Economy

Highlights Economy – The inflation question is unresolved, and it will remain that way for the rest of the year: August’s CPI report had something for everyone and ensured the debate will continue. Doves could celebrate the month-over-month decline while hawks could argue that upward inflation pressures are no longer a transitory phenomenon. Markets – Elevated valuations make equities vulnerable, but a little turmoil in China is not likely to trigger a de-rating wave: The demise of large Chinese property developer Evergrande may cause some upheaval in China but it is not likely to ruffle the S&P 500, corporate bonds or other US spread product. Strategy – Policymakers continue to hold the key. As long as the Fed is still easing, and households direct some of their excess savings to consumption, risk assets should outperform: We still think Goldilocks is far more likely that a too-cold or a too-hot outcome. Feature We continue to view the prospects for financial markets and the economy through a Goldilocks-and-the-two-tails lens, with the idea that equities and credit will thrive against a backdrop of supercharged growth and ongoing policy support (Figure 1). The Fed’s unusually pro-cyclical stance will prolong the macro sweet spot for risk assets and ensure positive excess returns provided growth doesn’t flop (the too-cold left tail), or the inflation genie doesn’t get out of the bottle (the too-hot right tail). Though both flanks pose a risk to our base-case Goldilocks scenario, we deem overheating to be the bigger concern. Unless a vaccine-resistant variant reestablishes COVID-19 as a mortal threat to the broad population, we think it is unlikely that growth will tumble below trend this year or next. Figure 1Goldilocks And The Two Tails One does not need to be a sworn devotee of rugged individualism to harbor some misgivings about the magnitude and scope of the direct transfers to American households or the broader fiscal effort to combat the economic effects of the pandemic. Egged on by support amounting to 25% of a year’s output, it remains entirely possible that aggregate demand might overwhelm productive capacity. The emergence of rolling bottlenecks in the spaces that were most crimped by COVID has focused attention on the threat of overheating, but the more lasting risk emanates from spaces that cannot be dismissed as unduly influenced by the pandemic. We have been closely monitoring the path of consumer prices and will continue to do so, but the ultimate outcome remains unclear. Though a Goldilocks macro backdrop remains our base-case expectation, it is far from assured. In this week’s report, we consider three potential disruptions: too much inflation, a change in the Fed’s policy course and a credit shock from China. We do not think that any of the potential disruptions is likely to change the picture in a material way and we therefore reiterate our view that investors with a twelve-month timeframe ought to maintain at least an equal weight exposure to equities and credit in a multi-asset portfolio. Fitting The August CPI Tile Into The Inflation Mosaic The pace of consumer price increases cooled in August, according to the headline and core CPIs. Both measures came in below market expectations, and the leading month-over-month series (Chart 1, dashed line) decelerated more than their year-over-year counterparts (Chart 1, solid line). Although the data were encouraging on their face, the ongoing inflation debate is nowhere near resolved. COVID continues to play havoc with the spaces it impacted most heavily, defying simple interpretations of aggregate CPI data. Base effects have warped year-over-year data once the peak pandemic months of last spring and summer entered the equation. As category-by-category analyses of the April CPI release showed, the lion’s share of the aggregate core CPI increase was powered by new and used cars and a handful of badly disrupted services like air travel, car rental, lodging and in-person entertainment. Chart 1Inflation Seems To Have Peaked Chart 2A Stunning Reversal On Used-Car Lots The semiconductor-driven production squeeze pushed up new car prices and took used car prices along for the ride as consumers turned to them as a ready substitute. Used car prices then rose even more as rental car companies frantically reversed 2020’s culling of their fleets to meet revived 2021 demand (Chart 2). By July, however, several of those categories had come off the boil and began to make more modest contributions to month-over-month core CPI growth. In August, they turned into headwinds, limiting core CPI’s sequential gain to just 0.1%. While the core index grew at its slowest rate since February, the segments that weren’t as heavily affected by the pandemic – the gray portion of the stacked bars in Chart 3 – experienced their largest price increases of the year. Those core categories less sensitive to transitory pandemic factors have eased a bit on a year-over-year basis (Chart 4, bottom panel) but the leading month-on-month measure suggests they will turn higher going forward. Chart 3Passing The Baton Shelter costs account for 41% of the core CPI basket and though spiking hotel rates (Chart 5, second panel) have made an outsized contribution to their bounce off the bottom (Chart 5, top panel), the much weightier owners’ equivalent rent and primary residence cost measures