Debt Trends
Highlights Why is the gap between the stock market and the economy so wide?: It is well established that stocks can diverge considerably from fundamentals in the near term, but lately it is as if the stock tables and the front-page headlines are from entirely different newspapers. It may be because the virus poses much less of a threat to the owners of equities than the general populace: More affluent households are more readily able to work from home and to practice social distancing. They also have access to better medical care. With the S&P 500 having hit technical resistance, however, the gap may be nearing its upper limit: Large-caps have run in place since retracing half of their peak-to-trough losses, and the next Fibonacci resistance level is only another 5% higher. Where are the shoddy loans?: During the expansion, corporations were able to borrow on prodigally easy terms. If banks aren't holding the loans, who is? Feature That’s New York’s future, not mine – “Hold On” (Reed) For someone who entered the business as a sell-side trader, it is a matter of course that prices can diverge from fundamentals. The trading desk had a one-day horizon, and the traders necessarily made their way on price signals while barely considering fundamentals. Though the junior traders had been exposed to dividend discount models at their fancy colleges, the ones who lasted recognized they weren’t relevant to the desk’s mission. Trading the daily flow required accepting that new news can have a dramatically larger effect on stocks in the here and now than it would on the lifetime stream of earnings available to common shareholders. Long-run fair value might solely turn on the fundamentals, but animal spirits hold sway over any given tick. The sudden stop imposed by stay-at-home orders has made backward-looking economic data nearly irrelevant, but the sizable upward surprises in unemployment claims should not be ignored. Our Global Investment Strategy colleagues showed last week just how difficult it is for even severe near-term shocks to materially alter the present value of aggregate future earnings.1 Furthermore, the market effects of negative earnings shocks are inherently self-limiting at the margin because they tend to be accompanied by lower interest rates, driving up the equity risk premium and making stocks more attractive relative to “safe” fixed income alternatives. Bear markets coincide with recessions, though, as near-term earnings expectations are revised lower and animal spirits droop (Chart 1). Given that the recession just begun is expected to be the worst since the Great Depression, one would expect that equities would be stumbling in search of a bottom as investors remained fearful of taking on risk. Chart 1Joined At The Hip They have instead been acting like the S&P 500 found that bottom on March 23rd, when the index completed a 35% peak-to-trough decline in just 23 sessions. It then proceeded to gain 28.5% over the next eighteen sessions. Some retracement is to be expected after a sudden, sharp move, and the S&P 500 has only recovered half of the ground that it lost. It certainly priced in a great deal of bad news on the way down, but the data have been worsening, and investors have been forced to give up on the notion of a swift economic recovery. Why are stocks rising when economic projections are being downwardly revised and good virus news has been few and far between? We ourselves have been barely glancing at backward-looking economic data releases that merely confirm the well-understood fact that draconian social distancing measures have wrung much of the life out of the economy. The degree to which job losses have outrun consensus forecasts stands out nonetheless. Aggregate initial unemployment claims over the last five weeks have exceeded consensus expectations by 5.5 million (Table 1). Even though the forecasts have caught up to the situation on the ground, the claims data suggest that unemployment is now pushing 20%, a worst-case-scenario level that is far above the first forecasts that incorporated the effects of stay-at-home orders. Claims may well have peaked, but they’re still an order of magnitude higher than normal, and they are not finished exerting upward pressure on the unemployment rate. Table 1Job Losses Have Been Worse Than Expected Meanwhile, COVID-19 data have yet to provoke much optimism. The rate of US infections has yet to come down to Italy’s level (Chart 2), and hopes that remdesivir might prove to be a wonder drug were dashed late last week. Clients are increasingly asking us why the stock market is traveling such a dramatically different path than the economy and the virus. How could stocks have plunged at a record rate as the coronavirus drew a bead on the United States, but surged after crippling social distancing measures were put in place? Chart 2The US Has Fallen Behind Italy's Pace A Tale Of Two Boroughs The simplest answer is that the Fed’s response was swifter and more far-reaching than expected. Ditto Congressional actions, and we expect that DC will continue to deploy its fiscal firepower to try to shield households and businesses from the worst of the effects of the anti-virus measures. We believe the monetary and fiscal efforts will make a difference, and do not think it’s a coincidence that equities turned around the week of March 23rd, which began with the Fed’s rollout of a formidable new arsenal and ended with the passage of the CARES Act. But the market action has not accounted for the shift from expectations of a V-bottom to talk of Us, Ls and Ws. Two articles published a week apart in The New Yorker vividly illustrated a demographic virus gap. The first looked at COVID-19 from the perspective of financial professionals at hedge funds and other sophisticated investment aeries.2 Although the views of the investors in the