Economy

Highlights Our leading indicator for China’s “old economy” remains weak, and the beneficial trade front-running effect that has supported some of China’s macro data over the past year is beginning to wane. Our "earnings recession" model for Chinese investable stocks suggests that a trade deal alone is not enough to prevent a contraction in earnings growth over the coming year. A meaningful rebound in credit relative to GDP would also be required, one that would retrace roughly 50% of the decline that has occurred since late-2017. An overweight cyclical stance (i.e. over a 6-12 month period) towards Chinese stocks versus their global peers remains premature. The equity market is conceptually supported until the beginning of March if trade talks continue to make progress, but will face (potentially severe) headwinds thereafter until credit durably accelerates at some point in the second half of the year. Feature China’s macro data remains at the forefront of investor attention, and December’s updates did not provide market participants with much comfort. Our leading indicator for China’s “old economy” deteriorated anew in December after a shallow three-month rise (Chart 1), driven by a currency-driven retracement in monetary conditions, as well as slowing growth in both M3 and adjusted total social financing (TSF). The flow of adjusted TSF relative to GDP technically ticked higher in December, but only because of a material slowdown in nominal GDP growth from 9.6% in Q3 to 8.1% in Q4 (Chart 2). This decline in nominal GDP means that it has retraced 70% of its rise from 2015 to 2017. Chart 1A Relapse In Our Leading Indicator For China's Old Economy Chart 2A 70% Retracement In Chinese Nominal GDP Growth On the housing front, sales volume growth ticked slightly higher but remains negative (and well below the pace of construction growth), and pledged supplementary lending from the PBOC, a factor that we have identified as a core driver of China’s housing market since 2015,1 decelerated further. Finally, December’s trade data was uniformly negative, with import and export growth decelerating 6-7 percentage points even on a smoothed basis, depending on whether measured in U.S. dollars or local currency. Revisiting The Measurement Of China’s “Old Economy” One notable exception to the weak data was the Bloomberg Li Keqiang index (LKI) itself, which rose from 8.4 in November to 9.3 in December. Our alternative LKI rose to exactly the same level, closing the gap with Bloomberg’s measure that had existed earlier this year (Chart 3). Chart 3Our Coincident Measures Of The Old Economy Are Trending Higher... In fact, the LKI has been providing a different message than our LKI leading indicator for several months, and the apparent uptrend in the series raises the question of whether the Chinese economy is actually strengthening rather than weakening. With high conviction, our answer to this question is no. As we have highlighted in previous reports, our view is that the gap can be explained by the (anomalous and only temporary) positive impact that the trade war has had on economic activity since March last year, as Chinese exporters rushed to front-load the production and shipment of goods to the U.S. in advance of the imposition of tariffs. Panel 1 of Chart 4 makes this point explicitly, by showing the percentile rank of the two most cyclical components of the LKI. From 2010 to early-2018, electricity production and railway freight volume moved closely together, with the former leading the latter somewhat from 2017 to early-2018. While the trade war-driven bounce in electricity production has since rolled off, railway cargo volume remains elevated and is only now rolling over. December’s extremely poor trade data suggests that a material further decline is likely in Q1 of this year. Chart 4...Because Of A (Temporarily) Beneficial Trade War Effect Panel 2 shows that bank lending, the third component of the LKI, has begun to pick up over the past few months. However, this reflects, at least in part, the goal of policymakers to shrink the size of shadow banking in the economy and reorient the provision of credit back to traditional financial institutions (Chart 5). A sustainable rise in bank loan growth that overwhelms a shrinking shadow banking sector will almost certainly show up in our preferred measure of aggregate credit growth (adjusted total social financing), which for now remains in a clear downtrend. From a bigger picture perspective, it is worth revisiting why we focus on the LKI at all. Our use of the index to represent China’s investment-relevant economic activity dates back to a November 2017 Special Report,2 in which we noted that it correlated well with China’s nominal import growth and led the growth in earnings for the MSCI China index ex-technology. Real GDP growth, by contrast, has shown barely any cyclicality over the past four years in the face of large changes in Chinese import growth and the prices of China-related assets (Chart 6). This underscores that aggregate Chinese real GDP is not, by and large, investment-relevant. Chart 5A Stunning Collapse In Shadow Banking Activity Chart 6Chinese Real GDP Growth Is Not Relevant For Investors What can we infer about the trend in China’s old economy if the LKI is combined with other closely correlated measures of investment-relevant economic activity? Panel 1 of Chart 7 answers this question by presenting the standardized LKI alongside standardized nominal import growth and nominal manufacturing output, the measure of Chinese coincident activity preferred by BCA’s Emerging Markets Strategy service. Panel 2 of the chart shows an equally-weighted average of all three measures alongside our leading indicator for the LKI. We note four key observations from Chart 7: Chart 7China's Investment-Relevant Economic Activity Is Trending Lower Since 2010, the primary trend in the LKI, nominal import growth, and nominal manufacturing output has been the same The modest uptrend in the LKI since early-2018 is not corroborated by imports or manufacturing output Economic activity in China has been stronger over the past year than our leading indicator would have suggested, even after abstracting from the anomalous uptrend in the LKI The gap between our leading indicator and China’s actual economic activity is now beginning to close. These observations support the conclusion that we reached when analyzing the components of the LKI itself: a temporary boost from trade front-running has masked an underlying slowdown over the past year. But this boost has now begun to wane, implying that actual activity will continue to slow in the coming months. Is A Trade Deal Enough To Prevent An Earnings Contraction? While most global investors would acknowledge that China’s domestic economy is slowing, the performance of China-related assets over the past year highlights that the market views the trade war with the U.S. as being at least equally important as slowing Chinese money & credit growth. Chart 8 highlights that our market-based China growth indicator did not break down until the second quarter of 2018, when the threat of tariffs from the Trump administration became a reality. The indicator’s prior resilience was in contrast to a steady deterioration in our LKI leading indicator, which peaked at the beginning of 2017. Chart 8Investors Are Largely Focused On The U.S./China Trade War The surge in the indicator since early-December underscores that investor expectations of a trade deal with the U.S. have materially improved sentiment about China’s growth profile, despite the fact that Chinese money & credit growth have yet to meaningfully improve. Given that our geopolitical strategy team assigns odds as high as 45% of a framework deal emerging by the March 1 deadline,3 how can investors gauge the net impact of an improving external outlook and still-weak domestic demand? Chart 9 illustrates one method of approaching this question, using a model of Chinese investable earnings growth that we introduced in our January 16 Special Report.4 The model is designed to predict the likelihood of a serious investable earnings contraction over the coming 12-months, and includes data on credit, trade, and forward earnings momentum as predictors. The chart shows what would have to happen to the flow of adjusted total social financing as a share of GDP in a trade deal scenario, calibrated in a way that the odds of a major earnings contraction fall to 33% (the highest historical reading of the model that did not correspond to a major earnings decline). Chart 9A Trade Deal Is Not Enough To Avoid An Earnings Recession In China The chart shows that a meaningful rebound in credit flow to GDP would be required, one that would retrace roughly 50% of the decline that has occurred since late-2017. In short, our analysis shows that a trade deal alone is likely not enough to prevent a contraction in Chinese earnings growth over the coming year. Importantly, Chart 10 shows what this would imply for the volume of credit that would need to be created over the coming several months in order for the scenario shown in Chart 9 to come to pass (assuming an 8% growth rate in nominal GDP). The chart highlights that China would need to create approximately RMB 26 trillion in new credit over the coming 12 months (nearly US$ 4 trillion at current exchange rates), which would exceed the prior high set in late-2017 by a non-trivial amount. While this goal looks on its way to being achieved based on a 6-month annualized rate of change (panel 2), this largely reflects a one-month surge in local government bond issuance in September. Over the past 3-months, the annualized pace of credit creation has fallen well below the RMB 26 trillion mark, implying that either traditional credit growth, shadow credit, or local government bond issuance will have to pick up significantly over the coming several months in order for the domestic demand situation to stabilize. We expect this to occur, but it has not occurred yet. Chart 10China Needs To Create 26 Trillion RMB In Credit In 2019 Investment Conclusions The key conclusion of our analysis above is that an overweight cyclical stance (i.e. over a 6-12 month period) towards Chinese stocks versus their global peers remains premature. We noted in our December 5 weekly report that a tactical (0-3 month) overweight was probably warranted due to the prospect of a framework trade deal with the U.S. on March 1, but Chart 9 makes it clear that an improving external demand outlook is not a sufficient basis to expect that Chinese stocks will avoid an earnings recession. In this regard, investors should conceptualize the absence of a significant pickup in the volume of credit as a “gap” in a bridge representing the market support for Chinese stocks over the course of the calendar year (Chart 11). Assuming leaks from the negotiations continue and are consistent with the agreement of a framework deal, the market is conceptually supported until the beginning of March. However, following March 1, a gap in support emerges until credit durably accelerates at some point in the second half of the year. In our view, investors who go long Chinese stocks today with a 6-12 month time horizon are betting not only on the success of trade negotiations, but that this gap will close by the time that a deal is announced. This is a risky gamble given the still-relevant desire of policymakers to avoid another major credit overshoot, and as such our cyclical recommendation remains unchanged: wait. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Special Report “China's Property Market: Where Will It Go From Here?”, dated September 13, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report “The Data Lab: Testing The Predictability Of China's Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3 Please see Geopolitical Strategy and China Investment Strategy Special Report “Is China Already Isolated?”, dated January 23, 2019, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks”, dated January 16, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights So What? A 70% tax on Americans with income over $10 million is not far-fetched. Why? The median U.S. voter wants higher taxes on the wealthy; Both populism and geopolitics make it impossible to cut spending; The next recession, no matter how shallow, will elicit unconventional policy. Feature The New Year has brought a chill to the investment community. No, it is not the weather, but rather a proposal by U.S. Congresswoman Alexandria Ocasio-Cortez (AOC) to create a new top-income bracket, starting at $10,000,000, that would be taxed at 70%. The reaction to the self-described Democratic Socialist has been swift. Her strategy of soaking the rich would not work, would cause an exodus of job-creators out of the U.S., and would slow down the pace of growth. A CNBC headline screamed: “The super rich at Davos are scared of Alexandria Ocasio-Cortez’s proposal to hike taxes on the wealthy.”1 In these pages, we are not going to discuss the merits of the proposal, although it would not raise enough revenue to fund the Democrats’ other policy proposals. Instead, we are going to forecast that Representative Ocasio-Cortez will get what she wants. Within our investment horizon. Probably following the next recession, which is nigh. However, how she gets what she wants will ultimately matter more than what the tax rate is on every dollar over $10,000,000 of income. The Median American Voter Since before the 2016 U.S. election and the Brexit vote, we have argued that the Median Voter is moving to the Left, particularly in the laissez-faire economies of the U.S. and the U.K. These two Anglo-Saxon economies swerved most enthusiastically to the right of the economic spectrum during the 1980 supply-side revolutions. They embraced both neo-liberal economic policy and globalization. While these reforms allowed them to outperform their less enthusiastically capitalist peers on a number of measures of economic performance, they also produced higher income inequality and a slower pace of social mobility (Chart 1). Over time, and particularly following the 2008 Great Recession, this pernicious mix of factors produced a surge in populism. There has been plenty of evidence that our view is on track. Take for example the performance of the über-left leaning Labour Party in the U.K.’s 2017 election or the breakdown of the Washington Consensus on global trade. Still, many clients have resisted our thesis. This is because President Trump did manage to push a sweeping supply-side tax cut through Congress in 2017. Given that we forecast that Republicans would get their way on tax cuts, our clients were left wondering how our thesis of a shift to the left could coexist with a Reagan-esque lowering of tax rates? The answer is that the move of the Median Voter to the left is a structural geopolitical view. A tax cut policy in 2017 was a tactical/cyclical view that deviated from the long-term trend. Trump was a candidate who promised faster economic growth while the Republican Party was a political machine that sought a low tax regime as a matter of policy and ideology. We expected the GOP, and House leader Paul Ryan, to use the Trump presidency as a way to get one last tax cut while they had control. However, since the tax cuts were passed, much has gone awry for America’s center-right party. First, the Democrats campaigned enthusiastically against the tax cuts in the midterm elections. On the other side of the aisle, Republican members of Congress quickly found out that they got no applause from constituents for their signature piece of legislation. The tax cut therefore disappeared from GOP messaging ahead of the November 2018 election. Steve Bannon, Trump’s political strategist, had apparently predicted this outcome when he cautioned against cutting tax rates for the top income bracket. He suggested a hike on taxes for the wealthy to boost Trump’s populist credentials. (Bannon’s proposal was for a 44% rate on those who earn income over $5,000,000, mathematically on the path towards Ocasio-Cortez’s end-point!).2 Second, the Republicans went on to lose their majority in the House. Granted, presidents usually lose their first midterm. However, with unemployment at 3.7% last November and the economy clocking in at a 3% clip, the GOP had a clear upper hand on economic messaging. And yet it did not avert major losses. The commentary from the right is that the Democrats are going to dig their own grave with their increasingly “Socialist” talk. But will they? We present three reasons that suggest that Ocasio-Cortez (and, ironically, Steve Bannon) are going to get what they want. Income taxes in America will rise over the next decade. Reason #1: The Median Voter Wants Higher Taxes On The Wealthy There is nothing sacred in politics. A society’s volonté générale swings like a pendulum between thesis and antithesis. The idea that Americans embody the laissez-faire spirit, while the French are socialists, is simply a product of linear extrapolation based on the timeline of a single generation.3  Chart 2 suggests a different story. As recently as the early 1970s, the U.S. and France were like peas in a pod when it came to income distribution, while the U.K. – the epicenter of the supply-side revolution — was the most redistributive Western economy. Chart 2France Was Once Less Socialist Than America! Today, Americans are much more in line with AOC than with Paul Ryan, which is why only one of the two has a job in the U.S. Congress. Ryan knew when to take his winnings and go home. According to a poll published merely weeks after AOC’s proposal, 59% of Americans support the 70% marginal tax rate. Democrats support the idea at a 71% clip, which suggests that Ocasio-Cortez is not on the fringes of the party. Independents support it at 60% and even 45% of registered Republicans support the idea. One could argue that the much-cited poll above is merely a flash in the pan, that it signifies nothing. We disagree for two reasons. First, if 60% of Americans – including 45% of Republicans – support a 70% tax rate now, when the economy is firing on all cylinders, GDP growth is above potential, and unemployment is at 3.9%, what will they support 12-36 months from now, when the inevitable recession hits? Or when America’s indebted corporations begin to deleverage by shedding jobs because they took on massive debts in order to buy back equities and return value to shareholders (which, completely coincidentally, includes senior management)? Second, there is evidence that a majority of Americans has thought that “upper-income people” have not been paying their fair share for some time now. A Gallup poll run since the early 1990s shows that the sentiment for higher taxes on upper-income individuals is off its lows in 2010 (Chart 3). We are still far from the early 1990s highs, but the trajectory of the public opinion is clearly going in the Left’s direction and has always hovered around the 60% mark. Bottom Line: It seems like ages ago that Grover Norquist, the anti-tax advocate, dominated the hallways of Congress, prodding legislators into pledging to “oppose any and all efforts to increase the marginal tax rate for individuals and businesses.” As recently as the 2012 election, 238 out of 242 House Republicans and 41 out of 47 Senate Republicans signed Norquist’s “Taxpayer Protection Pledge.” We subscribe to the theory that the median voter is the price maker in the political marketplace, the politician is the price taker. Trump and Ocasio-Cortez are merely vessels for the expression of the volonté générale, the median voter’s policy preference. And that preference runs counter to Norquist’s activism and the GOP’s tax cut policy in 2017. Reason #2: History Is On Ocasio-Cortez’s Side Chart 4 has already made the rounds, suggesting that Ocasio-Cortez is not making a ludicrous proposal given that the U.S. already had much higher marginal tax rates on top incomes in the past. Critics accuse her of simplifying history without considering context. This is an important point. First, defense spending as a percent of GDP was at 37.5% in 1945 and still at an elevated 7.4% in 1965, twenty years later. The U.S. exited World War II and then almost immediately stumbled into two major conflicts, one on the Korean Peninsula and one in Vietnam. Meanwhile, the Cold War competition with the Soviet Union created an existential threat that had to be resisted on land, sea, and space, justifying higher tax rates. Second, while the U.S. did indeed cut its top marginal rates throughout the second half of the century, so did everyone else! Chart 5 shows that the rest of the Western world was largely in lock-step with the U.S. In fact, it was the U.S. that came down to French levels of taxation (!!!) throughout 1960s and 1970s (again, remember Chart 2). As such, Chart 4 by itself is not a reason to excuse higher marginal rates. Of course we are completely disinterested in the merits of the policy. We are merely trying to forecast it. And Chart 4 does help us do so for two reasons. First, the key achievement of the Tax Cuts And Jobs Act of 2017 was the corporate tax cut to 21%. There is some bipartisan support for this policy, at least in the center of the Democratic Party (President Obama tried to cut the corporate tax rate from 35% to 28% in 2012). The last time corporate tax rates were this low, however, the top marginal income tax rate was at 79%. As such, we think that a bipartisan consensus could emerge on keeping corporate tax cuts at or below the OECD average of 24%, but at the cost of higher marginal tax rates for high-income earners. Second, it has been a key structural view of BCA’s Geopolitical Strategy, since inception, that the defining geopolitical feature of the twenty-first century will be the Sino-American conflict. If we are right on this issue, then perhaps an “existential conflict” to justify higher taxes on elites is already here. In other words, it is a fact that global challenges have required the U.S. to tax households and corporations at a higher rate in the past. It is also a fact that the U.S. faces greater global challenges today, specifically with China and Russia, than at anytime since the Cold War. Thus, while AOC may not be motivated by geopolitics, she may represent one aspect of a growing public policy consensus nonetheless. Simply put, with the U.S. facing both populism and geopolitical multipolarity, there is simply no political option for cutting either defense or non-defense spending. The only question is whether the U.S. will simultaneously shore up its ability to service its debts and maintain a reliable currency. AOC may find unlikely allies as geopolitical competition heats up. Reason #3: Policymakers Will Overreact To The Next Recession  President Trump was elected in November 2016, with the recession having ended 88 months prior, with the unemployment rate down 5.6%, and the economy on the path to recovery. But his economic populist message resonated with a lot of voters who did not participate in that recovery. Our concern is that the next recession is close at hand. BCA’s House View is that the next recession will be relatively shallow in the U.S., in part because there aren’t any obvious bubbles. For one, cyclical spending as a percent of GDP is at mid-cycle levels (Chart 6). Corporate debt is elevated, but not by international standards (Chart 7). U.S. banks are in a much sounder position than in 2007. So, from a macroeconomic perspective, the next recession is nothing to fear. Chart 6Are We Even Mid-Cycle Yet?   Chart 7Corporate Debt Load Is Not Excessive Policymakers, however, don’t care about macroeconomics. They care about the policy preferences of the Median Voter. And if that Median Voter elected an anti-establishment populist during relatively good times, who will he or she support when unemployment is high? Whoever is running the U.S. when the next recession happens, they will not wait around to find out. Unorthodox monetary, fiscal, and yes tax policy will overshoot norms and conventions regardless of how shallow the recession is. All bets are off at that point since policymakers will have a “recency bias” due to the trauma of 2008. While the recession may be shallow, the budget deficit will likely be at an elevated level. The U.S. is currently engaged in the first pro-cyclical economic stimulus since the late 1960s (Chart 8). This means that the recession will likely hit with the budget deficit already at around 5%-6% of GDP, compared to just 3%-4% when the last recession occurred. Given that the last four recessions raised the U.S. budget deficit by an average of 5% of GDP, it is safe to say that the U.S. budget deficit may rise to 2010 levels after the next downturn, regardless of how shallow the recession is. Chart 8Budget Deficits Will Be Very High In The Next Recession As with the  Great Recession, the public will demand that the government deals with the deficit. Unlike in the post-2008 environment, however, we think that the Median Voter will abandon the Norquist and Tea Party thesis of cutting spending and adopt the view that higher income brackets should see their taxes increased. That said, extremely high marginal rates at $10,000,000 will impact very few individuals and thus have a negligible revenue impact. What about higher marginal rates across the board? Chart 9 illustrates the evolution of marginal tax rates, using 2012 dollars for income brackets, across decades. The 1950s, 1960s, and 1970s saw multiple tax brackets, all with progressively higher marginal tax rates. In the 1970s, the 70% tax rate started at $460,000 in 2012 dollars, but a 50% rate began at $100,000 in 2012 dollars. The question for investors is whether Ocasio-Cortez’s proposal is merely a branding exercise. A 70% tax rate that begins at $10,000,000 – Option 1 on Diagram 1 – is largely irrelevant, macroeconomically and politically. But if that is an end point of a curve, that is something that investors will want to know. This is because policymakers could draw those curves either by cutting lower-class and middle-class marginal rates – such as in Option 2 – or by simply replicating the 1970s curve, such as in Option 3. The impact of new taxes on the part of society with a higher marginal propensity to consume is an important consideration for policymakers recovering from a recession. Diagram 1Is Ocasio-Cortez’s Proposal An End Point Of A Curve Or Just A Branding Exercise? At the moment, investors are probably not overly concerned about these issues. Options 2 and 3 look unlikely in the current political environment. But, again, they have been acceptable policy options in the past and could be revived if the Democratic Party decides to make income inequality the central issue of the 2020 election. Which makes the 2020 election the most significant U.S. election in a generation. Will Trump-style populism succeed or will Democratic Socialism emerge in the United States? At the moment, most of our clients would likely guess that trade and immigration – policy issues from 2016 – will dominate the debate again in 2020. This is likely incorrect linear extrapolation. Rarely do the same issues carry over from one election to another. As such, a left-leaning presidential candidate could push the Trump administration on its tax reform package and the continued growing income inequality, despite a falling unemployment rate. Throw in a potential recession and you have a witch’s brew. Not only would the rhetoric alarm the markets, but so would the electoral math. Democrats have a solid House majority while Republicans are clinging to a small Senate majority in a year when the electoral math clearly works in Democrats’ favor (20 out of 33 Senate seats up for reelection are held by the GOP). We are not ready to give a high conviction forecast on the presidential election – other than to say that a recession will virtually ensure Trump’s loss – but we do have a high conviction that whoever wins the White House in 2020 will also carry the Senate. As such, a Democratic sweep of both the White House and Congress is a possible scenario. At that point, the Options from Diagram 1 will no longer be an academic question. Finally, even if Trump emerges victorious, he may still have to agree with a Democratic Congress to modify his tax cuts in order to pay for his border wall, immigration reform, and a national infrastructure package. In that case, the median voter would have established the long-term bottom of U.S. tax rates even without a change in political parties. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1      Please see CNBC Markets, “The super rich at Davos are scared of Alexandria Ocasio-Cortez’s proposal to hike taxes on the wealthy,” dated January 22, 2018, available at cnbc.com. 2       Please see “Steve Bannon’s Plan to Raise Taxes on the Rich? Not Happening,” Fortune, dated July 31, 2017, available at fortune.com. 3      Also known as stereotyping.