have begun to hook up (Chart 5, third panel). Series that impact the supply and demand balance for residences, like the prime-age employment-to-population ratio (Chart 5, fourth panel) and the National Multifamily Housing Council’s measures of apartment market activity (Chart 5, fifth panel), suggest that the key rent series will continue moving higher. Chart 4Transitory Factors Are Abating ... Chart 5... But Rents Are Rising The bottom line is that the August CPI report, like much of the economic data in this particularly uncertain time, offered evidence to support opposing interpretations. We will simply have to wait and see how the data evolve over the rest of the year to gain a good read on its future trajectory. We expect that inflation will continue to come down from its summer peak while remaining comfortably above the Fed’s effective 2.3-2.5% core CPI target. Such a move will underscore that its inflation criteria have been met and focus investor attention squarely on the labor market’s progress toward regaining full employment. Much Ado About Nothing The bond market has cottoned on to the fact that the labor market, not consumer price inflation, is the swing factor for monetary policy settings, and the 10-year Treasury note has essentially ignored the core CPI breakout (Chart 6). Equities have evinced little concern, reflecting the causal relationship we noted last week. High inflation by itself is not kryptonite for stocks; the restrictive monetary policy measures the Fed eventually imposes in response to high inflation are. Inflation’s market importance thus turns on the tipping point at which it heralds restrictive monetary policy. Chart 6Treasuries Are On Board With The Transitory View A Fed that believes elevated inflation readings are transitory is a Fed that will wait to restrain the economy to contain them. A Fed that is determined to let the economy run hot so as to nurture broad-based strength in the labor market is a Fed with a less sensitive inflation reaction function than has prevailed since Paul Volcker’s tenure. The same goes for a Fed that has made no secret of its desire to reset inflation expectations higher. Putting it all together, the Fed appears determined to wait until it sees the whites of inflation’s eyes before it takes action that will undermine economic growth. Our view that the Fed’s inflation reaction function has become less sensitive is independent of the identity of the chair. The revised statement on longer-run goals and monetary policy strategy was issued by the entire FOMC, and investors should not be distracted by the quadrennial reappointment parlor game, which has settled on a contest between chair Powell and board member Brainard. Although Brainard has won progressives’ admiration for her advocacy of tighter bank supervision, policy would not be materially different under her stewardship than it would be under Jay Powell’s. Monetary policy will be accommodative for a long time regardless of who is chairing the FOMC on February 1st and the Biden administration’s nomination decision will not have lasting market implications. Could A Messy Evergrande Unwind Trip Up The US Bull? The financial press last week was filled with stories about the dire condition of Evergrande Property Group (Chart 7), one of China’s largest property developers. As noted in several of last week’s reports, Evergrande is the world’s most indebted developer and its leverage burden is not news to dollar bond investors, who have increasingly required outsized yields to lend to the company.1 All three major credit rating agencies have downgraded it to the equivalent of CC, reflecting their view that default is imminent. Though a technical default may be certain, per reports that Evergrande will fail to make scheduled interest and principal payments due this week, the ultimate ripple effects are unknown. As our Emerging Markets Strategy team has noted, a broad range of outcomes are possible. At the most benign end of the continuum, the event could mark a crescendo of concerns that have been weighing on sentiment and activity, and trigger policy stimulus that produces economic and market inflections. At the other end, Evergrande could intensify the existing credit crunch, sparking a wave of self-reinforcing defaults and bankruptcies, culminating in a systemic event on the order of Lehman Brothers’ bankruptcy. Absent government intervention, the defaults will be messy. Most of the company’s assets are in the form of unfinished properties that will require additional capital and know-how before they can be monetized. Even its portfolios of completed properties may not be easy to sell in a residential market that was already slowing (Chart 8). The pall its troubles have cast over the property market will make things worse by prodding other liquidity-constrained developers to slash prices to move their own inventories. Chart 7Boom And Bust Chart 8Not Exactly A Seller's Market Our China strategists believe that the government wants to make an example out of Evergrande to impose some discipline on investors and developers. Despite repeated warnings, it has remained on the wrong side of the three red lines policy makers recently established to rein in property market excesses. Some onshore investors may be bailed out, but party officials will have no qualms about leaving offshore investors holding the bag. As China goes, so too do small neighboring economies reliant on its appetite for imports. Resource economies like Brazil, Chile and Australia that export iron ore, copper and other base metals to feed the China construction and infrastructure juggernaut could slow. Suppliers of machinery and specialized manufactured components like Japan and Europe could also feel a bit of a chill. While the US is not immune to disruptions in the rest of the world, it is a comparatively closed economy that is generally less susceptible to external troubles and has minimal financial links with the Middle Kingdom. A review of the 2020 10-Ks for the SIFI banks and Goldman Sachs and Morgan Stanley confirmed that the American banking system has minimal direct exposures to China and Hong Kong. Only Citigroup, which operates a meaningful commercial banking franchise in Hong Kong, has direct cross-border exposures that amount to as much as 1% of assets (Table 1). Table 1SIFI Exposures To China And Hong Kong The bottom line is that we do not view Evergrande as China’s Lehman. Policymakers may want to make an example of it but not to the point that they will stand by in the face of a broad contagion. Even if it did produce a credit event that rippled across Asian EM markets and tempered investors’ enthusiasm for risk assets more generally, US markets would benefit in a relative sense befitting the dollar’s status as a defensive currency, Treasuries’ status as the predominant risk-free asset and the S&P 500’s low-beta nature. The fall of an overextended Chinese property developer is unlikely to push the US out of Goldilocks and into too-cold territory. Investment Implications Inflation will trigger a policy change once it stays high enough for long enough to trigger the Fed’s recalibrated reaction function. Markets will sniff out a policy change ahead of time and could even catalyze a policy change if the bond vigilantes awaken from their long hibernation. When we reiterate our constructive view on markets and the economy over a three-to-twelve-month timeframe, we are reiterating our assessment that markets will not begin to prepare for the policy change within the next twelve months and that growth will appear as if it will remain on an above-trend trajectory for some time beyond. We are confident that the next twelve months will remain “safe” from a policy and a growth perspective. We have much less conviction about the next six to twelve months following next September and are acutely aware that the outlook for the second half of 2022 and the first half of 2023 will exert a meaningful influence next summer. We will adjust our views based on the incoming data, but we do think the first three to six months of our cyclical timeframe will be conducive to risk asset outperformance and therefore reiterate our recommendation to overweight equities and credit while sharply underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Per Evergrande’s annual reports, its average annual interest rate on outstanding debt on 12/31/20 was 9.49%, up from 8.99% on 12/31/19, 8.13% on 12/31/18 and 8.09% on 12/31/17.

Dear Client, I will be holding a webcast next Friday, September 24th at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT) with BCA Research’s Chief Emerging Markets Strategist Arthur Budaghyan where we will debate the outlook for EM stocks. As this week’s report conveys, I am bullish, while Arthur is in the bearish camp. Please join us for what is sure to be a fiery debate. Also, instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the stability of the American political system. I hope you will find it insightful. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2021 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, October 7th. Best regards, Peter Berezin Chief Global Strategist Highlights After lagging the global indices, EM stocks are set to outperform during the remainder of this year and into 2022. Go long the EM FTSE index versus the global benchmark (ETF proxy: VWO versus VT). Five factors will support EM assets over the coming months: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Investors wanting to gain exposure to Chinese tech while still limiting risk should consider writing cash-covered puts. For example, a strategy of selling puts on Alibaba could generate a 9% annualized yield while giving investors access to the stock at a forward PE ratio of only 12.5. Go long an equally-weighted basket consisting of the Russian ruble and Brazilian real against the US dollar. Both currencies enjoy favorable interest rate differentials and will benefit from continued strength in commodity markets. Debating The EM Outlook BCA Research has some of the brightest, most creative strategists in the world. While we often agree on many issues, we sometimes disagree. The near-term outlook for emerging markets is a case in point. My colleague, Chief EM Strategist Arthur Budaghyan, is bearish on emerging markets over a 3-to-6 month horizon. In contrast, I am bullish. In this note, I explain why. I see five reasons why EM assets will do very well during the remainder of the year and into 2022: 1) The vaccination campaign in emerging markets is in full swing; 2) Domestic EM inflation will crest; 3) China will stimulate its economy; 4) The US dollar will weaken; and 5) EM valuations have discounted a lot of bad news. Let’s examine all five reasons in turn. Vaccine Access In Emerging Markets Is Improving The proportion of EM populations which have been vaccinated is rising rapidly (Chart 1). India is now vaccinating 10 million people per day, a number that would have seemed unimaginable just a few months ago. Chart 1EM Vaccination Rates Have Been Ramping Up Rapidly Globally, about 10 billion doses of vaccine will be produced this year (Chart 2). This does not include potential new mRNA vaccines that China is developing. China-based Walvax Biotechnology is conducting late-stage trials in Nepal, with mass production of the vaccine expected to start in October. Sinopharm is also working on its own mRNA vaccine. Meanwhile, the number of new Covid cases in most EM economies has peaked, permitting a relaxation of lockdown measures (Chart 3). Goldman’s Effective Lockdown Index for China has eased significantly since mid-August, although this week’s outbreak in Fujian province could partially reverse that trend. Chart 2At Least 10 Billion Doses Of Vaccine Will Be Produced This Year Chart 3EM Lockdown Measures Have Eased As The Number Of New Cases Has Peaked It is true, as Arthur has pointed out, that vaccine hesitancy is a problem in some emerging markets. However, this may not be as significant an issue as previously believed. The huge spike in cases in highly vaccinated countries such as Israel and the UK shows that herd immunity is a pipe dream. Given this reality, as long as everyone who wants a vaccine is able to receive it, the political pressure to maintain lockdowns will dissipate. Pandemic-Induced Spike In Inflation Is Fading As in most developed economies, many emerging markets have experienced a post-pandemic rise in inflation (Chart 4). Whereas DM central banks generally looked through the inflation spike, many EMs did not have that luxury. Chart 4Inflation Across The EM Universe   Worried about an unmooring of inflation expectations and currency depreciation, central banks in such countries as Brazil, Mexico, Chile, Colombia, Peru, Russia, and Turkey have all raised rates this year. Higher rates have weighed on EM growth and financial markets. The good news is that inflationary pressures are starting to abate. This week’s US CPI report for August showed an absolute decline in prices in pandemic-related categories such as airfares, hotels, admissions, and vehicles (Chart 5). Things are even improving on the semiconductor front. Chart 6 shows that memory chip prices are in a clear downtrend. Chart 5Pandemic-Driven Inflation Is Cresting Chart 6Chip Prices Are Off Their Highs Chart 7Agricultural Prices Have Stabilized, Which Will Help Cool EM Inflation Critically for emerging markets, agricultural prices have stabilized (Chart 7). Historically, food inflation has been a major driver of EM inflation. Chinese Stimulus On The Way Growth in China was quite weak in the first half of the year, averaging only 3.5% on a sequential annualized basis (Chart 8). The Bloomberg consensus estimate is for Q3 growth to hit 4.3%, reflecting the negative impact of lockdown measures and the lagged effect from policy tightening. Growth in the fourth quarter is expected to rebound to only 5.7%. This seems too low to us. Barring a major spike in Covid cases, Chinese industry will be saddled with fewer social distancing restrictions in the fourth quarter. Policy is also turning more stimulative. The PBOC cut bank reserve requirements in July. In the past, cuts in reserve requirements have been a reliable predictor of faster credit growth (Chart 9). Chart 8Chinese Growth Should Accelerate After A Disappointing First Half Of 2021 Chart 9Chinese Stimulus Is On The Way   With credit growth back to its 2018 lows, there is little need for further actions to reduce lending. On the contrary, the PBOC’s meeting with financial institutions on August 23rd revealed a desire to increase credit availability. Partly reflecting this development, new bank loans rose to RMB 1.22 trillion in August, up from RMB 1.08 trillion in the prior month. Chart 10EM Stocks Have Done Well When Global Industrial Stocks Have Outperformed On the fiscal side, the Ministry of Finance stated on August 27th its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. To reinforce the need for more stimulus, the authorities announced an additional RMB 300 billion in credit support for SMEs during the latest State Council meeting held on September 1st. Local Chinese government spending has typically flowed into infrastructure. Increased infrastructure spending should buttress metals prices while providing a tailwind for global industrial stocks. I agree with Arthur’s assessment that industrials will be a winning equity sector over the coming years. EM stocks have usually beaten the global benchmark during periods when global industrial stocks were outperforming (Chart 10).   