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Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Chart 11Canada: Trudeau Takes A Calculated Risk In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Chart 17Refugees Will Not Change Game In German/French Elections Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE). This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2 Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday. Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation. Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at 56%. Chart 6 Chart 7 Footnotes 1 Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2 Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3 Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021. 4 Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights China’s credit tightening may have surpassed maximum strength. Monetary policy will remain accommodative and fiscal policy will become more supportive in the rest of the year. However, overall regulatory oversight is still restrictive, limiting the scope of reflationary effects on the economy. There were signs that the “cross-cyclical” approach – a new catchphrase from the July Politburo meeting - emerged even before the start of the pandemic. The current policy backdrop resembles the situation in 2H2018. China’s new “common prosperity” plan, which sets up guidance for long-term policy direction, will likely have cyclical implications. Chinese investable stocks are in oversold territory and will probably rebound in the near term. In the next 6 to 12 months, however, we remain cautious given the lack of a catalyst to revive investor sentiment. Feature Chart 1Chinese Stocks Are Oversold In Absolute Terms China’s economic momentum has slowed, while regulatory crackdowns show no signs of dissipating. Meanwhile, Chinese investable stocks in absolute terms have slumped into technically oversold territory (Chart 1). Global investors are looking at fiscal and monetary policy easing for clues to what may be next. A shift in policy direction from restrictive to reflationary will help to shore up market sentiment and the outlook for the economy. Fiscal policy implementation in 1H21 was tighter than budgeted, leaving room for more support in 2H21. The PBoC’s unexpected reserve requirement ratio (RRR) cut in early July may have been a signal that policy tightening has ended. In short, China’s financial tightening has most likely passed its peak strength. Chart 2Valuations Are Almost Back To 2018 Lows We have no doubt that China will announce some compensatory measures in the coming months in response to rising downward pressures on the domestic economy. However, we continue to hold the view that the bar for a fresh round of material stimulus is higher today than it was in the past. The policy focus pivoting from a countercyclical to cross-cyclical adjustment, the rising emphasis on common prosperity, and the ongoing regulatory clampdowns in an array of industries, all limit the extent to which authorities can deploy the expected magnitude in infrastructure spending and bank lending. Therefore, we continue to recommend investors remain underweight Chinese stocks versus their global peers – a stance we have maintained since earlier this year – despite cheapened relative valuations in Chinese equities (Chart 2). Shifting To A Cross-Cycle Approach China’s policy shift to a cross-cyclical stance has gained more market attention since the late-July Politburo meeting. However, there were signs that the cross-cyclical approach emerged even before the start of the pandemic. Chart 3Size Of Stimulus Was Already Getting Smaller During the height of the 2018/19 US-China trade war, policymakers responded to the economic shocks from imposed import tariffs with much more measured stimulus than in previous cycles (Chart 3). President Xi repetitively used the “Long March” analogy during the trade war, warning Chinese citizens to prepare for protracted hardship stemming from conflict with the US.1 The metaphor had important market implications because the attitude was fundamental to how the government handled the cyclical slowdown in 2018/19. Despite aggressive RRR and policy rate cuts in the second half of 2018, authorities maintained tight restrictions on bank lending and local government spending. Consequentially, aggregate credit growth continued to slide through end-2018 (Chart 4). Furthermore, authorities became uneasy about the sharp rise in the rate of credit expansion in Q1 2019. Following a public spat between the Premier Li Keqiang and the central bank, bank lending slowed sharply in the rest of the year. As a result, the improvement in infrastructure investment growth was small and short-lived. Despite an acceleration in local government bond issuance in 2H18 and Q1 2019, infrastructure investment growth remained on a structural downward trend throughout most of 2018 and 2019 (Chart 5). Chart 4China: A Deja Vu Of 2018-2019? Chart 5Improvement In Infrastructure Investment Was Short-Lived In 2019 Chart 6Financial De-Risking Mode Is Still On The current policy backdrop resembles the situation in 2H2018: while the central bank has kept interest rates at historically low levels and preemptively cut the RRR rate in July, lending standards remain tight and shadow bank credit continues to shrink (Chart 6). In the past Chinese authorities stimulated substantially following exogenous shocks, but did not stimulate much when business cycle was slowing in an orderly manner. A resurgence of domestic COVID cases and the severe flood in central China in July and August represent exogenous shocks and occured when the economy was losing steam. Hence, there are higher odds authorities will provide some support in response to these exogenous shocks. However, the recurring battle against COVID and lingering tensions with the US have likely prompted Chinese top leadership to extend their cross-cycle strategy. Officials may feel that a modest easing in both monetary and fiscal policies will be sufficient to offset the current economic weakness without overstimulating the economy. Bottom Line: A cross-cycle policy approach means not only responding early to small shocks with piecemeal stimulus to stabilize growth but also limiting the scope of stimulus and preparing for “protracted battles”. The response from Chinese leaders during the trade war with the US in 2018/19 may be a roadmap for policy direction in the next 12 months. Cyclical Implications From “Common Prosperity” President Xi Jinping laid out a plan for “common prosperity”, a guideline for the country’s national policy in the coming decades, at the August 18th Central Committee for Financial and Economic Affairs. Most of the plan’s objectives have 2035 deadlines and will be achieved gradually in multiple phases.2 However, in the next 12 months and leading to the 20th National Party Congress in the fall of 2022, we expect the authorities to accelerate some reform agendas that are consistent with the 14th Five-Year Plan (2021-2025). A key area that may gain momentum is increasing labor income and household consumption share in national output. Both labor compensation and household consumption as a share of GDP improved from 2011 to 2016, but the progress stalled in recent years and further deteriorated last year in the wake of the pandemic (Chart 7). Policy decision makers can reverse the falling share by either boosting income/consumption or lowering the share of capital formation in the national output, or a combination of both. Regulatory tightening in the property market has reduced investment growth in the sector, which accounts for 66% of the country’s total fixed-asset formation (Chart 8). We expect policy restrictions to continue curbing real estate investment in the rest of the year and into 2022, further shrinking the share of capital formation in the aggregate output.3 Chart 7China's Economic Rebalancing Progress Has Stalled In The Past Five Years Chart 8Policymakers Are Moving Away From The 'Old Economy' Pillars Chart 9Recovery In Household Income And Consumption Has Significantly Lagged Other Sectors Recovery in household income and consumption has significantly lagged other sectors in China’s recent economic rebound (Chart 9). In addition to short-term, pandemic-related factors, household consumption has been sluggish due to China’s long-standing imbalanced income distribution. Given that China will be under more pressure to deliver economic progress in 2022, boosting wage growth and consumption will help to facilitate both the nation’s cross-cyclical economic strategy and President Xi’s longer-term reform plan for income and wealth redistribution. If successfully implemented, a rebalancing of labor income and consumption as a share of the national aggregate will have long-term economic benefits. However, for investors with a cyclical time frame, the transition will likely have the following implications on the market: Policymakers will keep a large fiscal budget deficit and increase spending in public services and social welfare, but there will be more pressure on the central government to keep local government debt in check. The increased fiscal burden also means that while the government will provide subsidies for households and key new-economy industries, policy at margin may move away from boosting investment in traditional infrastructure and construction (Chart 10). Chart 10Traditional Infrastructure Investment Will Remain Subdued Empirical research shows that lower-income households have a higher marginal propensity to consume.4 Last year China refrained from meaningful stimulus to incentivize consumption. In contrast, the statement from the August 18th meeting indicated the focus is on securing living standards and wages among lower-income households. Common prosperity related policies may boost consumption of staples and some durable goods but will likely discourage splurging in high-end luxury goods and services. Large corporations and high-net-worth individuals will be expected to share social responsibility and the cost of reducing income inequality, either through higher and stricter tax burdens, raising minimum wages for employees, and/or donations. Bottom Line: The “common prosperity” theme will mostly entail long-term policy initiatives, but it may also have some cyclical market repercussions. Investment Recommendations Chart 11Tactical Bounce Gave Way To Cyclical Downturn In Previous Cycles We do not rule out the possibility of a tactical (within the next three months) / technical rebound in Chinese stocks. Our August 4th report discussed how prices managed to rebound strongly within 90 days of the policy-triggered market riots in both 2015 and 2018. However, the rallies quickly faded and stocks fell to new lows (Chart 11). Prices bottomed when policy decisively turned reflationary. For now, the risks to Chinese equities are largely to the downside. Although there are some remedial measures to ease monetary and fiscal policies, officials have not sent a clear signal to ease on the regulatory front. Conversely, there are two scenarios that could prompt us to upgrade Chinese stocks to either neutral or overweight in both absolute and relative terms. Chart 12No Clear Signal Chinese Policymakers Will Ease On The Regulatory Front The first scenario is that the economy does not slow further and a modest policy easing is sufficient to stabilize the economic outlook. This may happen if strong global economic growth and demand continue to support China’s export and manufacturing sectors, while domestic household consumption improves. In this case, the downside risks on the overall economy would abate, but the gradual underlying downtrend in China's old economy would be intact. We would need an additional reflationary tailwind, such as a boost from fiscal spending or a reversal of industry policy tightening, to upgrade Chinese stocks to overweight. We have argued in the past that housing appears to be the best candidate; the catalyst is missing at the moment (Chart 12). In the second scenario, Chinese policymakers may determine that the downside risks to growth are unacceptably large given existing slowdowns in the industrial and service sectors, and decide to temporarily reverse course on structural reforms. We will watch for indications of a shift in attitude. For now, we think that China’s leadership has a higher pain threshold than in the past, suggesting that this outcome is not yet probable. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1"Xi Jinping calls for ‘new Long March’ in dramatic sign that China is preparing for protracted trade war", South China Morning Post. 2"Xi stresses promoting common prosperity amid high-quality development, forestalling major financial risks", Xinhua, English.news.cn 3We use fixed-asset investment (FAI) as a proxy for gross fixed capital formation (GFCF) because the National Bureau of Statistics of China does not publish the GFCF breakdown by sectors. GFCF comprises FAI, less the purchase of existing fixed assets, land and some minor items. Historically, the two series have closely tracked each other. 4"The Stimulative Effect of Redistribution", Federal Reserve Bank of San Francisco Market/Sector Recommendations Cyclical Investment Stance
Highlights Jackson Hole: The message from Jackson Hole is that the majority of the FOMC – including Fed Chair Powell - is ready to begin tapering asset purchases before year-end. There is less unanimity within the FOMC over the timing of interest rate increases following the taper. Fed Policy: The Fed is trying to communicate a separation of the balance sheet and interest rate components of its monetary policy, hoping to limit bond volatility stemming from markets pulling forward the timing of rate hikes during the taper. A tightening US labor market will make that separation difficult given the shallow path for interest rates currently discounted in the US yield curve - particularly if the current surge in US inflation proves not to be as transitory as the Fed is expecting. US Treasury Yields: Expect higher Treasury yields over the next 12-18 months as the Fed transitions from talking about tapering to actual tapering and, eventually, to rate hikes starting in H2/2022. A September To Remember? Chart 1The Fed Faces Some Tough Decisions The much anticipated Jackson Hole speech from Fed Chair Jerome Powell offered a balanced tone.1 Powell did say that the Fed could begin tapering asset purchases by the end of this year, given the “substantial further progress” on the Fed’s 2% average inflation goal, if the US economy evolved in line with the Fed’s forecasts. However, Powell also noted that rate hikes would not occur without greater improvements in the US labor market, particularly given the Fed’s view that the current surge in US inflation will not prove lasting. Several other Fed officials speaking to the media before Powell’s speech hinted at a much more accelerated timetable, with tapering to begin in September and rate hikes potentially starting as soon as mid-2022. The Fed’s messaging is part of an extended conversation with financial markets to prepare for a withdrawal of pandemic-era policy stimulus from quantitative easing (QE). The FOMC is well aware that valuations on asset prices of all stripes have been boosted by loose monetary settings. Powell’s Jackson Hole comments were more nuanced than those of his FOMC colleagues, but this is no surprise as the words of the Fed Chair carry the greatest weight among investors. The Fed Chair does not want to risk a repeat of the 2013 Taper Tantrum in Treasury yields, or the December 2018 plunge in US equity prices, by sounding unexpectedly hawkish and triggering a market rout that tightens US financial conditions (Chart 1). Our baseline assumption has been that the Fed would signal a tapering at the December FOMC meeting and begin to slow asset purchases in January 2022, leading to an eventual liftoff of the fed funds rate by the end of next year. The comments from Powell and others have raised the risk that the Fed moves a bit faster than our expectations on tapering, and perhaps even for liftoff (Chart 2). This would also be faster than the expectations among bond investors. Chart 2The Fed May Be Set To Move Faster Than Our Expected Timeline The New York Fed’s Survey of Primary Dealers in July showed that tapering is expected by Q1 of next year but a rate hike was not projected until the latter half of 2023 (Table 1). Current pricing in the US overnight index swap (OIS) forward curve is a bit more hawkish than that, with a full 25bp rate hike discounted by January 2023. Table 1Primary Dealers Expect A Taper, Not Rate Hikes The Fed’s next move will depend on how the questions regarding the Delta variant, the true state of the US labor market and underlying US inflation momentum are resolved. Dismissing The Delta Threat? There has been a clear hit to US economic confidence from the spread of the variant. The August readings from the University of Michigan consumer sentiment survey, the Philadelphia Fed business outlook survey and the ZEW survey of US growth expectations all showed sharp declines (Chart 3). The August flash estimate of the Markit PMIs fell to 8-month and 4-month lows, respectively, indicating that the pace of US economic activity slowed. Higher frequency data like restaurant reservations and hotel bookings have also dipped in recent weeks, potentially a sign of US consumers turning more cautious on leaving home during the Delta surge. Yet there is some tentative positive news on the spread of the variant. The 7-day moving average of new COVID-19 cases in the US appears to be rolling over (Chart 4). In the more stricken states in the US south like Florida, Texas and Louisiana, the effective reproduction number has fallen below one and cases are clearly peaking, suggesting that the transmission of Delta is slowing. If these trends continue, the full hit to US growth from the variant could prove to be minimal and potentially contained to only August data Chart 3A Hit To US Confidence From The Delta Variant Chart 4Has The US Delta Wave ##br##Peaked? Fed officials have been highlighting Delta as a potential near-term risk to the economy, but some comments made last week suggested only a modest level of concern that would not derail tapering plans. For example: Dallas Fed President Robert Kaplan: “[…] what I'm seeing is, in certain sectors, as you would expect, travel-related, you're seeing weakness in some other sectors but by and large, predominantly, what we're seeing is resilience across the indicators that we look at.”2 Kansas City Fed President Esther George: “[…] by and large, I think, unlike what we experienced last year, people have mechanisms to continue to interact with the economy in a way that we didn't before. And so that gives me some confidence in the outlook that we see, that we could continue to push through this.”3 Atlanta Fed President Raphael Bostic: “What I have seen is some suggestion that things are slowing down, but they are still just slowing from extremely high levels. I have not seen big changes in the underlying dynamic.”4 Even Powell himself noted in his speech that “while the Delta variant presents a near-term risk, the prospects are good for continued progress toward maximum employment.” If the hit to the domestic US economy from Delta proves to be modest and short-lived, the Fed will want to see confirmation of this in the US employment data. Labor market slack overestimated? It is clear from other comments made last week that FOMC officials will be watching the August payrolls report very closely, especially given the perception that the US job market may be a lot tighter than the headline unemployment rate suggests. For example, Fed Governor Christopher Waller noted that “when you adjust the labor force for early retirements, if we get another million [jobs in August] we will recover about 85% of the jobs that were lost and that took almost seven years after the last recession.”5 Kaplan noted that “we do think that the labor market is much tighter than the headline statistics indicate. We've had 3 million retirements since February 2020.” Our colleagues at BCA Research’s The Bank Credit Analyst came to a similar conclusion on labor market tightness in a report published last week.6 They determined that the single largest factor driving the US labor force participation rate lower since the onset of the pandemic has been individuals choosing to retire (Chart 5). Only some of that decline has been related to early retirement decisions made in response to COVID. There has been a structural trend of a falling participation rate, by an average of 0.3 percentage points per year, since 2008 due to demographic factors. The labor force participation rate does not need to fully return to pre-pandemic levels for the Fed to conclude that its maximum employment goal has been reached, after accounting for retirements and other demographic shifts (Chart 6). This fits with the comments from Waller and Kaplan indicating that there has likely been enough labor market improvement to begin tapering asset purchases. Chart 5Most Of The Pandemic Decline In Labor Force Participation Has Occurred Due To Retirement Chart 6Full Employment Without A Pre-COVID Participation Rate Transitory or persistent inflation? In his Jackson Hole speech, Fed Chair Powell downplayed many of the factors that have driven US headline inflation higher in 2021 as “[…] the product of a relatively narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy.” He also noted that the current surge in durable goods inflation, which has contributed “about one percentage point to the 12-month measures of headline and core inflation”, was likely to end once current supply chain disruptions fade. Durables would then return to the deflationary trend of the past 25 years and help cool off current overheated US inflation. Chart 7US Inflation Is Not Slowing Down Powell also noted the absence of significant US wage growth as reason not to be overly worried about a sustained period of high inflation. He also highlighted that “there is little reason to think” that ongoing structural disinflationary forces like technology and globalization “have suddenly reversed or abated” and that “it seems more likely that they will continue to weigh on inflation as the pandemic passes into history.” This is the message that the Fed has consistently communicated over the past several months, that high inflation was merely “transitory” and the inevitable result of year-over-year base effect comparisons and temporary supply squeezes. The problem with this interpretation is that we are now well into the summer months of 2021, past the period where base effects would be expected to boost US year-over-year inflation rates (the level of both the CPI and PCE deflator indices fell between January and May 2020 before starting to climb again in June). The July 2021 readings on annual headline and core PCE inflation were 4.2% and 3.6%, respectively, the highest rates seen since 1991 (Chart 7, top panel). The year-over-year increase appears to have been concentrated in a few components, with the Dallas Fed’s trimmed mean PCE 12-month inflation for July only climbing to 2.0%. However, the 6-month annualized measure was a more rapid 2.6% - the fastest such pace in 13 years - suggesting that the momentum of US inflation is both broadening and accelerating on the margin (second panel). Chart 8A Sustainable, Not Transitory, Rise In Global Inflation Powell, like many other developed market central bankers, is making a big bet that the “transitory” inflation narrative will prove to be correct and the current surge in inflation will soon subside. Yet already, global supply chain disruptions have lingered longer than the Fed has been expecting. There are also deeper underlying trends in inflation that are challenging the “transitory” narrative. The NFIB small business survey showed that a net 52% of respondents reported raising selling prices in July, while a net 44% planned future price hikes (third panel), both readings last seen during the days of double-digit US inflation in the late 1970s. US firms are successfully passing on rising input costs to US consumers, which is influencing US consumer inflation expectations. The University of Michigan consumer survey for August showed that US households expect inflation over the next year of 4.6% and over the next 5-10 years of 2.9%, with both series well above pre-pandemic lows (bottom panel). The trends in higher inflation seen in the US, and elsewhere, are not just limited to commodity prices where supply squeezes were most prevalent earlier this year and where price momentum is peaking (Chart 8). A GDP-weighted average of core inflation rates for 14 developed market economies reached 2.50% in June and 2.4% in July, levels last seen in the mid-1990s. Higher core inflation readings are consistent with intensifying price pressures stemming from diminished economic slack. The broad swings in our global core inflation measure correlate strongly with the IMF’s estimate of the output gap for the advanced economies (bottom panel). The current acceleration in global core inflation is entirely consistent with the rapid narrowing of the global output gap projected by the IMF for 2021 and, more importantly, 2022. This suggests that underlying inflation pressures, both within and outside the US, will linger into next year, providing an offset the expected drag on “non-core” inflation from slowing commodity price momentum. Already, lingering supply squeezes and stubbornly high US inflation are causing concern among some FOMC members, as noted in these comments last week: Robert Kaplan: “[…] headline PCE inflation next year, we think is going to be in the neighborhood of 2.5%, and there's risk that could be higher. And so we think some of these supply-demand imbalances for materials, some of them will not moderate, but some of them are going to persist longer than people think.” Esther George: “[…] if you continue to have supply constraints and strong demand, you might expect that those will persist more through this year or longer than we originally anticipated.” Chris Waller: “I do think it’s going to be more persistent than I may have thought back in May.” Chart 9Fed Tapering To Deal With Financial Stability Risks? Importantly, the senior FOMC leadership - Powell, Lael Brainard, Richard Clarida – has been sticking with the “transitory” narrative. However, even Clarida noted in a speech in early August that he would consider core PCE inflation at or above 3% at year-end to be “much more than a “moderate” overshoot” of the Fed’s 2% inflation objective.7 In his role as Fed Chair, Powell must speak on behalf of the entire FOMC, even if those views are not necessarily his own. Given the growing chorus of Fed voices expressing concern that US inflation could remain higher for longer, it will be increasingly difficult for Powell to do what he did at Jackson Hole – sound more dovish than the individual FOMC members with regards to inflation risks. What about financial stability risks from QE? Fed officials have been understandably cautious in their comments about how QE (and a 0% funds rate) could be influencing asset prices (Chart 9). However, with equity markets at record highs, corporate bond yields near record lows despite high levels of corporate leverage, and US house prices soaring – the S&P CoreLogic Case-Shiller national index rose 18.6% on a year-over-year basis in June, the fastest pace in its 35-year history - it is difficult not to see the role of the Fed’s easy money policies in boosting risk seeking, yield chasing activities. Stimulative financial conditions are also creating future upside growth risks, with the Conference Board leading economic indicator now reaccelerating (bottom panel). Robert Kaplan, Boston Fed President Eric Rosengren and St. Louis Fed President James Bullard have voiced concerns that QE, particularly the Fed’s buying of agency mortgage-backed securities (MBS), have played a significant role in the current US housing boom. The senior FOMC leadership has avoided any such comments for obvious reasons – imagine the market reaction if Powell expressed concerns about high house prices or equity market valuations. However, for those at the Fed already looking to begin tapering sooner, booming asset prices are an additional reason to vote that way as soon as the September FOMC meeting. Separating Tapering From Rate Hikes It seems clear that the majority of the FOMC is now leaning towards starting to taper before year-end, if US growth and employment maintain recent strength. The common message of Fed officials, from Powell on down, is that enough progress has been made on the Fed’s 2% average inflation target objective to justify tapering. Market-based inflation expectations from the TIPS and CPI swap markets are consistent with that interpretation, with breakevens and forward inflation rates within the 2.3-2.5% range consistent with the Fed’s 2% inflation mandate (Chart 10). Yet while our Fed Monitor continues to flag the need for tighter US monetary policy, only 100bps of rate hikes are discounted in the US OIS curve by the end of 2024 – and only after a first rate hike not expected to occur until January 2023. Despite the common messaging on the start of the taper, the Fed voices were singing a bit less in harmony about the potential timing of the first interest rate hike post-taper. Powell went out of his way to note in his Jackson Hole speech that “the timing and pace of the coming reduction in asset purchases will not be intended to carry a direct signal regarding the timing of interest rate liftoff, for which we have articulated a different and substantially more stringent test.” That test, of course, is when the Fed deems that its maximum employment objective has been reached. Can the Fed continue to successfully separate guidance on balance sheet decisions from guidance on future interest rate moves? Current pricing from US OIS and CPI swap forward curves indicates that the market is discounting negative real policy rates, with the Fed never raising rates above inflation, for the next decade (Chart 11). This goes a long way to explain the persistence of negative real US Treasury yields at a time of elevated inflation readings. Although a decade of negative real interest rates is also consistent with the market believing the equilibrium real interest rate (i.e. r-star) is negative – a view currently expressed by no one on the FOMC. Chart 10Too Few Rate Hikes Discounted In The US OIS Curve Chart 11Markets Believe The Fed Will Never Raise Rates Above Inflation That persistent pricing of negative real rates make sense when there is modest headline inflation and ample spare capacity in the US economy and labor markets. However, that complacency on future rate hikes will be shaken if the US economy approaches full employment and inflation remains above the Fed’s 2% target – outcomes that we expect to occur by the second half of next year. That will lead to the first fed rate hike of the next cycle in Q4 2022, but only after the taper that we expect to start in either December 2021 or January 2022 is completed in Q3 2022. Bottom Line: A tightening US labor market will make the Fed’s current guidance on the separation of tapering from rate hikes increasingly unconvincing, given the shallow path for interest rates currently discounted in the US yield curve - particularly if the current surge in US inflation proves not to be as transitory as the Fed is expecting. Jackson Hole Investment Conclusion – Expect Higher US Treasury Yields Chart 12Stay Below-Benchmark On US Duration With such a modest path for future rate hikes, and bond yields, discounted in US forward interest rate curves, we continue to advocate positioning for higher US Treasury yields on a strategic (6-18 months) basis (Chart 12). We see the benchmark 10-year Treasury yield eventually reaching a peak in the 2-2.25% range by the end of 2022. We recommend maintaining a below-benchmark duration stance in the US, while staying underweight US Treasuries in US and global bond portfolios. There is even a case to be made for a more tactical (i.e. shorter-term) bearish stance on US Treasuries with the US data surprise cycle set to turn towards upside surprises, especially if the negative impact of the Delta variant on confidence and spending begins to wane as case numbers start to decline in the coming weeks. Bottom Line: Expect higher Treasury yields over the next 12-18 months as the Fed transitions from talking about tapering to actual tapering and, eventually, to rate hikes starting in H2/2022. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 A transcript of Powell’s speech can be found here: https://www.federalreserve.gov/newsevents/speech/powell20210827a.htm 2 https://finance.yahoo.com/news/dallas-fed-president-robert-kaplan-yahoo-finance-transcript-august-2021-215700082.html 3 https://finance.yahoo.com/news/kansas-city-fed-president-esther-george-yahoo-finance-transcript-august-2021-113024734.html 4 https://www.reuters.com/business/exclusive-feds-bostic-says-reasonable-begin-bond-buying-taper-october-2021-08-27/ 5 https://finance.yahoo.com/news/fed-gov-waller-strong-august-jobs-report-will-be-green-light-for-taper-202340105.html 6 Please see BCA Research The Bank Credit Analyst September 2021 Section II, “The Return To Maximum Employment: It May Be Faster Than You Think”, available at bca.bcaresearch.com 7 https://www.federalreserve.gov/newsevents/speech/clarida20210804a.htm Recommendations Duration Regional Allocation Spread Product Yields & Returns Global Bond Yields Historical Returns
This week I have been holding client calls and roundtables with clients located in the EMEA region. In next week’s report we will share our answers to the most common client questions. In the meantime, this week we are sending you a report about Peru that discusses the political situation and the outlook for the nation’s financial markets. Best regards, Arthur Budaghyan Highlights Do not bottom fish in Peruvian financial markets. Political volatility has not yet reached its apex. Clashes between the government and congress are inevitable. Either president Pedro Castillo will be impeached and massive protest will follow, or his party’s radical leftist agenda will be at least partially legislated. Neither scenario bodes well for Peru’s financial markets. Capital outflows and lower metal prices pose a threat to the exchange rate. Go short the sol versus the US dollar. Dedicated EM equity and fixed-income managers should continue underweighting Peru in their respective portfolios. Feature Chart 1Peru: Absolute And Relative Equity Performance Peru’s financial assets have plummeted due to the election of left-wing president Pedro Castillo. Some investors may be tempted to bottom fish in these markets due to their lower valuations and oversold conditions (Chart 1, top panel). Some may attempt to draw parallels with Brazil’s 2002 election of Lula da Silva which initially triggered a selloff in Brazilian financial markets followed by a substantial rally during the president’s two terms in office. Will that be the case with Peruvian markets? We do not think so. Unlike twenty years ago in Brazil, Peru is currently facing a much worse political and economic outlook. Overall, the political volatility as well as deteriorating macro fundamentals warrant a higher risk premium on Peruvian assets. Thus, we recommend investors underweight Peru within EM equity, local, and sovereign fixed-income portfolios (Chart 1, bottom panel). A Political Showdown Is Looming One could argue that Peruvian financial markets have hit a floor and that much of the bad news has already been priced. Another argument is that Castillo will not be able to pass sweeping socio-economic reforms because of strong opposition from congress. In our opinion, Peru has yet to reach peak political tensions, which may very well end with a bang. Given this heightened political uncertainty, investors should brace themselves for a rocky ride. We identify two main risks plaguing Peruvian politics. First, the unsustainable ideological divide within Castillo’s proposed cabinet between far-left militants and the pragmatic center-left. Second, the looming clash between a government that wants to upend the country’s socioeconomic system and a notoriously harsh congress keen on making the president’s job unbearable. Intra-Government Dichotomy The ideological divide in Castillo’s government is extreme. On one side is the Marxist-Leninist wing, headed by Free Peru’s party leader, Vladimir Cerrón, and prime minister candidate, Guido Bellido. On the other side is the left-to-center members, headed by Pedro Francke, the minister of finance candidate. The more extremist Marxist-Leninist camp constitutes the majority, while moderates are a minority. Critically, the Marxist-Leninist radicals will make few concessions to the moderate ministers, as the former believe they have a mandate from the people to upend the country’s socio-economic system. Nevertheless, the policies supported by the general public are more nuanced than that. According to a national Ipsos survey from August, 85% of respondents believe president Castillo should govern with technocrats in his governments’ key positions. Only 11% support him making the ideology of his party the centerpiece of his policies and promoting (radical) members of his party. This shows how Castillo’s victory was more of a national referendum against Fujimori and the corrupt political elites than support for a radical socialist government. We elaborated on this topic in our previous report on Peru. The wide ideological divide between the party and a few moderate members of the cabinet in key positions will make governing extremely difficult. Cracks are already beginning to form. Bellido and Francke hold different views on the role of the state in the economy. Bellido, on the one hand, has stated he supports state-owned companies in commodity-extracting sectors (particularly natural gas and hydroelectricity) and the drafting of a new constitution to give the state greater ownership of mining contracts. Francke, on the other hand, wants to reinstate fiscal spending caps and is less harsh with multinational companies, favoring an increase only in mining taxes. Furthermore, there is significant uncertainty around the government’s official fiscal plan, as Francke has avoided giving clear figures on fiscal expenditures and social programs. To make matters worse, there is growing concern that it is party leader Cerrón who is de facto in charge, and that he has an enormous influence on Castillo. Cerrón is unpopular among voters as a result of his criminal allegations, close ties to the Cuban regime, and often apologetic stance toward the Maoist terrorist group, Shining Path. Although he intended to run as the presidential candidate for Free Peru, he was banned from the election because of ongoing criminal accusations, which is why he handpicked Castillo as his replacement. Without a doubt, he intends to be heavily involved in government decision-making. According to the same Ipsos poll we cited earlier, 61% of Peruvians believe Cerrón is either de facto in charge of the government or holds considerable sway over Castillo. The biggest risk to financial markets will be the eventual dismissal or resignation of finance minister Francke. This may happen as he eventually realizes that the radicals will concede very little. This would also lead to a resignation of orthodox central bank governor Julio Velarde, who Francke has been able to convince to remain in his post. These two resignations would result in another riot in Peruvian markets, as the investment and business communities fully lose confidence in Castillo’s government. An Inevitable Clash Between The Government And Congress Being president in Peru is a notoriously difficult job due to the large sway that congress has on legislation and governing. The outcome of this constant confrontation between the president and congress has been five different presidents in the past five years alone. Critically, this tension has never been higher. The government and congress hold diametrically opposed views on the broad vision and strategy for the nation and how the economy should be managed. On the one hand, congress is mainly composed of traditional centrist parties and the opposition holds a majority—Castillo’s coalition has only about 39% of the seats. On the other hand, the government has just been elected on a far-left reformist platform. In essence, both the government and congress have incentives and the determination to be as obstructive as possible for each other. As tensions ramp up and confrontation becomes inevitable, the risks of unrest and clashes between supporters of Castillo and congress will rise. Table 1Peru: Voters Support More Moderate Politicians In congress’s point of view, they have a mandate to serve as an opposing force to Castillo’s radicalism: There is some validity to this claim. The opposition holds a majority, and congress president Maricarmen Alva is by far more popular than the leaders of the Free Peru party like Cerrón and Bellido (Table 1). Given that Castillo’s ideology is a threat to the nation’s current socio-economic model and, thereby, to the political establishment, the majority in congress would prefer to block all radical legislation, including the appointments of controversial cabinet members. In addition, they will use all manner of accusations and alleged linkages between cabinet members and Shining Path to impeach Castillo. Congress needs only 87 votes, which means they need to convince only eight members from the governing alliance to impeach Castillo. In turn, the government argues it was elected to upend the country’s status quo and confront the unpopular political elites: Critically, the president has the ability to dissolve congress after two votes of no confidence, thereby putting pressure on congress to abide by the government’s radical proposals. This latter point and the fact that congress has little popular support provide leverage for the government over congress. Given the fact that current congressional members cannot be reelected, they might be more careful about how they maneuver, so that they do not provoke Castillo to dissolve congress. There are, therefore, two extreme possible outcomes. On one hand, congress may impeach the president, triggering a social revolt from Castillo’s hardline supporters against congress. On the other hand, congressional members may allow the passing of a leftist legislative agenda in order to maintain their seats, which would gravely reduce corporate profitability and productivity in Peru. Both scenarios would result in a collapse of investor and business confidence, leading to more capital flight and a riot in Peruvian financial markets. Bottom Line: Political volatility in Peru has not yet reached its apex. Clashes between the government and congress are inevitable, as well as among key cabinet members. Such elevated political volatility warrants a higher risk premium on Peruvian assets. Return Of Macro Instability Peru enjoyed a period of relative macro stability from the early 2000s until recently. Its currency, local interest rates, and sovereign spreads have fluctuated less than those in other Latin American countries. However, the nation’s economy and financial markets have entered a period of heightened volatility. Both domestic and external macro factors have turned into headwinds for the Peruvian economy and financial markets. Chart 2Peru: Business Confidence Will Continue Plummeting Domestically, the economic recovery has been uninspiring, and multiple indicators point to growth disappointments ahead: Business confidence took another serious