profile shifted with the tide of the incoming data, they were generally of the mind that the health threat was being dramatically overhyped. One retired hedge fund manager boasted about his and his family’s non-stop early March air travel between New York, London and a Wyoming ski resort. The second article followed an emergency room resident at Elmhurst, a publicly funded hospital in a working-class Queens neighborhood, which has been described as the epicenter of the outbreak in several local media reports.3 “‘It’s become very clear to me what a socioeconomic disease this is,’” he said. “‘Short-order cooks, doormen, cleaners, deli workers – that is the patient population here. Other people were at home, but my patients were still working. A few weeks ago, when they were told to socially isolate, they still had to go back to an apartment with ten other people. Now they are in our cardiac room dying.’” Stock ownership is largely reserved to the affluent, with the top percentile of households owning 53% of equities as of the end of 2019, and the rest of the top decile owning another 35% (Chart 3). For households in the top decile, maintaining a healthy distance from the virus isn’t that difficult. Knowledge workers equipped with a laptop and a reliable internet connection can work from anywhere, unlike the Elmhurst patients in low-skilled service positions who have to work onsite. The tonier precincts of Manhattan feel nearly deserted, with their residents having decamped for second homes in lower-density areas. Perhaps it's because the Fed's attempts to shore up the economy have far more personal relevance for investors than the spread of the virus. There are no comprehensive data series on virus infections and outcomes by zip code, which would facilitate analysis of the link between household wealth and COVID-19, but New York state reports age-adjusted fatality rates in four racial/ethnic categories. In New York state ex-New York city, which has lesser extremes of wealth than the city itself, the cross-category disparities are striking (Chart 4). Race/ethnicity is far from an ideal proxy for inequality, but it is fair to conclude that financial market participants have a sound basis for being more sanguine about the virus than the overall population. Assuming that more affluent households will be able to remain out of the virus’ reach, the dichotomy can persist for as long as the economic impacts do not become so bad that investors cannot reasonably look through them. Chart 3Demographics Drive Stock Ownership ... Chart 4... And COVID-19 Fatalities Technical Resistance Back on the trading desk, technical analysis was the go-to tool for traders pricing large blocks of stock in real time. Following sizable moves, the Fibonacci sequence provided a popular method for assessing how far a stock might retrace its steps before resuming its course. The most widely used Fibonacci retracement levels are 38% and 62%, and 50%, a round number exactly between the two, has also become an anticipated stopping point. From the February 19 closing high of 3,386.15 to the March 23 closing low of 2,237.40, the S&P 500 lost 1,148.75 points. The 38%, 50% and 62% retracement levels are 2,673.93, 2,811.78 and 2,949.63, respectively. The S&P paused at the 38% level for just two days before breaking through it decisively, but it’s had more trouble making its way through 2,812, failing to hold above it for more than a day or two at a time (Chart 5). Should it escape 2,812, the 2,950 level waits just 5% higher. Chart 5Fibonacci Retracement Levels For The S&P 500 We are fundamental investors who do not get hung up on technical levels, though they can become self-fulfilling prophecies if enough participants are following them. Given the popularity of Fibonacci retracement, it is possible that a critical mass of short-term investors may view 2,812 and 2,950 as preferred levels for exiting long positions in the S&P. Our bigger near-term concern is that it is hard to see US equities making much more headway while the virus and ongoing distancing measures have the potential to cause investors to revise their fundamental expectations lower and/or lose a little bit of their policy-fueled nerve. Who's Left Holding The Bag? Multiple commentators have expressed alarm at the post-2008 increase in corporate debt, especially given anecdotal reports that lending covenants had been loosened dramatically. If the banks don’t hold the debt, as we’ve argued, who does, and could a wave of virus-inspired defaults cause larger problems in the financial system? The Fed’s fourth quarter Flow of Funds report, published last month, provides some clues, but does not answer the question definitively. As we saw in higher frequency data on aggregate banking system exposures, bank loans to nonfinancial corporations grew modestly (3.2% annualized) since December 31, 2008. Nonfinancial corporations borrowed in the bond market at double that rate (6.2% annualized). Foreign loans, powered by near doubling in 2017 and 2018, grew at an annualized 13.4% pace, and are four times as large as they were at the end of 2008. Finance company loans have shrunk, and trade payables grew at a modest 2% rate. (Chart 6). Chart 6Debt Risks Are Pretty Well Diffused Publicly available data from Preqin on the capital raised by direct lending funds suggests that their impact has been modest, accounting for only about a quarter of outstanding bank loans if every dollar they’ve raised is currently deployed. Demand for leveraged loans, senior floating-rate debt issued to high-yield borrowers, was occasionally intense as investors sought protection from rising rates. The desire for duration protection has faded as rates have plunged to new lows, but ETFs and CLOs were eager buyers at points during the last expansion. In a Special Report published last summer, our US Bond Strategy and Global Fixed Income Strategy services concluded that the ownership of leveraged loans is diffuse enough that credit strains are unlikely to pose a systemic threat. They were also encouraged that leveraged loans and high yield corporate bonds act as substitutes, keeping one another in check as investor preferences for fixed and floating instruments wax and wane. They also noted that leveraged loan lending standards had tightened last year, with a reduced share of covenant-lite loans being issued, though standards have eased again since they published their report (Chart 7). Chart 7Covenant Protections Have Eroded Chart 8Diverse Corporate Bond Ownership Will Help Mitigate The Effect Of Defaults There is no way around the fact that high yield corporate bondholders (Chart 8), owners of CLO tranches rated below AAA and leveraged loan holders face elevated credit losses as the broad economic shutdown provokes a wave of defaults in instruments without Fed support. We expect that the default losses will be spread out across enough constituents that they will not become worryingly concentrated, but they may contribute to a further erosion of risk appetites. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 23, 2020 Global Investment Strategy Weekly Report, "Could The Pandemic Actually Raise Stock Prices?" available at gis.bcaresearch.com. 2 Paumgarten, Nick. "The Price of a Pandemic." The New Yorker, April 20, 2020, pp. 20-24. The article, relaying traders’ conversations, contains some profanity. 3 Galchen, Rivka. "The Longest Shift." The New Yorker, April 27, 2020, pp. 20-26. The article, relaying ER conversations, contains some profanity.
Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks. We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies. Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated. Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3 However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER). Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7). Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more. The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed? A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12). Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one. At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming. But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization. When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14). But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15). Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm 6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations
Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them. At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure. Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation. This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation. Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II) Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021. Chart 16Inflation Is A Lagging Indicator Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2 Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights Investors should remain overweight global stocks relative to bonds over the next 12 months and begin shifting equity exposure towards non-US markets. Bond yields will rise next year as global growth picks up, while the dollar will sell off. The extent to which bond yields increase over the long term depends on whether inflation eventually stages a comeback. Today’s high debt levels could turn out to be deflationary if they curtail spending by overstretched households, firms, and governments. However, high debt levels could also prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. Which of these two effects will win out depends on whether central banks are able to gain traction over the economy. This ultimately boils down to whether the neutral rate of interest is positive or negative in nominal terms. While there is little that policymakers can do to alter certain drivers of the neutral rate such as the trend rate of economic growth, they do have control over other drivers such as the stance of fiscal policy. Ironically, a structural shift towards easier fiscal policy could lead to a decline in government debt-to-GDP ratios if higher inflation, together with central bankers' reluctance to raise nominal rates, pushes real rates down far enough. This suggests that the endgame for today’s high debt levels is likely to be overheated economies and rising inflation. Stay Bullish On Stocks But Shift Towards Non-US Equities We returned to a cyclically bullish stance on global equities following the stock market selloff late last year, having temporarily moved to the sidelines in June 2018. We have remained overweight global equities throughout 2019. Two weeks ago, we increased our pro-cyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. Our decision to upgrade non-US equities stems from the conviction that global growth has turned the corner. Manufacturing has been at the heart of the global slowdown. As we have often pointed out, manufacturing cycles tend to last about three years – 18 months of weaker growth followed by 18 months of stronger growth (Chart 1). The current slowdown began in the first half of 2018, and right on cue, the recent data has begun to improve. The global manufacturing PMI has moved off its lows, with significant gains seen in the new orders-to-inventories component. Global growth expectations in the ZEW survey have rebounded. US durable goods orders surprised on the upside in October. The regional Fed manufacturing surveys have also brightened, suggesting upside for the ISM next week (Chart 2). Chart 1A Fairly Regular Three-Year Manufacturing Cycle Chart 2Some Manufacturing Green Shoots Unlike in 2016, China has not allowed a major reacceleration in credit growth this year. Instead, fiscal