A Weaker US Dollar Will Benefit Emerging Markets EM stocks tend to perform best when the US dollar is on the back foot (Chart 11). We expect the greenback to weaken over the next 12 months. As a countercyclical currency, the dollar is likely to struggle in an environment of above-trend global growth (Chart 12). Chart 11EM Stocks Tend To Outperform The Global Benchmark When The Dollar Is Weakening Chart 12The Dollar Is A Countercyclical Currency Interest rate differentials have moved sharply against the dollar (Chart 13). The US trade deficit has surged over the past 16 months. The way the US has been financing its trade deficit – relying heavily on fickle equity inflows – also leaves the dollar in a vulnerable position (Chart 14). Chart 13Interest Rate Differentials Have Moved Against The Dollar Chart 14Volatile Equity Inflows Have Been Financing The US Trade Deficit, Putting The Dollar In A Vulnerable Position Go Long BRL And RUB Against a backdrop of broad-based dollar weakness, EM currencies will strengthen. Currently, the 12-month interest rate differential between Brazil and the US stands at 8.7%, up from a low of 2.1% last year. Russian rates have also risen rapidly relative to US rates (Chart 15). The Russian ruble will benefit from the cyclical recovery in oil prices. Bob Ryan and BCA’s commodity team project that the price of Brent will rise 5% to $80/bbl in 2023, whereas market expectations are for a 12% decline (Chart 16). Likewise, Brazil will gain from both higher oil prices and rising Chinese demand for metals. Chart 15Interest Rate Differentials Favor The RUB And BRL Versus The USD Chart 16Oil Prices Have More Upside Accordingly, we are initiating a new trade going long an equally-weighted basket consisting of BRL/USD and RUB/USD. Are EMs A Value Trap? Emerging market stocks currently trade at a Shiller PE ratio of 14.7, compared to 36.8 for the US, 22.2 for Europe, and 24.1 for Japan. The EM discount to the global index is as large now as it was during the late 1990s. Other valuation measures tell a similar story (Chart 17). Chart 17AEM Equities Are Trading At A Large Discount (I) Chart 17BEM Equities Are Trading At A Large Discount (II) A low PE ratio for EM stocks could be justified based on weak expected earnings growth. However, it is far from clear that such an expectation is warranted. While EM earnings growth has lagged the US since 2011, this follows a decade when EM earnings grew much faster than in the US (Chart 18). Chart 18AEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (I) Chart 18BEM Earnings Have Moved Sideways Since 2011 After Blazing Higher Over The Preceding Decade (II) Chart 19EM Stocks Underperformed Their US Peers By More Than What Is Suggested By Earnings On that note, it is worth mentioning that US earnings have risen by only 6 percentage points more than EM earnings since mid 2019 (20% versus 14%), even as EM stocks have underperformed their US peers by 29% over this period (52% versus 23%) (Chart 19). China’s Regulatory Crackdown The regulatory crackdown on Chinese tech companies has weighed on the sector. Chinese tech stocks have underperformed their global tech peers by 48% since February (Chart 20). Chart 20Chinese Tech Stocks Have Been Underperforming Their Global Tech Peers Chinese tech is 44% of the China investable index and 15% of the MSCI EM index. Thus, the outlook for Chinese stocks is relevant not just for China-focused investors, but for EM investors more broadly (especially those who invest in index products). The current crackdown bears some resemblance to the one in 2018, which saw Tencent lose $20 billion in market capitalization in a single day. Like other Chinese tech names, Tencent shares quickly recovered from that incident. Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to buttress its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (i.e., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support. A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party just as US companies have pledged allegiance to woke ideology. If that were to happen, the Chinese government may allow them to operate normally, cognizant of the fact that it is easier to monitor a few large internet companies than many small ones. While such an outcome is far from assured, current valuations offer enough cushion to prospective investors. As we go to press, Alibaba is trading at 16.4-times earnings, Baidu is trading at 17.9-times earnings, and Tencent is trading at 26.7-times current year earnings. In comparison, the NASDAQ 100 trades at nearly 30-times earnings. Investment Conclusions Sentiment towards EM stocks is very bearish (Chart 21). Investor angst towards China is especially elevated, with the media replete with stories about the tech crackdown and problems at Evergrande, the country’s largest property developer. Chart 21Sentiment Towards EM Stocks Is Highly Bearish All these downside risks to EM assets are well known. What are less well known are the upside risks stemming from higher vaccination rates, an easing of domestic inflationary pressures, Chinese stimulus, a weaker US dollar, and favorable valuations. With that in mind, we are upgrading our rating on EM equities and currencies to strong overweight in the view matrix at the back of this report. We are also reinstating a long EM/Global equity trade (ETF proxy: VWO versus VT). The risk-reward of buying Chinese internet stocks is reasonably appealing. Investors who want to mitigate risk should consider writing cash-covered puts. For example, a BABA put with a strike price of $130 expiring on December 16th 2022 trades for about $16. If the price of BABA does not fall below $130, you will pocket the premium, realizing an annualized yield of 9%. If the price does fall to $130, you get the stock at an attractive PE ratio of 12.5 based on current forward earnings estimates.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores