経済成長
Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1 last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2 they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month. The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May. The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April. PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Rising Bond Yields: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Central banks will remain highly accommodative given the lack of inflationary pressures after the deep COVID-19 recessions. There are still significant risks in the coming months from a potential second wave of coronavirus after economies reopen, worsening US-China relations and domestic US sociopolitical turmoil. Duration Proxy Trades: Given those lingering uncertainties, we prefer to focus on “duration-lite” trades in the developed economies, like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Feature Dear Client, Next week, instead of publishing a regular Weekly Report, we will hold a webcast on Tuesday, June 16 at 10:00 am ET, discussing our latest views on global fixed income markets. The format will be a short presentation, followed by a Q&A session. We hope you will join us, armed with interesting questions. Kind regards, Rob Robis, Chief Fixed Income Strategist Chart of the WeekBond Yields Bottoming, But Backdrop Not Yet Bearish Bond yields around the world awoke from their COVID-19 induced slumber last week, responding to a growing body of evidence indicating that global growth has bottomed. Over a span of four days, benchmark 10-year government bond yields rose in the US (+20bps), Germany (+13bps), Canada (+20bps), China (+14bps), Japan (+4bps), Mexico (+13bps) and the UK (+12bps). There is potential for yields to continue drifting higher over the next few months, as more countries reopen from virus-related shutdowns. The bounce already seen in survey data like manufacturing and services PMIs, as well as economic sentiment measures like the global ZEW index, should soon translate into real improvements in activity data. This comes at a time when rising commodity prices, most notably oil, suggest that depressed inflation expectations can lead bond yields higher. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator (Chart of the Week). However, economic policy uncertainty remains elevated as devastated economies try to reopen from lockdowns. In addition, our Central Bank Monitors continue to indicate pressure on policymakers to keep interest rates as low as possible to maintain easy financial conditions as easy as possible. Tighter monetary policies remain a distant prospect, given very high unemployment rates. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator. Amid those uncertainties, we recommend maintaining a neutral strategic (6-12 months) and tactical (0-6 months) stance on overall duration exposure in fixed income portfolios. Instead, we prefer focusing on lower volatility trades that will benefit from improving global growth and policy reflation, like going long inflation-linked bonds versus nominal government debt throughout the developed markets with breakevens looking too low on our models. Why Are Bond Yields Rising Now? We see five main reasons why global bond yields have started to move higher: 1) Investor risk aversion is declining There has been a sharp recovery in global risk appetite since late March, diminishing the demand for risk-free global government debt. In the US, the S&P 500 is up 43% from its March lows, while the NASDAQ index is back to the all-time highs reached before the coronavirus turned into a global pandemic (Chart 2). US corporate debt has also performed well since the March 23rd peak in spreads, with investment grade and high-yield spreads down -227bps and -564bps, respectively. Non-US assets are also flying, with emerging market (EM) equities up 29% and EM USD-denominated corporate debt up 14% in excess return terms over US Treasuries since the March trough. Even severely lagging assets like European bank stocks are showing a pulse, up 38% since the lows of May 15. Commodity prices are also improving, led not only by gains in oil after the April crash by recoveries in the prices of growth-sensitive commodities like copper (+17%) and lumber (+42%). Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds. The flipside of the boom in risk appetite is weakening prices for safe haven assets (Chart 3). The price of gold in US dollar terms is down -4% from the 2020 high on May 20, while the euro price of gold is down –6%. Safe haven currencies like the Japanese yen and Swiss franc have underperformed, while interest rate volatility measures like the US MOVE index and long-dated euro swaption volatility are back to the pre-coronavirus lows. Chart 2Risk Assets Are Booming Worldwide Chart 3Safe Haven Trades Losing Luster Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds that helped drive yields lower when risk assets were tanking in late February and March. 2) Global growth is improving One of the reasons for the improvement in investor risk appetite is belief that the world economy has exited from the severe COVID-19 global recession. While timely real data is still coming in slowly given reporting lags, there has been a notable bounce in survey data in many countries. PMIs for both manufacturing and services climbed higher in May (Chart 4). The expectations components of economic confidence measures like the ZEW indices have also recovered the losses seen in February and March. Data surprises have also been increasingly on the positive side of late in China, Europe and the US, including the shocking 2.5 million increase in US employment in May. However, the US unemployment rate remains very high at 13.3%, indicating abundant spare capacity that will likely take years, not months, to work off – a problem that most of the world will continue to deal with post-recession. 3) Central bank liquidity is booming The other main reason for the boom in risk asset performance that has started to put upward pressure on bond yields is the extremely accommodative stance of global monetary policy. This is occurring through 0% policy rates in the developed economies but, even more importantly, the aggressive expansion of central bank balance sheets through quantitative easing (QE). The Fed has its foot firmly on the monetary accelerator, with year-over-year growth in its balance sheet of 87% (Chart 5). The European Central Bank (ECB) is no slouch, though, with its balance sheet up 19% from a year ago and having expanded its Pandemic Emergency Purchase Program (PEPP) by another €600 billion last week. Chart 4Signs Of Life In The Global Economy Chart 5'QE Forever' Driving Money From Bonds To Risk Assets The combined annual growth of the central bank balance sheets for the “G4” (the Fed, ECB, Bank of Japan and Bank of England) is now up to 26%. The rate of G4 balance sheet expansion has been a reliable leading indicator of global risk asset performance since the 2008 financial crisis (with about a 12-month lead), and the current boom in “liquidity” suggests that the current rise in global equity and corporate bond markets can continue over the next year. Easing global financial conditions are now returning to levels that should support economic growth in the coming months, helping to mitigate (but not eliminate) the potential credit stresses from companies that have suffered during the COVID-19 recession. This recovery remains fragile, however, and policymakers will continue to maintain an extremely dovish policy bias – even with significant fiscal stimulus measures also in place to help economies climb out of recession. This suggests that the current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. The current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. Chart 6Global Bond Sentiment Is Still Very Bullish 4) Bullish sentiment for bonds is at extremes From a contrarian perspective, another factor helping put a floor underneath bond yields is investor sentiment towards fixed income, which remains bullish. The widely followed ZEW survey of economic forecasters also contains a question on the expected change in bond yields over the next year. The latest read on the surveys shows a net balance still expecting lower bond yields in the US, Germany, the UK and Japan, nearing levels seen prior to the end of the recessionary bond bull markets in the early 2000s and after the 2008 financial crisis (Chart 6). In addition, the Market Vane survey of bullish sentiment on US Treasuries is nearing past cyclical peaks, suggesting limited scope for new bond buyers that could drive US yields to new lows. 5) Inflation expectations are moving higher Finally, global yields are rising because the inflation expectations component of yields has started to move higher. The hyper-easy stance of monetary policy is playing a role here. Market-based inflation expectations measures like the breakevens on inflation-linked bonds (or CPI swap rates) are a vote of confidence by investors in the “appropriateness” of policy settings. The fact that inflation expectations are now drifting higher suggests that bond markets now believe that central banks are now "easy" enough to give inflation a shot at rising sustainably as growth recovers. Global yields are rising because the inflation expectations component of yields has started to move higher. Chart 7Oil Prices & Breakeven Inflation Rates Are Both Recovering This move higher in inflation expectations can continue in the coming months, particularly with global oil prices likely to move even higher. Our colleagues at BCA Research Commodity & Energy Strategy are quite bullish on oil prices, forecasting the benchmark Brent oil price to rise to around $50/bbl by the end of 2020 and continuing up to $78/bbl by the end of 2021. Such an outcome would push up market-based inflation expectations, and likely put more upward pressure on nominal bond yields, given the strong correlation between oil and inflation breakevens in the developed economies that has existed over the past decade (Chart 7). Bottom Line: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy For The Next Few Months The trends in growth, inflation and financial conditions all suggest bond yields can continue to drift higher over at least the next 3-6 months. Yet given the potential for a negative shock from a second wave of coronavirus infection, or geopolitical uncertainties in a volatile US election year, a below-benchmark global duration stance is not yet warranted. This is especially true with unemployment rates in most countries remaining elevated even as growth rebounds from recession, forcing central banks to maintain a very dovish policy posture. Our “Risk Checklist” that we have been monitoring to move to a more aggressive recommended investment stance on global spread product – the US dollar, the VIX and the number of new COVID-19 cases - can also be helpful in helping us determine when to shift to a more defensive bias on global duration. On that note, the Checklist still argues for a neutral duration stance, rather than positioning for a big move higher in yields. The US dollar has started to soften, but remains at a very high level relative to interest rate differentials (Chart 8). A weaker greenback is a source of global monetary reflation, primarily through changes in the prices of commodities and other traded goods that are denominated in dollars, but also by helping alleviate funding pressures for companies that have borrowed heavily in US dollars (especially in the emerging world). The dollar is also an “anti-growth” currency that appreciates during periods of slowing global growth, and vice versa, so some depreciation should unfold as more of the world economy emerges from lockdown (middle panel). The VIX index – a measure of investor uncertainty - continues to climb down from the massive surge in February and March, now sitting at 26 after peaking around 80. This is the one part of our Risk Checklist that argues for reducing duration exposure now. We prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. The daily number of new reported cases of COVID-19 (using data from the World Health Organization) has come down dramatically in Europe, but in the US the decline in new cases has stalled over the past month – a worrisome sign as the country continues to reopen amid mass protests in major cities (Chart 9). New cases outside the US and Europe are rapidly moving higher, however, primarily in major Latin American countries like Brazil and Mexico. This suggests that while there is a concern about a “second wave” of coronavirus later in the year, the risks from the first wave are far from over. Chart 8Still Not Much Reflationary Push From A Weaker USD Chart 9The COVID-19 Threat Has Not Gone Away Instead of shifting to a below-benchmark recommended stance on overall portfolio duration too soon in the cycle, we prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. Specifically, we like owning inflation-linked government bonds versus nominal debt, while also positioning for steeper government yield curves (on a duration-neutral basis). Longer-dated breakeven inflation rates within the major developed markets are becoming increasingly correlated to both the level of 10-year government bond yields (Chart 10) and the slope of the 2-year/10-year yield curve (Chart 11). Chart 10Rising Inflation Expectations Will Lead To Higher Bond Yields ... Chart 11... And Steeper Yield Curves In terms of country selection for these trades, we look to the valuations on inflation-linked bond breakevens from our modeling framework that we introduced back in late April.1 In that framework, we model 10-year breakevens as a function of oil prices, exchange rates and the long-run trend in realized inflation. Chart 12Global Inflation Breakevens Look Cheap On Our Models In Chart 12, we show the deviation of 10-year inflation breakevens from the model-implied fair value, shown both terms of standard deviations and basis points. The “cheapest” breakevens from our models are for inflation-linked bonds in Italy and Canada, although almost all counties (outside of the UK) have breakevens to look far too low. This suggests that global bond investors should consider a multi-country portfolio of inflation-linked bonds versus nominal paying equivalents – or in countries where the inflation-linked bond markets are small and illiquid, duration-neutral yield curve steepeners - as a more efficient way to play for a continuation of the current reflationary global backdrop without taking duration risk. Bottom Line: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Given the lingering uncertainties about a second wave of coronavirus, and the rising political and social tensions in the US only five months before the presidential election, we prefer to focus on “duration-lite” trades in the developed economies - like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 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
Highlights This year’s NPC refrained from announcing a numeric economic growth target. However, the targeted employment growth will be a reliable indicator of the government’s pain threshold. The announced stimulus package did not exceed market expectations. At the same time, the government is keeping the liquidity tap open and the fiscal budget flexible. We expect the government to utilize both policy tools before July. The stimulus focuses on supporting infrastructure investment and consumption, with marginal loosening of property market restrictions. While we maintain a positive view on Chinese equities in the next 6 to 12 months, we favor large cap stocks in domestic demand-driven sectors, to hedge rising geopolitical risks. We also recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. Feature This year’s National People’s Congress (NPC) delivered two surprises on opening day: a new national security bill on Hong Kong SAR, which will be voted on at the May 28th plenary session;1 and a lack of an annual economic growth target in the Government Work Report (GWR), for the first time since the early 1990s. Chinese stock prices in both the onshore and offshore markets plunged following Friday’s NPC session (Chart 1). Chart 1Messages From This Year's NPC Did Not Bode Well For Market Sentiment Numeric targets in the stimulus package announced at the NPC did not exceed the consensus. However, citing global geopolitical and economic uncertainties, Chinese policymakers have kept the liquidity tap open and the fiscal budget flexible. This means that policymakers can add to the existing stimulus without the approval of the NPC at the Politburo’s mid-year review in July. Investors will likely turn their focus back to economic fundamentals in the coming months. In Q2, the market will trade on the back of disappointing corporate earnings and news from the geopolitical front. In H2, however, a confluence of further domestic policy easing and a global economic recovery should lift Chinese corporate earnings. As such, our cyclical (6-12 months) outlook on both China’s economic recovery and equity performance remains upbeat. The Economy: No Growth Target ≠ No Growth The GWR set targets for this year’s urban job creation and unemployment rate, even though it refrained from setting an explicit objective for economic growth in 2020 (Table 1). A numeric target on job growth implicitly provides a floor to the economy, i.e., stimulus will have to step up if the economy does not provide adequate jobs to meet the employment target. Table 1No Growth Target, But Big Spending Anecdotes indicate that, to keep the unemployment rate in abeyance, the government has mandated corporations to retain their employees on payrolls even if there is no pay. This may help to explain the meager 6.0% unemployment rate in China compared with a near 20% rate in the US. It is undoubtedly much harder to create new jobs than to maintain a stable unemployment rate. Economic and demand growth is still the foundation for job growth, and administrative measures can only go so far in creating new jobs, particularly in the private sector. The government pledges to create 9 million new jobs in 2020, about 20% lower than the target of 11 million new jobs set for last year. In 2019, 13.52 million urban jobs were created and the nominal GDP expanded at 7.8%. A back-of-the-envelope calculation suggests that China economy needs to grow by 4-5% from 2019 (in nominal terms) to achieve the employment target for this year. Given that Q1 registered a 5.3% contraction, China’s economy must expand by at least 8% (year on year) in H2 (Chart 2). Chart 2Employment Growth Will Be This Year's Government Policy Anchor Stimulus: Keeping Options Open “We will use a variety of tools such as required reserve ratio reductions, interest rate cuts, and re-lending to enable M2 money supply and aggregate financing to grow at notably higher rates than last year.” – Li Keqiang at the NPC, May 22, 2020. Chart 3Further Monetary Easing Likely In June This statement makes it clear that policymakers intend to keep the liquidity tap running. The easing of local government financing vehicle (LGFV) borrowing and shadow banking regulations also indicates that Chinese policymakers have given an all-clear signal to accelerate money and credit growth. We expect another round of cuts in interest rates and required reserve rates ahead of the July Politburo meeting. The credit impulse should reach around 35% of China's GDP this year, well above the 25% in 2019 (Chart 3). A notable exception in this year’s GWR is that it did not put a lid on the size of fiscal stimulus. The fiscal deficit for 2020 is set at an ambiguous “above 3.6% of GDP”. Furthermore, the GWR states that the current policies “can be improved according to changes in the economic situation,” which will allow for greater leeway in easing. We believe that while the government pledges to maintain a measured stimulus, more easing actions are inevitable. China’s post-pandemic economic recovery is on track and not yet close to the policymakers’ pain threshold. However, the global economy faces tremendous uncertainties. The pandemic is not yet controlled worldwide and the US-China rivalry is expected to grow more acrimonious in the months to come. A temporary setback in China’s economic recovery and financial market in Q2 is a strong possibility. Employment is also set to come under more pressure in Q2 when an estimate of 8.7 million new college graduates enter the job market. As mentioned in our previous report, China’s job losses so far are concentrated in lower-skilled, lower-income manufacturing and service sectors.2 However, the new graduates will seek middle-income, white-collar jobs, which can only be provided by real demand in the economy. Young middle-class professionals in China are not only a major source of consumption growth, but also are a source of domestic instability if they are discontent – a political risk we do not think the Chinese leadership is willing to take. Fiscal Stimulus: Largest On Record Raw material prices have closely tracked Chinese credit cycles since the Global Financial Crisis (GFC). China’s fiscal impulse and government-led investment have helped to speed up commodity price recoveries and bridged the gap between economic slowdowns and a rebound in the private sector (Chart 4). Fiscal deficit will likely be enlarged by more than 3% of GDP in 2020 from last year's near 5% of GDP, and will be the largest annual deficit increase on record. The announced budgetary fiscal deficit in 2020 is set at above 3.6% of GDP, but the broad-measure fiscal deficit will most likely reach to more than 8% of GDP this year when taking into account both government budgetary and fund expenditures (Chart 5). Chart 4Commodity Prices Will Get A Lift From Fiscal Stimulus Chart 5Fiscal Deficit Largest In Decades Chart 6"New Infrastructure" Investment Moved Into The Fast Lane The local government special purpose bond (SPB) budget is set at 3.75 trillion, 1.6 trillion above last year. We expect 80% of the 2020 SPB to be invested in infrastructure projects. With the additional 700 billion yuan of central government budgetary investment fund, infrastructure investment will be increased by 2.5 trillion compared with 2019, a 10% growth (Chart 6). A reason why the market reacted negatively to the announced stimulus is that the headline figure for central government special treasury bonds (STB) is below market expectations. However, STBs are special transfers from the central government to localities to replenish fiscal reserve funds, which have little stimulative impact on business activity. The fact that the figure is below market expectations does not have the same kind of market relevance as government expenditure or local government SPB. Real Estate: More Dovish Chinese policymakers have always maintained an enigmatic attitude towards the housing sector. Although no housing stimulus was announced this year, the tone on keeping housing demand in check has softened. Phrases have been added to this year’s GWR, allowing provincial and city officials to adjust their housing policies. Housing policy has become progressively less restrictive since mid-2019 and we anticipate some modest property stimulus going forward. Chart 7Construction Set To Pick Up As mentioned in our previous reports, the massive contraction in fiscal revenue growth this year will inevitably push up land auctions and housing construction activity (Chart 7). We continue to expect a strong recovery in housing demand, particularly in China’s top-tier cities. Lower mortgage rates, easier access to bank loans and the preference to hold hard assets to hedge inflation, all will drive up housing demand among higher-income Chinese households. High-frequency data show that since the beginning of May, the contraction in property sales in tier-1 and tier-2 cities have narrowed by 17 percentage points from April. Investment Conclusions The NPC delivered a stimulus package that did not exceed market expectations, which means that investors will be re-focusing on China’s economic fundamentals in the near term. We think that geopolitical tensions and weak corporate earnings will dominate the performance of equities in Q2. On the geopolitical front, Beijing’s move to pass a new national security law on Hong Kong will likely be met with retaliatory actions from the US, adding fuel to the US-China tensions. The near-term response in the equity market will be negative if President Trump follows through with his retaliatory threats. Consequently, we recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. On China’s domestic economy, industrial profit growth will likely remain in contraction during most of Q2, before returning to modest positive growth in H2. As such, near-term investors’ risk appetite will experience periods of setbacks, and there will be better price entry points to go long on Chinese stocks in both relative and absolute terms. We remain positive on Chinese equities in the next 6 to 12 months. The speed of the economic recovery will likely accelerate in H2, and there is a distinct possibility that the stimulus will step up following a lackluster economic recovery in Q2. Some cyclical industries will significantly benefit from the ongoing stimulus and recover ahead of the broad market. We favor consumer discretionary stocks in both onshore and offshore equity markets.3 We also recommend that investors focus on large cap firms that draw their revenues from domestic demand-oriented industries. This will help to hedge volatilities created from escalating US-China trade frictions. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 We will discuss the implications from the Hong Kong national security bill proposal in future research. 2 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com 3 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Uncertainty over the duration of lockdowns globally will continue to hamper the estimation of the global demand recovery for commodities. This uncertainty will continue to fuel safe-haven demand for USD for the balance of 2Q20. In addition, markets continue to experience a shortage of USD, which can become acute for EM debtors servicing dollar-denominated debt. The combination of safe-haven demand and a continued dollar shortage will keep the USD well bid, which will, at the margin, suppress commodity demand, compounding the effects of COVID-19-induced demand destruction. The Fed will continue to accommodate USD demand, in an ongoing attempt to reverse a tightening of global financial conditions, which also reduces the level of economic activity and commodity demand. Commodity demand will recover in 2H20. Given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the Communist Party of China (CCP) – base metals and grain prices should recover earlier than other commodities. Oil likely recovers in 3Q20, as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. We remain long gold as a portfolio hedge against continued global policy uncertainty. Feature The short-term path forward for commodity prices will be a function of uncertainty regarding the global economic recovery and its impact on the US dollar, which, at present, remains well bid and is keeping global financial conditions tight. The sharp USD appreciation – mostly vs. EM currencies – is a response to the COVID-19 economic shock, which intensified in March. This significantly tightened global financial conditions (Chart of the Week). EM economies’ capacity to withstand the hit to aggregate demand locally – caused by widespread lockdown measures meant to contain the spread of the virus – has led to capital outflows. EM economies, therefore, are forced to combat a combination of plunging currencies, crumpling domestic and export demand, and increasing financing costs. Low risk appetite globally and diminished liquidity in money and credit markets add to USD demand, and will keep it elevated over the next few months. Chart of the WeekEM Currencies Plunged Vs. The USD Chart 2Commodity-Intensive Industries Are Vulnerable To USD Shocks After that, we expect the dollar will reverse – mostly on the back of massive Fed accommodation to redress these factors – in 2H20. As COVID-19-induced demand destruction abates, this weakening in the USD will propel EM economic growth higher and bolster commodity demand (Chart 2). USD Well Bid On Safe-Haven Demand, Dollar Shortage The dollar could retest its recent highs in the short term. Heightened volatility over the past two months powered a surge in demand for safe havens and highly liquid risk assets globally. We expect this to persist as stringent lockdowns remain in place to combat the COVID-19 pandemic. This will keep economic policy uncertainty elevated. Over the short term, the USD will benefit in this environment. Demand for USD and dollar-denominated assets will remain strong. Indeed, our FX strategists believe the dollar could retest its recent highs (Chart 3).1 Chart 3Global Uncertainty Lifts The US Dollar And Rates Since the Global Financial Crisis (GFC), US dollar movements have been a prime driver of cross-currency basis swaps and can be indicative of risk-taking capacity in capital markets.2 Also, a rising dollar limits the cross-border supply of dollar-denominated loans and increases funding costs. The Fed is monitoring domestic and global liquidity conditions closely, and is fulfilling the role of global USD lender of last resort. Its rapid extension of swap lines to foreign central banks, as well as a temporary repo facility for foreign and international monetary authorities (FIMA), temporarily eased liquidity concerns in some regions (Chart 4). Chart 4Fed Actions Have Eased Global Liquidity Constraints It is too early to presume the dollar liquidity constraints have been wholly contained. However, it is too early to presume the dollar liquidity constraints have been wholly contained. The Fed cannot force foreign central banks to direct these dollars to the sectors in which they are needed in their domestic economies. Besides, not all EMs have access to these swap lines. This means much-needed swap lines are inaccessible to a significant portion of the global financial system. In addition, close to 60% of outstanding foreign exchange swaps/forwards involve non-bank financial and other institutions.3 It is highly likely, therefore, the Fed will have to provide additional liquidity to struggling foreign entities. We believe the Fed is well aware of these constraints on global growth and is addressing the need for additional global USD liquidity. However, as has been the case throughout the post-GFC period, policy action will continue to be uncertain as to its duration and its effectiveness. Combined with expanding fiscal deficits in the US, we believe this extraordinary accommodation by the Fed will considerably increase USD supply this year. Following a volatile 2Q20, we expect the US dollar will face severe downward pressures – assuming lockdown measures are successful in containing the pandemic and are gradually lifted. With interest rates now close to zero in most DM economies, relative balance-sheet dynamics will become important drivers of exchange rates (Chart 5). Ample liquidity globally will propel pro-cyclical currencies up and the combination of fiscal and monetary easing could lead to a debasing of the dollar next year as inflationary pressures intensify. Momentum will start working against the dollar in 2H20. Chart 5Massive QE In The US Will Pressure The USD Downward USD Strength Hinders Global Growth The dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened. The strong dollar remains a headwind to global growth – particularly in EM economies – as it pushes up funding costs and tightens financial conditions. This negative dollar shock adds to the devastating effects of lockdowns, record portfolio outflows, and collapsing commodity prices on EM economies (Chart 6). Since the GFC, the dollar’s importance as a driver of EM – and global – industrial production cycles has increased and, because EM economies account for a larger share of aggregate commodity demand, its link with commodity prices also has strengthened (Chart 7). EM economies’ rising responsiveness to dollar movements is in part explained by their growing share of foreign USD-denominated debt, a larger foreign ownership of their sovereign debt, and increasing integration into global supply chains, in which transactions typically are invoiced in dollars (Chart 8). Chart 6Record Portfolio Outflows From EM Chart 7Brent Prices Are Closely Correlated With EM Currencies Post-GFC Chart 8EM Vulnerability To The USD Increased Since The GFC Elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Thus, elevated economic uncertainty – which drives up the dollar convenience yield and reduces cross-border dollar lending – pushes up the dollar and tightens financial conditions globally, and ultimately spills over to the real economy. Interestingly, this relationship is non-linear and asymmetric – i.e. the dollar’s impact on commodity prices is higher in dollar bull markets, and positive dollar changes have a greater impact. For instance, its impact on oil prices is 30% stronger in dollar-appreciation cycles. Large increases in the relative value of the USD – on a monthly, weekly, or daily basis – have a disproportionate negative impact on oil prices compared to large decreases (Chart 9). Hence, sudden rushes to safe and liquid assets in periods of rising global economic uncertainty have a magnified negative effect on commodity prices. This means the recovery in commodity prices will be more gradual. Chart 9Asymmetric Impact Of USD Changes On Commodity Prices Base Metals Could Recover In 2Q20 Gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. The USD strength is keeping commodity demand growth in check. Until uncertainty re the speed of economic recovery dissipates – mainly vis-à-vis EM economies – commodity prices will remain under pressure (Chart 10). Base metals and grain prices could recover earlier than other commodities given the expected earlier recovery of China from the COVID-19-induced commodity-demand destruction – and the fiscal and monetary stimulus being deployed by the CCP. Specifically, copper prices could decouple from the USD, following China’s economic growth as it contributes close to 50% of both supply and demand of refined copper (Chart 11). Chart 10USD Strength Will Weigh Down Commodity Prices In 2Q20 Chart 11Metals' Prices Will React To China's Economic Recovery Oil will rebound in 3Q20 as the COVID-19 pandemic is contained and supply cuts – voluntary and involuntary – take hold. China consumes a smaller 14% of world oil demand, which is not sufficient to support a sustainable rally in prices on its own. For 2Q20, the correlation with the USD will intensify and weigh down its price (Chart 12). Lastly, gold will benefit from the continued uncertainty and system-wide risk aversion over the coming months. Bottom Line: As the global economy recovers from the COVID-19 pandemic and things get back to normal in 2H20, the USD will weaken and commodity prices will rebound. These two factors will halt the deflationary impulse from the COVID-19 demand shock. On the back of this improvement, we expect inflation expectations to recover throughout 2021 (Chart 13). Chart 12Oil Prices' Correlation With The USD Increases In Contango Chart 13Weaker USD, Rising Commodity Prices Will Revive Inflation Expectations Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Oil price volatility as measured by the Crude Oil ETF Volatility Index (OVX) surged to above 300% earlier this week as WTI futures for May 2020 delivery fell to a low of -$40.40/bbl (Chart 14). Unprecedented negative pricing for the North American benchmark crude oil will accelerate supply destruction and bankruptcies among highly levered, unprofitable E+P companies operating in the principal shale basins, particularly the Permian. We will be looking at the supply-side implications of the massive price volatility, coupled with the first-ever negative pricing for the benchmark crude oil in next week’s publication. We currently expect US production to fall 1.5mm b/d this year. Base Metals: Neutral Front month Singapore Iron Ore Futures continue to perform relatively well, with the 62% Fines contracts hovering around $83/MT. This contract is down 5.3% ytd, after having peaked in January at $92/MT. Chinese steel inventories while elevated, have started to turn the corner since Mid-March when they reached a record 26 Mn MT (Chart 15). Resilience in iron ore and steel reflects favorable fundamentals, as Chinese manufactures starting to get back to business are reviving demand in China, and as supply concerns stemming from reduced mine activity among major mining groups around the world persist. Precious Metals: Neutral We are going long palladium at tonight’s close, following its break below $2,000/oz. We expect the global economy to recover in 2H20 on the back of massive fiscal and monetary stimulus. We expect this will be supportive of consumer spending, particularly automobiles. Palladium is essential to pollution-abatement technology in gasoline-powered cars. While work is being undertaken to rehabilitate South Africa’s derelict power grid, this is at least a five-year effort. In the meantime, rolling backouts will continue to threaten the 73% of global palladium supply produced in South Africa. Ags/Softs: Underweight CBOT corn May futures fell 1.55% on Tuesday, closing at $3.09/bu, the lowest level since 2009. Corn has been under pressure in recent weeks as the COVID-19 pandemic caused large demand destruction for this grain. Initially, this stemmed from a lower ethanol demand. However, concerns over a slowdown in demand for cattle feed has impacted corn demand as meat plants close in North America. Chart 14Crude Oil ETF Volatility Index Surged Over 300% Chart 15Chinese Steel Inventories Have Turned The Corner Footnotes 1 Please see QE And Currencies, published by BCA Research’s Foreign Exchange Strategy April 17, 2020. It is available at fes.bcareserach.com. 2 Please see Avdjiev, Stefan, Wenxin Du, Cathérine Koch, and Hyun Song Shin. 2019. "The Dollar, Bank Leverage, and Deviations from Covered Interest Parity." American Economic Review: Insights, 1 (2): 193-208. 3 Please see Capitulation?, published by BCA Research’s Foreign Exchange Strategy April 3, 2020. It is available at fes.bcareserach.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
Highlights The Chinese economy is recovering at a slower rate than the equity market has priced in. There is a high likelihood of negative revisions to Q2 EPS estimates and an elevated risk of a near-term price correction in Chinese stocks. We expect a meaningful pickup in credit growth in H1 to improve domestic demand gain tractions in H2. This supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. There is still a strong probability that the yield curve will flatten, and the 10-year government bond yield may even dip below 2% in the wake of disappointing economic data in Q2. But our baseline scenario suggests the 10-year government bond yield should bottom no later than Q3 of this year. Feature This week’s report addresses pressing concerns from clients in China’s post-Covid-19 environment. China’s economy contracted by 6.8% in Q1, the largest GDP growth slump since 1976. Furthermore, the IMF’s baseline scenario projects a 3% contraction in global economic growth in 2020, with the Chinese economy growing at a mere 1.2%.1 This dim annual growth outlook means that the contraction in China’s economy will likely extend to Q2, dragging down corporate profit growth. In our April 1st report2 we recommended that investors maintain a neutral stance on Chinese stocks in the next three months due to uncertainties surrounding the pandemic, the oversized passive outperformance in Chinese stocks, and heightened risks for further risk-asset selloffs. On a 6- to 12-month horizon, however, we have a higher conviction that Chinese stocks will outperform global benchmarks. Our view is based on a decisive shift by policymakers to a “whatever it takes” approach to boost the economy. We believe that the speed of China’s economic recovery in the second half of 2020 will outpace other major economies. Q: China’s economy is recovering ahead of other major economies. Why did you recently downgrade your tactical call on Chinese equities from overweight to neutral relative to global stocks? A: China’s economy is recovering, but it is recovering at a slower rate than the equity market has fully priced in (Chart 1A and 1B). We believe the likelihood of negative revisions to Q2 EPS estimates is high, and the risk of a near-term price correction in Chinese stocks remains elevated. Chart 1AElevated Chinese Equity Outperformance Relative To Global Stocks Chart 1BChinese Stocks Largely Ignored Weakness In Domestic Economy The lackluster March data suggests that the pace of China’s economic recovery in April and even May will likely disappoint, weighing on the growth prospects for Q2’s corporate earnings (Chart 2). Chart 2EPS Growth Estimates Likely To Capitulate In Q2 The work resumption rate in China’s 36 provinces jumped sharply between mid-February and mid-March. However, since that time, the resumption rate among large enterprises has hovered around 80% of normal capacity (Chart 3). Chart 3Work Resumption Hardly Improved Since Mid-March The flattening of the work resumption rate curve is due to a lack of strong recovery in demand. Chart 4So Far No Strong Recovery In Domestic Demand The flattening of the resumption rate curve is due to a lack of strong recovery in demand. Although there was a surge in Chinese imports in crude oil and raw materials, the increase was the result of China taking advantage of low commodity prices. This surge cannot be sustained without a pickup in domestic demand. The March bounce back in domestic demand from the manufacturing, construction, and household sectors has all been lackluster (Chart 4). External demand, which growth remained in contraction through March, will likely worsen in Q2 (Chart 5). Exports shrunk by 6.6% in March, up from a deep contraction of 17.2% in January-February. Export orders can take more than a month to be processed, therefore, March’s data reflects pent-up orders from the first two months of the year. The US and European economies started their lockdowns in March, so Chinese exports will only feel the full impact of the collapse in demand from its trading partners in April and May. The work resumption rate will advance only if the momentum in domestic demand recovery increases to fully offset the collapse in external demand. The current 83% rate of work resumption implies that industrial output growth in April will remain in contraction on a year-over-year basis (Chart 6). Chart 5External Demand Will Worsen In Q2 Chart 6Will Q2 Industrial Output Growth Remain In Contraction? Although we maintain a constructive outlook on Chinese risk assets in the next 6 to 12 months, the short-term picture remains volatile in view of the emerging economic data. As such, we recommend investors to maintain short-term hedges for risk asset positions. Q: China’s policy response to mitigate the economic blow from COVID-19 has been noticeably smaller than programs rolled out in key developed economies, especially the US. Why do you think such measured stimulus from China warrants an overweight stance on Chinese stocks in the next 6-12 months relative to global benchmarks? A: It is true that the size of existing Chinese stimulus, as a percentage of the Chinese economy, is smaller than that has been announced in the US. But this is due to a different approach China is taking in stimulating its economy. In addition, both the recent policy rhetoric and PBoC actions suggest a large credit expansion is in the works. This will likely overcompensate the damage on China’s aggregate economy, and generate an outperformance in both Chinese economic growth and returns on Chinese risk assets in the next 6 to 12 months. China’s policy responses have an overarching focus on stimulating new demand and investment, which is a different approach from the programs offered by its Western counterparts. In the US, the combination of fiscal and monetary stimulus amounts to 11% of GDP as of April 16, with almost all policy support targeted at keeping companies and individuals afloat. In comparison, China’s policy response accounts for a mere 1.2% of its GDP.3 However, this direct comparison understates the enormous firepower in the Chinese stimulus toolkit, specifically a credit boom. As noted in our February 26 report,4 China has largely resorted to its “old economic playbook” by generating a huge credit wave to ride out the economic turmoil. Our prediction of the policy shift towards a significant escalation in stimulus was confirmed at the March 27 Politburo meeting. Moreover, the April 17 Politburo meeting reinforced a “whatever it takes” policy shift with direct calls on more forceful central bank policy actions, a first since the global financial crisis in 2008.5 Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles. The PBoC’s recent aggressive easing measures have pushed down the interbank repo rate below the central bank’s interest rate on required reserves (IORR). The price for interbank borrowing is now near the lower range of the rate corridor, between the IORR and the interest rate on excess reserves (IOER). Since 2008, the overnight repo rate’s breaking into the IORR-IOER corridor has been a reliable indicator leading to impressive credit upcycles (Chart 7). Such credit super cycles, in turn, have led to both economic booms and an outperformance in Chinese stocks. Chart 7Another Credit Super Cycle Is In The Works Chart 8Financial Conditions Were Extremely Tight In 2011-2014 The 2012-2015 cycle was an exception to the relationship between the overnight interbank repo rate, credit growth and Chinese stock performance. A steep pickup in credit growth in 2012 coincided with a leap in the overnight interbank repo rate, and the credit boom did not help boost demand in the real economy or improve Chinese stock performance. This is because corporate borrowing was severely curtailed by high lending rates during a four-year monetary tightening cycle from 2011 to 2014 (Chart 8). The credit boom during that cycle was largely driven by explosive growth in short-term shadow-bank lending and wealth management products (WMP), and did not channel into the real economy.6 We do not think such an extreme phenomena will replay under the current circumstances. Monetary stance will likely remain tremendously accommodative through the end of the year to facilitate a continuous rollout of medium- to long-term bank loans and local government bonds. Chinese financial institutions’ “animal spirits” may have been unleashed. But under the scrutiny of the Macro-Prudential Assessment Framework and the New Asset Management Rules,7 the "animal spirits" are unlikely to run up enough risks to prompt the PBoC to prematurely tighten liquidity conditions in the interbank market. Marginal propensity in China is pro-cyclical, which tends to lag credit cycles by 6 months. Chart 9Marginal Propensity In China Is Pro-Cyclical Both corporate and household marginal propensity, a measure of the willingness to spend, will pick up as well. Marginal propensity is pro-cyclical, which tends to lag credit cycles by 6 months (Chart 9). In other words, when interest rates are low and credit growth improves, corporates and households tend to spend more. The meaningful expansion in credit growth, which started in Q1 and will sustain in the coming two to three quarters, will help corporate and household spending gain tractions in H2. This constructive view on Chinese stimulus and economic recovery supports our overweight stance on Chinese stocks in the next 6-12 months, in both absolute and relative terms. Q: The yield curve in Chinese government bonds has steepened following PBoC’s aggressive monetary easing announcements. Has the Chinese 10-year bond yield bottomed? A: No, we do not think the 10-year bond yield has bottomed. There is probability the 10-year government bond yield may briefly dip below 2% in Q2. However, barring a multi-year global economic recession, we think the 10-year government bond yield will bottom no later than Q3 this year. Chart 10A Wide Gap Between The Long and Short The short end of the yield curve dropped disproportionally compared with the long end, following the PBoC’s announcement to place its first IOER cut since 2008 (Chart 10). This led to a rapid steepening in the yield curve. While our view supports a flattening of the yield curve in Q2 and even a 50bps drop in the 10-year government bond yield, we think that the capitulation will be brief. In order for the 10-year government bond yield to remain below 2% for an extended period of time, the market needs to believe one or more of the following will happen: The pandemic will cause a multi-year global economic recession, preventing the PBoC from normalizing its policy stance in the foreseeable future. The duration and depth of the economic impact from the pandemic are still moving targets. Our baseline scenario suggests that the Chinese economic recovery will pick up momentum in H2 this year. The PBoC will not normalize its policy stance even when the economy has stabilized. The PBoC has a track record as a reactive central bank rather than a proactive one. Still, during each of the past three economic and credit cycles, the PBoC has started to normalize its interest rate on average nine months following a bottom in the business cycle (Chart 11). The tightening of interest rate even applied to the prolonged economic downturn and deep deflationary cycle in 2015/16 (Chart 12). Chart 11The 'Old Faithful' PBoC Policy Normalization Pattern Chart 12Policy Normalized Even After A Long Economic Downturn Chart 132008 Or 2015? How the yield curve has historically behaved also depended on the market’s expectations on the speed of the economic recovery, and the timing of the subsequent monetary policy normalization. The yield curved spiked in the wake of substantial monetary easing and pickup in credit growth, in both 2008 and 2015 (Chart 13). While in 2008 the yield curve moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation, in the 2015/16 cycle the yield curve spiked initially but quickly flattened. The long end of the yield curve capitulated as soon as the market realized the economic slowdown was a prolonged one. The 10-year government bond yield, after trending sideways in early 2016, only truly bottomed after the nominal output growth troughed in Q1 2016 (Chart 13, bottom panel). Will the yield curve behave like in 2008, or more like in 2015 in this cycle? We think it will be somewhere in between. The current economic cycle bottomed in Q1, but the economy is only recovering slowly and we expect a U-shaped economic recovery rather than a 2008-style V-shaped one. At the same time, our baseline scenario does not suggest the current environment will evolve into a 4-year deflationary cycle as in the 2012-2016 period. Therefore, we expect the low interest rate environment to endure for another two to three quarters before the PBoC starts to reverse its policy stance back to the pre-COVID-19 range. As such, the yield on 10-year government bonds will fall, possibly by as much as 50bps, when the economic data disappoint in Q2 and more rate cuts are forthcoming. But it will bottom when the economic recovery starts to gain traction in H22020 and the market starts to price in a subsequent monetary policy normalization. When growth slows and debt rises sharply, the PBoC will need to join its western counterparts to permanently maintain an ultra-low interest rate policy to accommodate its high debt level. We acknowledge the fact that China’s potential output growth is trending down (Chart 14). But it has been trending downwards since 2011. A structurally slowing rate of economic growth has not prevented the PBoC from cyclically raising its policy rate. Hence, unless we see evidence that the pandemic is meaningfully lowering China’s potential growth on par with growth rates in the DMs, our baseline scenario does not support a structural ultra-low interest rate environment in China. China’s debt-to-GDP ratio will most likely rise substantially this year, given that the credit impulse will gain momentum and GDP will grow very modestly. However, this rapid rise in the debt-to-GDP ratio will most likely not be sustained beyond this year. Even if we assume that credit impulse will account for 40% of GDP in 2020 (the same magnitude as in 2008/09), a sharp reversal in the output gap in 2021, as predicted by IMF,8 will flatten the debt-to-GDP ratio curve (Chart 15). Moreover, following every credit super cycle in the past, Chinese authorities have put a brake on the debt-to-GDP ratio. Chart 14China's Potential Growth Is Likely To Trend Lower... Chart 15...But Has Not Stopped PBoC From Flattening The Debt Curve All in all, while we see a high possibility for the 10-year government bond yield to fall in Q2, the decline will be limited in terms of duration. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1IMF World Economic Outlook, April 2020 2Please see China Investment Strategy Weekly Report "Investing During A Global Pandemic," dated April 1, 2020, available at cis.bcaresearch.com 3IMF, Policy Responses To COVID-19 https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19#U 4Please see China Investment Strategy Weekly Report "China: Back To Its Old Economic Playbook?" dated February 26, 2020, available at cis.bcaresearch.com 5“Stable monetary policy must become more flexible” and “use RRR reductions, lower interest rates, re-lending and other measures to preserve adequate liquidity and guide the loan prime rate downwards.” Statements from Xi Jinping, April 17, 2020 Politburo Meeting. http://www.gov.cn/xinwen/2020-04/17/content_5503621.htm 6 Bankers’ acceptances - short-term debt instruments guaranteed by commercial banks - swelled by 887% between end-2008 and 2012. The outstanding amount of WMPs jumped from 1.7 trillion RMB in 2009 to more than 9 trillion RMB by H12013. In contrast, the amount of RMB-denominated bank loans increased by only 67% during the same period. 7The Macro-Prudential Assessment Framework and the New Asset Management Rules were implemented in 2016 and 2018, respectively. They are designed to create additional restrictions to curb shadow-bank lending and broaden the PBoC’s oversight on banks’ WMP holdings. 8The April IMF World Economic Outlook predicts a 1.2% Chinese GDP growth in 2020 and a 9.2% GDP growth in 2021. Cyclical Investment Stance Equity Sector Recommendations