Equities

Special Report

Highlights China’s healthcare expenditure is projected to rise due to the increasing affluence and rapid aging of its population. The desire to access healthcare services beyond the basic coverage provided by the public health insurance will increasingly prompt people to purchase health insurance products from private insurers. We recommend going long Chinese insurance stocks in absolute terms. We also recommend accumulating and overweighting Chinese healthcare stocks on a 15% correction. Feature The aging population and the rapidly expanding middle class in China entail that healthcare expenditures will remain on a secular growth trajectory. The COVID-19 outbreak will function as a catalyst for the rapid transformation of China's healthcare system. In fact, many game changing trends in global healthcare systems will probably be attributed to the COVID-19 pandemic. Healthcare Expenditures: Still Low Health expenditures per capita in China grew substantially over the same period of time, but their level is still below those in most countries. Chart 1Chinese Healthcare Expenditure Will Grow 10% CAGR Health expenditures in China have grown considerably since the economic reforms started in 1978.  Between 1978 and 2018, total health expenditures in China grew at a compound annual growth rate (CAGR) of 17% in nominal terms, higher than the 15% growth in nominal GDP (Chart 1, top panel). Notwithstanding the rapid expansion of China’s healthcare market, expenditures remained at a modest 6.4% of China’s GDP in 2018 (Chart 1, bottom panel), far below the OECD average of 9%. Health expenditures per capita in China grew substantially over the same period of time, but their level is still below those in most countries. In 2017, health expenditures per capita in China were $841 in PPP (purchasing power parity) terms, ranking 92nd worldwide. Japan, by comparison, ranks 18th with $4,550, and Korea ranks 31th with $3,000, both in PPP terms (Chart 2). Chart 2China Ranks Low In Health Expenditure Per Capita Worldwide Healthcare Capacity And Healthy China 2030 Chart 3China Healthcare Capacities Are Rising Fast Access to adequate healthcare is crucial to social and economic development, as healthy human capital fosters productivity and economic growth. In China, healthcare capacity is still subdued. After the pandemic, authorities will divert resources to this sector to ensure it expands quickly. In 2018, the number of physicians and nurses per 1000 Chinese people was 2.6 and 2.9, respectively (Chart 3), far below the OECD average of 3.5 physicians and 8.8 nurses per 1,000 people. Hospital beds per 1000 people is 4.3 in China, compared to an average of 4.7 across OECD countries. In Japan and Korea, the measure is much higher, at 13.1 and 12.3 beds per 1,000 people, respectively (Chart 3, bottom panel). China released the Healthy China 2030 (HC 2030) blueprint in 2016, covering public health services, environmental management, the medical industry, and food and drug safety. The five specific goals of this blueprint are to improve the population’s health, control against major risks, increase the capacity of healthcare services, grow the scale of the healthcare industry, and improve the health service system generally. This program has set targets for health service capacity, including an increase in the number of doctors, nurses and beds per 1,000 people to 3, 4.7 and 6, respectively, by the year 2030. The blueprint also aims to further ease the financial burden imposed on the population by the cost of healthcare and medical treatments. Currently, in China, 29% of health costs are paid by individuals; HC 2030 recommends a reduction to 25%. We will discuss these objectives in the next section. Healthcare Financing: A Looming Funding Crunch The aging population, along with its rising income, will drive up health expenditures in the years to come. Chart 4China Elderly Population Will Rise Significantly There are currently more than 167 million people over the age of 65 in China. By this measure, China is already the largest eldercare market in the world in terms of the absolute number of elderly people. What is more, China’s elderly population is growing rapidly and is expected to reach almost 200 million by 2025 (Chart 4). The aging population, along with its rising income, will drive up health expenditures in the years to come. As health expenditures grow, so will investment opportunities. Global healthcare systems can generally be classified into the three categories shown in Table 1. China’s health insurance system more closely resembles Germany’s national social health insurance system than the US commercial health insurance model. China’s healthcare system and insurance scheme is illustrated in Table 2. Table 1Overview Of Major Healthcare Systems Worldwide Table 2Main Features Of China's Three Basis Social Health Insurance Schemes In 2000, just over 20% of Chinese citizens had healthcare coverage. The SARS outbreak in 2003 was a wake-up call for Chinese leaders. Thanks to heavy government subsidies and political commitments, China achieved universal health insurance coverage in 2011, when nearly 95% of its 1.4 billion people had health insurance. This represents the largest and fastest expansion of insurance coverage in human history. Chart 5Individuals Health Expenditures Remain High However, the government-sponsored health insurance plan provides for only basic coverage. Government budgetary spending accounted for 28% of total health expenditures in 2018 and the population’s out-of-pocket costs amounted to 29%, such that the remaining 43% was covered by the public social health insurance contributions (Chart 5). China’s health insurance is supervised at the national level and guided by the principle that all citizens are entitled to receive basic healthcare. Nevertheless, local governments are ultimately responsible for funding and offering these health services. This leads to unevenly distributed healthcare capacities across different provinces, as more resources are concentrated in wealthier jurisdictions. People can only receive a reimbursement for healthcare costs from their province of residence, as indicated on their hukou registration documents. Migrant urban professionals and laborers have to return to the place of their household registration to access healthcare. Chinese policy makers have been working on reforming the reimbursement system now for many years. As of the end of 2019, 3.95 million people have benefited from inter-provincial health insurance settlements. Relying heavily on local government contributions to healthcare expenditures is the primary reason why government spending on healthcare is relatively low, at only 1.7% of GDP and 7% of total general (central and local) government spending1 (Chart 6). Government expenditures on social security (which includes contributions to social health insurance, pension, unemployment and work injury insurance) make up 12% of overall government spending.1 The outbreak of COVID-19 sounded the alarm across Chinese society. Building a comprehensive and effective healthcare system with adequate capacity will become one of the most important priorities over the coming decade. The people’s well-being will be critical to social stability as its increasingly affluent population is asking for better healthcare services. Chart 6Government Spending In Healthcare Chart 7China: A Rapidly Aging Population However, the overall sustainability of the current healthcare financing scheme is questionable. Chart 7 shows the old age-dependency ratio, defined as the ratio of older dependents (people over the age of 64) to the working-age population (25 to 64-year old). The ratio is expected to increase from the current 19% to 30% in 2030. This means a decreasing contribution to social insurance budgets from the working population and an increase in healthcare spending on seniors. What makes the situation worse is the opacity of the National Social Security Fund (SSF). The SSF manages money reserved for pension and insurance disbursements related to medical, unemployment and injury needs for future use. Of the 2.6 trillion RMB under SSF management, at the end of 2019, over 90% are invested domestically. The fund’s average 10-year investment return is close to 6%, which is lower than the average nominal GDP growth rate of 11%, over the same period. With declining revenues from workforce contributions and rising healthcare costs, the ability of the social security system to finance proper healthcare service provisions  is endangered. Furthermore, the replenishing of the SSF, so far, has depended on central government contributions and asset transfers from state-owned enterprises to the SSF. Bottom Line: As demand for healthcare services increases, the current public scheme for financing healthcare is going to be increasingly unable to cover the costs. Private Health Insurance Private health insurance offers a more extensive level of protection than the state-based coverage. Currently, most private health insurance plans provide supplementary insurance products to complement public health insurance plans. Supplementary insurance and critical illness products are the most popular because the public insurance systems cannot fully cover the cost of catastrophic illnesses. The private health insurance industry has been thriving in recent years and is expected to continue growing  because of increased consumer awareness. The written premiums attributed to health insurance registered a compound annual growth rate of 36% between 