policy has been loosened significantly. The official general government deficit has increased from around 3% of GDP in mid-2018 to 6.5% of GDP at present. The augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019. This is a bigger deficit than during the depths of the Great Recession (Chart 3). As a result of all this fiscal easing, the combined Chinese credit/fiscal impulse has continued to move up. It leads global growth by about nine months (Chart 4). Chart 3China Has Been Stimulating, Fiscally Chart 4Chinese Stimulus Should Boost Global Growth The dollar tends to weaken when global growth strengthens (Chart 5). The combination of stronger global growth and a softer dollar will disproportionately benefit cyclical equity sectors. Financials will also gain thanks to steeper yield curves (Chart 6). The sector weights of non-US stock markets tend to be more tilted towards deep cyclicals and financials. As a consequence, non-US stocks typically outperform when global growth picks up (Chart 7). Chart 5The Dollar Is A Countercyclical Currency Chart 6Steeper Yield Curves Will Benefit Financials In addition, valuations favor stocks outside the US. Non-US equities currently trade at 13.8-times forward earnings, compared to 18.1-times for the US. The valuation gap is even greater if one looks at price-to-book, price-to-sales, and other measures (Chart 8). Chart 7Non-US Equities Usually Outperform When Global Growth Improves Chart 8US Stocks Are Relatively More Expensive Trade War Remains A Key Risk The US-China trade war remains a key risk to our bullish equity view. President Trump continues to send conflicting signals about the status of the talks. He complained last week that Beijing is not “stepping up” in finalizing a phase 1 agreement, adding that China wants a deal “much more than I do.” This Wednesday he struck a more optimistic tone, saying that negotiators were in the “final throes” of deal. However, he made this statement on the same day that he decided to sign the Hong Kong Human Rights and Democracy Act into law, a decision that was bound to antagonize China. According to our BCA geopolitical team, Trump had little choice but to sign the bill. The Senate approved it unanimously, while the House voted for it 417-1. Failure to sign it would have resulted in an embarrassing veto by the Senate. The key point is that the new law does not force Trump to take any immediate actions against China. This suggests that the trade talks will continue. In fact, from China's point of view, Congress’ desire to pass a Hong Kong bill may provide a timely reminder that getting a deal done with Trump now may be preferable to waiting until after the election and potentially facing someone like Elizabeth Warren who is likely to make human rights a key element of any deal to roll back tariffs. Waiting For Inflation If global growth accelerates next year, history suggests that bond yields will rise (Chart 9). Looking further out, the extent to which bond yields will continue to increase depends on whether inflation ultimately stages a comeback. Right now, most of our forward-looking inflationary indicators remain well contained (Chart 10). However, this could change if falling unemployment eventually triggers a price-wage spiral. Chart 9Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 10An Inflation Breakout Is Not Imminent Many investors are skeptical that such a price-wage spiral could ever emerge. They argue that automation, globalization, weak trade unions, and demographic changes make an inflationary outburst rather implausible. We have addressed these arguments in the past1 and will not delve into them in this report. Instead, we will focus on one argument that also gets a fair bit of attention, which is that high debt levels will prove to be deflationary. Are High Debt Levels Inflationary Or Deflationary? Total debt levels in developed economies are no lower today than they were during the Great Recession. While private debt has fallen, public debt has risen by roughly the same magnitude, leaving the overall debt-to-GDP ratio unchanged (Chart 11). Meanwhile, debt levels in emerging markets have risen substantially. A common rebuttal to any suggestion that inflation might rise over the medium-to-longer term is that high debt levels around the world will cause households, firms, and governments to pare back spending. While this may be true, it could also be argued that high debt levels could prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. So which effect will win out? Given the choice, it is likely that most policymakers would opt for higher inflation. This is partly because high unemployment and fiscal austerity are politically toxic. It is also because falling prices make it very difficult to reduce real debt burdens. The experience of the Great Depression bears this out: Private debt declined by 25% in absolute terms between 1929 and 1933. However, due to the collapse in nominal GDP, the ratio of debt-to-GDP actually increased more in the first half of the 1930s than during the Roaring Twenties (Chart 12). Chart 11Global Debt Levels Remain High Chart 12The Experience Of The Great Depression Shows Deleveraging Is Impossible Without Growth Means, Motive And Opportunity Chart 13A Kinked Relationship: It Takes Time For Inflation To Break Out There is a big difference between wanting to engineer higher inflation and being able to do so. The distinction between success and failure ultimately boils down to a seemingly technical question: Is the neutral rate of interest – the interest rate consistent with full employment and stable inflation – positive or negative in nominal terms? When the neutral rate is above zero, central banks can gain traction over the economy. Even if the neutral rate is only slightly positive, a zero rate would be enough to keep monetary policy in expansionary territory. When monetary policy is accommodative, the unemployment rate will tend to drop. Eventually the “kink” in the Phillips curve will be reached, resulting in higher inflation (Chart 13). In contrast, when the neutral rate is firmly below zero, monetary policy loses traction over the economy. Since there is a limit to how deeply negative policy rates can go before people decide to hold cash, the central bank could find itself out of ammunition. This could set off a vicious circle where high unemployment causes inflation to drift lower, leading to an increase in real rates. Rising real rates will then further curb spending, causing inflation to fall even more. Drivers Of The Neutral Rate Two of the more important determinants of the neutral rate of interest are the growth rate of the economy and the national savings rate. If either the savings rate rises or economic growth slows, the stock of fixed capital will tend to pile up in relation to GDP, leading to a higher capital-to-output ratio.2 As Chart 14 shows, this has already happened in Europe and Japan. An increase in the capital-to-GDP ratio will drag down the rate of return on capital. A lower interest rate will be necessary to ensure that the capital stock is fully utilized. Chart 14Capital Stock-To-Output Ratios Have Risen Realistically, there is not much that policymakers can do to raise trend GDP growth. While looser immigration policy would allow for a faster expansion of labor force growth, this is politically contentious. Increasing productivity growth is also easier said than done. Fiscal Policy And The Neutral Rate In contrast, policymakers already have a ready-made mechanism for lowering the savings rate: fiscal policy. The fiscal balance is a component of national savings. If the government runs a larger budget deficit in order to finance tax cuts or higher transfer payments to households, national savings will decline and aggregate demand will rise. Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. Since one can think of the neutral rate as the interest rate that brings aggregate demand in line with the economy’s supply-side potential, anything that raises demand will also lift the neutral rate. Once the neutral rate has risen above the zero bound, monetary policy will gain traction again. This implies that central banks should never run out of ammunition in countries whose governments can issue debt in their own currencies. While higher inflation stemming from fiscal stimulus will erode the real value of private sector debt obligations, won’t the impact on total debt be offset by the increase in public debt? Not necessarily. True, larger budget deficits will raise the stock of government debt. However, nominal GDP will also rise on account of higher inflation. Standard debt sustainability equations state that the government debt-to-GDP ratio could actually fall if higher inflation pushes real policy rates down far enough. As discussed in Box 1, such an outcome is quite likely when inflation accelerates in response to an overheated economy, but the central bank nevertheless refrains from raising nominal rates. The Final Verdict We are finally ready to answer the question posed in the title of this report: Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. People with a 30-year fixed rate mortgage will always favor inflation over deflation. And there are more voters who owe mortgage debt than own mortgage debt. Chart 15Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Politics is moving in a more populist direction. Whether it is left-wing populism of the Elizabeth Warren/Jeremy Corbyn variety or right-wing populism of the Donald Trump/Matteo Salvini variety, the result is usually bigger budget deficits and higher inflation. Even in those countries where populism has been slow to take hold, there may be pragmatic reasons for loosening fiscal policy. For example, Germany’s trade surplus with the rest of the euro area has fallen in half since 2007, largely because German unit labor costs have increased more than elsewhere (Chart 15). As Germany loses its ability to ship excess production to the rest of the world, it may end up having to rely more on easier fiscal policy to bolster demand. Of course, the path to higher inflation is paved with interest rates that stay lower for much longer than the economy needs to reach full employment. This means we are entering a period where first the US economy, and then many other economies, will start to overheat, and yet central banks will still refrain from tightening monetary policy until inflation rises well above their comfort zones. Such an environment will be positive for stocks for as long as it lasts, even if it eventually produces a mighty hangover. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Box 1 When Does A Large Budget Deficit Lead To A Lower Government Debt-to-GDP Ratio? Footnotes 1 Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could It Happen Again? (Part 2),” dated August 24, 2018. 2 This point can be seen through the lens of the widely used Solow growth model. In steady state, the desired level of investment in the model is given by the formula: I=(a/r)(n+g+d)Y where a denotes the output elasticity of capital, r is the real rate of interest, n is labor force growth, g is productivity growth, d is the depreciation rate, and Y is GDP. Savings is assumed to be a constant fraction of income, S=sY. Equating savings with investment yields: r=(a/s)(n+g+d). A decrease in the growth rate of the economy (n+g) shifts the investment schedule downward, leading to a lower equilibrium rate of interest. This initially makes investing in fixed capital more attractive than buying bonds. Over time, however, the marginal return on capital will fall as the capital stock expands in relation to GDP. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades