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Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Dear Client, Next week I will be presenting our 2021 outlook on China at our last webcasts of the year "China 2021 Key Views: Shifting Gears In The New Decade". The webcasts will take place next Wednesday, December 16 at 10:00AM EST (English) and at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). In addition, our final weekly publication for 2020 will be on Wednesday, December 16, 2020. Best regards, Jing Sima, China Strategist Highlights Chinese policymakers have shifted their focus from supporting economic growth at all costs to risk management. The trend will likely gather speed in 2021. A deceleration in credit growth next year is almost a certainty. While policymakers will be data dependent and the slowdown will be managed, our baseline scenario suggests a decline of approximately three percentage points in credit impulse in 2021. Chinese stocks could still trend higher in Q1, but prices will falter as the market starts to price in a tighter policy environment and slower profit growth in 2H21. We recommend a tactical neutral stance in both the onshore and offshore markets. We continue to favor Chinese government bonds on a cyclical basis, while gyrations in the onshore corporate bond market will endure for at least the next six months. Feature China’s economic growth momentum has strengthened in recent months, but the nation’s policy stance has also turned more hawkish. As set out in the 14th Five-Year Plan, 2021 will mark the beginning of a new era in which policymakers will switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation.” The pivot means China’s top officials may tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms by allowing more bankruptcies and industry consolidations. As we pointed out in our November 4, 2020 Strategy Report,1 external challenges combined with a stronger domestic leadership will allow China to initiate more meaningful reforms in the next decade than in the past ten years. The reforms will strengthen our structural view on China’s economy and financial assets, but this restructuring will create headwinds for growth in the short to medium term. Therefore, investors should maintain low expectations for Chinese growth and financial asset prices. In 2021, credit growth will decelerate, regulations will be tightened and the “old economy” will moderate in the second half of the year. We will discuss four main themes in our outlook for 2021. Key Theme #1: Macro Policy: Turning More Hawkish Government officials recently stepped up mention of financial risk containment in their public announcements, along with tightened industry regulations. Many market commentators are downplaying the risk of a tighter policy in 2021, citing China’s fragile recovery and a weak global economy. However, the current environment resembles the policy backdrop in late 2016/early 2017 when President Xi Jinping began his financial deleveraging campaign. Our policy framework suggests that China currently faces fewer constraints than in 2016/2017. Thus, the odds are high that the leaders will turn their tough rhetoric into action in the next six to twelve months. Importantly, despite low year-over-year GDP growth, the pace of China’s domestic economic recovery has been faster than in 2016 (Chart 1). The PMIs in both the manufacturing and service sectors have been above the 50 percent boom-bust threshold for nine consecutive months (Chart 2). The laggards in the economy - manufacturing investment and household consumption - have been consistently improving (Chart 3). Bond yields have climbed sharply, but given that corporate bond issuance only accounts for 10% of total social financing, the economic impact from rising corporate bond yields has been more than offset by the large number of government bonds issued (Chart 4). Moreover, the recovery in China’s export sector and current account balance has fared surprisingly well this year, propelled by the global demand for medical supplies and stay-at-home electronic goods (Chart 5). Portfolio inflows also have been strong, fueling a rapid appreciation in the RMB. Chart 1Current Economic Recovery In Better Shape Than In 2016 Chart 2PMI Remains Strong Chart 3The Laggards Are Catching Up Chart 4Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Chart 5Exports Surged Chart 6Chinese Business Cycle Upswing Still Has Steam Looking forward, China’s economic recovery should continue for at least another two quarters due to this year’s credit expansion. Economic activities usually lag the turning points in credit growth by six to nine months (Chart 6). Moreover, headline economic data in 1H21 should be impressive, given the deep slump in domestic output during the same period in 2020. The strengthening economic data will provide China’s leadership with a long-awaited opportunity to focus on risk management. Chart 7A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus Furthermore, the ongoing deflation in the ex-factory prices should not stop the authorities from scaling back policy support. It is worth noting that Xi’s administration doubled down on squeezing shadow banking activity in early 2017 when the CPI was decelerating; the PPI turned positive only due to a low base factor from deep contractions in 2016 (Chart 7). In this vein, as long as the deceleration in both the CPI and PPI does not drastically worsen, we think that policymakers will see less need to reflate the economy. China’s external environment will be less challenging in 2021 than in 2016/2017. Geopolitical tensions are set to ease, at least temporarily, with US President-elect Joe Biden taking office in January. This contrasts with 2016/2017 when President Xi began his financial deleveraging campaign despite increasing strain from then newly-elected President Donald Trump. In hindsight, Xi’s intention may have been to solidify China’s financial sector in preparation for a trade war with the US. The same logic can be applied to our view for next year: Xi will accelerate structure reforms to mitigate risk in the domestic economy before the Biden administration turns its focus to China. We do not think the Communist Party’s 100th anniversary next year will prevent Xi from adopting a hawkish policy bias either. Xi plowed ahead with tightening financial regulations in 2017 even as the ruling Communist Party Committee (CPC) was preparing for a generational leadership reshuffle. In the past two years, the escalation in US-China tensions has strengthened Xi’s power in the CPC and Chinese society. The recent large number of changes in provincial CPC leaders should help Xi to further consolidate his centralized power over local governments. All signs indicate that both the domestic and external landscapes should provide Xi with even more room to undertake reforms in 2021 compared with 2017. Key Theme #2: Stimulus: Deceleration Ahead A deceleration in both credit growth and fiscal support in 2021 is almost a certainty in light of the more hawkish tone by Chinese policymakers. Chart 8 shows that between 2017 and 2019, policymakers came close to stabilizing the macro leverage ratio, but the progress was more than reversed this year due to the pandemic. If policymakers are to allow the increase in the 2021 debt-to-GDP ratio to be within the range of the past four years, then credit may expand at a rate slightly above nominal GDP growth in 2021 (assuming nominal output growth at around 10-11% next year). This scenario, which is our baseline view, is in line with recent statements from the PBoC, which calls for aligning credit growth with nominal GDP in 2021. Our calculation suggests that credit impulse will reach around 29% of next year’s GDP, about 2 to 3 percentage points lower than in 2020 (Chart 9). Chart 8Financial Deleveraging Efforts Erased By COVID-19 Chart 9Credit Growth Will Decelerate In 2021 Even if the PBoC keeps its official policy rate (i.e. the 7-day interbank repo rate) steady, tightening regulations and repricing credit risk will lead to higher funding costs and a lower appetite for borrowing (Chart 10). Banking regulators have made it clear that some of the one-off easing measures from this year, such as the extension of loan payments (through March 2021) and the delay of macro-prudential assessments (through end-2021), will end next year. Financial institutions will need to slow the pace of their asset balance sheet to comply with these regulations. The regulatory pressures will lead to de facto deleveraging. On the fiscal front, we expect the large budget deficit to remain intact next year. Targeted stimulus through subsidies and tax cuts to support household consumption and small businesses will likely continue. Government spending in the new economy sectors such as semiconductor and tech-related infrastructure will even accelerate. However, the new-economy infrastructure investment is estimated to only account for about 1% of China’s total capital formation, having limited impact on the overall economy.2 Chart 10Higher Funding Costs Will Discourage Corporate Borrowing Chart 11Fiscal Boost For Infrastructure Will Scale Back The proceeds from the large number of the local government special purpose bonds (SPBs) this year will continue to provide tailwinds for infrastructure investment into Q1 2021. However, as the laggards in the economic recovery catch up and government tax revenue improves next year, 2021 quotas for government general and SPBs are likely to be scaled back, reining in expenditure growth in the traditional infrastructure sector (Chart 11). Finally, investors should watch for signs of further hawkishness from China’s leaders at the Central Economic Work Conference this December and the National People’s Congress next March. While we expect policymakers to be data dependent and keep a controlled deceleration in credit and economic growth, risks of a policy overkill cannot be ruled out. A more bearish scenario would be if policymakers decide to fully revert the pace of debt accumulation to the average rate in 2017-2019. In this case, credit impulse in 2021 could fall by more than 5 percentage points compared with 2020 (Scenario 2 in Chart 9 on Page 6). Key Theme #3: Chinese Equities: Position For A Peak In Prices This year’s cyclical (6- to 12 months) call to overweight Chinese stocks within a global portfolio has panned out. In the next 12 months, the risks in Chinese stocks relative to global benchmarks are to the downside; Chinese stocks are vulnerable to setbacks in policy support next year, in both absolute and relative terms. We are closing the following trades: Long MSCI China Index/Short MSCI All Country World Index, for a 1.5% profit; Long MSCI China A Onshore Index/Short MSCI All Country World Index, for a 5.6% profit; Long MSCI China Ex-TMT/Short MSCI Global EX-TMT, for a 0.7% loss; Long Investable Materials/Short broad investable market, for a 5.6% profit; and Long Onshore Materials/Short broad A-Share market, for a 9.3% profit. Chart 12Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 In absolute terms, Chinese onshore stocks on an aggregate level could still inch higher in the next quarter, supported by an improving business and profit cycle (Chart 12). However, in Q2 the market may start to price in slower economic and profit growth in 2H21, erasing the gains from the first quarter. The resilient performance in Chinese stocks against a tightening policy backdrop in 2017 is not likely to repeat itself next year. Current valuations in both China’s onshore and offshore equity markets are higher than at the end of 2016; the price-to-forward earnings ratios in both markets this year have breached the peak levels achieved in 2017 (Chart 13A and 13B). Recovering earnings in the next year will help to digest the currently elevated valuations, i.e. the market has already priced in a substantial post-pandemic profit recovery and investors’ focus will soon switch to a more pessimistic outlook for corporate earnings in 2H21. Chart 13AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Chart 13BA-Shares Are Less Expensive, But Valuations Still Elevated Additionally, a property market boom in 2017 boosted the stock performance of real estate developers and related sectors in the supply chain (Chart 14). Policies have already turned much more restrictive in the past month, and deleveraging pressures faced by property developers may weigh on both the sector’s profit growth and stock performance in the next six to twelve months.3 The investable market may not be insulated from tighter domestic policies either. Recent anti-trust regulations in China could create headwinds for mega-cap technology stocks in the near term. Global investors will demand a higher risk premium for China’s tech sector than in the past, as the rich valuations of tech stocks pose more downside risks in a less friendly policy environment (Chart 15). Chart 14Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Chart 15Valuations In Chinese Tech Stocks Are Elevated Chart 16A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months Furthermore, if we presume a policy overkill with more aggressive deleveraging and a further appreciation in the RMB in 2021, our model shows a significant increase in the probability of a profit growth contraction in the next 12 months (Chart 16). In this scenario, selloffs in Chinese stock prices may start in Q1, a risk that cannot be ruled out. In relative terms, Chinese stocks will likely underperform global equities. It is doubtful that the impressive outperformance in Chinese investable stocks throughout 2017 will be repeated in 2021. Chinese equities have benefited from the successful containment of China’s COVID-19 situation in the past year (Chart 17). As breakthroughs in vaccines make the pandemic less threatening to the global economy, Chinese risk assets relative to global ones will become less appealing. Global cyclical stocks, particularly European and Japanese equities, should benefit from improvements in business activities and relatively low valuations (Chart 18). Chart 17Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chart 18...But Vaccines Will Give A Boost To Other Markets Next Year Importantly, despite strong inflows this year from foreign investors to China’s bond market, foreign portfolio flows into China’s onshore equity market have been less than one-third of that in 2019 (Chart 19). Looking ahead, global investors will be less keen to support Chinese stocks, based on the expectation of tighter onshore liquidity conditions and less buoyant economic growth. Chart 19Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Everything considered, we anticipate that Chinese A-shares and investable stocks will start descending in Q2 in absolute terms. Their performance relative to global equities will also peak. We recommend a neutral stance on both bourses in the next three months to minimize the downside risks. Key Theme #4: Chinese Bonds: Favor Onshore Government Over Corporate Bonds We continue to recommend a cyclical long position in Chinese government bonds within a global fixed-income portfolio. However, we are closing our long Chinese onshore corporate bond trade for now, for a 17% gain (Chart 20). The large interest rate differential between yields in Chinese bonds versus those in other major developed nations should remain intact into the new year. The yield on the short-duration government notes will continue to trend higher in 1H21, based on the prospect of tighter monetary policy. The yield on long-dated bonds will also escalate as the outlook for the economy continues to improve. We are pricing in a 70BPs increase in the 1-year government bond yield and a 40BPs rise in the yield of the 10-year bond from their current levels (Chart 21). Chart 20Handsome Returns On Chinese Government Bonds Chart 21Our Projections On Government Bond Yield Hikes Next Year Chart 22RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year The ongoing appreciation in the RMB will also make Chinese government bonds attractive to global investors. The speed of the gain in the RMB against the US dollar may slow in 2021, but the economic fundamentals do not yet suggest that this trend will reverse. Relative growth and interest rates between China and the US will probably narrow and the geopolitical tailwinds affecting the RMB following the Biden win in the US election will subside in the new year (Chart 22). However, China's strong export sector should still support a record high trade surplus and provide a floor to the Chinese currency against the USD. Chinese onshore corporate bonds have undergone a major shakeout in the domestic corporate bond market in the past month. A slew of state-owned enterprise (SOE) bond defaults has pushed up the yields on the lower-rated corporate bond by nearly 40BPs in one month. In our view, the recent panic selloff in the onshore corporate bond market is overdone and domestic corporate bonds are starting to look attractive on a cyclical basis. Bloomberg data shows that the value of defaulted bonds in the first three quarters of this year is in fact much lower than in the past two years: it dropped to 85Bn RMB from 142Bn RMB defaults in 2019 and the default of 122Bn RMB in 2018. Bondholders have been spooked by the fact that the Chinese local government and top financial regulators allow defaults by state-backed firms. The policy change to shift risk to the markets should result in a continuation of risk-off sentiment among investors, inducing selling pressure in the domestic corporate bond market in the near term. However, on a cyclical basis, such selloffs could present good buying opportunities. While we expect China’s onshore corporate bond defaults to be higher in 2021, the default rate remains below the global average (Chart 23). As we pointed out in our previous report, since 2017 Chinese onshore corporate bonds have been priced with a significantly higher risk premium than their global peers, which in our view is overdone (Chart 24). Chart 23Chinese Corporate Bond Default Rate Lower Than Global Average... Chart 24...And Much Lower Than Their Risk Premiums Imply Chart 25Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes In addition, Chart 25 shows that the total returns on Chinese onshore corporate bonds briefly declined in 2017 when the government’s financial de-risking efforts intensified. It sequentially rebounded in 2018, suggesting a turnaround in investors’ sentiment after the first cleanup wave in the corporate sector. As such, while we do not favor Chinese onshore corporate bonds in the next six months, on a 12-month horizon, conditions could become more favorable to initiate a long position. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see China Investment Strategy Report "The 14th Five-Year Plan: Meaningful Transformations Ahead," dated November 4, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Special Report "Chinese Economic Stimulus: How Much For Infrastructure And The Property Market?" dated March 25, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Special Report "China: The Implications Of Deleveraging By Property Developers," dated October 21, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Every year we review our best and worst calls – both in terms of geopolitics and markets. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. We correctly forecast the presidency, Senate, Democratic nomination, and impeachment outcome. We anticipated “stimulus hiccups” but expected them to be resolved by November 3. The Georgia runoff on January 5 presents a 30% risk to our Senate prediction. In the main, we were right on Chinese politics, EU politics, US-Iran tensions, and Russian politics. US-China tensions kept rising, as expected, but the market ignored it. We missed the Saudi-Russia cartel break-up in Q1. The jury is still out on Brexit. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. Stay long cyber-security stocks in general, but close the pair trade versus Big Tech. Close the 10-year Treasury hedge. Feature Chart 1The Black Swan The COVID-19 pandemic took investors by surprise, defined the year 2020, and caused the shortest bear market in history, lasting 33 days (Chart 1). On the whole this year’s crisis illustrates how geopolitical analysis is not primarily concerned with “black swan” events, which are inherently unpredictable. Rather the wholly unexpected pandemic reinforced several of our pre-existing geopolitical themes and trends: de-globalization, American sociopolitical instability, European integration, and US-China conflict. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. Whether these and other trends will continue in 2021 will be the subject of our strategic outlook due next week. This week we offer our annual report card, which reviews our best and worst calls for the year with a desire to hold ourselves accountable to clients, learn investment lessons from mistakes, and hone our geopolitical method of analysis. Successful Strategy, Debatable Tactics Overall our performance this year was good. Specifically, our political forecasting was on target and our investment recommendations got the big moves correct. But our risk-averse tactical trades were less successful. In last year’s annual outlook, “2020 Key Views: The Anarchic Society,” our main investment recommendation was long gold – based on sky-high geopolitical risk and a shift toward reflationary policy by the Federal Reserve, China, and the European Union (Chart 2). We maintain this trade today, despite its losing some altitude recently, as we expect to see low real rates, reflationary global policy, and rising inflation expectations. Geopolitical risk will also remain elevated despite dropping off from recent peaks, and not only during President Trump’s “lame duck” final days in office. We sounded the alarm for clients in our January 24 report, “Market Hurdles: From Sanders To Iran,” warning that global equities and risk appetite would suffer “in the very near term” due to conventional political risks as well as the new coronavirus, which we feared would explode as a result of Chinese New Year. In retrospect we were not bearish enough even in these reports. In our March 27 report, “No Depression,” we advised that the extraordinary monetary and fiscal response to the crisis would reflate the global economy and thus went long Brent crude oil. From this point onward we gradually added risk to our strategic portfolio, including by going long global equities relative to bonds in June (Chart 3). Chart 2Gold Paid Off When Black Swan Arose Of course, despite getting these big moves right, we abandoned several of our strategic recommendations during the crisis and some of our tactical trades went awry throughout the year. Chart 3When Crisis Hits, Buy Risk Assets! Our Worst Calls Of 2020 We chose a very bad time, last December, to bet heavily on global equity rotation from growth to value and away from tech sector leadership. US equities and tech stocks surged ahead of global equities on the back of the pandemic. Our long energy / short tech trade proved disastrous. Only now, with a vaccine on the horizon, are these recommendations coming to fruition. On the other hand, we should have remained committed to our long EUR-USD position rather than cutting it short when the crisis erupted (Chart 4). Global stimulus and the Fed’s sharp reduction in interest rates and gigantic infusion of US dollar liquidity ensured that the dollar would plummet. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. In some cases our geopolitical forecast proved dead-on while our market recommendation faltered. One of biggest geopolitical forecasts, in September 2019, was that the US and China could well conclude a trade deal but that it would be extremely limited in scope and strategic tensions would continue to rise dangerously. This prediction has proved accurate, judging by US high-tech export controls and China’s suppression of Hong Kong this year. But we misjudged the market response, particularly after China contained the virus: the renminbi saw a tremendous rally this year while we remained short, suffering a 4.96% loss so far (Chart 5). Chart 4Stick With Your Guns...Even Amidst Crisis Chart 5US-China Tensions Persisted, But The Market Didn't Care Along these lines, President-elect Joe Biden’s statement that he will maintain President Trump’s tariffs is another confirmation of one of our most contrarian views over the past year.1 We would expect the People’s Bank to allow the yuan to slip both to deal with lingering deflationary pressures and to build up some poker chips for the coming negotiations with Biden. We also would expect the US dollar to witness a near-term tactical bounce. However, if we are wrong, our short CNY-USD trade will fall further and we will have to cut our losses. Chart 6You Can't Time The Market Other mistakes occurred when solid economic and political views combined with bad market timing. Our long position in cyber-security stocks is well grounded – we remain invested – but once again we jumped the gun on the rotation away from Big Tech, which constituted the short end of two of our pair trades, now closed. Separately, we coupled our long gold bet with a long silver bet that came far too late into the rally – though we remain strategically optimistic on silver due to its industrial uses, which should revive in the post-pandemic context. Lamentably, we ran up against our stop-loss threshold on our structural position in US aerospace and defense stocks not long before the vaccine announcement would have begun the arduous process of recuperating losses (Chart 6). We have reinitiated the latter trade, albeit in global defense stocks rather than just American. The inverse also occurred, in which our political forecasting proved faulty but our market implications worked out quite well. One of our biggest political forecasting failures stemmed from an initial success. Beginning in May, we signaled that the US Congress would experience “stimulus hiccups” in trying to pass additional fiscal relief for the economy. This view proved prescient as negotiations fell through in July and a range of benefits expired. Real rates began to recuperate at this time. The problem is that we also predicted that the fiscal impasse was merely a hiccup, i.e. would be resolved prior to the election. It remains unresolved to this day. Fortunately, our market recommendation – to go long US municipal bonds relative to duration-matched treasuries – was rooted in the principle of “buy what the Fed is buying” and therefore continued to appreciate, along with our similarly justified position in investment grade bonds (Chart 7). Chart 7Stimulus Hiccup Occurred, But Was Not Resolved Our biggest error of political forecasting was the collapse of OPEC 2.0 at the beginning of the year. We signaled to clients in January that Russia was growing internally unstable and that this would result in an external action that would prove market-negative. This was correct, but we failed to anticipate that the most important consequence would be a temporary Russian rejection of Saudi demands for oil production cuts. Still, we advised clients to stay the course, arguing that the Russians and Saudis were geopolitically constrained and would return to their cartel, which proved to be the case, thus hastening the restoration of balance to oil markets. This view supported our long spot oil recommendation in late March, though the idea that US producers might collaborate proved fanciful. Alternatively we suggested that clients go long oil relative to gold, which has performed well. Other mistakes stemmed from our tactical trades. Generally, we were insufficiently bullish both during the summer and after the US election. In both cases we overemphasized the absence of US fiscal stimulus as a risk to the rally. In reality the first stimulus was sufficient and the V-shaped recovery of the private economy reduced the need for additional support over the course of the year. Our long tactical positions in US treasuries, consumer staples, and JPY-EUR did not pan out. The takeaway going forward, given that the market is not pressuring politicians to act, is that the risk of another congressional fiscal failure prior to Christmas is underrated. Lastly, some minor emerging market trades went awry, such as our long positions in Thai and Malay equities and our shorting the South African rand. We wrongly predicted that Michelle Obama would be Joe Biden’s pick for vice president, when in fact that honor went to Senator Kamala Harris. Our Best Calls Of 2020 While we got the big market moves right in 2020, our best calls were political and geopolitical in nature: Joe Biden won the US election. He won through his ability to win back blue-collar workers and compete in the Sun Belt as well as the Rust Belt, which we outlined as a key geographic strength during his run in the Democratic primary election (Map 1). We downgraded Trump from 55% odds of re-election to 35% in March, when the lockdowns occurred, and we upgraded Trump only to 45% in October when he rallied. The thin margins in the swing states confirmed this higher-than-consensus probability of a Trump win. Map 1Joe Biden Won The Rust Belt And The Sun Belt Republicans retained the Senate. Beginning in late September, we saw that President Trump was rallying and that this would increase the odds of a Republican Senate even if Trump himself fell short. On October 16 we signaled that the Senate was too close to call, and on October 30 we upgraded the GOP again and argued that a Democratic White House plus a Republican Senate was the most likely scenario (Chart 8). There is a lingering risk to this view: a double Democratic victory in the Georgia runoffs on January 5, 2021. But we put the odds of that at 30% at best. Chart 8Republicans Held The Senate (Pending Georgia Runoffs) Chart 9Biden Won The Democratic Primary Nomination Biden won the Democratic nomination, which we first highlighted in November 2018 and June 2019 and consistently thereafter, though we never underrated his challengers (Chart 9). Trump was acquitted of impeachment charges, which seems like ages ago. We said from the start that Democrats did not have the votes (Chart 10). China stimulated the economy massively and avoided massive domestic unrest. Investors doubted that Beijing would stimulate enough to lead to a global recovery, given the leadership’s preference to avoid systemic financial risk. We insisted that constraints would prevail over preferences and the stimulus would be gigantic. Our “China Play Index” skyrocketed, though it did not outperform global equities (Chart 11). We also argued that President Xi Jinping would not face significant domestic unrest after the crisis erupted, though we view domestic political risk as underrated for the coming years. Chart 10Impeachment Failed Long Emerging markets and deep cyclicals recovered. The combination of Chinese stimulus and a US “return to normalcy” led us to go long emerging markets after the election. We articulated this trade by going long Trans-Pacific Partnership countries, on the expectation that Washington will remain hawkish toward China over trade (Chart 12). We also went long deep cyclicals and US infrastructure plays on the basis of Chinese stimulus and the Biden-Trump common denominator on building projects (Chart 13). Chart 11China Stimulated Massively Chart 12Long Trans-Pacific Partnership Worked As EM Play The Taiwan Strait was a bigger geopolitical risk than the Korean peninsula, which markets are at last recognizing (Chart 14). Unfortunately for investors Taiwan remains a serious geopolitical risk regardless of Trump’s exit. Hong Kong attracted investors’ attention more than Taiwan in 2020, whereas we have treated Hong Kong as a red herring. Chart 13Long Infrastructure And Cyclicals Paid Off Chart 14Hong Kong Was A Red Herring, Korea Beat Taiwan Brexit has been a red herring throughout 2020, as expected, though an end-of-year failure to agree to a UK-EU trade deal would upend our predictions (Chart 15). Chart 15Brexit Was A Sideshow Germany’s shift to more dovish fiscal policy strengthened European solidarity, keeping peripheral bond yields and “break-up risk” contained (Chart 16). In August 2019 we argued that Germany was easing fiscal policy but would not surge spending until a crisis happened – which proved to be the case when the coronavirus prompted Olaf Scholz to wheel out the “bazooka” this year. We also argued that Europe would be willing to mutualize debt, which was officially confirmed when outgoing Chancellor Angela Merkel forged an agreement on an EU Recovery Fund with French President Emmanuel Macron (though not exactly a “Hamiltonian moment”). Chart 16European Solidarity Strengthened Chart 17Peak Shinzo Abe' Theme Boosted The Yen Japan saw “Peak Abenomics,” which was confirmed this year when he handed the helm over to his deputy, Yoshihide Suga, whose policies are continuous. Abe’s late-2019 tax hike was only one of many reasons we anticipated a rally in the yen, which was supercharged by this year’s crisis (Chart 17). Russia’s political risk premium spiked, as we expected, though we did not anticipate that the cause would be a temporary breakdown in OPEC 2.0 (Chart 18). We were more prepared for an event like the poisoning of Alexei Navalny and US sanctions against the Nordstream II pipeline. Our argument that Russia would lie low, for fear of domestic unrest, has so far borne out in the Belarus protests and the conflict in Nagorno-Karabakh. Whether it will continue to do so in the face of what will likely be a pro-democracy assault in eastern Europe from the US Democratic Party remains to be seen. Chart 18Russian Geopolitical Risk Spiked As Predicted India-China tensions were a red herring. India benefited from the western world’s turn against China. Partnerships and alliances were already taking shape before the coronavirus spurred a move in the West to diminish reliance on China’s health care exports. Our long Indian pharmaceuticals trade was highly profitable, though our overweight in Indian bonds was less so (Chart 19). Chart 19India Benefited From West's Anti-China Turn Brazilian political risk surged to the highest levels since the 2018 election, and President Jair Bolsonaro suffered a setback in municipal elections, as we expected, especially after witnessing his cavalier attitude toward the pandemic (Chart 20). However, his approval rating rose on the back of fiscal largesse, implying that debt dynamics will continue to trouble this market despite the bullish backdrop for emerging markets in 2021. Chart 20Brazil Remained A Muddle Chart 21Turkish Populism Exacted A Toll Chart 22A Bull Market In Iran Tensions The Turkish lira collapsed, as Turkish President Recep Erdogan maintained reckless domestic economic policies and foreign adventurism (Chart 21). As we go to press, Erdogan appears to be backing down from his aggressive approach to maritime-territorial disputes in the Mediterranean, for fear of European sanctions, which would be a positive surprise, albeit temporary. The “bull market in Iran tensions” continued, with US-Israeli sabotage and assassinations of key Iranian figures bookending the year (Chart 22). With Trump still in office for another 45 days, we would not be surprised to see another move on Iran, where hardliners are ascendant in the unstable advance of the Supreme Leader Ali Khamenei’s eventual succession. So far, Trump has taken market-negative actions in his “lame duck” period on Iran, China, and Big Tech, as we argued, which means more is coming despite the market’s enthusiasm over the partly sunny outlook for 2021. Investment Takeaways Geopolitical analysis is about structural themes and trends – not unpredictable black swans, which may even further entrench structural trends. When a crisis triggers a massive selloff, buy risk assets, then reassess. The gargantuan, coordinated monetary and fiscal response to this year’s crisis presented a clear buy signal. Once the virus was revealed not to be as deadly as first suspected, the rally gained steam. Political and geopolitical forecasts may be dead-on and yet fail to drive the market. There is a constant need to refine the ability to articulate and implement trades that seek to generate alpha from policy insight. Tactical views and attempts at cleverness are a liability when one’s strategic views – geopolitical, macro-economic, financial – are firmly grounded. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Thomas L. Friedman, "Biden Made Sure ‘Trump Is Not Going To Be President For Four More Years,’" New York Times, December 2, 2020, nytimes.com.
The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021. Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices. Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months. Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes. Chart 6Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector. Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021. Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21. Chart 24Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%. 3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations
Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Dear Client, Instead of our regular report next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. We will be back the week after with the GIS quarterly Strategy Outlook, where we will explore the major investment themes and views we see playing out in 2021. Best regards, Peter Berezin, Chief Global Strategist Highlights While a vaccine, ironically, could dampen economic activity in the near term, it will pave the way for faster growth in the medium-to-long term. Inflation is unlikely to rise much over the next two-to-three years. However, it could gallop higher later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative. Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is on the back foot, and social cohesion is fraying. The lackluster pace of productivity growth suggests that innovation is not occurring as fast as many people think. Rather, what seems to be happening is that the nature of innovation is changing in ways that are a lot more favorable to Wall Street than Main Street. Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future. Investors should remain overweight stocks for the next 12 months, while shifting equity allocation away from growth companies towards value companies and away from the US towards the rest of the world. The Waiting Game This week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak (Chart 1). In the US, there are faint indications that the number of new cases is stabilizing, especially in the hard-hit Midwest (Chart 2). Chart 1Covid Cases In Europe: Past The Worst Chart 2Covid Cases In The US: Approaching The Peak Of The Third Wave? Nevertheless, it is too early to breathe a sigh of relief. As with other coronaviruses, SARS-CoV-2 spreads more easily in colder temperatures. Moreover, this week is Thanksgiving in the US, and with the holiday season approaching in the wider world, there will be more opportunities for the virus to propagate. Chart 3The US May Have To Follow Europe In Tightening Lockdown Measures Despite the cresting in new cases, the absolute number of confirmed daily infections remains extremely high. The 7-day average currently stands at about 175,000 in the US. Adjusting for the typical three-week lag between new cases and deaths, the case-fatality rate is approximately 1.8%. The CDC estimates the “true” fatality rate is 0.7%.1 This implies that for every one person who tests positive for Covid-19, 1.5 people go undetected. Thus, around 450,000 Americans are catching Covid every day. That is 3.2 million per week or about 1% of the US population. Other estimates from the CDC suggest that the true number of new infections may now be even greater, perhaps as high as 11 million per week.2 Unlike in Europe, where governments have implemented a series of stringent lockdown measures, the US has taken a more relaxed approach (Chart 3). If the number of new infections fails to fall much from current levels, more US states will have to tighten social distancing rules. The availability of vaccines will pave the way for stronger growth in the medium-to-long term. Ironically however, as we pointed out two weeks ago, vaccine optimism could dampen economic activity in the near term. With the light clearly visible at the end of the tunnel, more people may choose to hunker down to avoid being infected. After all, how frustrating would it be to contract the virus just a few months before one can be vaccinated? It is like being the last guy shot on the battlefield in a war that is drawing to an end. The Outlook For Inflation Could inflation make a comeback once a vaccine is widely available? The pandemic put significant downward pressure on prices in a number of areas, particularly air transport, accommodation, apparel, and gasoline. While prices in some categories, such as used cars, meats and eggs, and certain toiletries did rise briskly, the net effect was still a substantial decline in overall inflation (Chart 4). Chart 4The Impact Of Covid On US Inflation Core PCE inflation stood at 1.4% in October, well below the Fed’s target. As Chart 5 illustrates, core inflation is below central bank targets in most other economies as well. A bounce back in prices in the most pandemic-afflicted sectors should lift inflation over the next six months. Our US bond strategists expect core PCE inflation to peak at 2¼% in the second quarter of next year, before falling back below 2% by the end of 2021. Chart 5Core Inflation Below Central Bank Targets Chart 6Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Ignoring the temporary oscillations in inflation due to base effects, a more sustained increase in inflation would require that labor market slack be fully absorbed. In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the major economies would fall back to its full employment level by around 2025 (Chart 6). While a vaccine will expedite the healing of labor markets, it is probable that unemployment will remain too high to generate an overheated economy for the next three years. What about beyond then? The fact that long-term bond yields are so low today implies that most investors think that inflation will remain subdued for many years to come (Chart 7). This is confirmed by CPI swaps, which in some countries go out as far as 50 years. For the most part, they are all trading at levels below official central bank inflation targets (Chart 8). Chart 7Long-Term Bond Yields Are Depressed... Chart 8… As Are Long-Term Inflation Expectations Heading Towards The Kink Is inflation really dead, or is it just dormant? We think it is the latter. Contrary to the claim that the Phillips curve has become defunct, Chart 9 shows that the wage version of the Phillips curve – which compares wage growth with the unemployment rate – is very much alive and well. What is true is that rising wage growth has failed to translate into higher price inflation in most economies since the early 1980s. However, this may have simply been due to happenstance: Every time the global economy was starting to heat up to the point that a price-wage spiral could develop, something would happen to break it. In 2019, the unemployment rate in the G7 hit a 46-year low. Perhaps inflation would have accelerated this year had it not been for the pandemic? Likewise, inflation might have risen in 2008 had it not been for the financial crisis, and in 2001 had it not been for the dotcom bust. Chart 9Is The Phillips Curve Really Dead? Chart 10Inflation Reached The ''Kink'' In 1966 Rather than being defunct, the price-version of the Phillips curve may turn out to be kinked at a very low level of the unemployment rate. Such was the case during the 1960s (Chart 10). US core inflation remained steady at around 1.5% in the first half of that decade, even as the unemployment rate drifted lower and lower. In 1966, with the unemployment rate nearly two percentage points below NAIRU, inflation blasted off, doubling to more than 3% within a span of six months. Core inflation would go on to increase to 6% by 1969, setting the stage for the stagflationary 1970s. A Less Deflationary Structural Backdrop Many pundits argue that the structural backdrop for inflation is vastly different today than it was during the 1960s, making any comparison with that decade next to worthless. They point out that unions had a lot more power back then, global supply chains were underdeveloped, and rapid population growth was creating more demand for goods and services than the economy could supply. We have addressed these arguments in the past and will not belabor the point this week other than to note that all three of these structural forces are now in retreat.3 Chart 11The Heyday Of Globalization Is Behind Us Granted, unions are not as powerful as they were in the 1960s. However, public policy is still moving in a more worker-friendly direction. Witness the fact that Florida voters, despite handing the state to President Trump, voted 61%-to-39% to raise the state minimum wage in increments from $8.56 an hour to $15 by 2026. Joe Biden has also pledged to hike the federal minimum wage to $15 from its current level of $7.25. Meanwhile, globalization is on the back foot, with the ratio of trade-to-output moving sideways for more than a decade (Chart 11). At the same time, baby boomers are departing the labor force en masse. Rather than remaining net savers, these retiring workers will become dissavers. This means that the global savings glut, which has suppressed interest rates and inflation, could begin to dry up. Perhaps most ominously, social stability is at risk of breaking down. Homicides in the US have risen by nearly 30% so far this year compared to the same period a year ago.4 Historically, the institutionalization rate has tracked the homicide rate quite closely (Chart 12). As was the case in the 1960s, a lot of the well-meaning discussion about criminal justice reform today could turn out to be counterproductive. Perhaps it was just a coincidence, but it is worth remembering that inflation exploded in the 1960s at exactly the same time that the murder rate shot up (Chart 13). Chart 12Dramatic Drop In Institutionalization Rate During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Chart 13Social Unrest Can Fuel Inflation The Role Of Innovation Technological innovation has been routinely cited as a driver of falling inflation. In many ways, this is rather odd. Economic theory states that faster innovation should lead to higher real income. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Moreover, the fixation on technology as a deflationary force is a bit strange considering that measured productivity growth has been exceptionally weak in most advanced economies over the past 15 years – weaker, in fact, than it was in the 1970s (Chart 14). Chart 14US Productivity Has Been Exceptionally Weak Over The Past Ten Years How, then, does one explain why tech stocks have fared so well? One often-heard answer is that productivity growth is mismeasured. We examined this argument carefully in our report entitled Weak Productivity Growth: Don't Blame The Statisticians, concluding that this does not appear to be the case. A more plausible answer is that while the pace of innovation has not sped up, the nature of innovation has changed dramatically in ways that have helped Wall Street a lot more than Main Street. The True Nature Of Corporate Profits Standard economics textbooks regard profit as a return on capital. This implies that if the price of capital goes down, firms should respond by increasing investment spending in order to further boost profits. In practice, that has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. While business investment did rise in 2018, this was all due to a rebound in energy spending. Outside of the oil and mining sector, business investment grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 15). Likewise, neither falling interest rates nor rising stock prices – two factors that should produce a lower cost of capital – have done much to buoy investment spending in recent years. Chart 15Overall Capex In 2017-2019 Was Boosted By The Oil And Mining Sector Chart 16A Winner-Takes-All Economy Why did the standard economic relationship between investment and the cost of capital break down? The answer is that the traditional approach does not take into account what has become an increasingly important driver of corporate profits: monopoly power. A recent study by Grullon, Larkin, and Michaely found that market concentration has increased in 75% of all US industries since 1997.5 Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times that of the median firm, a massive increase from the historic average of two times (Chart 16). The dispersion in performance has been particularly stark within the tech sector. According to BCA Research’s proprietary Equity Analyzer, the shares of “value tech” companies – that is, companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales – have not only lagged the shares of other tech companies, but they have also lagged the shares of similarly valued financial companies (Chart 17). This underscores the point that the outperformance of growth stocks over the past 12 years has not just been a story about technology. Rather, it has primarily been a story about some tech companies doing much better than other tech companies. Chart 17Value Tech Lagged Value Financials The Winner-Take-All Economy What explains the bifurcation in performance within the tech sector? Two reasons come to mind. First, tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. The role played by winner-take-all markets explains how a handful of companies were able to become mega-cap tech titans. Chart 18 and Chart 19 show that increased monopoly power, as reflected in rising profit margins and higher relative P/E ratios, has played a greater role in driving tech share outperformance since the mid-1990s than faster revenue growth. Chart 18Decomposing Tech Outperformance (I) Chart 19Decomposing Tech Outperformance (II) Reaching Adulthood History suggests that monopolists tend to experience an initial rapid growth phase in which they capture ever-more market share, followed by a mature phase where they effectively function as utilities – cranking out stable cash flows to shareholders without experiencing much further growth. While it is impossible to say how far along most of today’s tech leaders are in this cycle, it does appear that the period of rapid growth for many of them may be drawing to a close. As it is, close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. The shift away from “growth status” towards “utility status” for some tech monopolists could prompt investors to trim the valuation premium they assign to these stocks. In addition, it could lead to increased regulation by governments to ensure that monopoly power is not abused. This could further depress valuations. Monopolies And Inflation What about the implications for inflation? Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output could depress selling prices, thus leading to lower profit margins. As my colleague Mathieu Savary has emphasized,6 this implies that rising market power could simultaneously increase profits while reducing investment in new capacity. At least initially, this could be deflationary in two ways: First, lower investment spending will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. This helps explain why falling real interest rates and rising profits have failed to trigger an investment boom. Further down the road, the impact of monopoly power on inflation could turn on its head. Less investment spending will curb potential GDP growth, making it easier for economies to run up against capacity constraints. Low real interest rates could also induce governments to run larger budget deficits, boosting aggregate demand in the process. Finally, an economy where monopoly power runs unchecked will eventually spur a populist backlash, leading to reflationary policies that favor workers over business oligarchs. Investment Conclusions Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 20). Given the likelihood that economic growth could surprise on the downside in the near term, equities are vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Chart 20A Lot Of Bullishness Chart 21European Banks: A Low Bar For Success Equity investors should shift their allocation away from growth stocks towards value stocks and away from the US towards the rest of the world. We like European banks in particular. They currently trade at 0.6-times tangible book value and 7.2-times 2019 earnings. Earnings estimates for 2021 have been slashed but should rebound on the expectation of a vaccine-driven growth recovery later next year (Chart 21). Faster growth should produce a modest steepening in yield curves, boosting net interest margins in the process. Faster growth should also lead to stronger credit demand while reducing bad loans. Looking further out, this week’s report argues that inflation could accelerate meaningfully once unemployment returns to pre-pandemic levels in about two-to-three years. The departure of baby boomers from the labor market, sluggish productivity growth, fraying social cohesion, and a backlash against monopoly power could all push up inflation. These forces could also create a more challenging environment for stocks, particularly today’s mega-cap tech names. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. 2 Please see “Covid live updates: CDC estimates only eighth of infections counted,” NBC News Live Blog, November 25, 2020; and “The Latest: South Korea has most daily cases in 8 months,” Associated Press, November 26, 2020. 3 Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” October 25, 2019; Special Reports “1970s-Style Inflation: Could It Happen Again? (Part 1),” and “1970s-Style Inflation: Could It Happen Again? (Part 2),”dated August 10 and 24, 2018; and Weekly Report, “Is The Phillips Curve Dead Or Dormant?” dated September 22, 2017. 4 Please see this Twitter thread on the latest data from the 100 largest US cities by Patrick Sharkey, Professor of Sociology and Public Affairs at Princeton University. 5 Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are US Industries Becoming More Concentrated?” Oxford Academic, Review of Finance (23:4), July 2019. 6 Please see The Bank Credit Analyst Special Report, “The Productivity Puzzle: Competition Is The Missing Ingredient,” dated June 27, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights President Trump’s final actions and the US fiscal impasse pose non-trivial risks to the rally. Biden’s foreign policy cabinet picks have limited impact but are mildly positive for now. Biden’s multilateralism will eventually conflict with the need to get things done. Continuities with Trump foreign policy are underrated. The RCEP trade agreement is not a game changer but a pro-trade shift in the US would be. Europe is a clear winner of the US election but continental politics risk will pick up next year from today’s lows. Book profits on select risk-on trades, but go strategically long GBP-EUR. Feature Global financial markets are surging on a raft of good news. We are booking some gains as we expect the rally to be capped in the near term either by Trump’s final actions as president or by the US fiscal impasse. First, the good news. The US power transition is officially under way, reducing US policy uncertainty. The popular vote within the critical battleground states acted as a restraint on the Republican Party’s ability to dispute the results or appoint Republican electors to the Electoral College.1 Chart 1US And Global Policy Uncertainty Falling President-Elect Joe Biden is preparing the US for a return to rule by experts. This will not prevent grand policy errors in the future but it will give confidence to the market today. Biden is nominating a slate of White House advisers and cabinet members who are traditional Democrats or left-leaning technocrats. For example, former Fed Chair Janet Yellen looks to serve as Treasury Secretary, longtime Biden and Barack Obama adviser Anthony Blinken as Secretary of State, and former Hillary Clinton and Obama staffer Jake Sullivan as national security adviser. Biden may nominate a few far-left officials (e.g. for the Labor Department) but the most important positions are quickly filling up with conventional faces, a boon for financial markets. Democrats are unlikely to win control of the Senate on January 5 but even if they do their single-vote majority will probably be too small to enable any radical cabinet picks – or radical legislation.2 The downside is that spending will be constrained and monetary and fiscal policy will remain uncoordinated, regardless of Yellen’s unique ability to work with Fed Chair Jay Powell. With Biden reportedly leaning on House Democrats to cut a COVID fiscal relief deal, there is a 50/50 chance that a $500-$750 billion bill passes in the “lame duck” session of Congress prior to Christmas. This would be a positive surprise. We are not counting on a deal until the first quarter next year. Hence US policy uncertainty will remain elevated. Meanwhile global policy uncertainty could spike again as long as President Trump remains in office and seeks to achieve policy objectives on the way out. Biden does not take office until January 20, but over a 12-month horizon we see a clear case for cyclical sectors and European stocks to outperform defensive sectors and American stocks as a result of Biden’s trade peace dividend, i.e. eschewing sweeping unilateral tariffs (Chart 1). Chart 2Vaccine On The Horizon While COVID-19 spikes, consumer wariness, and partial lockdowns will weigh on fourth quarter economic activity, several vaccines are on the way. The latest wave of the outbreak is already rolling over in Europe, which bodes well for the United States (Chart 2). Again, the 12-month outlook is brighter than the near term. Over the long haul, investors also have reason to be optimistic about governance in the developed world. The takeaway from this year is that the US and UK, the two major developed markets that saw right-wing populist movements win big votes in 2016, and two governments whose handling of the pandemic was at best muddled, led the development of vaccines in record time to deal with an entirely novel coronavirus and global pandemic.3 The US constitutional system withstood a barrage of partisan assaults both from President Trump and his supporters and their opponents. The British constitutional system is handling Brexit. Most other developed markets also navigated the crisis reasonably well. Weaknesses were revealed, and there will be aftershocks, but the sky is not falling. Near term US policy uncertainty will remain elevated due to fiscal impasse. Bottom Line: The rise in global risk assets may overshoot on positive news, but the US fiscal impasse could undercut the rally, as could Trump’s parting actions over the next two months. Market Not Priced For Lame Duck Trump There is a fair chance of an American or Israeli surgical strike against Iran or its militant proxies to underscore the red line against nuclear weaponization. Financial markets are not prepared for a major incident of armed conflict. Neither Israeli nor UAE equities are priced for near-term risks to materialize. The same goes for UAE or Saudi credit default swaps (Chart 3). An even greater risk to financial markets comes from the Trump administration’s pending actions on China. Trump is highly likely to take punitive or disruptive actions against China. His major contribution to US foreign policy is the confrontation with China, which was also the origin of the coronavirus and hence his electoral defeat. Already since the election Trump has imposed sanctions on US investments in state-owned enterprises. China’s fiscal and quasi-fiscal stimulus is peaking at the moment. This provides some buffer for its economy and the global economy if Trump hikes tariffs or imposes sweeping sanctions. But there are signs of instability beneath the surface. Authorities have tightened interbank rates sharply and intervened to prevent asset bubbles. The country is seeing turmoil in the bond market as a result of these actions and ongoing economic restructuring (Chart 4). Chart 3Risk Of US Or Israeli Strike On Iran Chart 4Chinese Stimulus And Bond Market Volatility Once again the market is not prepared for another major shock in the US-China relationship. The People’s Bank has allowed the renminbi to appreciate drastically this year. This trend will reverse if President Trump punishes China. As China’s economic momentum wanes and a new US administration enters office, it would make sense to allow the currency to depreciate. After all, the Biden administration will expect the renminbi to appreciate just as all previous administrations have done, but the People’s Bank will not want the yuan to fall much below the ~6.2 level that prevailed just before the trade war started in early 2018 (Chart 5). Chart 5Renminbi Priced For Zero Trump Tariffs Biden’s Foreign Policy: Continuities With Trump It is too soon to speak of the “Biden Doctrine.” Cabinet appointments will have limited impact relative to geopolitical fundamentals. Neither Biden nor Blinken have a consistent theme to their foreign policy decisions. Michèle Flournoy may or may not be nominated as Defense Secretary. What is clear is that Biden is in favor of establishment national security policymakers who want the US to work more closely with allies and international institutions. Starting in January, this shift will make US foreign policy somewhat more predictable. On Iran, Biden will seek to rejoin the 2015 nuclear deal prior to the June 18, 2021 Iranian presidential election, but he will also have reason to sustain the Arab-Israel rapprochement that the Trump administration initiated via the Abraham Accords. News reports indicate that Israeli Prime Minister Bibi Netanyahu met with Saudi crown prince Mohammad bin Salman along with US Secretary of State Mike Pompeo in a “secret” meeting on November 23. The Saudis could eventually normalize ties with Israel, but only once an Israeli-Palestinian settlement is reached. The Democrats have a long-running interest in negotiating such a settlement. Progress can be made as long as the Saudis and Israelis do not try utterly to sabotage Biden’s Iran deal. They would risk isolation from American support – an intolerable risk for both states. An American détente with Iran combined with normalized Arab-Israeli relations would create something resembling a balance in the region, which is what the Biden administration needs in order to maintain the “pivot to Asia” that will be its dominant foreign policy agenda. Biden’s pivot to Asia will start with a diplomatic “reset” with China so that strategic dialogue can resume and areas of cooperation can be identified. As Chart 5 above shows, the market is priced for Biden to reduce tariffs back to their September 2018 level (25% on $50 billion of imports and 10% on $200 billion). Anything is possible, since tariffs are an executive decision, but we would not bet on Biden sacrificing all of his leverage when the US-China strategic tensions are fundamentally rooted in the US’s loss of global standing and China’s rejection of the liberal world order. What is clear is an emerging contradiction that Biden will eventually have to resolve between multilateralism and getting things done. The Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. If Biden relies on multilateral diplomacy to update and extend the Iranian nuclear deal, he will find it much more difficult to gain Russian and Chinese cooperation than Obama did. Russia’s interference in the 2016 election and Trump’s trade war have poisoned the well. If Biden does not give enough ground to get Russo-Chinese cooperation, then he will have to use unilateral American power (i.e. Trump’s maximum pressure policy) or just settle for rejoining the 2015 nuclear deal without any safeguards against ballistic missiles or militant proxies. The original deal expires in 2025. Chart 6Greater China Still Center Of Geopolitical Risk The same goes for Biden’s handling of Trump’s China policy. Biden wants to revive the World Trade Organization. But if he adheres to the WTO then he will have to rescind all of Trump’s tariffs, since they have been declared illegal. This will reduce his leverage on unresolved structural disagreements. Biden wants to reach out to the allies on how to handle China. It is not clear how he will respond to the Trump administration’s outgoing scheme to create an alliance of liberal democracies that would arrange to purchase each other’s goods and possibly implement counter-tariffs in response to Chinese boycotts, such as the one placed on Australia today. Biden may not adopt the scheme. But the alternative would be to leave states to succumb to China’s political boycotts, thus failing to build an effective multilateral response to China’s aggressive foreign policy. China’s fourteenth five-year plan reveals that the Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. Thus we expect the Biden administration to conduct a foreign policy that is tougher on China than the Obama administration, that retains most of the Trump tariffs and tech sanctions, and that more resolutely attempts to build a coalition to pressure China into adopting international liberal norms. This policy trajectory virtually ensures that Biden will have to adopt some of Trump’s policies. Chinese equities are not priced for this risk. The pronounced risk of a fourth Taiwan Strait crisis is just starting to be recognized (Chart 6). The risk to our view is a grand US-China re-engagement. This is possible, but we think the current trajectory of China will cause a new confrontation even if Biden is less hawkish than Trump. Bottom Line: Financial markets are underrating Chinese/Taiwanese political and geopolitical risks, both from Trump’s lame duck period and from Biden’s pivot to Asia. Did China Just Take Charge Of Global Trade? Several clients have written to ask us about the Regional Comprehensive Economic Partnership (RCEP), a large new free trade agreement (FTA) signed by China and its Asian trading partners. RCEP is not a game changer but it is marginally positive for the global economy. Moreover it has the potential to ignite a new round of trade agreements, for instance by provoking the US (and the UK) to join the Trans-Pacific Partnership. RCEP is a traditional free trade agreement that will cut tariffs by an average of 90% for its members. Membership includes China, Japan, South Korea, the Association of Southeast Asian Nations (ASEAN), Australia, and New Zealand. It has not been ratified and will take ten years to fully implement after ratification. Over the past 30 years, manufacturing-oriented East Asian nations have reflexively responded to global shocks and slowdowns by deepening their trade integration. RCEP shows that this trend remains intact. China is the only member of the pact that is seeing trade grow at the moment – the others are still seeing declines due to the global recession but are hoping to increase nominal growth by removing trade barriers (Chart 7). RCEP is also notable because it is China’s second multilateral trade deal (the first was the China-ASEAN FTA). Beijing normally prefers bilateral deals where its size gives it the advantage, but it is trying to demonstrate greater willingness to work multilaterally. President Xi Jinping has rhetorically positioned himself as an advocate of free trade and multilateralism on the global stage, despite his pursuit of import substitution and state industrial subsidies at home. As long as China continues expanding trade with others it will smooth the painful restructuring of its manufacturing sector and blunt some of the criticisms about mercantilism. Ironically it is Japan’s decision to join, rather than China’s, that makes RCEP distinct. Japan did not have an FTA with South Korea and it was the only member of RCEP that did not already have a free trade deal with China. (Japan also lacked a deal with New Zealand.) This decision is not new but reflects the paradigm shift in Japanese national policy that began after the global financial crisis of 2008. In 2011, Japan signed an FTA with India. Thereafter Abenomics supercharged international trade and investment policies as part of the “third arrow” of pro-growth structural reform, which Abe’s successor Yoshihide Suga is continuing. So why is RCEP not a game changer? Because all of these countries other than Japan already have FTAs with each other and their tariff rates are already quite low. Moreover there is nothing particularly advanced about RCEP. It is a traditional deal focused on trade in goods and does not really attempt anything groundbreaking with services, or to incorporate new industries, lay down standards for labor or environment, or remove non-tariff barriers. Contrast the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the trade deal originated by the United States for Pacific Rim countries that attempts to do all these things, but was hobbled by the Trump administration’s decision to withdraw from it. The real significance of RCEP is that even as it shows continuity in Asian economic policy, with China at the center, it will also provoke new deal-making. Now that China, Japan, and South Korea are joining a single trade agreement, they will have a foundation on which to move forward with their long-delayed trilateral FTA. These developments will provoke the Biden administration into rejoining the CPTPP, which in turn would create a new higher standard type of trade bloc that has the potential to attract democracies into a high-standards bloc that excludes China. Biden will also revive the Transatlantic Trade and Investment Partnership (TTIP), the European counterpart to the Pacific deal. On the campaign trail, Biden said that he would “renegotiate” Trans-Pacific Partnership in order to rejoin it, a Trumpian formulation. This is feasible. After the US withdrawal, the various members of the Trans-Pacific Partnership modified the deal (dubbing it the CPTPP) to remove provisions that the US had insisted on and restore provisions that the US had demanded they remove. But they will gladly readmit the US now that Trump is gone, creating a trade bloc of comparable size to RCEP but with much more ambitious aims (Chart 8). The UK, South Korea, Thailand and others will be interested in joining. But China can only join if it embraces liberal reforms that are at odds with its new five-year plan, including reduced support for state-owned enterprises. Chart 7Weak Trade Prompts Asian Trade Deal Chart 8Putting RCEP Into Perspective The Republican Senate will be required to get approval for CPTPP, which is an obstacle, but Biden’s secret weapon is that the CPTPP has special appeal for Republicans precisely because it excludes China. Pro-trade moderates will find common cause with China hawks. As long as Trade Promotion Authority is renewed by the deadline on July 1, 2021, then the US can rejoin CPTPP on a simple majority vote. This is precisely how Republicans ratified Trump’s USMCA (the revised NAFTA). Trump also signed a trade deal with Japan, revealing that even under Trump’s leadership the US agreed to TPP-like deals with its biggest trading partners within the CPTPP (Canada, Mexico, Japan). More broadly, Trump’s experiment with protectionism has revealed that American attitudes toward global trade are not uniformly hostile. Polls show that Americans are generally pro-trade, and while they are skeptical that global trade creates jobs and higher wages, they are mostly skeptical of business-as-usual with China.4 Geopolitically, the US will not be able to stand idly by while China increases its sphere of influence in Asia. Therefore we should expect the Biden administration to pursue the CPTPP and other trade initiatives. The GOP Senate is the key constraint but it is not utterly prohibitive. Bottom Line: China and Asia continue to expand trade in the face of economic slowdown. The US Senate will be the key bellwether for US trade initiatives in 2021-22, but the geopolitical need to counter China will likely force the US to rejoin the CPTPP. Strategically we are long CPTPP equities – which includes some key RCEP members – as well as RCEP equities like South Korea. Chinese equities have already rallied a lot this year due to the country’s better handling of the pandemic and quicker economic recovery – they also face headwinds from US policy. Whereas emerging Asia equities ex-China, relative to all global equities, have plenty of catching up to do and will be beneficiaries of a global recovery in which both the US and China are courting them. Not Too Late To Go Long Pound Sterling The Brexit finale is approaching as the UK and EU enter the eleventh hour in their negotiation of a post-Brexit trade deal for the period after December 31, 2020. The market expects the UK, which is more dependent on EU trade than vice versa, to capitulate to an agreement that prevents a 3% tariff hike on all of its exports to the EU. This hike would occur if the UK-EU relationship reverted to WTO Most Favored Nation status. Boris Johnson promised in the Conservative Party manifesto to negotiate a trade deal and won a resounding single-party majority in December 2019. This gives him the room to marginalize hard Brexiteers and get a deal passed in parliament. The pound has rallied by 1.45% against the dollar since the beginning of the year and it is now rallying against the euro, moving off the “hard Brexit” lows (Chart 9), suggesting that the market is tentatively anticipating a trade deal. Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Failing to get a trade deal would require Johnson to break the EU withdrawal deal, since that deal requires a system of trade checks on the Irish Sea that introduces a barrier between Northern Ireland and the rest of the United Kingdom. Johnson has no incentive to stick to this deal if he does not have privileged access to the EU’s single market. But then a hard border of physical customs checks would arise on Northern Ireland’s border with the Republic of Ireland. This would not only aggravate relations with Ireland and the EU but would alienate the incoming American administration, which would view it as a violation of the US-brokered Good Friday Agreement (1998) and refuse to agree to a trade deal with the UK. Irish equities are not behaving as if a 3% tariff on all imports from the UK is about to take effect (Chart 10). Both GBP-USD and Irish equities have considerable downside if the deal falls through. The fact that the GBP-EUR appreciation is slight suggests less downside and more upside here. Subjectively we have argued there is a 35% chance that the UK will quit the EU “cold turkey” at the end of the year. The cost of more than $6 billion in foregone trade, which would grow each year, is not prohibitive. The economy is already subsisting on monetary and fiscal stimulus due to COVID-19. Boris Johnson does not face an election until 2024. The hardest limitation facing the UK is the relationship with Scotland. The hardest limitation facing the UK is the relationship with Scotland. Northern Ireland is not likely to leave anytime soon but 45% of Scots voted for independence in 2014. Support for independence meets resistance at 50% of the population (Chart 11), but an economic shock stemming from a failure to get a trade deal would push it above the limit (given that 62% of Scots never wanted to leave the EU in the first place). Chart 10Irish Equities Already Priced UK Trade Deal Chart 11Scotland Drives UK Toward A Trade Deal Johnson has the ability to conclude a deal, avoid an economic shock on top of COVID, keep the Scots in the union, and then set about overseeing his government’s mammoth economic recovery plan. His popularity is tenuous enough that the other pathway is not only more economically costly but also more likely to get him unseated and potentially to burden him with the legacy of being the last prime minister of a united kingdom. Bottom Line: It is not too late to go long GBP-EUR. A near-term global risk-off move would work against this trade but it is a strategic opportunity. Low EU Political Risk Will Pick Up In 2021 In our annual outlook for 2020 we highlighted how the EU was relatively politically stable while its geopolitical competitors – Russia, China, even the US – were far from stable. Today this is still the case – Europe’s political fundamentals are fine. But risks are rising due to partial COVID lockdowns, fiscal risks, and the approach of a series of important elections from now through 2022. A major problem for the global economy is the looming contraction in fiscal deficits in 2021 as economies step down from this year’s extraordinary fiscal stimulus measures. This downshift will be especially disruptive for the US, UK, and Italy due to the size of their stimulus packages, resulting in a fiscal drag of 5% of GDP if no additional measures are taken. But even Germany, France, and other EU members face at least a 2.5% of GDP contraction (Chart 12). Chart 12Europe's Fiscal Cliff Needs Attention Chart 12Europe's Fiscal Cliff Needs Attention Adding more fiscal support should be feasible in a world where the Fed and ECB are maintaining ultra-dovish monetary policy for the foreseeable future and the EU has agreed to allow mutualized debt issuances. Germany has embraced deficit spending in the wake of the austerity-laden 2010s, which brought significant populist challenges to the European political establishment. However, developed market economies are still highly indebted, a constraint on deficits, and those with political blockages could still have trouble passing large enough spending measures to remove the impending fiscal drag. The US faces gridlock in 2021 and therefore its fiscal cliff is a significant headwind to financial markets. One positive factor in providing fiscal support thus far is that, with the exception of Spain and the UK, European leaders and ruling coalitions have received a bounce in popular opinion this year (Chart 13). Chart 13EU Leaders’ Approval Bounced – Now What? Mark Rutte and his People’s Party for Freedom and Democracy (VVD) have benefited more than other countries but the combined support for opposition parties is rising ahead of the March 17, 2021 general election (Chart 14, top panel). A leading anti-establishment candidate has dropped out of the race. Fiscal measures will depend on the election. Chart 14Will EU Elections Really Be A Cakewalk? Chart 15European Risk To Rise On Looming Elections The German and French governments have also seen a bounce in support but need to maintain it for a longer period, as they have elections due by October 24, 2021 and May 13, 2022 respectively. French President Emmanuel Macron can still summon majorities in the National Assembly, despite losing his single party majority, and has sidelined his structural reform agenda to boost the economy. Germany is also capable of passing new measures, and has time to do so before momentum wanes amid the contest to succeed Chancellor Angela Merkel. The leadership race in the ruling Christian Democratic Union will at least raise hawkish rhetoric (Chart 14, middle panels). But markets will be placated by the fact that popular opinion is not pro-austerity at present, and the alternative to the CDU is a fiscally profligate left-wing coalition consisting of the Greens, Social Democrats, and possibly the anti-establishment hard-left, Die Linke. Spain and Italy have the least stable governments, are the likeliest to see snap elections, and thus could surprise the market with fiscal risks. Both governments lack a strong mandate and rule over a divided political scene. Italy’s Prime Minister Giuseppe Conte has seen a swell of support but he is a fairly non-partisan character and his coalition has been flat in opinion polling. It is less popular than the combined right-wing opposition, which is striving for power ahead of the fairly consequential 2022 presidential election. In Spain, not only has popular approval dropped, but the Socialist Party and the left-wing Podemos run a minority government, meaning that there is potential for gridlock to increase fiscal risk (Chart 14, bottom panels). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections (Chart 15). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections. The silver lining is that Brussels, Berlin, and the wider political establishment have become fundamentally more accepting toward budget deficits during times of distress. The ECB and European Commission Recovery Fund provide a combined monetary and fiscal backstop. Negative interest rates on debt enable fiscal largesse with minimum implications for sustainability. And none of these elections raise systemic risks regarding EU and EMU membership, other than conceivably Italy. So while fiscal risk will become more relevant in 2021, it is not a problem while COVID is still raging, and there are better chances of maintaining a fiscally proactive policy than at any previous time over the past two decades. Bottom Line: European elections and a looming fiscal drag will keep EU political risk from collapsing after the latest round of lockdowns ease. Biden And Emerging Market Strongmen Most of the emerging market strongmen – Recep Erdogan, Vladimir Putin, Jair Bolsonaro – have increased their popular support this year, benefiting from national solidarity in the face of crisis. The exception is Narendra Modi, who is struggling (Chart 16). Still, Modi has a single-party majority and four years on the election clock, and is thus more stable than Bolsonaro, who fundamentally lacks a political base despite his bounce in polls, and Erdogan, whose increase in support will fade amid a host of domestic and international challenges ahead of the 2023 elections. The US election will have limited impact on these leaders. None of them have good relations with the Democratic Party and some were openly pro-Trump. But this is only marginally negative and may not have concrete ramifications. The key is that the Biden administration will be more conducive toward a global trade recovery, will relax restrictions on immigration, will favor US diversification away from China, and will put pressure on authoritarian regimes. Chart 16Strongman Popularity Boost Will Fade Other things being equal, Biden is therefore positive for India, neutral for Brazil and Turkey, and negative for Russia. Our GeoRisk Indicators suggest that political risk has peaked for Brazil and Russia and equities could bounce back, but we think Russian political risk will surprise to the upside (Chart 17). Chart 17Political Risk Still High In Emerging Markets In the case of Russia, the Biden administration will take a more confrontational approach than previous presidents, including Obama and Bush as well as Trump. However, it still needs to rejoin the Iran nuclear deal and extend the New START (Strategic Arms Reduction Treaty) with Russia through 2026, so the pro-democracy pressure campaign will have to be balanced with negotiations. Russia, for its part, is increasingly focused on the need for domestic stability, at least until Biden makes concrete steps with NATO that threaten Russian core interests. Bottom Line: Emerging market political risk is high, the vaccine will arrive more slowly, and the Biden administration will take a tougher approach toward authoritarian regimes. This creates an opportunity for India but a risk for Russia, and is neutral for Brazil and Turkey. Strategically we are constructive on EM equities but in the near 0-3 month time frame all bets are off. Investment Recommendations With clear near-term political and geopolitical risks, and extremely elevated equity prices and sentiment, we think it is a good time to book some profits. We are closing our long global equities relative to bonds trade for a gain of 27%. Chart 18Reinitiate Long Global Aerospace/Defense Stocks We are closing our long investment grade corporate bonds relative to similarly dated Treasuries for a gain of 15%. We are closing our long China Play Index trade for a gain of 7% in recognition that China’s stimulus is nearing its peak while the Trump administration will take punitive measures in his final two months. We will also retain our long gold trade. Gridlock in the US government is not reflationary but gold is still attractive due to geopolitical risk. Strategically we recommend going long GBP-EUR. We also recommend reinitiating a strategic long position in defense stocks. Specifically, global aerospace and defense stocks relative to the broad market (Chart 18). We have been long defense stocks since 2016 but COVID decimated the trade. The coming vaccines promise to reboot the aerospace part of this trade while there was never any reason to doubt the strong basis for global defense spending amid geopolitical great power struggle. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com We Read (And Liked) … Black Wave “What happened to us?” Black Wave seeks to answer the cardinal question facing both Middle Easterners and those looking into the Middle East from the outside.5 It takes us back four decades to events that shaped the region and walks us through time and space, politics, religion, history and culture, to where we stand – in the crosshairs of the very clash that started it all. Few are better equipped than author Kim Ghattas in doing so. A native of Beirut, she grew up amid the Lebanese civil war, living the events that created the post-1979 Middle Eastern reality. Later, she spent two decades covering the Middle East as a journalist for the BBC and Financial Times. A term first coined by Egyptian filmmaker Youssef Chahine, “black wave” characterizes the religious tide that swept Egypt in the 1990s from the Persian Gulf – one that Chahine saw as alien to Egyptians. Instead he argued that while Egyptians had always been very religious, they also had joie de vivre – enjoying art, music, talent, all taboos according to the Wahhabi interpretation of Islam. Iranians in the late 1970s were not much different from Egyptians in the 1990s. At the time, they were unified in their opposition to the Pahlavi dynasty for being too Western and corrupt. As an exile in the sacred Iraqi city of Najaf and later in the French village of Neauphle-le-Chateau, Ayatollah Ruhollah Khomeini’s speeches were capable of inspiring minds, galvanizing support, and gathering crowds. He was the right character, at the right time, but with the wrong ideas. Ideologically, Khomeini was an outsider in Najaf. The Iraqi clergy considered him too politically involved and his vision of wilayat al-faqih – a state based on Islamic jurisprudence – did not have widespread appeal. It was dismissed as outlandish by those around him who aimed to take advantage of his widespread appeal for their own gains, while hoping to limit Khomeini’s ideological influence on his audience. This proved to be a grave disregard for Iranians. 1979 was also a transformative year for Saudi Arabia. The young monarchy faced a national awakening as Juhayman al-Otaybi staged a siege on the Muslim world’s most sacred site, the Grand Mosque in Mecca. It was the first act of terrorism in opposition to Western influence – the birth of Saudi extremism – and was echoed in subsequent acts of violence in the kingdom, in 1995 and later in 2003. Fearing the spread of political Islam, the House of Saud responded by emphasizing Wahhabism, Riyadh’s homegrown Islamic movement, by empowering clerics and religious authorities. The quid pro quo was that the clerics supported the monarchy from both internal and external threats. The clash between the Iranian Revolution and Saudi Wahhabism in 1979 gave rise to the first sectarian killings. The 1987 Sunni-Shia clash in Pakistan marked the beginning of the modern day Sunni-Shia divide, spreading through Pakistan and eventually the Middle East to Lebanon, Iraq, and Syria. Today, as youth across the Middle East struggle in despair of the aftermath of these events, Ghattas sees hope. Protests ringing from Beirut to Baghdad call for a post sectarian political system. The Saudi monarchy is relaxing its puritanical grip, and a new generation brings newfound hope of rectifying past miscalculations. We ultimately agree with Ghattas’s optimism that these changes are hopeful indications that the people of the Middle East are ready to shift gears and move past the conflicts that have dominated the past four decades. However, there are other forces at play and the Saudi-Iranian rivalry is still a dominant feature of the region’s geopolitical landscape. True, Ghattas’s account not only highlights how deeply engrained the conflict is, but also that the early signs of tidal shifts can be easily missed. But we cannot ignore the specter of near-term risk facing the Middle East that continue to challenge its economic and political ascent. Thus, from an investment standpoint, we favor a more cautious approach and remain on the lookout for a better entry point once the near-term manifestation of these long-standing hurdles are overcome. Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Supreme Court could still rule that Pennsylvania should have stuck with its November 3 deadline for ballots, but such a ruling would not change the outcome of the election. As with Florida following the disputed election in 2000, the various states’ electoral systems will likely be stronger as a result of this year’s polarized contest and narrow margins. 2 Biden could use the Vacancies Act or recess appointments to ram through his cabinet picks, but it would be controversial and at present he looks to be taking advantage of the Republican veto to nominate center-left figures that are more ideologically lined with his lane of the Democratic Party. 3 US-based Moderna developed one vaccine while US-based Pfizer and Germany-based BioNTech developed another. The Anglo-Swedish company AstraZeneca jointly developed its vaccine with Oxford University. Vaccine trials were administered across these countries and others, including South Africa, India, Brazil, and the entire global health care and pharmaceutical supply chain contributed. 4 See Pew Research. 5 Kim Ghattas, Black Wave: Saudi Arabia, Iran, and the Forty-Year Rivalry That Unraveled Culture, Religion, and Collective Memory in the Middle East (New York: Henry Holt, 2020), 377 pages. Section II: GeoRisk Indicators China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
Highlights US Corporates: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. Global Corporate Strategy: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Feature When looking at the 2020 year-to-date total returns from global corporate credit, the performance at first blush has not been terrible. The Bloomberg Barclays Global Investment Grade Corporate index has returned 8.2% since the start of the year, while the benchmark global high-yield index has returned 3.6%. While the bulk of those returns have come from duration exposure as global bond yields have fallen sharply, a passive allocation to corporate bonds on January 1 has been a money-making investment in 2020. Chart of the WeekUS Credit Markets Need Less Policymaker Support Of course, a lot has happened since the beginning of the year. A global pandemic, a historically severe global recession, a massive selloff of risk assets in February and March and an equally robust recovery of equity and credit markets on the back of huge monetary and fiscal stimulus. It should come as no surprise that the 2020 peak in US corporate bond spreads occurred on March 23 – the day that the Fed and US Treasury introduced asset purchase vehicles designed to support stricken US credit markets. This is why the announcement last week that outgoing US Treasury Secretary Steve Mnuchin has decided to let those emergency lending facilities expire on December 31, with the Fed returning the US Treasury’s capital invested in those programs, is potentially of major significance for credit investors. It is reasonable to think that credit markets could suffer without the Fed’s involvement. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. The US economy remains surprisingly resilient, with the November flash estimate for the Markit composite PMI index reaching the highest level since 2015. This occurred even in the midst of a huge surge of global COVID-19 cases that has weighed heavily on European economies (Chart of the Week). Add to that signs that corporate bond markets are functioning smoothly - investors are willing to commit capital to credit markets, and borrowers are having no problem placing large volumes of debt at low yields and spreads – and it is easy to conclude that Fed’s explicit support is no longer required. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. From the point of view of corporate bond investment strategy, we continue to recommend a moderate overweight stance on global corporate debt versus government bonds over the next 6-12 months, favoring US investment grade and high-yield over European equivalents, even with the Fed pulling away its bid. Steve Mnuchin May Have A Good Point Even though Fed Chair Jerome Powell publicly disagreed with Treasury Secretary Mnuchin’s decision, the Fed will shut down the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, the Term Asset-Backed Loan Facility, the Municipal Liquidity Facility and the Main Street Lending Program on December 31. Those facilities are part of the US government support programs under the Coronavirus Aid, Relief and Economic Security (CARES) Act. The US Treasury seeded the facilities with $195 billion in capital, which the Fed levered up to create as much as $2 trillion in buying power (Table 1). Yet the actual usage of that spending capacity has been quite low, with only $13.3 billion spent in the Fed’s secondary market facility. Not a single dollar was spent in the primary market facility, as companies had no problems issuing debt directly to markets rather than selling new bonds to the Fed. Table 1US CARES Act Programs: Little-Used, But Highly Successful According to data from the Securities Industry and Financial Markets Association (SIFMA), the pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years (Chart 2). This occurred after a surge of issuance activity in Q2 as issuers took advantage of the vastly improved trading conditions in corporate bond markets after the initiation of the Fed’s liquidity backstop. Treasury Secretary Mnuchin noted these trends in his letter to Fed Chair Powell that was essentially an order to shut down the Fed’s emergency lending facilities.1 Chart 2US Credit Markets Are Functioning Normally Chart 3No Stomach For Nation-Wide Lockdowns In The US US credit markets are not only functioning well, so is the US economy. The Markit US services PMI rose in November to 57.7 (from 56.9 in October), while the same index fell to 41.3 (from 46.9) in the euro area and 45.8 (from 51.4) in the UK (Chart 3). As services industries like dining, travel and retail spending are most directly impacted by lockdowns related to COVID-19, it should not be a surprise that the data underperformed massively in Europe, where severe economic restrictions have been imposed to slow the spread of the virus. This compares to the US where the restrictions have been far more modest and varying across cities and regions. The pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years. Some slowing of US domestic economic activity should be expected over the next month or two, with more parts of the country putting greater restrictions on activities like indoor dining and in-person schooling. However, the political will to impose the sort of harsh nation-wide “shelter at home” type lockdowns currently in place in Europe is simply not there in the US after the shock of the Q2 lockdown-induced economic slump. US growth should thus continue to outperform – to the benefit of US corporate bond market performance relative to US Treasuries and European corporate equivalents. US corporate bond yields, both for investment grade and high-yield credit, have already declined massively in 2020, as have yields for European credit and even emerging market bonds (Chart 4). Given our view that US Treasury yields have bottomed and will likely drift higher over the next 6-12 months, it will be difficult to see further declines in corporate bond yields that are already near record lows. Chart 4Corporate Yields Falling To New Lows Chart 5Corporate Spreads Approaching 2020 Lows Corporate bond spreads, on the other hand, do have room to compress even just to levels seen before the February/March credit market rout – especially for US high-yield. The option-adjusted spread (OAS) for the Bloomberg Barclays US investment grade index is now 17bps away from the 2020 low, while the OAS for the euro area and UK are 7bps and 8bps away, respectively. For high-yield, the US index OAS is 107bps above the 2020 low, compared to 95bps for euro area high-yield and 81bps for UK high-yield (Chart 5). The near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Given the severity of the lockdown-induced economic slump in the euro area and UK, which is likely to linger over the holiday season and into the early part of 2021, the near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Bottom Line: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. A Quick Look At Corporate Bond Spread Valuations In The US & Europe The tremendous rally in global corporate bond markets since late March has pushed credit spreads down to levels that raise concerns about valuations. Thus, it is now a good time to revisit some of our favorite spread valuation metrics. One simple way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX index. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. Chart 6US Corporate Spreads Look Tight Vs Equity Vol Chart 7Euro Area Corporate Spreads Look Tight Vs Equity Vol We show the ratio of the US investment grade and high-yield index OAS to the VIX index in Chart 6. For both higher-quality and lower-rated corporate credit, the spread-to-VIX ratio is now close to the lowest level seen since 2000 – both around 1.7 standard deviations below the long-run mean – suggesting that spreads are tight relative to overall macro volatility We show similar ratios for euro area corporates versus the VStoxx European equity volatility index in Chart 7, and UK corporates versus the IVI UK equity volatility index in Chart 8. The conclusions are similar to US credit, with spread-to-volatility ratios for both investment grade and high-yield now at low levels, one standard deviation below the mean since 2000. Chart 8UK Corporate Spreads Look Tight Vs Equity Vol Chart 9Notable Duration Differences Between Corporates It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. Thus, we need to look at other valuation tools. Our more preferred metric to assess credit spreads is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that must occur for a credit product to have a return equal to a duration-matched, risk-free government bond over a one-year horizon. We look at the historical percentile ranking of the 12-month breakeven spreads to determine how current levels compare with the past. It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. To calculate the 12-month breakeven spreads for corporate bonds, we take the ratio of the index OAS to the index duration for the specific bond market in question. This allows a comparison of breakeven spreads across different markets with varying risks, with duration being a main source of price risk (Chart 9). The 12-month breakeven spreads for the investment grade and high-yield corporate debt for the US, euro area and UK are shown in Charts 10, 11 and 12, respectively. For the US, the breakeven spread for investment grade corporates is currently in the bottom decile of its history, suggesting that the spread does not look particularly attractive on a risk-adjusted basis. Chart 10US Corporate Bond Breakeven Spread Percentile Rankings Chart 11Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 12UK Corporate Bond Breakeven Spread Percentile Rankings Euro area and UK investment grade breakeven spread percentile rankings are a bit higher than in the US, right on the cusp of the bottom quartile for both. Although for euro area corporates, the breakeven spread is boosted by the much lower duration of the euro area investment grade index and does not necessarily suggest that spreads there are currently more attractive than in the US and UK. Turning to junk bonds, the US high-yield 12-month breakeven spread is currently in the 67th percentile of its own history, suggesting that spreads are relatively attractive. The UK high-yield breakeven spread is also above average, with the latest reading in the 55th percentile. Euro area high-yield is the least attractive, with the latest 12-month breakeven spread in the 33rd percentile of its own history. Taking the 12-month breakeven spread as a measure of value (and, hence, a gauge of prospective future returns), we can compare it to a measure of spread volatility to evaluate the risk/return tradeoff for various credit markets. To measure spread risk, our preferred metric is duration times spread (DTS). We show a scatter chart of the latest 12-month breakeven percentile ranking for the overall US, UK and euro area corporate bond markets – for investment grade and high-yield, and including all the major credit rating tiers – in Chart 13. The most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Chart 14A Lingering Positive Impact On Credit Markets From Global QE What stands out in the chart is that the most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). At the other end of the spectrum, US investment grade offers one of the least attractive risk/reward tradeoffs. This suggests a potential attractive opportunity to move down in quality within US corporate debt, particularly with ultra-accommodative global monetary policies providing a lingering tailwind for global corporate bond performance over the next 6-12 months (Chart 14). We prefer scaling into that trade on any bouts of US high-yield weakness, however. There are still near-term risks associated with the rapid spread of COVID-19 in the US and the lack of momentum on US fiscal stimulus negotiations during the transition period to the new Biden administration. Turning across the Atlantic, euro area high-yield looks far less attractive than US high-yield on a risk/reward basis. This fits with our current recommendation to underweight euro area junk bonds versus US equivalents (see our strategic recommendation tables on page 14). We also continue to recommend an overweight stance on UK investment grade corporates, which still offer a slightly more attractive risk/return tradeoff versus US equivalents. Bottom Line: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Mnuchin’s letter to Powell can be found here: https://home.treasury.gov/system/files/136/letter11192020.pd Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns