Economy

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance

Highlights Fed: The Fed is embroiled in a debate about whether to move more quickly toward rate hikes. Our expectation is that the Fed will remain relatively dovish unless 5-year/5-year forward inflation expectations show signs of breaking out. We continue to expect liftoff in December 2022. TIPS: We recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Investors should short 2-year TIPS outright, enter 2/10 inflation curve steepeners and 2/10 real (TIPS) curve flatteners. Corporate Bonds: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios. Should The Fed Take Out Some Insurance? Inflation has arrived much earlier in the cycle than usual and it has put the Fed in a tough spot. The so-called Misery Index – the sum of the unemployment and inflation rates – has moved in the wrong direction this year (Chart 1), and there is increasing disagreement about how the Fed should respond. Chart 1A Setback For The Fed The Case For Buying Insurance On the one hand, some people – both inside and outside the FOMC – are calling for the Fed to move more quickly toward tightening. One notable external voice is the former Chair of the Council of Economic Advisers Jason Furman who just published a report calling for the Fed to speed up the pace of tapering so that it can prepare markets for rate hikes starting in the first half of 2022.1 Such a policy shift would significantly impact bond markets, which are currently priced for Fed liftoff to occur at the July 2022 FOMC meeting and for 69 bps of rate hikes in total by the end of 2022 (Chart 2). This equates to 100% odds of two 25 basis point rate hikes in 2022, with a 92% chance of a third. Chart 22022 Rate Expectations Furman makes the point that the Fed has already achieved its new Flexible Average Inflation Target (FAIT). The PCE deflator has averaged more than 2% annual growth since the target was adopted in August 2020 and even since just before the pandemic (Chart 3). Inflation has still averaged only 1.7% annual growth during the post-Great Financial Crisis period, but FOMC participants have generally focused on shorter look-back periods when discussing the FAIT framework. Chart 3The Fed's Flexible Average Inflation Target In Action In addition to its FAIT framework, the Fed has articulated a three-pronged test for when it will lift rates. The Fed has promised to only lift rates once (i) PCE inflation is above 2%, (ii) PCE inflation is expected to remain above 2% for some time and (iii) labor market conditions have reached levels consistent with “maximum employment”. Furman argues that the Fed should abandon this three-pronged liftoff test on the grounds that it leaves no room for assessing how far inflation is from its goal. For example, Furman says that if we take the Fed’s guidance literally then “it would not lift rates in the face of a 10 percent inflation rate if the unemployment rate was even 0.2 percentage points above its full employment level.” Chart 4Short-term Inflation Expectations Effectively, Furman is arguing for the Fed to take out some insurance against the risk of long-lasting inflationary pressures. Inflation is high right now. It may come back down naturally, but it may not. Furman argues that it makes sense for the Fed to marginally tighten policy in the meantime to lessen the risk of falling behind the curve and having to play catch-up. Fed Governor Christopher Waller seems to agree with most of Furman’s arguments. Waller also argued for speeding up the pace of tapering in a recent speech, and while he didn’t go so far as to say that the Fed should abandon its maximum employment test for liftoff, he implied that his personal definition of “maximum employment” could be achieved very soon.2 Waller said that after “adjusting for early retirements, we are only 2 million jobs short of where we were in February 2020”. This would suggest that just four more months of +500k employment gains, like we saw in October, would be enough for Waller to argue for rate increases. In his speech, Waller also mentioned the risk he sees from rising inflation expectations. He specifically pointed to elevated readings from the 5-year TIPS breakeven inflation rate, the New York Fed Survey of Consumers’ 3-year expectation, and the University of Michigan Survey’s 1-year expectation (Chart 4). Waller cautioned that: [I]f these measures were to continue moving upward, I would become concerned that expectations would lead households to demand higher wages to compensate for expected inflation, which could raise inflation in the near term and keep it elevated for some time. This possibility is a risk to the inflation outlook that I’m watching carefully. The Case Against Insurance    San Francisco Fed President Mary Daly sits on the other side of the argument. She argued against the Fed taking preemptive action to tame inflation in a recent speech.3  Her main argument is that rate hikes would do little to lower inflation in the near-term and may end up harming the economy down the road: Chart 5Long-term Inflation Expectations Monetary policy is a blunt tool that acts with a considerable lag. So, raising rates today would do little to increase production, fix supply chains, or stop consumers from spending more on goods than on services. But it would curb demand 12 to 18 months from now. Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers. Like Waller, Daly also pointed to possible risks from rising inflation expectations. If the high readings on inflation last long enough, they could seep into our psychology and change our expectations about future inflation. Households would then expect prices to keep rising and ask for higher wages to offset that. Businesses, of course, would pass those increases on to consumers in the form of higher prices, causing workers to ask for even higher wages. And on it would go, in a vicious wage-price spiral that would end well for no one. However, unlike Waller, Daly said that “there is little evidence” that such an expectations-driven spiral is starting to take hold. To make her point, Daly stressed that long-term inflation expectations remain well-anchored near levels consistent with the Fed’s target. This is certainly true. Five-to-ten year ahead inflation expectations, whether from survey responses or derived from TIPS prices, have been remarkably stable during inflation’s recent surge (Chart 5). This would seem to suggest that people generally believe that current high inflation will fade over time, and that the Fed’s medium-term inflation target is not at risk. The BCA View Our sense is that there are a number of FOMC participants in both the hawkish and dovish camps. But for the time being, the fact that 5-year/5-year forward inflation expectations remain well-anchored tips the scale in favor of the doves. As a result, the Fed will watch the incoming data as it tapers asset purchases between now and June. If 5-year/5-year forward inflation expectations remain stable during that period, the Fed will wait until its “maximum employment” goal is met before lifting rates. However, if the 5-year/5-year forward TIPS breakeven inflation rate rises above 2.5%, the doves will capitulate and abandon the “maximum employment” liftoff target. The committee will move quickly toward tightening to stave off the sort of wage/price spiral described by both Waller and Daly. Our own view is that realized inflation will trend lower between now and next June. This will prevent 5-year/5-year forward inflation expectations from rising and will push down shorter-dated inflation expectations. As a result, the Fed will wait until its “maximum employment” target is met before lifting rates. We continue to think the first rate hike is most likely to occur at the December 2022 FOMC meeting, slightly later than what is currently priced in the market. On Inflation And TIPS Valuation We continue to recommend a neutral allocation to long-maturity (10-year+) TIPS versus nominal Treasuries. While there is a risk that a lengthy period of high inflation will eventually lead to a break-out in long-maturity TIPS breakeven inflation rates, that risk must be weighed against the fact that our TIPS Breakeven Valuation Indicator shows that the 10-year TIPS breakeven inflation rate is too high relative to different measures of underlying inflation (Chart 6). Chart 6TIPS Are Expensive Relative To Nominals Our TIPS Breakeven Valuation Indicator has a strong track record, with readings between -1 and -0.5 usually coinciding with a subsequent drop in the 10-year TIPS breakeven inflation rate (Table 1). Table 1TIPS Valuation Indicator Track Record Moreover, we continue to think that inflation is very likely to trend down during the next 6-12 months. The most important driver of today’s high inflation rate has been a remarkable surge in core goods inflation, from near 0% prior to the pandemic to 8.5% today (Chart 7). This jump in core goods prices is explained by a shift in the composition of consumer spending away from services and toward goods (Chart 8). This shift started during the worst of the pandemic when spending on services was not an option. Households diverted their spending toward goods at a time when COVID prevented factories from running at full capacity. Chart 7Goods Inflation Chart 8Consumer Spending: Goods v. Services Our sense is that as the impact of the pandemic fades, we will see the composition of spending shift back toward services and firms will also be able to increase capacity. The result will be a drop in core goods inflation during the next 6-12 months, one that is significant enough to send the overall inflation rate lower. In fact, there are already signs that inflation is close to peaking. The Baltic Dry Index – an index that measures the cost of transporting raw materials – has plunged (Chart 9), and other measures of the price of shipping containers are starting to top out (Chart 9, bottom 2 panels). All of these indicators tracked inflation’s recent rise and are now signaling an easing of bottlenecks in the goods supply chain. The upshot from an investment perspective is that falling inflation will keep a lid on long-maturity TIPS breakeven inflation rates during the next 6-12 months. It will also send short-maturity TIPS breakeven inflation rates lower, and we recommend an underweight allocation to TIPS versus nominal Treasuries at the front-end of the curve. The top panel of Chart 10 shows that the 2-year TIPS breakeven inflation rate has greatly exceeded the Fed’s target range. In contrast, the 10-year TIPS breakeven inflation rate is only slightly above target. If we assume a base case scenario where both rates trend toward the middle of the Fed’s target range during the next 12 months, and a base case scenario for nominal yields consistent with the Fed lifting rates in December 2022 and then hiking at a pace of 100 bps per year until reaching a 2.08% terminal rate (Chart 10, bottom panel), we see that the 2-year real yield has a lot of upside during the next 12 months (Chart 10, panel 2). This is true both in absolute terms and relative to the 10-year real yield. Chart 9Peak Shipping Costs Chart 10The Upside In Real Yields As a result, our view that inflationary pressures will ease during the next 6-12 months leads to the following investment recommendations: Short 2-year TIPS outright Enter 2/10 TIPS breakeven inflation curve steepeners Enter 2/10 real (TIPS) yield curve flatteners Corporate Balance Sheets Are In Great Shape Gross corporate leverage – the ratio of total corporate debt to pre-tax profits – has plunged during the past few quarters. This indicator is the backbone of our macro default rate model and, as such, its drop explains why there have been so few corporate defaults this year.4 Digging beneath the surface, we see that a great deal of leverage’s decline is explained by soaring profit growth, but a sharp drop in debt growth is also partly to blame (Chart 11). If we broaden our scope of corporate balance sheet indicators, the evidence further points to the fact that balance sheets are in great shape. Our Corporate Health Monitor – a composite indicator consisting of six different balance sheet metrics – is deep in “improving health” territory, aided by extremely high readings from the Free Cash Flow-to-Total Debt and Interest Coverage ratios (Chart 12). Chart 11Gross Leverage Is Falling Chart 12Corporate Health Monitor One thing that seems certain is that corporate profits will not continue to grow by more than 50%, as they did during the past four quarters. As such, we hesitate to make too big a deal out of balance sheet ratios that are directly tied to profit growth. However, even if we look at different measures of the amount of debt versus equity on corporate balance sheets, we arrive at the same conclusion that balance sheets are extremely healthy. The top panel of Chart 13 shows the ratio between total corporate debt and the market value of equity. This ratio is at its all-time low, but one could argue that it is being inappropriately flattered by elevated stock valuations. If we look at the ratio of total debt-to-net worth, where net worth is the difference between assets and liabilities with real estate assets valued at market value and non-real estate assets valued at replacement value, we also see a significant improvement and the lowest ratio since 2010 (Chart 13, panel 2). Finally, we also find the lowest ratio of debt-to-net worth since 2013 even if we value all non-financial corporate assets at historical cost (Chart 13, bottom panel). In other words, the message is clear. Corporate balance sheets have repaired themselves considerably since the pandemic and leverage ratios are the lowest they’ve been in years. This fact has not gone unnoticed by ratings agencies who’ve announced far more upgrades than downgrades so far this year (Chart 14). Chart 13Leverage Ratios Chart 14Upgrades Much Higher Than Downgrades What about the path forward for balance sheets? Our view is that balance sheet health will stop improving at the margin, but that it still has a long way to go before it poses a risk for defaults or corporate bond spreads. The recent spike in profit growth will recede in the coming quarters. This sort of large jump in profits following a recession is fairly typical, but it also tends to be short-lived (Chart 11, panel 2). Further, while corporate debt growth probably won’t surge next year it is likely that it will start to increase. At present, slow corporate debt growth is explained by the fact that company earnings have far outpaced capital investment requirements (Chart 15). This is partly because earnings have been strong and partly because capex requirements have been low. This is about to change. Inventory-to-sales ratios are near record lows and we have already seen a jump in core durable goods orders. All of this points to a capex resurgence in 2022 that will be partially financed by rising corporate debt. Chart 15Debt Growth Will Rise In 2022 Bottom Line: The amount of debt relative to equity on corporate balance sheets is the lowest it has been in several years. We expect that corporate balance sheet health will start to deteriorate next year as capital spending and debt issuance ramp up. However, it will be some time before balance sheet health threatens higher defaults or wider corporate spreads. Stay overweight spread product in US bond portfolios.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.piie.com/sites/default/files/documents/furman-2021-11-17.pdf 2 https://www.federalreserve.gov/newsevents/speech/waller20211119a.htm 3 https://www.frbsf.org/our-district/press/presidents-speeches/mary-c-daly/2021/november/policymaking-in-a-time-of-uncertainty/ 4 For more details on our Default Rate Model please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Highlights Last month we published a report on the US corporate margins, titled “Marginally Worse.” In the report, we concluded that margins are likely to contract next year, hobbled by a slowdown in top-line growth, falling productivity, a decline in corporate pricing power, and soaring costs of labor and materials. Q3-2021 – another stellar earnings season: Companies achieved superior earnings growth and expanded margins. However, many companies guided down for Q4-2021 and 2022 citing mounting challenges, such as higher costs of labor, shipping, and raw materials. As such, deciphering which sectors are best positioned to maintain profitability is of paramount importance. Framework for Sector Margin Scorecard: We introduce a framework to rank the S&P 500 sector based on the expected resilience of their margins. It is based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. The four factors driving changes in operating margins are: Sell-side operating margins forecasts as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between annualized sales growth in 2020 and 2021 and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Sectors with most resilient margins: According to this scorecard, Financials, Healthcare, Energy, and Utilities are in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Energy Sector - Upgrade to Overweight The medium-term supply/demand backdrop is highly supportive of the current crude oil prices, with a Brent price target of $81 and upside price risk due to inadequate capex. Margins are still below the pre-pandemic peak and the street expects them to increase by 7.74 percentage points over the next 12 months. High operating leverage converts growing demand from the global economic recovery into profitability. Financials – Overweight: O/W Banks, EW Insurance While sell-side analysts anticipate Financials margins will decline, we believe that margins may surprise on the upside: The sector has high operating leverage, is somewhat insulated from supply chain disruptions, sees green shoots in loan growth, and its pricing power is improving. Further, the BCA house view expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting net interest margins. Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector” and upgraded it to Overweight. The Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive in nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months. Further, there is still significant pent-up demand for the health care services, and specifically for the elective procedures – the most lucrative segment of the Healthcare Sector. Pricing power has recently picked up.    Feature Last month we published a report on US corporate profit margins, titled “Marginally Worse.” In that report, we took a close look at corporate margins by analyzing their key drivers. We have concluded that margins are likely to contract next year, driven by a slowdown in top-line growth, falling productivity, and a decline in corporate pricing power. The sales side of the margin equation will fail to offset upward cost pressures imposed by the tight labor market, soaring input prices and transportation costs, rising depreciation expense, and a potential increase in tax rates. We also developed a simple model that encapsulates all the moving parts (Chart 1). Our forecast, based on the model, reiterates that the path of least resistance for US corporate margins is lower. In this report, we will take a close look at the S&P 500 sectors to gauge their ability to grow earnings and preserve margins. We aim to rank them by their ability to maintain profitability. Q3-2021 Earnings Season: Stellar Results Operating sector margins are a focal point for investors in the current environment of soaring shipping costs, PPI readings unseen for the last forty years, and a wage-price spiral that may lead to prolonged periods of elevated inflation. While rising costs have been a concern for a while now, the Q3-2021 earnings season has surprised on the upside, with 81% of companies exceeding analyst earnings expectations. Earnings increased by 42% year-over-year and sales 17%. The two-year annualized growth rate (CAGR) for S&P 500 earnings is 14.6% and 5.7% for sales. The pandemic trough has been all but forgotten, and earnings are back to their trend (Chart 2). All sectors, except for Industrials and Consumer Discretionary, have earnings and sales that exceed pre-pandemic levels (Chart 3). Energy, Materials, and Tech enjoyed annualized eps growth over the past two years in excess of 20%. And of course, because of such robust earnings growth, most sectors have reached 2010 -2021 peak margins (Chart 4). And these are unprecedented high peaks: Most sectors’ margins are more than two standard deviations away from their five-year averages. From a statistical standpoint, Z-scores in this “zip code” indicate that the probability of even higher margins is minuscule (Chart 5). ​​​​​​​ How were companies able to achieve such stellar earnings growth and peak margins despite all the cost and supply chain disruption headwinds? The answer is strong sales growth, efficiency in managing suppliers, ability to pass on costs to customers by raising prices, and finally, high operating leverage. Here is what happened in the words of the companies: Home Depot: “Professional home improvement contractors have had huge backlogs of work to do, and impatient customers have in many cases been willing to pay up in order to get the goods needed despite supply chain problems.” Microsoft: "We do have good understanding of lead times required to meet the capacity and signals that we’re seeing. I think we do a good job managing that. It’s not to say we’re not impacted. Multiple suppliers are important to be able to manage through that, and I feel the team has done a very good job.” Union Pacific Corporation: "The Union Pacific team successfully navigated global supply chain disruptions, a major bridge outage, and additional weather events to produce strong quarterly revenue growth and financial results." Honeywell: "Our disciplined approach to productivity and pricing helped deliver a strong third quarter despite an uncertain global environment marked by supply chain constraints, increasing raw material inflation, and labor market challenges.” Coca-Cola: Our results through the first nine months of 2021," CEO Frank Harrison said, "reflect a strong balance of volume growth, price realization, and prudent expense management." However, there are also multiple cracks in the foundation, with companies such as Target and Amazon guiding lower both for Q4-2021 and 2022 citing higher costs of labor, shipping, and raw materials. As such, deciphering which sectors can maintain profitability is of paramount importance. Building A Sector Margin Scorecard So which sectors have the best ability to preserve or even expand margins over the next year? Forecasting profitability by sector is tricky, as every sector is different, and has disparate drivers of sales and costs, making cross-sectional comparisons challenging. However, we have an advantage – we are not aiming to predict a point estimate for each sector margin a year from now, but rather rank all sectors from best to worst in terms of their ability to maintain profitability. To do so, we have created a scorecard based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. These factors also implicitly incorporate a potential mean reversion, i.e., high readings are unlikely to move even higher. Four factors capturing future changes in the profit margins are: Sell-side forecasts of operating margins over the next 12 months as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between 2019-2021 sales CAGR and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Factor 1: Expected Change In Operating Margins Over The Next 12 Months Top-down sector margin expectations for the next 12 months are an aggregation of the bottom-up company forecasts. Since the stock market is a market of stocks, this is an important summary of companies' trends which we incorporate into our ranking framework. In line with our view, sell-side analysts expect S&P 500 margins to contract by 1.2% over the next 12 months. Margin contraction is expected across the board with two notable exceptions: Energy and Healthcare. In the scorecard, we rank sectors based on the expected magnitude of the margin change, such that sectors with the least compression, or outright growth, are scoring better (Chart 6). Factor 2: Pent-up Demand For The Sector’s Products Most sectors have enjoyed a fantastic sales and earnings recovery this year (Chart 7), with sales exceeding pre-pandemic levels thanks to strong consumer demand. However, to gauge the level of pent-up demand for each sector, we compare 2020-2021 CAGR of sales growth with a long-term sales growth rate. We call this factor “sales growth differential.” Our thinking is that if recent sales growth is below a pre-pandemic normal, there is still demand left on the table. For example, the Consumer Discretionary sector is not yet back to the pre-pandemic “normal” pace of growth. Therefore, there is still strong demand for its products and services. This aligns well with what we were observing for months now. Fears of Covid-19 have resulted in a shift of spending from services to goods. As a result, demand for goods has overshot pre-pandemic levels, while demand for services is below its pre-pandemic trend and is enjoying a rebound (Chart 8). Chart 8There Is Still Pent-up Demand For Services In the scorecard, we assign a higher score to the sectors like Industrials and Consumer Discretionary expecting a more significant pickup in sales growth, and a lower score to the sectors with sales growth that exceeds the historical average on the concern that mean reversion may be in store: A strong bounce back in sales has already materialized, and demand has been pulled forward. Factor 3: Pricing Power Pricing Power is a proprietary BCA indicator based on the PPI and CPI indices for the 60 different industries. Industries are rolled up into sector indices and the market index.1 Sectors with higher pricing power can pass on their costs to their customers. However, at some point, they may no longer be able to raise prices as that will dampen demand for their products. As a result, after a series of price increases, companies’ pricing power wanes. Today, pricing power of companies in most sectors is already two-to-three standard deviations above the five-year average, suggesting that the probability of further gains is extremely low, i.e., one percent or less (Chart 9). The only exceptions are the Healthcare and Financial sectors whose pricing power has barely budged. What sectors do we prefer? Ones with a very high pricing power that is about to roll over or the ones whose pricing power is handicapped by outside political pressures and competitive headwinds? Since we believe that markets are driven by the second derivative, waning pricing power may have a detrimental effect on sector performance, while low and stable pricing power is already priced into expectations. To reflect this thinking, we penalize sectors whose pricing power is high relative to five years of history, expecting mean reversion. Factor 4: Degree Of Operating Leverage The degree of operating leverage (DOL), which gauges the company’s ability to spread its costs over sales, is largely determined by the cost of each marginal unit sold. This is a metric that assesses the cost structure of the sector in terms of fixed costs vs. variable costs. Sectors with higher fixed costs have higher operating leverage: It costs next to nothing to produce a marginal unit of sales, which leads to higher profitability as volume grows. We calculate DOL as the following: DOL= % Change in Operating Income/ % Change in Sales Percentage of change in operating income and sales is a five-year change to smooth out volatility and assess the longer-term relationship. Further, to obtain a comprehensive picture of the longer-term DOL, we calculate a median reading for each sector from 2010 to 2021. Median ignores extreme values and is better at capturing the “normal”. We also exclude negative and zero readings from our calculations to gauge DOL only when the companies are profitable (Chart 10). Bringing It All Together: Operating Margins Sector Scorecard We have ranked all 11 sectors along the four dimensions described above. As a result, we expect Financials, Healthcare, Energy, and Utilities to be in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Energy Sector - Upgrade To An Overweight Energy profit margins are linked to underlying commodity prices. BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate capex. Current operating margins remain well below the previous cyclical peak (Chart 11) and are expected to increase by 7.74 percentage points over the next 12 months. Although the price of oil has risen above the breakeven levels, energy companies are reluctant to invest in capex due to pressure from shareholder activists and newly found financial discipline. As a result, prices are likely to remain high until “high prices cure high prices”. In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yield. Chart 11The Street Expects the Energy Sector Margins To Expand. We concur... Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Upgrade Energy from an Equal Weight to an Overweight Financials – Overweight: O/W Banks, EW Insurance 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. There are early signs that lending is likely to pick up next year (Chart 12). According to JPM: "The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again" Regional banks already see the green shoots. According to Key Bank:"We are pleased with the trajectory of our loan growth." Chart 12Early Signs Of Lending Picking Up  ​​​​​​​Insurance companies are faring worse than Banks. Higher costs of labor and materials result in higher replacement costs, and higher customer payouts. However, insurers succeed in incorporating these higher expenses into pricing. While sell-side analysts anticipate margins will decline, (Chart 13) we believe that they may surprise on the upside: High operating leverage, improving pricing power (Chart 14) and growing demand for loans will contribute to strong profitability. Further, BCA expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting wider net interest margins. Chart 13While The Street Has Doubts About The Financial Sector Margins, We Are Constructive... Chart 14Pricing Power Is Improving Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector.” In this report, we upgraded the Healthcare sector to an overweight. Today, we reiterate the call. First, in a slowdown stage of the business cycle, Healthcare tends to outperform. Second, the Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive by nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months (Chart 15). Further, there is still significant pent-up demand for health care services, and specifically for elective procedures – the most lucrative segment of the Healthcare market. Pricing power has recently picked up (Chart 16). Companies concur that life is getting better: According to JNJ:” many of the hospitals and other providers have to pay more for their input, and that's going to be reflected in the economics as we go forward. And of course, all that is reflected in how we price going forward”. Chart 15The Healthcare Margins Are Posed To Widen Chart 16After A Prolonged Decline, Healthcare Pricing Power Is Finally On The Rise Consumer Staples - Underweight Our sector margins scorecard has identified Consumer Staples as a sector most susceptible to a margin squeeze. Sell-side expects margins to contract by 2% (Chart 17). This is a sector that has low operating leverage which indicates that the marginal cost of producing each additional unit is high, and is particularly vulnerable to rising input costs. At the same time pricing power of the sector is likely to wane: companies were able to raise prices throughout 2021, and now pricing power is over four standard deviations above the five-year average (Chart 18). Raising prices in the environment when fiscal stimulus is in the rearview mirror, against a backdrop of negative real wage growth, will be challenging. Walmart surely knows its customers: It decided to “absorb higher costs and keep prices low for customers all across the business.” Operating Margins of Consumer Staples are likely to contract in 2022. Chart 17Consumer Staples Margins Are Expected To Plunge Chart 18Pricing Power Is Not Sustainable Investment Implications Our analysis indicates that companies in most sectors have reached their peak margins in Q3-2021. Looking ahead, there will be distinct profitability tracks, with some sectors expanding margins while others will experience margin compression. Sectors that have higher operating leverage, pent-up demand left over from the pandemic slowdown, and whose pricing power may still increase will fare best. Our scorecard screened all the 11 sectors based on these conditions, and Financials, Energy, Healthcare, and Utilities have the best shot at maintaining and even expanding their margins. We have been overweight Financials and Healthcare in our portfolios for a while now, and the expectation of resilient profitability only reinforces our conviction. We are upgrading Energy from neutral to an overweight on the back of the expected margin expansion and high oil price target. We are still underweight Utilities which we consider as a bond proxy, unlikely to outperform in a rising rates environment. Bottom Line In this report, we introduce a framework to rank the S&P 500 sectors based on the expected resilience of their margins. Factors we consider are operating leverage, pricing power, pent-up demand, and sell-side margin expectations. As a result of the analysis, we believe that Financials, Energy, Healthcare, and Utilities are posed for strong profitability in 2022.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Appendix: Chart 19 Chart 20 Chart 21 Chart 22 Chart 23 Chart 24 Chart 25 Chart 26 Chart 27 Chart 28 Chart 29 Chart 30 Footnotes 1     Pricing power is calculated by finding the difference between how much the industry has been able to increase prices and the change in the cost of the raw materials due to inflation.  For example, for airlines, pricing power would be measured as the difference in the airfare CPI and jet fuel inflation. The exact calculation is industry specific.  Industries are rolled up into sector indices and the market index.   Recommended Allocation