2013 and 2019 (Chart 8). However, penetration into China’s health insurance market remains far behind that of more developed markets, signaling huge growth potential. One measure of insurance industry penetration is insurance depth. It is defined as the percentage of the GDP attributed to the total written premium for insurance. China’s insurance depth is currently 0.7% for health insurance and 4.2% for overall insurance (Chart 9), whereas the overall insurance depth is 11% in South Korea, 9% in Japan, and 7% in the US. Chart 8Health Insurance Premiums Are Skyrocketing Chart 9China: Health Insurance Penetration Faced with financial strains and a growing demand for healthcare services, the government is supporting private healthcare providers by relaxing regulatory restrictions and offering tax incentives to Chinese consumers when they buy health insurance. Private health insurance offers the growing middle-income class a more extensive level of protection than the state-based coverage. In regard to insurance companies’ asset management, the regulators raised the equity investment cap for all insurers earlier this month from 30% to 45% of total assets. In May of this year, regulators also allowed insurers to invest in the secondary capital bonds issued by banks, as well as in perpetual bonds. This expanded investment opportunity should help insurers diversify their investment portfolios and therefore increase the efficacy of their asset/liability management (ALM). Bottom Line:  Private health insurance offers the growing middle-income class a more extensive level of protection than the state-based coverage. This underdeveloped private insurance market presents substantial opportunities. Investment Conclusions As China’s population ages, incomes rise and private healthcare services expand, investment opportunities will also increase. In short, the growth trajectory of China’s healthcare sector warrants investors’ attention. To play on this healthcare theme in China, we are initiating two strategic investment positions: First, go long Chinese insurance companies in absolute terms. Chinese insurer stocks have rallied in absolute terms since March lows, but then lagged relative to the benchmark (Chart 10 & 11); Chart 10Chinese Insurance Stocks: Rising In Absolute Terms... Chart 11…But Underperforming The Benchmark Double-digit CAGR of insurance premiums entails a steady asset expansion (Chart 8 on page 8). High and steady growth at a time of a low discount factor warrants high equity multiples. The private insurance industry’s gross profit margin proxy, calculated as insurance premiums minus insurance payments, divided by insurance premiums, amount to a whopping of 67%, with health insurance at 65% and life insurance at 87% (Chart 12). The equity valuations are reasonable. Unlike the tech and media sectors of the new economy, that have sky-high multiples, the trailing price to earnings ratio for insurers is still 8.8, 45% lower than the 10-year average. (Chart 13). Chart 12Chinese Insurance Companies: Outstanding Gross Profit Margins Chart 13Attractive Valuations Insurance company assets will be better managed going forward due to the new asset/liability management (ALM) requirements imposed by the regulators. The ALM requirements were announced in March 2018 and then fully implemented in July 2019. The rules introduced quantitative risk-adjusted measurements to help insurers more accurately capture the risk of duration mismatch, negative spread and liquidity strain. The CBIRC regularly evaluates and ranks the competence of insurers’ ALM against peers. The key risk to shareholders of insurance companies is the credit risk of their portfolio. 39% of insurance sector portfolios are invested in other investments, which include long-term equity investments, project-based debt schemes, trust plans and asset management (Chart 14). Credit risks stemming from credit claims and asset management products warrant careful investor consideration. Chart 14Investment Portfolio Of The Insurance Industry Chart 15Healthcare Stocks Have Rallied Massively... Second, accumulate Chinese healthcare stocks on a 15% correction in absolute terms (Chart 15). While we believe that healthcare stocks are in a secular bull market, they have already rallied a lot since recent lows, and they are pricing in a lot of short-term good news. Chinese investable healthcare stocks registered 55% returns since the outbreak of COVID-19. The trailing P/E ratio reached 51, a decade high since 2010 (Chart 16). We are reluctant to buy and overweight this sector now and would wait for a better entry point. Chart 16...And Are Now Too Expensive   Lin Xiang, CFA Research Analyst LinX@bcaresearch.com   Footnotes 1Does not include quasi-fiscal (off-balance sheet) government spending.

The SPX started the week on the right foot, but we continue to recommend investors avoid chasing equities at this point. Two key risks we have flagged recently are: rising concentration risk of market leaders, and geopolitical-related risks. Today we highlight three additional sources of near-term stress for equity investors. The SPX has failed to outperform gold and a worrisome technical lower high formation has taken root warning of an overall market pullback (top panel). This is eerily similar to the trouble gold sniffed out early in the year, as we highlighted in our mid-January report. The bond market also disagrees with the SPX rally over the past six weeks, as long duration bond prices have been besting the broad equity market since the June 8 peak (middle panel). Tack on the flattening yield curve since then, and a plethora of warning signs reiterate our near-term cautious view (bottom panel). Bottom Line: While our cyclically sanguine broad equity market view remains intact, we are cautious on the short-term prospects of the S&P 500.  

Our intra-real estate pair trade long S&P homebuilders / short S&P REITs vaulted roughly to the 15% return mark intraday yesterday, compelling us to institute a 5% rolling stop in order to protect handsome profits since the late-May inception. Our thesis for putting on this market-neutral trade remains intact. The Fed’s ZIRP policy as far as the eye can see is perhaps the biggest catalyst for US homebuilders, especially as the one-off pandemic effects begin to wear off and people are able to take advantage of all-time low mortgage rates that recently breached 3%. In fact, the chart below suggests that the pair trade is poised for additional gains in the coming months. Bottom Line: We continue to recommend the long S&P homebuilders / short S&P REITs pair trade as more gains are in store, but from a portfolio management perspective we are instituting a 5% rolling stop in order to protect gains.

Highlights Equities and other risk assets face near-term headwinds from the surge in Covid cases in the US Sun Belt and the looming fiscal cliff. We think these problems will be resolved, but the next few weeks could be rough sledding for markets. Government bond yields have moved sideways-to-down since late March even though inflation expectations have rebounded. The resulting decline in real yields has been an important, if rather overlooked, driver of higher equity prices. The failure of government bond yields to rise in line with higher inflation expectations can be attributed to the ongoing dovish shift in monetary policy. Nominal yields are likely to increase modestly over the next two years as growth recovers. However, inflation expectations should rise even more. Hence, real yields may fall further, justifying an overweight position in TIPS and a generally positive medium-term view on equities. As long as there is spare capacity in the economy, fiscal stimulus will not push up real yields. This is because bigger budget deficits tend to raise overall savings, thus creating the resources with which to finance the deficits. Once economies return to full employment in about three years, the fiscal free lunch will end. At that point, the combination of easy monetary and fiscal policies could cause inflation to accelerate. Central banks will welcome higher inflation initially. However, they will eventually be forced to hike rates aggressively if inflation continues to march upwards. When this happens, bond yields will rise sharply, while stocks will tumble. A Curious Divergence Government bond yields have moved sideways-to-down in most developed economies since stocks bottomed in late March (Chart 1). In contrast, inflation expectations have risen. As a result, real yields have declined. In the US, TIPS yields have fallen into negative territory across all maturities (Chart 2). Chart 1Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Chart 2TIPS Yields Have Fallen Into Negative Territory Across The Board The decline in real yields has been one of the unsung drivers of higher equity prices this year. The forward P/E ratios of the major US indices have moved closely in line with real yields (Chart 3). Gold prices have also risen, as they are often wont to do when real yields go down (Chart 4). Chart 3Lower Real Yields Have Lifted Stock Multiple Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields It is fairly uncommon for inflation expectations to rise without a commensurate increase in nominal bond yields (Chart 5). As a rule of thumb, when the economic data surprise to the upside, as has occurred over the past few months, bond yields go up (Chart 6). Chart 5It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields Chart 6Bond Yields Usually Rise When Economic Data Surprise To The Upside An important exception to this rule occurs when monetary policy is becoming more expansionary. Bond yields tend to follow the path of expected policy rates (Chart 7). When central banks guide rate expectations lower, bond yields can fall, even as the reflationary impulse from lower yields delivers an upward kick to inflation projections. Chart 7ABond Yields Tend To Follow The Path Of Expected Policy Rates Chart 7BBond Yields Tend To Follow The Path Of Expected Policy Rates The last time such a divergence between yields and inflation expectations occurred was in early 2019. The stock market crash in late 2018 forced the Fed to abandon its plans to hike rates. Jay Powell’s dovish pivot occurred just three months after he said that rates were “a long way” from neutral. The Fed would go on to cut rates by 75 bps over the course of 2019. Real Yields Could Fall Further Chart 8Inflation Expectations Are Still Quite Depressed In Most Countries The key question for investors is how much longer the pattern of rising inflation expectations and stable bond yields can persist. Our sense is that nominal bond yields will rise modestly over the next few years as growth recovers. However, inflation expectations are likely to rise even more, justifying an overweight position in TIPS relative to nominal bonds. Inflation expectations are still quite depressed in most countries (Chart 8). If global growth rebounds, both actual and expected inflation should edge higher. Chart 9 shows that the US ISM manufacturing index leads core inflation by about 12-to-18 months. Higher oil prices should also lift inflation expectations (Chart 10). Will global growth recover? The answer is “yes” if we are talking about a horizon of 12 months or so. That said, as we discuss below, there are some near-term risks to growth. This implies that equities and other risk assets could trade nervously over the next few weeks.   Chart 9Global Growth Recovery Will Lead To Higher Inflation Down The Line Chart 10Inflation Expectations And Oil Prices Move In Lockstep   Near-Term Risks To Global Growth The two biggest threats to global growth over the coming months are the Covid outbreaks in a number of countries and the possibility that fiscal stimulus will be rolled back, especially in the US, where a “fiscal cliff” is looming. Despite progress in suppressing the virus in Europe, Japan, and most of East Asia, the number of reported daily infections continues to rise globally (Chart 11). In the developed world, the US remains a major hotspot. Although the number of cases appears to have peaked in Arizona, it is still rising in the other Sun Belt states (Chart 12). Among emerging markets, the epicenter has moved from Brazil and Russia to India (Chart 13). Chart 11Despite Progress In Europe, Japan, And Most Of East Asia, The Number Of Covid Infections Continues To Rise Globally Chart 12A Second Wave Is A Key Macro Risk Chart 13BRICs: Covid Leaving No Stone Unturned While efforts to contain the virus will boost growth in the long run, they will weigh on economic activity in the near term. Over half of the US population lives in states that have either reversed or suspended reopening plans (Chart 14). Chart 14Not So Fast Google data on visits to shopping malls, recreation centers, public transport facilities, and office destinations have dipped in recent weeks. The decline in visits has occurred alongside a decrease in the New York Fed’s high-frequency economic activity indicator (Chart 15). Initial unemployment claims also rose this week. At this point, it looks likely that the recovery in US consumer spending will stall in July and August. Chart 15Covid Outbreak Is Weighing On Spending While it is difficult to know what will happen starting in September, our guess is that the pandemic will ebb in the southern states, just like it did in the northeast. This is partly because mask-wearing is becoming more widespread. Back in early March, when most mainstream news sources were tweeting out misinformation such as “Oh, and face masks? You can pass on them,” we noted that both logic and evidence suggest that masks are an effective tool against the virus. Increased testing should also help identify asymptomatic people before they have had the chance to spread the virus to many others. Meanwhile, improved medical care should also help reduce the mortality and morbidity rates from the disease. Just this week, scientists presented the results of a double-blind clinical trial showing that the inhalation of interferon beta, a cytokine used to treat multiple sclerosis, reduced the risk of developing severe Covid symptoms by nearly 80%. Fiscal Cliff Ahead? In addition to the pandemic, investors have to grapple with uncertainty over whether fiscal policy will remain sufficiently accommodative to reflate the economy. Unlike the EU, which managed to cobble together a framework for creating a 750 billion euro pandemic relief fund earlier this week, the US Congress remains deadlocked on the size and complexion of a new stimulus bill. Under current law, US households will stop receiving expanded unemployment benefits at the end of July. These benefits were legislated as part of the original CARES Act and currently total over 4% of GDP. The Paycheck Protection Program for small businesses is also nearly drained, while state and local governments are facing a major cash crunch due to evaporating tax revenues and higher pandemic-related spending needs. We estimate that about $2-to-$2.5 trillion in new stimulus will be necessary to keep fiscal policy from turning unduly restrictive. Senate Majority Leader Mitch McConnell has been floating a number of $1.3 trillion. If McConnell gets his way, risk assets will likely sell off. Our guess is that he will not prevail, however. President Trump favors a larger stimulus bill, as do the Democrats. Critically, more than four out of five voters, both nationwide and in swing states, support extending benefits (Table 1). Thus, there is a high probability that Senate Republicans will agree on a much larger package than what they are currently proposing. Table 1There Is Much Public Support For Fiscal Stimulus Fiscal Stimulus And Bond Yields Could continued fiscal stimulus deplete national savings, leading to significantly higher real yields? For the next few years, the answer is no. National savings depend not just on how much people spend, but on how much they earn. To the extent that fiscal stimulus raises GDP, it also raises national income. For the global economy as a whole, savings must equal investment. If fiscal stimulus in the major economies prompts firms to undertake more investment spending than they would have otherwise, overall savings will rise. How can that be? The answer is that fiscal stimulus raises private savings by more than it reduces government savings when an economy is operating below its full capacity. From the perspective of the bond market, this means that currently, large budget deficits are self-financing. Bigger budget deficits will produce an even bigger pool of private income, allowing the private sector to buy more government bonds.   Indeed, a premature pullback in fiscal support would almost certainly raise real rates by depressing inflation expectations. If that sounds far-fetched, recall that this is precisely what happened in March. Full Employment And Beyond Chart 16Government Debt Levels Have Surged In The Wake Of The Pandemic The fiscal free lunch will end only when economies return to full employment. At that point, bigger budget deficits will no longer be able to raise output since everyone who wants to work will already have found a job. Rather, increased government borrowing will crowd out private-sector investment. National savings will decline. If monetary and fiscal policy stay accommodative, inflation could accelerate. Central banks will probably welcome the initial burst of inflation, since they have been lamenting below-target inflation for many years now. However, if inflation continues to march higher, central banks may get spooked and start talking up the prospect of rate hikes. Higher rates would create a lot of problems for debt-saddled governments (Chart 16). It would not be at all surprising if politicians leaned on central banks to keep rates low. Governments could also end up forcing central banks to buy more debt in order to keep long-term yields from rising. In the extreme case, governments could even force central banks to cap yields. While such measures would prevent bond prices from tumbling, this would be cold comfort for bondholders. If central banks were to keep bond yields below their equilibrium level, inflation would rise even further, thus eroding the purchasing power of the bonds. In the end, central banks would still have to raise rates, probably more than they would have had they acted more swiftly to quell inflation. Investment Conclusions To answer the question posed in the title of this report, yes, bond yields will eventually go up. However, they are not likely to rise very much until inflation reaches intolerably high levels. That point is at least three years away. Despite the near-term risks posed by the pandemic and the looming fiscal cliff, investors should remain overweight equities over a 12-month horizon. Given the run-up in some of the large cap US tech names, we suggest shifting equity exposure to other parts of the stock market. The cyclically-adjusted price-earnings ratio is significantly lower outside the US, implying that international stocks are well placed to outperform their US peers over the coming decade (Chart 17). A weaker dollar should also help non-US stocks as well as the more cyclical equity sectors (Chart 18). Chart 17Non-US Stocks: The Place To Be Over The Coming Decade Chart 18A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Current MacroQuant Model Scores