Economy

Executive Summary The recent 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history. An overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend. This unfortunate asymmetry means that the recent overspend on goods at the expense of services makes the economy vulnerable to a downturn. And the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. As the 30-year T-bond rallies, so too will other long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the S&P 500 versus short-duration stock markets such as the FTSE 100. Fractal trading watchlist: We focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. If A 26 Percent Overspend On Goods Is Not A Massive Economic Imbalance, Then What Is? Bottom Line: As the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, and long-duration stock markets such as the US versus non-US. Feature My colleague Peter Berezin recently wrote that recessions tend to happen when: “1) the build-up of imbalances makes the economy vulnerable to downturn; 2) a catalyst exposes these imbalances; and 3) amplifiers exacerbate the slump.” Peter is spot on. Using this checklist, I would argue that right now: There is a massive imbalance that makes the economy vulnerable to a downturn. Specifically, a 26 percent overspend on durable goods constitutes one of the greatest imbalances in economic history – the 26 percent overspend on durables refers to the US, but other advanced economies have experienced similar binges on goods. The catalyst that exposes this massive imbalance is the realisation that durables are, well, durable. They last a long time. So, if you front-end loaded many of this year’s purchases into last year, then you will not buy them this year. If you overspent by 26 percent in 2021, then the risk is that you symmetrically underspend by 26 percent in 2022. If central banks hike rates into this demand downturn, they will amplify and exacerbate the slump. A Massive Imbalance In Spending Makes The Economy Vulnerable To A Downturn Much of the recent overspend on goods was spending displaced from the underspend on services which became unavailable in the pandemic – such as eating out, going to the movies, and going to in-person doctor’s appointments. Raising the obvious question, can a future underspend on goods be countered by a future overspend on services? The answer is no. The consumption of services is constrained by time, opportunity, and biology. For example, there is a limit on how often you can eat out, go to the movies, or go to the doctor. If you are used to eating out and going to the movies once a week, and the pandemic prevented you from doing so for a year, that does not mean you will eat out and go to the movies an extra 52 times for the 52 times you missed! Rather, you will quickly revert to your previous pattern of going out once a week. This constraint on services spending means that the underspend will not become a symmetric overspend. In fact, the underspend on certain services will persist. This is because we have made some permanent changes to our lifestyles – for example, hybrid office/home working and more online shopping and online medical care. Additionally, a small but significant minority of people have changed their behaviour, shunning services that require close contact with strangers. To repeat the crucial asymmetry, an overspend on goods is corrected by a subsequent underspend; but an underspend on services is not corrected by a subsequent overspend (Chart I-1 and Chart I-2). Therefore, the recent massive overspend on goods at the expense of services makes the economy vulnerable to a downturn, and the risk is exacerbated by central banks’ intentions to hike rates in response to inflation. These hikes will prove to be overkill, because inflation is set to cool of its own accord. Chart I-1An Overspend On Goods Can Be Corrected By A Subsequent Underspend...   Chart I-2...But An Underspend On Services Cannot Be Corrected By A Subsequent Overspend   Durables Are Driving Inflation, And Inflation Is Driving The 30-Year T-Bond The recent binge on goods really comprises three mini-binges, which peaked in May 2020, January-March 2021, and October 2021. With a couple of months lag, these three mini-binges have caused three mini-waves in core inflation. To see the cause and effect, it is best to examine the evolution of inflation granularly – on a month-on-month basis – which removes the distorting ‘base effects.’ The mini-binges in goods lifted the core monthly inflation rate to an (annualised) 7 percent in July 2020, 10 percent in April-June 2021, and 7 percent in January 2022 (Chart I-3). Chart I-3Spending On Durables Is Driving Inflation Worryingly, the sensitivity of inflation has increased in each new mini-binge in goods spending, possibly reflecting more pressure on already-creaking supply chains as well as more secondary effects. Nevertheless, the key driver of the mini-waves in core inflation is the demand for durables, and as that demand wanes, so will core inflation. As monthly core inflation eases back, so too will the 30-year T-bond yield. What about the 30-year T-bond yield? Although it is a long-duration asset, its yield has recently been tracking the short-term contours of core inflation. So, when monthly inflation reached an (annualised) 10 percent last year, the 30-year T-bond yield reached 2.5 percent. At the more recent 7 percent inflation rate, the yield has reached 2.35 percent. It follows that as monthly core inflation eases back, so too will the 30-year T-bond yield (Chart I-4). Chart I-4Inflation Is Driving The 30-Year T-Bond Get The 30-Year T-Bond Right, And You’ll Get Most Things Right For the past year, the story of stocks has been the story of bonds. Or to be more precise, the story of long-duration stocks has been the story of the 30-year T-bond. Through this period, the worry du jour has changed – from the Omicron mutation of SARS-CoV-2 to an Evergrande default to Facebook subscriber losses and now to Russia/Ukraine tensions. Yet the overarching story through all of this is that the long-duration Nasdaq index has tracked the 30-year T-bond price one-for-one (Chart I-5). And the connection between S&P 500 and the 30-year T-bond price is almost as good (Chart I-6). Chart I-5Get The 30-Year T-Bond Right, And You'll Get The Nasdaq Right Chart I-6Get The 30-Year T-Bond Right, And You'll Get The S&P 500 Right The tight short-term connection between long-duration stocks and the 30-year T-bond makes perfect sense. The cashflows of any investment can be simplified into a ‘lump-sum’ payment in the future, and the ‘present value’ of this payment will move in line with the present value of an equal-duration bond. So, all else being equal, a long-duration stock will move one-for-one in line with a long-duration bond. The story of long-duration stocks has been the story of the 30-year T-bond. ‘Value’ stocks and non-US stock markets which are over-weighted to value have a shorter-duration. Therefore, they have a much weaker connection with the 30-year T-bond. It follows that if you get the 30-year T-bond right, you’ll get most things right: The performance of other long-duration bonds (Chart I-7). The performance of long-duration growth stocks (Chart I-8). The performance of ‘growth’ versus ‘value’ (Chart I-9). The performance of growth-heavy stock markets like the S&P 500 versus value-heavy stock markets like the FTSE100 (Chart I-10). Of course, the corollary is that if you get the 30-year T-bond wrong, you’ll get most things wrong. Observe that the 1-year charts of long-duration bonds, growth stocks, growth versus value, and S&P 500 versus FTSE100 are indistinguishable. Proving once again that investment is complex, but it is not complicated! Chart I-7Get The 30-Year T-Bond Right, And You'll Get The 30-Year German Bund Right Chart I-8Get The 30-Year T-Bond Right, And You'll Get Growth Stocks Right   Chart I-9Get The 30-Year T-Bond Right, And You'll Get Growth Versus Value Right Chart I-10Get The 30-Year T-Bond Right, And You'll Get S&P 500 Versus FTSE100 Right Our expectation is that as the spending on durable goods wanes, so too will monthly core inflation and the 30-year T-bond yield. Go overweight long-duration bonds, long-duration stocks, long-duration sectors, and long-duration stock markets such as the US versus non-US. Fractal Trading Watchlist This week we focus on emerging markets, add financials versus industrials, and review tobacco versus cannabis, CAD/SEK, and biotech. Emerging markets (EM) have been a big underperformer through the past year, but it may be time to dip in again, at least relative to value-heavy developed market (DM) indexes. Specifically, MSCI Emerging Markets versus MSCI UK has reached the point of fractal fragility that signalled previous major turning-points in 2014, 2018, and 2020 (Chart I-11). Accordingly, this week’s recommended trade is to go long MSCI EM versus UK (dollar indexes), setting the profit-target and symmetrical stop-loss at 10 percent.  Chart I-11Time To Dip Into EM Again, Selectively Financials Versus Industrials Is Approaching A Turning-Point CAD/SEK At A Top Awaiting A Major Entry-Point Into Biotech Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area   Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations I   Indicators To Watch - Interest Rate Expectations III    

Executive Summary Foreign And Domestic Politics Won't Stop The Fed Investors woke up to the Ukraine risk this week. It is not yet resolved. Stay defensive. Market reactions to Ukraine suggest investors will favor defensive sectors and growth stocks in the short term, with the notable exception of the energy sector. External risks will not dissuade the Fed from hiking rates in the face of 6% core inflation. Later the Fed might adjust to foreign crises but the stock market faces more downside in the interim. Polarization is reviving ahead of the midterm elections, which will usher in gridlock. Gridlock is disinflationary, reinforcing a tactically defensive market positioning despite our cyclical House View. Bottom Line: Biden’s external risks are not yet subsiding. The Fed will hike rates even in the face of external supply shocks. Stay tactically defensive. Feature Our three key views for the year are: gridlock, executive power, and foreign policy. First, Congress will become gridlocked even prior to the midterm elections. Second, President Biden will have to shift to executive power to achieve policy objectives. Third, Biden’s focus will be forced to engage in foreign policy more than he would prefer due to rising external risks. The Ukraine crisis – covered extensively in our Geopolitical Strategy – is the most pressing external risk but it is not the only one that we think will trouble markets this year. We expect politically induced volatility to persist all year. The cyclical investment view should be driven by the underlying macroeconomic reality. But that macro reality will change if external risks materialize and cause greater supply disruptions or if they alter the US midterm election outlook. We maintain our tactically defensive positioning for now. Mr. Market Wakes Up To Ukraine Risk The reason for the crisis is the historic Russian military buildup on all sides of Ukraine, in the face of US defense cooperation with Ukraine, not the “hysterical” American propaganda over the risk of war. When and if Russian forces withdraw, the crisis will melt away. But for now, Russia’s reported withdrawal of some troops is contradicted by movements of other troops as well as the fact that the Russian navy has effectively blocked off the Black Sea. Investors must judge by capabilities, not intentions, and Russia still has the capability to stage a limited attack at present so investors should maintain a defensive or cautious approach. In this context investors are rightly bidding up the US dollar and bidding down US equities in absolute terms (albeit not relative to European equities). Bond yields have not responded much to the external risk due to the high rate of inflation, which is pushing yields up (Chart 1). If Russia re-invades, stocks and bond yields will fall at least temporarily and the dollar will rise higher. When Russia initially invaded Ukraine eight years ago, in February 2014, the US stock-to-bond ratio moved sideways for several months but cyclicals outperformed defensives. Energy stocks rallied, until the oil crash in summer 2014. Small caps underperformed large caps, yet value outperformed growth stocks (Chart 2). Small caps likely suffered from risk-off sentiment and expectations of a drag on global growth, while value benefited from gently rising interest rates at that time. Chart 1Ukraine Crisis Escalates Chart 2Market Response To Crimea Invasion, 2014 Comparing the situation today, the difference is that cyclicals are trailing defensives and small caps are trailing large caps even more than they were in 2014. Yet value stocks have performed far better against growth now than then, in accordance with higher inflation and bond yields (Chart 3). Further escalation of the Ukraine crisis should drive investors to favor defensives, large caps, and growth stocks on a tactical time frame, even though this decision runs against our BCA House View on a cyclical time frame. The past week’s market moves reinforce the 2014 experience in general, with the stock-to-bond ratio faltering and cyclicals falling back (Chart 4). Small caps and value have benefited but these charts suggest that a negative hit to global growth will hurt small caps, while value is overextended relative to growth in the short term. The market only really began to discount the risk of a new war in Europe this past week, specifically on Friday, February 11 and Monday, February 14. Chart 3Market Response 2022 Versus 2014 Chart 4US Equities Just Woke Up To Ukraine There is not yet a solid diplomatic solution as we go to press on Tuesday, February 15, but some positive signs are fueling a rebound in risk assets. Fade these improvements in risk appetite until Russia makes its decision on whether to use military force and, if so, until Europe makes its decision on whether to impose crippling sanctions.  Bottom Line: Tactically stay long growth stocks versus value, but prepare to switch back to overweighting value if the Ukraine crisis abates. The Energy Sector Response To Ukraine So Far Commodity prices and the energy sector are naturally benefitting from rising supply risks. But there is a risk that they will suffer later if a war breaks out and generates a supply shock and energy price shock that weigh on European and global growth. Russia will likely maintain energy production to help pay for its military adventures. The Saudis could increase production to prevent demand destruction. It is also possible that a US-Iran nuclear deal could release Iranian oil to the market. The global economy can handle gradually rising energy prices but maybe not a sharp supply shock. Oil prices are rising on signs of escalating tensions and energy sector equities are generally outperforming the broad market and other cyclical sectors. Domestically oriented small cap energy stocks are rising relative to large caps, suggesting that the market does not believe that global growth will suffer greatly from any conflict. Apparently investors do believe that US energy companies will benefit from shipping more fossil fuels abroad (Chart 5). Bottom Line: Cyclically stay long small cap energy stocks versus their large cap brethren. Chart 5US Energy Sector Just Woke Up To Ukraine Peak-To-Trough Drawdowns Amid Geopolitical Crises The peak-to-trough equity drawdown amid major geopolitical crises ranges from 11%-15%, depending on the magnitude and nature of the crisis (Chart 6). In this case, the US will not be directly involved in any war in Ukraine, but US NATO allies will be right next door and providing aid to Ukraine. For “limited incursion” scenarios we looked at over a dozen crises, from the Berlin Blockade of 1949 to the Russian invasion of Crimea in 2014. The peak-to-trough drawdown averages 10%. For an unlimited or “full-scale” invasion, we looked at the S&P500 reaction to major invasions at the dawn of World War II as well as significant wars in the twentieth century, down to the US invasion of Iraq and NATO’s intervention in Libya in 2011. The peak-to-trough equity drawdown averaged 13%. Chart 6Range Of US Equity Peak-To-Trough Drawdowns Amid Geopolitical Crisis Given that the S&P500 has fallen by 8% since its peak on January 3, 2022, investors should be prepared for more downside. Health care stocks and consumer staples are outperforming the broad market this year so far, though they are underperforming energy where the supply squeeze is happening (Chart 7). The magnitude of war and sanctions will determine whether energy ultimately falls in expectation of demand destruction. Bottom Line: It is too soon to buy the dip in the S&P 500. Stay long health stocks relative to the broad market. Chart 7Health Care And Consumer Staples Will The Fed Respond To External Risks? No. Over the past year, we have argued with investors who tried to differentiate the current bout of inflation from the inflation of the 1970s by arguing that there is no energy supply shock. We argued that an energy shock could transpire by pointing to external risks such as Russia and Iran. While the Biden administration will likely prove risk-averse, for fear that higher prices at the pump will weigh on the Democratic Party in the midterm elections, what about the Federal Reserve? During the Arab oil embargo of late 1973, and the Iranian revolution of 1979, the Federal Reserve continued to hike interest rates, responding to domestic inflation and rising bond yields. Foreign supply shocks threatened to push up inflation, so the Fed was not deterred from hiking rates (Chart 8). When the US itself engages in war, the Fed might react differently (Chart 9). Chart 8The Fed Responds to Oil Shocks by Hiking Rates But... Chart 9... US At War Could Trigger Looser Monetary Policy In 1990, the Fed cut the policy rate once after the US entered the Iraq war, then kept rates flat for a few months before cutting more at the end of the year. Bond yields were falling due to recession. In 2001, the Fed was already cutting rates due to the business cycle and the September 11 terrorist attacks reinforced that process. In 2003, the Fed cut rates after the beginning of the Iraq war and did not start hiking rates until mid-2004 when the initial phase of the war ended. The implication is that Fed Chair Alan Greenspan accommodated both the war and the 2004 presidential election. Most external risks will not prevent the Fed from hiking rates, especially during an inflation bout when the nature of the external risk may be an energy supply disruption that pushes up prices. However, while we do not doubt that the Fed could hike by 50bps in March, we doubt that the consensus of 175bps in hikes in 2022 will pan out. The combination of initial hikes, fiscal drag, and foreign growth shocks would temper the Fed’s enthusiasm. Bottom Line: Stocks face more downside risk in this environment.   Bipartisanship And The Return Of Gridlock Polarization and partisanship are recovering. The Philadelphia Fed “Partisan Conflict Index” is now only 0.6% below its 2020 peaks as the midterm election approaches (Chart 10). Interestingly, one of our key views from last year – bipartisan reform – is still taking place beneath the surface. Our 2022 view of gridlock has not yet fully set in. Congress is stealthily cooperating on fiscal spending, the US Postal Service, women’s issues, public servants’ stock trading, and an attempt to revise the Electoral Count Act. Congress is also passing a bipartisan bill to make the US more economically competitive with China and impose sanctions against Russia. Chart 10Foreign And Domestic Politics Won't Stop The Fed The only area where bipartisanship is not happening is Biden’s “Build Back Better” reconciliation bill, which even lacks sufficient support from moderate Democratic senators due to high inflation. Passage is still possible in a partisan, watered-down, and deficit-neutral form. These developments show that Republican lawmakers are demonstrating some pragmatic governing ability and will use their voting records to make a case in the midterms, while pinning the blame for inflation, crime, immigration, and any foreign crises on Democrats. As such they reinforce the market consensus that Republicans are likely to take back Congress this fall. Thus while last year’s bipartisanship is spilling into the current legislative session, gridlock is rapidly approaching. When investors look to the second half of the year and beyond, they should expect to see legislative cooperation dry up, especially if Republicans only take the House and not the Senate. Bottom Line: Gridlock will freeze fiscal policy, which is non-inflationary or disinflationary for 2022-24. As such the midterm election is not fully priced. Midterm dynamics will support an overweight or at least neutral stance toward defensives and growth stocks. Investment Takeaways Tactically stay long defensives, notably health care, and growth stocks. Cyclically remain invested in the bull market – and stay long energy small caps. The chief risks to these views would be a speedy diplomatic resolution to the Ukraine and Iran conflicts or a dramatic revival of the Democratic Party’s popular support ahead of the midterm election. Diplomacy would remove risks to global growth, whereas a Democratic comeback would boost inflation expectations.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes  

Executive Summary China Needs To Create RMB35 Trillion In Credit In 2022 The pace of credit creation in January increased sharply over December. However, the jump was less than meets the eye compared with previous easing cycles and adjusted for seasonality. Our calculation suggests that a minimum of approximately RMB35 trillion of new credit, or a credit impulse that accounts for 29% of this year's nominal GDP, will be needed to stabilize the economy. January’s credit expansion falls short of the RMB35 trillion mark on a six-month annualized rate of change basis. Our model will provide a framework for investors to gauge whether the month-over-month credit expansion data is on track to meet our estimate of the required stimulus. Despite an improvement in January's credit growth from December, it is premature to update Chinese stocks (on- and off-shore) to overweight relative to global equities. Bottom Line: Approximately RMB35 trillion in newly increased credit this year will probably be needed to revive China’s domestic demand.  Any stimulus short of this goal would mean that investors should not increase their cyclical asset allocation of Chinese stocks in a global portfolio. Feature January’s credit data for China exceeded the market consensus. The aggregate total social financing (TSF) more than doubled in the first month of 2022 from December last year. However, on a year-over-year basis, the increase in January’s TSF was smaller than in previous easing cycles, such as in 2013, 2016 and 2019. Furthermore, underlying data in the TSF reflects a prolonged weak demand for bank loans from both the corporate and household sectors. While January’s uptick in credit expansion makes us slightly more optimistic about China’s policy support, economic recovery and equity performance in the next 6 to 12 months, we are not yet ready to upgrade our view. An estimated RMB35 trillion in newly increased credit this year will likely be necessary to revive flagging domestic demand. In the absence of seasonally adjusted TSF data in China, our framework will help investors determine whether incoming stimulus is on course to meet this objective. Interpreting January’s Credit Numbers Chart 1A Sharp Increase In Credit Creation In January January’s credit creation beat the market consensus to reach RMB6.17 trillion, pushed up by a seasonal boost and a frontloading of government bond issuance (Chart 1). However, the composition of the TSF data reflects an extended weakness in business and consumer credit demand. On the plus side, net government bond financing, including local government special purpose bonds, rose to RMB603 billion last month, more than twice the amount from January 2021 (Chart 1, bottom panel). Corporate bond issuance also picked up, reflecting cheaper market rates and more accommodative liquidity conditions (Chart 2). Furthermore, shadow credit (including trust loans, entrust loans and bank acceptance bills) also ticked up in January compared with a year ago. The increase in informal lending sends a tentative signal that policymakers may be willing to ease the regulatory pressure on shadow bank activities (Chart 3). Chart 2Corporate Financing Through Bond Issuance Also Increased Chart 3Shadow Banking Activity Ticked Up For The First Time In A Year Meanwhile, several factors suggest that the surge in January’s credit expansion may be less than what it appears to be at first glance. First, credit growth is always abnormally strong in January. Banks typically increase lending at the beginning of a year, seeking to expand their assets rapidly before administrative credit quotas kick in. In recent years loans made during the first month of a year accounted for about 17% - 20% of total bank credit generated for an entire year. Secondly, the credit flow in January, although higher than in January 2021, was weaker than in the first month of previous easing cycles. Credit impulse – measured by the 12-month change in TSF as a percentage of nominal GDP – only inched up by 0.6 percentage points of GDP in January this year from December, much weaker than that during the first month in previous easing cycles (Chart 4). TSF increased by RMB980 billion from January 2021, lower than the RMB1.5 trillion year-on-year jump in 2019 and the RMB1.4 trillion boost in 2016 (Chart 4, bottom panel). Chart 4The Magnitude Of Increase In January’s Credit Impulse Less Than Meets The Eye Chart 5Corporate Demand For Bank Credit Remains Soft Furthermore, China’s households and private businesses have significantly lagged in their responses to recent policy easing measures and their demand for credit remained soft in January (Chart 5). Bank credit in both short and longer terms to households were lower than a year earlier due to downbeat consumer sentiment (Chart 6A and 6B). Chart 6AConsumption Was Unseasonably Weak During Chinese New Year Chart 6BHouseholds' Propensity To Consume Continues Trending Down How Much Stimulus Is Necessary? Our calculation suggests that China will probably need to create approximately RMB35 trillion in new credit, or 29% of GDP in credit impulse, over the course of this year to avoid a contraction in corporate earnings. In our previous reports, we argued that the state of the economy today is in a slightly better shape than the deep deflationary period in 2014/15, but the magnitude of the property market contraction is comparable to that seven years ago. Chart 7 illustrates our approach, which uses a model of Chinese investable earnings growth. The model is designed to predict the likelihood of a serious contraction in investable earnings in the coming 12 months. It includes variables on credit, manufacturing new orders and forward earnings momentum. The chart shows that the flow of TSF as a share of GDP needs to reach a minimum of 28.5% in order that the probability of a major earnings contraction falls below 50%. The size of the credit impulse necessary is 2 percentage points higher than that achieved last year, but still lower than the scope of the stimulus rolled out in 2016. Assuming an 8% growth rate in nominal GDP in 2022, the credit flow that should to be originated this year would be about RMB35 trillion, as illustrated in Chart 8. The chart also shows that this amount would exceed a previous high in credit flow reached in late-2020. Chart 7China Needs At Least A 29% Credit Impulse In 2022 To Avoid An Earnings Recession Chart 8China Needs To Create RMB35 Trillion In Credit In 2022 Based on a 3-month annualized rate of change, January’s credit growth appears that it will achieve the RMB35 trillion mark. However, the jump in TSF largely reflects a one-month leap in frontloaded local government bond issuance and it is not certain if private credit will accelerate in the months ahead. For now, we contend the stimulus have been insufficiently provided during the past six months (Chart 8, bottom panel). Chance Of A Stimulus Overshoot? We will closely monitor whether the month-to-month pace of credit growth is consistent with the scope of the reflationary policy response required to revive China’s domestic demand. Despite a sharp improvement in January’s headline credit number, we view the policy signal from January’s credit data as neutral. China’s unique cyclical patterns and the lack of official seasonally adjusted data make monthly credit figures difficult to interpret. Charts 9 and 10 represent an approach that we previously introduced to help gauge whether the pace of credit creation is on track to meet the stimulus called for to stabilize the economy. Chart 9Jan Credit Growth Looked To Be Stronger Than A “Half-Strength” Credit Cycle… Chart 10…But It Is Too Early To Conclude It Is In Line With What Is Needed The charts show an average cumulative amount of TSF as the year advances, along with a ±0.5 standard deviation, based on data from 2010 to 2021. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate. Chart 9 shows the cumulative progress in credit, assuming a 27% new credit-to-GDP ratio for the year, whereas Chart 10 assumes 30%. The 27% ratio scenario shown in Chart 9, which is slightly higher than the magnitude of stimulus in 2019, would correspond to a very measured credit expansion. If the thick black line continues to trend within this range, it would suggest that policymakers are reluctant to allow credit growth to surge. Consequently, global investors should continue an underweight stance on Chinese stocks. In contrast, Chart 10 represents a 30% rate of TSF as a share of this year’s GDP; this would be the adequate stimulus needed for a recovery in domestic demand. A cumulative amount of TSF that trends within or above this range would provide more confidence that a credit overshoot similar to 2015/16 and 2020 would occur.   Investment Conclusions It is premature to upgrade Chinese stocks to an overweight cyclical stance (i.e. over 6-12 months) within a global portfolio. For now, we recommend investors stay only tactically overweight in Chinese investable equities versus the global benchmark, given their cheap relative valuations. Meanwhile, the increase in January’s TSF, while registering an improvement relative to previous months, does not signal that the pace of credit growth will be strong enough to overcome the negative ramifications of the ongoing deceleration in housing market activity. Therefore, in view of policymakers’ steadfast desire to avoid another major credit overshoot, our cyclical recommendation to underweight Chinese stocks remains unchanged.   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations