-making. According to the same Ipsos poll we cited earlier, 61% of Peruvians believe Cerrón is either de facto in charge of the government or holds considerable sway over Castillo. The biggest risk to financial markets will be the eventual dismissal or resignation of finance minister Francke. This may happen as he eventually realizes that the radicals will concede very little. This would also lead to a resignation of orthodox central bank governor Julio Velarde, who Francke has been able to convince to remain in his post. These two resignations would result in another riot in Peruvian markets, as the investment and business communities fully lose confidence in Castillo’s government.  An Inevitable Clash Between The Government And Congress Being president in Peru is a notoriously difficult job due to the large sway that congress has on legislation and governing. The outcome of this constant confrontation between the president and congress has been five different presidents in the past five years alone. Critically, this tension has never been higher. The government and congress hold diametrically opposed views on the broad vision and strategy for the nation and how the economy should be managed. On the one hand, congress is mainly composed of traditional centrist parties and the opposition holds a majority—Castillo’s coalition has only about 39% of the seats. On the other hand, the government has just been elected on a far-left reformist platform. In essence, both the government and congress have incentives and the determination to be as obstructive as possible for each other. As tensions ramp up and confrontation becomes inevitable, the risks of unrest and clashes between supporters of Castillo and congress will rise. Table 1Peru: Voters Support More Moderate Politicians In congress’s point of view, they have a mandate to serve as an opposing force to Castillo’s radicalism: There is some validity to this claim. The opposition holds a majority, and congress president Maricarmen Alva is by far more popular than the leaders of the Free Peru party like Cerrón and Bellido (Table 1). Given that Castillo’s ideology is a threat to the nation’s current socio-economic model and, thereby, to the political establishment, the majority in congress would prefer to block all radical legislation, including the appointments of controversial cabinet members. In addition, they will use all manner of accusations and alleged linkages between cabinet members and Shining Path to impeach Castillo. Congress needs only 87 votes, which means they need to convince only eight members from the governing alliance to impeach Castillo. In turn, the government argues it was elected to upend the country’s status quo and confront the unpopular political elites: Critically, the president has the ability to dissolve congress after two votes of no confidence, thereby putting pressure on congress to abide by the government’s radical proposals. This latter point and the fact that congress has little popular support provide leverage for the government over congress. Given the fact that current congressional members cannot be reelected, they might be more careful about how they maneuver, so that they do not provoke Castillo to dissolve congress. There are, therefore, two extreme possible outcomes. On one hand, congress may impeach the president, triggering a social revolt from Castillo’s hardline supporters against congress. On the other hand, congressional members may allow the passing of a leftist legislative agenda in order to maintain their seats, which would gravely reduce corporate profitability and productivity in Peru. Both scenarios would result in a collapse of investor and business confidence, leading to more capital flight and a riot in Peruvian financial markets. Bottom Line: Political volatility in Peru has not yet reached its apex. Clashes between the government and congress are inevitable, as well as among key cabinet members. Such elevated political volatility warrants a higher risk premium on Peruvian assets. Return Of Macro Instability Peru enjoyed a period of relative macro stability from the early 2000s until recently. Its currency, local interest rates, and sovereign spreads have fluctuated less than those in other Latin American countries. However, the nation’s economy and financial markets have entered a period of heightened volatility. Both domestic and external macro factors have turned into headwinds for the Peruvian economy and financial markets. Chart 2Peru: Business Confidence Will Continue Plummeting Domestically, the economic recovery has been uninspiring, and multiple indicators point to growth disappointments ahead: Business confidence took another serious hit with the election of Castillo and ensuing uncertainty (Chart 2). Imminent political volatility will further depress business confidence, and, consequently, capital expenditures and hiring in the coming months. This will curb household income growth and consumer spending. Peru remains one of the world’s deadliest COVID-19 hotspots (Chart 3, top panel). In addition, vaccination rates are the lowest among major Latin American economies (Chart 3, bottom panel). As the more infectious Delta variant becomes dominant, there will not be enough immunity to hold back new cases. Consequently, either the government will introduce lockdowns or people will voluntarily limit their activities, thereby inhibiting the nascent economic recovery. The unemployment rate remains far above its pre-pandemic level (Chart 4). Thus, household income remains very depressed. The latter does not bode well for debtors’ ability to service debt. Chart 3Peru: The Government Has Grossly Mismanaged The Pandemic Chart 4Peru: Labor Market Has Not Fully Recovered   As a result, loan delinquencies will rise anew, weighing on banks’ appetite to lend. Notably, local currency loans to the private sector will contract (Chart 5).    Chart 5Peru: Prepare For A Credit Slump Commercial banking profitability is also vulnerable, as president Castillo aims to strengthen the state bank (Banco de la Nación) by expanding its operations and undercutting private banking fees. Given financials of the bourse’s market cap, poor banking profitability is a major risk to this stock market. Unrelenting currency depreciation—see below for a more detailed analysis of the exchange rate—will prompt the central bank to hike rates further. This will not only weigh on new credit demand, but also augment loan delinquencies in the banking system. As a result, banks will become very risk averse and shrink their balance sheets. A credit crunch will ensue. Even though fiscal spending will be increased, it is unlikely to propel economic growth. The basis is that fiscal primary spending accounted for less than 15% of GDP before the pandemic and is now 17% due to the pandemic distortion (Chart 6). In the meantime, consumer spending constitutes 63% of GDP, capital spending 21%, and exports 25%. Externally, deteriorating balance of payments dynamics will weigh down on the currency: Peruvian assets tend to move with the country’s trade balance and global metal prices. The fact that Peruvian stock prices have plummeted in the face of rising industrial and precious metal prices supports a bearish thesis on this bourse (Chart 7). Chart 6Peru: Fiscal Expenditures Have Risen Due To The Pandemic Chart 7Rising Metal Prices Have Failed To Boost Peruvian Stocks Chart 8China's Slowdown Portends A Fall In Commodities Export revenue will contract as a result of a decline in commodity prices brought on by China’s slowing “old economy” (Chart 8). Precious and industrial metals together account for 66% of Peru’s merchandise exports. A meaningful decline in metal prices will erode the trade surplus and weigh on the exchange rate. Furthermore, Peru is already experiencing capital flight. Potential anti-market policies from this government could trigger more capital exodus. The capital account deficit will widen as both FDI and portfolio inflows fall due to the negative commodity outlook as well as political uncertainty (Chart 9). Foreigners still hold 45% of local currency bonds, and they will reduce their holdings (Chart 10). Chart 9Peru: FDI Inflows Will Decline Chart 10Peruvian Domestic Bonds: Will Banks Make Up For Foreign Investor Retrenchment? Chart 11Peru: The Dollarization Rate Has Room To Rise Currency depreciation will also be reinforced by locals converting their sol deposits into foreign currency. The dollarization rate—the ratio of foreign currency banking deposits to total deposits—will rise (Chart 11). A weakening currency will also lead to higher inflation expectations, to which the central bank will respond by raising rates. The monetary authorities already hiked the policy rate by 25 basis points this month due to higher-than-expected inflation and a rapidly depreciating currency. As Peru’s exchange rate continues to weaken, the central bank might also sell foreign currency reserves to prevent large fluctuations in the value of the currency. This foreign exchange intervention will, in turn, shrink banking system local currency liquidity and lift interbank rates (Chart 12). Chart 12FX Reserve Sales Will Shrink Banking Liquidity And Lift Interbank Rates In short, the central bank has enough international reserves to stabilize the exchange rate, but this will come at the cost of tighter liquidity and higher interest rates. The latter will only reinforce sluggish growth in domestic demand. Bottom Line: Heightened political volatility and lower metal prices are working against the Peruvian economy and its financial markets. Peru is experiencing large capital flight, which will exacerbate currency depreciation. Investment Recommendations Keep an underweight allocation to the Peruvian bourse within an EM equity portfolio. We recommend currency traders go short the Peruvian sol versus the US dollar. While the sol has already depreciated considerably, the domestic and external headwinds entail more downside. For fixed-income investors, we maintain an underweight allocation to Peruvian sovereign credit in an EM credit portfolio. The basis for this position is that the nation’s fiscal policy may undergo a major shift, entailing larger fiscal spending and wider budget deficits. We are downgrading local bonds from neutral to underweight in an EM domestic bond portfolio. Critically, the share of foreign ownership of Peruvian local fixed income remains one of the highest in the EM universe—it has only fallen from around 55% to 45% of domestic fixed-income instruments in the past six months (Chart 10 on page 9). Thus, there is a major risk that foreign investors will sell domestic bonds as the currency depreciates further, which will weigh down on local bonds. Juan Egaña Research Analyst juane@bcaresearch.com Footnotes

Highlights The baht will depreciate further, given the state of the economy and external accounts. Domestic demand was already relapsing, even before the latest surge in COVID-19 cases. Now, the recovery will be delayed more. The authorities have little to offer by way of fiscal or monetary support. Credit to the job-intensive SME sector has collapsed. The balance of payment dynamics remains negative for the currency. Investors should stay short the baht. Dedicated EM asset allocators should continue to be neutral on Thailand within respective equity and domestic bond portfolios. Feature Chart 1Thai Stocks Are Facing Several Headwinds Our negative view on the baht has played out as expected.1 The Thai currency is down 10% versus the dollar since its peak in February of this year. It has also been the worst performer in Asia. The country’s stock market is struggling and going down in both absolute terms and relative to their EM counterparts (Chart 1). Going forward, odds are that the baht will remain weak. A weak currency will continue to stifle both Thai stocks’ and local currency bonds’ relative performance. Investors should stay short the baht and remain neutral Thai equity and local currency bonds within their respective EM portfolios. Relapsing Growth Chart 2Surging New COVID-19 Cases... The latest spike in new COVID-19 cases has dashed hopes for any early recovery of the Thai economy (Chart 2). Earlier this month, the central bank revised down their GDP forecast for 2021 from 1.8% to 0.7%. We concur with this bearish outlook: Private consumption in real terms was languishing as of June this year at 10% below 2019 levels. Car sales, both personal and commercial, are even more downbeat (Chart 3). After the latest surge in new COVID-19 cases, those numbers must have weakened further. Incidentally, the country’s vaccination rate, at 26% of total population (7.5% fully vaccinated), remains low. It could be, therefore, several months before any meaningful recovery in consumer demand takes place. Faced with low demand, the country’s manufacturing and shipment volumes are also weak. They are both breaking down anew from well below the 2019 levels (Chart 4, top panel). Chart 3...Will Further Delay Domestic Demand Recovery Chart 4Manufacturers Are Saddled With High Inventory Amid Weak Orders...   Weak demand also means that businesses are stuck with high inventories. Indeed, there is a widening disparity between inventory levels and shipments (Chart 4, middle panel). Furthermore, order books have slipped back to levels not seen since the height of the COVID-19 scare early last year. The combination of high inventories and tumbling orders does not portend a manufacturing recovery anytime soon (Chart 4, bottom panel). Notably, jobs and wages are also weak. Employment in the manufacturing sector is well below pre-pandemic levels (Chart 5). This trend, in turn, is hurting household income and consumer demand, completing a vicious cycle of depressed demand, weak production, falling employment and household income, and further reduced demand. The softness of the economy is accentuating the disinflationary pressure that was already entrenched. Headline and core CPI in Thailand have stayed mostly below 1% over the past five years — the lower band of the central bank’s inflation target. Now, they are flirting with outright deflation. In fact, if the impact of food and oil prices is excluded, the prices are actually deflating (Chart 6). Chart 5...Which Is Hurting Jobs And Wage Growth Chart 6Thailand Is Flirting With Outright Deflation...   Outright deflation makes it harder for borrowers to service their debts, which then discourages both borrowing and spending — making the recovery much harder. Notably, the banks’ prime lending rates remain high at 5.4%, which means real prime lending rates are quite steep at 5% (deflated by core CPI). This is at a time of very low household income and business revenue growth expectations. This trend is a strong disincentive for borrowing and consuming /capital spending. Little Policy Support What is more concerning for the economy is that policymakers can offer little to boost the economy. Fiscal stimulus has waned: government expenditure, after a surge last year, is now contracting (Chart 7). The budget proposal for the next fiscal year (October 2021 - September 2022) that was passed by the parliament in June 2021 (first reading)2 stipulates a 5.7% cut in nominal spending. Part of the reason is that fiscal deficits have already ballooned to a staggering 8% of GDP — from an average of 2.5% in the past ten years. The IMF estimates that the fiscal thrust will be zero this year, and a negative 2.4% of GDP in 2022 (Chart 7, bottom panel). The monetary policy transmission is also paralyzed. Despite easing by the Bank of Thailand — the policy rate is at an all-time low of 0.5% since May last year — credit growth is dismal. Lenders are wary of rising NPLs and are holding back new credit: The share of impaired loans (NPLs plus Special Mention Loans) of total bank loans has dramatically increased to 10%. In the case of small and medium enterprises (SMEs), that ratio is 20%. By comparison, loss provisions are much lower, at just 5.2% as of June of this year (Chart 8, top panel). Chart 7...Yet, The Government Is Planning To Cut Fiscal Spending Chart 8Sharp Rise In Banks' Stressed Loans Amid Tanking Profits...   Notably, both operating and net profits of banks had already halved (as a % of assets) by June 2021 — as both interest and non-interest incomes dropped. Profits are slated to contract further, since banks will have to make greater provisions in the future as the recent surge in new cases will produce more loan delinquencies (Chart 8, bottom panel). The specter of rising NPLs has prompted banks to retrench loans. In particular, bank credit to SMEs has plunged by a massive 34% from 2019 levels (Chart 9). Before the pandemic, banks’ SME loans made up a significant 30% of GDP. Now, they are down to 21%. Credit retrenchment of this order to the job-intensive SME sector is going to have a significant negative ripple effect. Employment will shrink further as small businesses go bust. Shrinking jobs will dent household income, and, in turn, consumer demand. Incidentally, loans to other business segments are also not rising much. Bank loans to all non-financial corporates are growing rather minimally, at 1.5% year-over-year. Going into the pandemic, the Thai household sector was already highly leveraged. Over the past two decades, banks and other financial institutions have been lending ever more to households, shunning non-financial corporates. Households’ borrowing from banks have now risen to 40% of GDP; and those from other institutions another 50%. These loans had helped boost consumer demand all those years, but now, at a time when incomes are uncertain, households have very limited appetite to borrow more to spend. This means a consumer debt-fueled demand recovery is not in the cards (Chart 10). Chart 9...Induced Banks To Massively Reduce Credit To The Job-Intensive SME Sector Chart 10Thai Households Are Too Indebted To Borrow More And Spend   In brief, Thai businesses are in the middle of a toxic combination of contracting sales, absent fiscal support, slashed credit facilities, and rather high borrowing costs in real terms. Chart 11 shows that corporate profit margins of non-financial firms are struggling at a low level. It is no wonder that businesses are reluctant to invest, expand, and hire. The message is similar when we examined all companies included in the MSCI Thailand stock index. On the one hand, their EPS has fallen to 10-year lows. Thai stock prices, on the other hand, have not yet fallen as much as the shrinking EPS would imply (Chart 12, top panel). The consequence is that the valuations are remarkably stretched—near a 20-year high (Chart 12, bottom panel). Chart 11Low Margins Are Discouraging Thai Firms To Borrow, Invest, Or Hire Chart 12Thai Profits, At A Decade-Low, Are Also A Headwind For Stock Prices   All in all, for Thai share prices to stage a sustainable rally, an economic recovery is essential. The first indications of that usually come from an improving order book. The latter currently shows little glimmer of hope. But investors should keep an eye on this indicator, as Thai stocks’ performance is geared to the ebbs and flows of the business order book (Chart 13). Thailand Needs A Weaker Currency The state of the Thai economy not only warrants exchange rate depreciation, but also needs a much weaker currency to help an economic recovery. The country’s balance of payment is in deficit — for the first time since 2014. A crucial reason is that the baht is still expensive, which continues to weigh on exports. Of all the export-oriented Asian economies, Thai exports recovery has been the weakest (Chart 14). Chart 13Keep An Eye On The Order Book For A Sign In Stock Recovery Chart 14An Expensive Baht Held Back Thai Exports Recovery   The fact that a quarter of Thai exports go to other ASEAN countries — where demand has been and remains weak due to the lingering pandemic — doesn’t help either. As a result, the Thai trade surplus has narrowed significantly, and the current account has slipped into deficit (Chart 15, top and middle panels). The other main external revenue source of Thailand, tourism, continues to be near absent at 0.6% of GDP — a far cry from a high of 12% before the pandemic (Chart 15, bottom panel). What’s more, there is little hope of any recovery in the near future. The government now expects the number of foreign tourists this year to be as low as 0.3 million versus 40 million in 2019. On the capital account front, Thailand continues to hemorrhage both FDI and portfolio capital — just as it did the past several years. Despite that, the baht had remained strong until early this year, as a result of a substantial repatriation of bank deposits by Thai residents and, to a lesser extent, foreign borrowings. Those inflows prevented the Thai baht from depreciating. But such panic-stricken, one-off savings/deposit repatriations by Thai residents will certainly slow materially going forward (Chart 16). Chart 15The Thai Current Account Balance Will Struggle To Stay In Surplus... Chart 16...While The Capital Account Balance Will Slip Deeper Into Deficit...   There’s also little hope that FDI and portfolio inflows will pick up the slack. The reason is that the Thai economy is very weak and the return on capital is low. The latter discourages capital inflows. The fact that the baht continues to be an expensive currency in real terms, and therefore not as competitive as some of its neighbors’, doesn’t help either. The multi-nationals who are planning to re-locate out of China might find some other countries — where the currency is more competitive (such as in India, Malaysia, or the Philippines) — more attractive. Overall, the Thai capital account balance will likely slide deeper into deficit, at a time when the current account will also struggle to stay in surplus. The result will be a further deterioration in the country’s balance of payment, hurting the baht (Chart 17). Considered from another angle, if the return on capital on Thai assets is any guide, the baht could drop much more from its current levels (Chart 18). Chart 17...Putting Downward Pressure On The Baht Chart 18Thai Firms' Low Rates Of Return Point To More Baht Depreciation     The reality is that, given Thailand’s current macro backdrop, a cheaper currency is what the nation needs. That will help boost growth significantly by aiding exports and promoting import substitution. Since foreign trade makes up an impressive 90% of GDP, a boost therein could kickstart the entire economy. Another result of a weaker currency will be higher inflation, something the economy seriously needs. Higher inflation will contribute to lower real interest rates which, in turn, will encourage borrowing and spending. Higher spending and inflation will help achieve higher nominal sales, boost firms’ profits, employment, and eventually, household incomes. All in all, it could allow a productive cycle to unfold. Given all these possible benefits and given that policymakers have few other tools at their disposal at this juncture, chances are the central bank will let the baht depreciate more, albeit in an orderly fashion, in the months to come. What About Bonds? Chart 19Mantain A Neutral Allocation To Thai Domestic Bonds In An EM Basket Thai local currency bonds’ absolute return in US dollar terms, as expected, is highly dependent on the exchange rate (Chart 19, top panel). Given the weak currency outlook, foreign investors should refrain from holding Thai domestic bonds outright. For foreign asset allocators, however, the matter is more nuanced. Thai domestic bonds’ relative return versus that of overall EM did not depend on the baht movement alone. This is because Thailand has been a defensive market owing to the following: a traditionally strong current account, a manageable public debt (now 47% of GDP), and a relatively low holding of bonds by foreign investors (now 12% of total). A robust current account surplus for years meant that during periods of negative growth shocks, the baht often fell less than many other EM currencies — that is, in periods of distress, the baht helped boost the relative performance of Thai bonds vis-à-vis overall EM bonds in US dollar terms. Those periods of distress also saw Thai bond yields fall as the central bank was able to cut rates due to low inflation. In addition, during those periods, local investors moved from equities to government bonds. Since the holdings of local bond investors far outweighed those of foreign investors, Thai bond yields managed to go down, even when some foreign investors dumped EM and Thai domestic bonds. As a result of these factors, Thai bonds outperformed their EM counterparts during the commodity/EM slowdown in 2014-15, and again at the height of the COVID-19-scare in early 2020 — even though the baht fell versus the US dollar during those periods (Chart 19, middle panel). All that said, the reality in the ground has changed somewhat since early last year. The Thai current account is no longer in surplus, and, given the dismal tourism outlook and slowing trade surplus, it will probably stay that way for the foreseeable future. That will keep the baht relatively weak weighing on Thai bonds’ relative performance versus their EM peers. On the other hand, the grim outlook of the Thai economy and looming deflation risk means that Thai bond yields could fall going forward relative to their EM counterparts. That will be a tailwind for Thai domestic bonds’ relative outperformance versus their EM counterparts. There is, therefore, a good chance that the headwind from a relatively weaker baht could be somewhat compensated for by a drop in Thai local yields versus their EM peers. Indeed, the periods of the baht’s weakness usually coincided with Thai bonds’ relative yield compression (Chart 19, bottom panel). This calls for a neutral outlook for relative bond performance going forward. Investment Conclusions Currency: The baht outlook remains precarious. Investors would do well to remain short the baht versus the US dollar. Domestic Bonds: Thai bond yields will go down. The Bank of Thailand will have no choice but to cut rates further. Local investors should stay long bonds. For international dedicated EM fixed-income portfolios, we downgraded Thai bonds in February of this year, from overweight to neutral in an EM bond portfolio, in view of the impending baht weakness. That turned out to be a good decision. Going forward, investors should continue to have a neutral allocation on Thai bonds, as the headwind from the baht will be mitigated by the tailwind from relative bond yield compression. Foreign absolute-return investors, however, should avoid Thai bonds in view of expected currency depreciation. Chart 20A Vulnerable Baht Will Keep Foreign Equity Investors Away Stocks: A struggling economy offers little hope for corporate margins or profits recovery soon. A vulnerable currency makes Thai stocks even less appealing to foreign investors. Without their participation, it will be hard for this market to rise sustainably in absolute terms or outperform their EM counterparts (Chart 20). Thai equities are not cheap either: the P/Book ratio is at par with EM. That said, given the Thai market’s already very steep underperformance versus the EM equity benchmark, from a portfolio strategy point of view, we recommend investors stay neutral this market within an EM equity portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to the EMS report “Thailand: Beset By A Vulnerable Baht,” dated February 24, 2021. 2 The budget bill has to pass the second and third readings expected in August before it goes for senate and royal approval.

Special Report

Please note: There will be no European Investment Strategy report Monday, August 23. Our next report will be on Monday, August 30. Feature The past year has seen an unprecedented explosion of nonfinancial corporate debt as companies took on extraordinary leverage to weather the pandemic (Chart 1). This is a risk we recently highlighted in BCA Research European Investment Strategy, arguing that while euro area debt loads are not bad enough to make us turn bearish on European credit immediately, they still represent a concern for the future.  Rising debt servicing costs are also a risk, with aggregate euro area nonfinancial corporate debt servicing costs, as a percentage of operating cash flows, now pulling ahead of global peers. This increase has been led by France, where debt servicing costs now eat up a whopping 73.2% of cash flows. At the same time, value has steadily disappeared from European credit markets, with investment grade (IG) and high-yield (HY) spreads nearing 2018 lows (Chart 2). Our 12-month breakeven spread metric, which measures the amount of spread widening required over a 12-month period for corporate bond returns to break even with a duration-matched position in government bond securities, confirms this message. Ranked against their own history, IG and HY breakeven spreads are now at only their 16th and 13th percentiles, respectively. Chart 1Euro Area Debt Loads Are Rising Chart 2Value Has Disappeared From European Credit Against this backdrop, it pays to adopt a more cautious approach towards European credit. To that end, we are introducing our new and improved bottom-up Corporate Health Monitors (CHMs) for investment grade and high-yield issuers in the euro area. The CHMs are composite indicators of balance sheet and income statement ratios that are designed to assess the financial well-being of the overall non-financial corporate sectors in major developed economies. Before we jump into the message from our new European CHMs, however, it is important to review the methodology used to construct these indicators. A Quick Note On Methodology We begin by constructing a representative sample of euro area issuers to assess broader nonfinancial corporate health in the euro area. To accomplish this, we use the list of issuers from the Bloomberg Barclays IG and HY Corporate Bond Indices. Financials (mostly banks) are excluded from the calculations as they have very different balance sheet profiles, requiring a different set of metrics to properly assess the health of that sector. As an improvement of the previous euro area CHMs, we now use a dynamic sample of issuers that is updated every year. This allows us to account for the changing compositions of these indices over time, as issuers move up and down in quality, and are added or dropped from the index. This also accounts for the survivorship bias that arises as companies that go out of business are dropped from the sample. Note that our sample is static prior to 2012. Before this date, we do not have the data on index constituents needed to construct a dynamic sample. As of Q1/2021, the sample for the euro area IG CHM consists of roughly 200 issuers, covering 50% of the index, while the sample for HY consists of 50 issuers or so, covering only 25% of the index. As we can only get bottom-up data for publicly-listed companies, we are unable to include private companies that issue corporate debt but do not necessarily tap into the public equity market.    We then pull key financial statement ratios for these issuers on a quarterly basis. Specifically, we use the following six ratios: Profit Margins: Operating profits as a percent of corporate sales Return On Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBIT divided by value of interest expense Leverage: Total debt as a percent of market value of equity Liquidity: Total current assets excluding total inventories divided by the value of total current liabilities It is important to note that we are using the same financial ratios as the CHMs that we have previously published for other developed markets. This could prove useful later when we search for relative performance relying exclusively on CHMs. To construct the CHM, we pick the medians of the individual ratios for every quarter, which we then de-trend, by subtracting out the 12-quarter moving average, and standardize. Finally, we take an equal-weighted average of all six ratios to calculate the CHM. Using median ratios precludes excessive influence from outliers, while de-trending them introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Lastly, we calculate a version of the CHM that includes only domestic issuers, which allows us to look at the health of European nonfinancial firms in isolation. This is important, as foreign issuers make up roughly 60% of both the IG and HY samples. US issuers account for most of the foreign issuers for both samples, meaning that part of the message from our overall indicator is on US corporate health. However, we include our overall indicator for the sake of completeness. Unveiling Our New European Corporate Health Monitors Chart 3 presents the all-issuer and domestic issuer versions of our new European IG corporate health monitor. A negative indicator signals improving nonfinancial corporate health and vice versa. Both indicators have shown steady improvement since Q2/2020, with the domestic indicator peaking out in Q1/2020. However, there has recently been a notable divergence between the two, with domestic issuers recovering at a significantly slower pace. The recovery in the IG CHMs has been broad-based, with all component ratios showing an improving trend (Chart 4). However, domestic firms have clearly lagged behind, with the overall indicator especially outperforming on the return on capital, leverage, and interest coverage metrics. It is important when looking at falling leverage, however, to consider the “denominator effect” of rising share prices on equity market value. Chart 3Euro Area Investment Grade Corporate Health Monitor Chart 4Euro Area IG CHM: Component Ratios The HY monitor offers a more balanced picture between the domestic and all-issuer CHMs, with both indicators signaling a modest improvement in corporate health (Chart 5). This picture is confirmed by the constituent ratios, which, in the case of HY, tend to track more closely between domestic and all-issuer (Chart 6). Again, decreasing leverage contributed positively to the situation, while rebounding profits provided a strong boost to interest coverage ratios.     Chart 5Euro Area High-Yield Corporate Health Monitor Chart 6Euro Area HY CHM: Component Ratios Overall, the underperformance of domestic issuers on corporate health can largely be explained by a delayed reopening in Europe and weaker overall European fiscal stimulus response relative to the US. However, we expect this picture to change in coming quarters as vaccination rates continue to climb, European stimulus expands, and pent-up demand is released.  For both HY and IG, metrics such as profit margins or leverage have not yet returned to pre-Covid levels. While it may appear difficult to reconcile this with the highly optimistic readings from the CHM, we note again that the ratios are de-trended before they are incorporated into the CHM. That makes the CHM a better indicator of how corporate health is turning on the margin rather than in absolute terms.    Chart 7Euro Area: CHMs Vs. Spreads Our new CHMs undoubtedly provide an important signal on corporate health, but we are interested in the implication for corporate credit spreads. Chart 7 shows that the domestic issuer CHMs have been reliable at catching periods of major spread widening/tightening. Generally speaking, the year-over-year change in the CHM is a coincident indicator and can be used to confirm if movements in spreads are in line with underlying corporate fundamentals. Clearly, the recent narrowing in spreads has not kept pace with the drastic improvement in the CHM over the past two quarters. This likely reflects how close spreads are to post-crisis lows, meaning that they have little room left to fall regardless of how much corporate health improves. This asymmetry of returns, where credit has little to benefit from improving nonfinancial corporate health while remaining exposed to a deterioration, is a longer-term concern for investors. While spreads in level terms have been on a slow and steady narrowing trend this year, they are, on a rate of change basis, moving towards a more neutral level. This message will be confirmed by the CHMs in coming quarters as the monitors revert to the mean from their most recent optimistic readings. While Chart 7 displays the coincident properties of the indicators, we can also tune into the forward-looking aspect by looking at how spreads have performed historically over different time horizons given the levels of the CHMs. Table 1 presents the performance of both IG and HY spreads over the subsequent 3-12 month period when their respective CHMs were positive or negative. Table 1CHM Direction And Subsequent Spread Performance Over 3-12 Months For both IG and HY, there are a few key conclusions. Firstly, when the domestic-only CHM is negative, spreads tend to widen in the subsequent 3-12 months. Conversely, they narrow, on average, when it is positive. This reflects the mean-reverting property of our indicators. After the indicator has been positive for a while, indicating deteriorating health, it is naturally going to trend back towards zero. Spreads tighten in the coming quarters as a reaction to this marginal improvement in corporate health. The same relationship holds in the opposite direction.    On the whole, however, the domestic-only CHM is more reliable than the overall CHM as an indicator of whether spreads are going to widen/narrow. This discrepancy is most pronounced for HY, where the all-issuer version largely provides a misleading signal, with spreads usually continuing to narrow after the CHM is negative and widening after it is positive. One possible explanation for this is that European spreads are sensitive to European events, and since the overall CHM has a large presence of US corporate issuers, it does not properly reflect how investors should be compensated with regard to nonfinancial corporate health. Beyond just looking at the change in spreads following a positive or a negative reading on the CHMs, we can also see how spreads change when the CHMs fall into different ranges. Table 2 presents spread performance for periods when the CHM was within specific ranges: below -1, between -1 and 0, between 0 and +1, and greater than +1. This analysis makes an even stronger point on the mean reverting property of the indicator. When the CHMs reach extremely stretched positive (negative) readings, spreads tend to narrow (widen) a lot. The impact is also most pronounced over a 12-month horizon, with HY spreads narrowing, on average, a whopping 452bps twelve months after the CHM hits a level greater than +1. Table 2CHM Level And Subsequent Spread Performance Over 3-12 Months Bottom Line: Our new bottom-up European CHMs have been signaling a broad-based and consistent improvement in corporate health since Q2/2020. The CHMs are coincident indicators that can be used to confirm if changes in spreads are in line with fundamentals. On a forward-looking basis, stretched positive (negative) levels of the CHM indicate potential for future spread tightening (widening). Investment Conclusions While our CHMs are currently flashing a positive message on nonfinancial corporate health, there are some reasons to be cautious on European credit. Firstly, debt loads are at historically high levels in the euro area, a message confirmed by the bottom-up data shown in Charts 4 and 6. Spreads, on an absolute and breakeven basis, are also near post-crisis lows, implying meagre prospects for further tightening and are, on the other hand, exposed to any deterioration in corporate health. Lastly, the mean-reverting property of our CHM indicates that the monitors are likely to move back towards “deteriorating” territory on the margin, a historically negative sign for spreads. However, it is hard to recommend staying out of European credit at a time when fiscal and monetary policy are overly accommodative, and growth looks poised to surprise to the upside. The European Central Bank has already marked itself as one of the most dovish developed market central banks and will likely do “whatever it takes” to prevent a blow-up in spreads and the associated tightening in financial conditions. And currently, spreads still offer a decent yield pickup over sovereigns, even if they do not have much room to tighten. Thus, balancing the positives and negatives suggests it still makes sense to hold neutral exposure to credit within a European fixed-income portfolio, but adding to this exposure is now unwarranted. In the euro area, BCA Research Global Fixed Income Strategy is currently neutral on investment grade and overweight on high-yield credit.  Within high-yield, we recommend staying up in quality, favoring Ba-rated credit and avoiding lower tiers which will be hit first if corporate health deteriorates and do not offer adequate compensation for credit risk. Likewise, our European Investment Strategy recommends a selective approach, favoring sectors with more defensive risk profiles. Bottom Line: Even though there is some cause for concern on the horizon, it is too early to pivot out of European credit with the macro backdrop still accommodative. Remain neutral on euro area investment grade and overweight high-yield while avoiding riskier sectors and credit tiers within the high-yield allocation.               Jeremie Peloso,                         Associate Editor                          JeremieP@bcaresearch.com  Shakti Sharma, Senior Analyst ShaktiS@bcaresearch.com

Special Report

Highlights Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory. Investors in Chinese TMT/new economy stocks are facing uncertainty on multiple fronts which warrants lower valuation multiples. These companies will experience weaker profit growth and lower profitability relative to the past due to disruptions to their business models. Elsewhere, widening credit spreads among Chinese property developers reflects the property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. This poses a material risk to raw material prices and, consequently, EM in general. Feature Chart 1Chinese Growth/TMT Share Prices And P/E Ratio The Chinese MSCI Investable Growth stock index is down by 35% from its February peak (Chart 1, top panel). Such a drawdown in the previous market leaders has produced a temptation to buy. The enticement is especially strong given that US FAANGM stocks are hitting new all-time highs. Is the latest crash in Chinese new economy/growth/TMT stocks a bad dream that will soon end, or does it mark a new reality for these companies? In our opinion, Chinese authorities’ regulatory crackdown on new economy companies reflects new socio-political and economic shifts in China. Hence, this regulatory crackdown is not transitory but is a part of China’s ongoing transformation. In brief, these companies are facing a new reality. What’s more, their outlook is very uncertain and equity valuations are not low enough to offset potential risks related to owning these stocks. Overall, investors should not start bottom fishing in Chinese stocks in general and Chinese TMT stocks in particular. Uncertainty = Lower Equity Multiples Immense uncertainty surrounds the outlook for Chinese TMT share prices. Even though China’s growth stocks have been de-rated, their trailing P/E ratio remains at 36.5 (Chart 1, bottom panel). Table 1A Snapshot Of Drawdown And Valuations Table 1 shows the drawdowns and trailing P/E ratios for TMT/new economy/growth indexes as well as their largest constituencies: Alibaba, Tencent and Meituan. These equity multiples are still high given the uncertainty these companies are facing. By extension, investors in Chinese TMT/new economy stocks are also facing uncertainty on multiple fronts: Regulatory crackdowns mean that the business models of many of these companies will have to undergo substantial changes. Corporations may need to overhaul their product lines or abandon existing products/markets and find new niches and introduce new offerings. It is impossible to know what the long-term revenue and profit growth rates of these companies will be so that they can be properly valued. Such heightened uncertainty about the long-term outlook warrants a higher equity risk premium and, hence, lower equity multiples. President Xi Jinping’s long-term objective is to reduce income equality and achieve more equal wealth distribution. There will therefore be little tolerance for excessive profitability of individual companies. Chart 2 illustrates the large income gap between the top 10% and bottom 50% of the population. In turn, the mean-to-median wealth ratio points to a large and rising wealth gap – a higher ratio reflects greater wealth concentration among rich households (Chart 3). Chart 2China: Income Disparity Has Not Been Narrowing Chart 3Wealth Concentration Remains High In China   President Xi’s goal is to appease the broader population, not shareholders or businesses. Top authorities have been using phrases such as “disorderly expansion of capital” since last fall. This language marked a major shift in government policies regarding market power and dominance of private companies. Investors should take note that they are now dealing with a new investment regime in China. For some time, we have argued that China’s regulatory tightening on private platform companies would aim to limit their monopolistic or oligopolistic power and ration their profitability. As a result, we alleged that these new economy companies would end up being regulated like utilities or become quasi-government entities. Consequently, their profitability would decline to close to that of utilities or SOEs. Yet, utility stocks or SOEs in China command much lower equity multiples than those at which platform companies’ stocks have been trading. Even as of today, the trailing P/E ratio on the China MSCI Growth Investable index is 36.5. Meanwhile, global utility stocks command a trailing P/E ratio of 19. It is hard to know where the P/E ratios of these Chinese TMT stocks will settle, but our hunch is that their multiple compression is not over yet. Regulatory clampdowns will not only curtail their revenues and pricing power but also increase their costs. These companies will need to spend money to comply with the new regulatory regime. They will, for instance, be expected to take on more in the way of social responsibilities, as SOEs in China have been doing. This and other measures will eat into their profit margins and will lower the return on capital. Finally, many Chinese TMT companies that have their ADRs listed in the US have been caught in the crossfire of the “big data war” between the US and China. On the one hand, US authorities want to oblige these Chinese issuers to comply with US regulations in terms of information and risks disclosure. On the other hand, Chinese authorities are reluctant to allow more data/information disclosure by their dominant platform companies to foreign investors. Given that the US-China confrontation is likely to escalate on many fronts going forward, odds are low that there will be a lasting solution to this conflict around US-traded Chinese equities. Authorities in the Middle Kingdom are not very sensitive to the fact that foreign shareholders are losing money in Chinese offshore trading stocks. Unless the crash in offshore stocks spills into the domestic financial markets and the economy, their willingness to compromise will be limited. In turn, the US will not “encourage” American investors to invest more in Chinese stocks where its regulatory authority and influence is weak. Overall, such high uncertainty regarding offshore Chinese stocks in general and the ones trading in the US in particular warrants a higher equity risk premium and lower equity multiples. Despite these negatives, there is a silver lining: China’s new economy segments have been and will continue expanding at a rapid pace. Chinese authorities are genuinely interested in supporting new economy sectors which could help boost productivity and be growth engines as the growth contribution from construction/infrastructure/manufacturing diminishes. The challenge for investors is to find companies that benefit from the continued expansion of new economy sectors, and acquire their stocks at reasonable multiples to secure limited drawdowns during market selloffs. Bottom Line: Chinese growth stocks/TMT share prices – on the index level – remain at risk of further de-rating/multiple compression. These companies also face potentially weaker profit growth and lower profitability compared to the past due to disruptions to their business models and/or higher costs of doing business. A Breakdown In Chinese Property Stocks And Bonds Is Flying Under The Radar Chart 4Property Stocks And Bond Prices Have Crashed While Chinese TMT stocks are at the center of the global investment community’s interest, there has been a breakdown in mainland real estate share prices and a spike in property companies’ offshore credit spreads (Chart 4). The rising cost of capital imply that real estate developers will curtail their new property launches and construction. In addition, authorities will not ease regulatory tightening in the property market in general and property companies in particular. The objective is to halt the rise in property prices so that the continuous increase in personal income brings down the household income-to-property price ratio. The latter is extremely high in China making housing unaffordable for average Chinese. Authorities are very sensitive to the issue of housing unaffordability. Not only are property developers under pressure from tightening but also authorities are curbing demand for housing. In particular, two weeks ago the PBoC ordered banks in Shanghai to raise the rate of mortgage loans for first-time homebuyers to 5% from 4.65% and for people who are buying second homes to 5.7% from 5.25%. This measure might be extended to other tier-1 cities if house prices do not stop rising. As a result of the clampdown on property developers and move to restrain investment/speculative demand for housing, construction activity will shrink. The top panel of Chart 5 illustrates that the level of aggregate building construction starts has turned down. Residential property sales are decelerating and starts are contracting (Chart 5, bottom panel). Bottom Line: Property construction in China will start shrinking in the coming months. This will spill into other industrial/manufacturing sectors that supply construction and produce durable consumer goods. Chinese industrial output is set to decelerate materially as is predicted by a relapse in the nation’s manufacturing PMI’s new and backlog orders (Chart 6). This poses a material risk to raw material prices and, consequently, to EM in general. Chart 5Chinese Property Construction Is Set To Contract Chart 6China's Manufacturing To Decelerate   Investment Conclusions From a short-term perspective, Chinese growth stocks are oversold, however this is not true from a long-term perspective. As shown in the top panel of Chart 1 above, the Chinese MSCI Investable Growth Stock Index is only back to its June 2020 levels. In fact, the parabolic rise in Chinese TMT stocks in late 2020 and early 2021 reflected investor euphoria that typically occurs at the end of a major bull market. Hence, the February peak in these equities could mark a major top. If so, these stocks are unlikely to embark on a sustainable bull market any time soon. For now, investors should fade rebounds in Chinese TMT stocks. We have been overweight Chinese stocks within an EM equity portfolio but this has been a bad call. However, among Chinese stocks we have recommended the following strategy since March 4th of this year: long A shares/short Investable stocks. The basis has been that we foresaw more downside risks in TMT stocks than onshore equities indexes (Chart 7). This recommendation is up by 15.5% since then and investors should maintain this strategy. Chart 7Stay Long Chinese A-Shares / Short Offshore Trading Stocks Chinese equities are oversold relative to the EM index, and we are reluctant to downgrade them now. We are also waiting for our view of the continued US dollar rebound and lower commodities prices to play out before we downgrade Chinese equities. Other EM bourses typically underperform when the US dollar rallies and commodities sell off markedly. As we argued in last week’s report, the weakness in EM equities has not been limited to Chinese TMT stocks. EM ex-TMT share prices have also rolled over, which is consistent with rising EM corporate bond yields (Chart 8). Chart 8Rising EM Corporate Bond Yields Herald Lower EM ex-TMT Share Prices Although most of the rise in EM corporate bond yields/spreads can be attributed to Chinese property companies, their widening credit spreads reflect the mainland property market’s poor outlook. In turn, shrinking Chinese construction heralds weaker demand for commodities and manufacturing goods. Notably, Chart 9 reveals that there has been a widening gap between a declining Chinese manufacturing PMI and resilient industrial metals prices. Odds are that commodity prices will recouple with China’s manufacturing PMI to the downside. Chart 9An Unsustainable Divergence: Beware Of Risks To Commodity Prices We continue to recommend underweighting EM versus DM for global equity and credit portfolios, a strategy we initiated on March 25, 2021. We also recommend shorting a basket of EM currencies versus the US dollar and maintaining a cautious stance on commodity prices. The full list of our country recommendations for equity, fixed-income and currency investors is available at the end of this report. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com