hit with the election of Castillo and ensuing uncertainty (Chart 2). Imminent political volatility will further depress business confidence, and, consequently, capital expenditures and hiring in the coming months. This will curb household income growth and consumer spending. Peru remains one of the world’s deadliest COVID-19 hotspots (Chart 3, top panel). In addition, vaccination rates are the lowest among major Latin American economies (Chart 3, bottom panel). As the more infectious Delta variant becomes dominant, there will not be enough immunity to hold back new cases. Consequently, either the government will introduce lockdowns or people will voluntarily limit their activities, thereby inhibiting the nascent economic recovery. The unemployment rate remains far above its pre-pandemic level (Chart 4). Thus, household income remains very depressed. The latter does not bode well for debtors’ ability to service debt. Chart 3Peru: The Government Has Grossly Mismanaged The Pandemic Chart 4Peru: Labor Market Has Not Fully Recovered As a result, loan delinquencies will rise anew, weighing on banks’ appetite to lend. Notably, local currency loans to the private sector will contract (Chart 5). Chart 5Peru: Prepare For A Credit Slump Commercial banking profitability is also vulnerable, as president Castillo aims to strengthen the state bank (Banco de la Nación) by expanding its operations and undercutting private banking fees. Given financials of the bourse’s market cap, poor banking profitability is a major risk to this stock market. Unrelenting currency depreciation—see below for a more detailed analysis of the exchange rate—will prompt the central bank to hike rates further. This will not only weigh on new credit demand, but also augment loan delinquencies in the banking system. As a result, banks will become very risk averse and shrink their balance sheets. A credit crunch will ensue. Even though fiscal spending will be increased, it is unlikely to propel economic growth. The basis is that fiscal primary spending accounted for less than 15% of GDP before the pandemic and is now 17% due to the pandemic distortion (Chart 6). In the meantime, consumer spending constitutes 63% of GDP, capital spending 21%, and exports 25%. Externally, deteriorating balance of payments dynamics will weigh down on the currency: Peruvian assets tend to move with the country’s trade balance and global metal prices. The fact that Peruvian stock prices have plummeted in the face of rising industrial and precious metal prices supports a bearish thesis on this bourse (Chart 7). Chart 6Peru: Fiscal Expenditures Have Risen Due To The Pandemic Chart 7Rising Metal Prices Have Failed To Boost Peruvian Stocks Chart 8China's Slowdown Portends A Fall In Commodities Export revenue will contract as a result of a decline in commodity prices brought on by China’s slowing “old economy” (Chart 8). Precious and industrial metals together account for 66% of Peru’s merchandise exports. A meaningful decline in metal prices will erode the trade surplus and weigh on the exchange rate. Furthermore, Peru is already experiencing capital flight. Potential anti-market policies from this government could trigger more capital exodus. The capital account deficit will widen as both FDI and portfolio inflows fall due to the negative commodity outlook as well as political uncertainty (Chart 9). Foreigners still hold 45% of local currency bonds, and they will reduce their holdings (Chart 10). Chart 9Peru: FDI Inflows Will Decline Chart 10Peruvian Domestic Bonds: Will Banks Make Up For Foreign Investor Retrenchment? Chart 11Peru: The Dollarization Rate Has Room To Rise Currency depreciation will also be reinforced by locals converting their sol deposits into foreign currency. The dollarization rate—the ratio of foreign currency banking deposits to total deposits—will rise (Chart 11). A weakening currency will also lead to higher inflation expectations, to which the central bank will respond by raising rates. The monetary authorities already hiked the policy rate by 25 basis points this month due to higher-than-expected inflation and a rapidly depreciating currency. As Peru’s exchange rate continues to weaken, the central bank might also sell foreign currency reserves to prevent large fluctuations in the value of the currency. This foreign exchange intervention will, in turn, shrink banking system local currency liquidity and lift interbank rates (Chart 12). Chart 12FX Reserve Sales Will Shrink Banking Liquidity And Lift Interbank Rates In short, the central bank has enough international reserves to stabilize the exchange rate, but this will come at the cost of tighter liquidity and higher interest rates. The latter will only reinforce sluggish growth in domestic demand. Bottom Line: Heightened political volatility and lower metal prices are working against the Peruvian economy and its financial markets. Peru is experiencing large capital flight, which will exacerbate currency depreciation. Investment Recommendations Keep an underweight allocation to the Peruvian bourse within an EM equity portfolio. We recommend currency traders go short the Peruvian sol versus the US dollar. While the sol has already depreciated considerably, the domestic and external headwinds entail more downside. For fixed-income investors, we maintain an underweight allocation to Peruvian sovereign credit in an EM credit portfolio. The basis for this position is that the nation’s fiscal policy may undergo a major shift, entailing larger fiscal spending and wider budget deficits. We are downgrading local bonds from neutral to underweight in an EM domestic bond portfolio. Critically, the share of foreign ownership of Peruvian local fixed income remains one of the highest in the EM universe—it has only fallen from around 55% to 45% of domestic fixed-income instruments in the past six months (Chart 10 on page 9). Thus, there is a major risk that foreign investors will sell domestic bonds as the currency depreciates further, which will weigh down on local bonds. Juan Egaña Research Analyst juane@bcaresearch.com Footnotes
Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) Footnotes 1 See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2 Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.