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Highlights Economic policy uncertainty is rising in the US and will generate volatility this fall. But by the end of the year the result should be more fiscal reflation. Biden’s approval rating is now “underwater” – net negative – but this was expected. Unless he suffers another black eye, he can still shepherd his two big bills through Congress by year’s end. Public support for Biden’s tax hikes is weak. Some tax hikes are likely but aggressive hikes are now off the table. The midterm elections were already likely to produce a Republican win in the House. History supports this consensus. But the Senate is still an open game. The presidential election outlook is only marginally affected, at most, by the messy Afghanistan pullout. Value stocks are re-testing their low point against growth stocks. We do not expect them to break down when Congress is about to pass historic new spending increases. Feature Economic policy uncertainty is reviving in the US and set to increase this fall. This is true in absolute terms and relative to global uncertainty, even at a time when China’s sweeping regulatory crackdown is generating a lot of global uncertainty (Chart 1). Chart 1US Relative Policy Uncertainty Reviving Chart 2Policy Uncertainty Breakdown The latest increase in the policy uncertainty index is largely driven by rising uncertainty over future government spending (Chart 2, panel 2) and expiring tax provisions (Chart 2, panel 3), more so than by public sentiment reflected in the mainstream media or even the inflation debate. The looming budget battle this fall will have major implications for taxes and spending and will lift the uncertainty indicators regarding sentiment and consumer prices. Volatility will ensue in the coming months. But by the end of the year, Congress will have passed at least one, likely two, new laws that will increase government fiscal support for the economy and dispel deflationary tail risks. The lingering pandemic will if anything help concentrate lawmakers’ minds on passing more stimulus. Therefore we expect US equities and cyclical sectors to grind higher. The passage of these bills will mark the high point in policy reflation, after which clouds will loom on the horizon in 2022. Biden’s Net Negative Approval Rating President Biden’s job approval rating is now officially “underwater” – more people disapprove of his leadership than approve (Table 1). This is raising serious doubts about his ability to shepherd legislation through Congress this fall. However, these doubts are overrated. Table 1Biden’s Net Approval Is Officially Negative Biden’s approval has mostly fallen due to his mishandling of the US military’s withdrawal from Afghanistan – which most Americans agree was necessary, however much they deplored the commander-in-chief’s handling of it. Therefore Biden’s approval rating will not fall much farther – at least not until he suffers another black eye. Until that happens, Biden’s approval will stabilize in the range of Obama’s and above Trump’s. The reason is that he retains a solid political base of support – and his political base is larger than President Trump’s, so his general approval will stay higher. Indeed his approval is still stronger than Obama’s among Democrats (Charts 3A and 3B). This is counterintuitive since Obama was a charismatic, young, and progressive Democrat. The reason is that Democrats are still very cognizant and fearful of the alternative: President Trump. This anti-Trump tailwind will help Biden for some time. Support among Democrats is critical for maintaining party discipline in passing the reconciliation bill this fall. It is also important for the midterm elections. Chart 3ABiden’s Job Approval Collapses Chart 3BBiden’s Approval Holding Up Among Democrats On specific issues, Biden is weaker than Obama on foreign policy and than Trump on the economy (Charts 4A and 4B). The economy will remain the central concern, notwithstanding Afghanistan, and on this front Biden should stabilize or improve. However, other foreign policy issues could rise to the fore and hurt him at any time given today’s fraught geopolitical environment. Chart 4ABiden’s Falling Approval On Economy Chart 4BBiden’s Falling Approval On Foreign Policy We say Biden’s score on the economy will improve because consumer confidence will rebound once the Delta variant of COVID-19 subsides (Chart 5). Both manufacturing and service sectors are performing better than when Biden was elected and employment is holding up in both sectors. The new orders-to-inventories measures suggest the service sector will continue to improve (Chart 6). The headline unemployment rate has dropped to 5.2%. Chart 5Consumer Confidence Should Support Biden Chart 6PMIs Also Offer Some Support For Biden Given the above, Biden still has enough clout to steer his signature legislation through Congress this fall, albeit with major modifications to his unwieldy $3.5 trillion American Families Plan. Moderate Democratic Senator Joe Manchin of West Virginia has called for a pause in new big spending legislation, but a close look at his words shows that he does not oppose the bill, he merely wants to water it down, which is not a change from his earlier position.1 He speaks for other moderates. The left-wing faction led by Senator Bernie Sanders of Vermont will make counter-threats yet ultimately has no choice other than to support the most progressive social legislation in recent memory. The bill will be watered down. Could this watering down process result in a total jettison of the Democrats’ proposed tax hikes? The Wall Street Journal reports that congressional support for tax hikes is losing steam.2 While aggressive tax hikes are off the table, we highly doubt that all tax hikes will be removed. Financial markets have not responded much to the threat of higher taxes. Small business owners, who are most sensitive to the risk of new taxes and regulation imposed by Democrats, have not shown much concern for either issue this year – they are much more worried about inflation (Chart 7). We assume the equity market would rally if tax hikes were dropped but we do not think this is likely to happen. Americans support higher taxes – but only Democrats are enthusiastic about across-the-board hikes on individuals, corporations, and capital gains. Polls show that 59% of independent voters, not to mention Democrats, support higher taxes on high-income earners, although the proposed 28% corporate is increasingly likely to be cut down (Chart 8). This is the fundamental reason for investors to expect Democrats to band together in the eleventh hour and include tax hikes in their reconciliation bill. If nothing else, a partial reversal of President Trump’s Tax Cut and Jobs Act will be necessary to give a veneer of affordability to Biden’s giant spending bill to get it past Senate moderates. Chart 7Business Will Worry About Tax Hikes When (If) They Pass Chart 8Look Out: Americans Support Higher Taxes The impact of Biden’s corporate tax hike is expected to be a 5%-8% one-off hit to corporate earnings, according to our Global Investment Strategy. The impact could be less than that but the combination of popular opinion and the Democratic Party’s need to finance their social agenda suggests that investors should plan for the worst, which in this case is not that bad – key tax rates will still be lower than they were under President Obama. The chief risk to Biden’s legislation is that passing the bipartisan infrastructure bill (80% subjective odds) consumes so much political capital that there is not enough left for Biden’s reconciliation bill (50%-65% subjective odds, depending on circumstances). This is possible. Congressional Democrat leaders want to tie these two bills together but most likely the quick success of infrastructure, which is more popular than social welfare, will lead Democrats to conclude that a bird in the hand is worth two in the bush. They will pass infrastructure on less-than-perfect assurances from Senate moderates that they will support reconciliation. Then a separate battle over reconciliation will ensue, in which Biden must cajole the left-wing and moderate factions of his party into a “yea” vote while Republicans obstruct. The second major risk to Biden’s legislation – and the macro backdrop – comes if he mismanages foreign policy more generally, such as with the looming crisis over Iran. A foreign policy failure beyond Afghanistan could cause permanent damage to his political capital. And yet Democrats would be even more desperate for a legislative victory then, as they would face a wipeout in the midterm elections if they had no legislative victories and two foreign policy humiliations. In other words, Biden is nowhere near so unpopular that moderate Democrats will abandon his signature legislative agenda and condemn their party and his administration to a heavy defeat in 2022. Bottom Line: Biden’s legislation will pass, including some tax hikes. The revised magnitude of tax hikes will not be known until later this fall when the Senate and House start producing legislative text. Policy uncertainty and equity volatility will trend upward this fall but the end-game is more reflationary policy, which should keep equities grinding higher at least through Christmas. Midterm Elections: The Best Case For Democrats Is Not Good Enough Are Republicans more likely to take Congress now that Biden’s approval is underwater? How would this impact the policy and macroeconomic outlook? While Republicans are highly likely to retake the House of Representatives, the Senate is still slightly tipped for the Democrats. Biden would have to fail to pass legislation or commit another major policy mistake to give Republicans full control of Congress, although this outcome is slightly favored in online betting markets. The House currently consists of 220 Democrats and 212 Republicans. There is always some fluctuation in the exact numbers. Three vacancies should be filled in November’s special elections, which could bring the count to 222 Democrats and 213 Republicans.3 With 218 votes needed to pass legislation on an absolute majority vote, Democrats can only afford to lose three votes at present. This is an extremely tight margin and shows that this fall’s reconciliation bill is at risk in the House as well as the Senate. In the midterm elections, Republicans only need to take five-to-six seats to regain the majority (218). This is easy on paper: the average seat gain for the opposition in midterm House elections is 35. Biden’s latest approval rating puts Democrats in line to lose 37 seats based on history. The opposition typically makes gains in the midterm because it is fired up whereas the presidential party is complacent. In addition Republicans are expected to gain two seats (possibly as many as four) via gerrymandering in 2022. True, Democrats have some underrated supports in 2022. In all probability the pandemic will be waning while the economy will be waxing. Biden will likely have passed at least a bipartisan infrastructure deal. The divisions within Republican ranks over Trumpism will also persist, which may or may not increase Democratic turnout and vote-switching from suburban Republicans. Hence it is reasonable to ask whether Democrats could surprise to the upside and retain the House. Online betting markets put the probability at 29%, and these odds make sense to us. The historical record helps to define what kind of events might alter the outlook for the midterms. Table 2 shows the midterm elections in which the presidential party performed best (the opposition party disappointed the historical norm). The following points are salient: Table 2Best-Case Outcomes For Presidential Party In Midterm Elections There are only two cases in which the presidential party gained seats (Clinton 1998, Bush 2002) and three cases in which they only lost a few seats (Kennedy 1962, Reagan 1986, arguably Bush 1990). The Democratic victory of 1998 occurred at the top of an economic boom while the Republican victory of 2002 occurred one year after the 9/11 terrorist attacks. Neither is likely to be replicated for Democrats in 2022. Republicans’ mild losses in 1990 occurred just after Iraq invaded Kuwait. Republican’s mild losses in 1986 occurred despite a big legislative victory (tax reform). If either of the last two scenarios played out for Democrats in 2022, Democrats would likely lose the House by a whisker. Only if the Democrats’ 1962 scenario played out would Democrats retain the House in 2022, and only by a single seat. Yet the 1962 election occurred in the midst of the Cuban Missile Crisis! The takeaway is that a foreign policy crisis could help Democrats pare their losses in the midterms if Biden is deemed to have handled the crisis adroitly. But even then the ruling party would likely lose the House judging by history. Needless to say these are just historical examples. They also show that Democratic fortunes could turn around drastically between now and next fall (e.g. Kennedy went from a recession and the Bay of Pigs fiasco to gaining his party seats). The Senate outlook is less straightforward. Biden’s approval rating suggests a loss of four seats for Democrats based on the historical pattern. But the same pattern suggested Republicans would lose four seats in 2018 and instead they gained two. Our quantitative Senate election model, which we update every week in the Appendix, still tips the Democrats to gain one seat (a 51-49 majority) or at least retain their de facto one seat majority (50-50). Chart 9Presidential Vetoes In History What are the macroeconomic implications? A Republican House and Democratic White House would play “constitutional hardball,” just as occurred from 2011-14, given that the country is still at historically peak levels of political polarization.4 There are likely to be critical differences between 2011 and 2023 – populism has fundamentally weakened support for fiscal austerity – but the most likely result is gridlock and deadlock. Republicans will not be able to slash spending or cut taxes as Biden will have the presidential veto, but Democrats will not be able to increase spending or hike taxes (Chart 9). The problem for Biden would be the need to avoid a national default when and if the Republicans insist on spending cuts to raise the debt ceiling. The looming debt ceiling showdown this fall will increase uncertainty and volatility but ultimately Democrats have the votes to avoid a default. That would not necessarily be the case if Republicans controlled the House. And this time around Republicans could be driven to impeach the president, for whatever reason, in retaliation for President Trump’s impeachment in 2019. This situation obviously cannot be ruled out, even though it would be virtually impossible for the Senate to convict. At the same time, some bipartisanship could occur, as it did under Trump following the 2018 midterms. Anti-trust legislation and immigration reform are the two most important policy areas to watch on this front. Republican gains in Congress would marginally weaken the Democrats’ hold on the White House in 2024, though we continue to believe that Democrats are favored. American voters are likely to be better off in November 2024 than they were in November 2020, amid a pandemic, recession, and nationwide social unrest. Our quantitative model tips Democrats with 308 electoral votes (Appendix). Professor Allan Lichtman’s “13 Keys” to the presidency – a nearly flawless prediction system since 1984 – currently suggest that the Democrats only have three keys turned against them. They would need to see six or more in order to lose the White House (Table 3). Obviously the long-term status of the economy will be a critical factor (Chart 10). Table 3Lichtman’s Keys To The Presidency (Updated Sept 2021) Chart 10Will Biden's Economy Grow Faster Than That Of His Two Predecessors? Bringing it all together, US fiscal policy has taken a more proactive turn but it is still likely to freeze after this fall. It will be hard to pass major budget bills in 2022 ahead of the election and gridlock is the likeliest outcome, making 2025 the next realistic chance for major fiscal changes. The immediate implication is that Biden and Democratic leaders will have to disconnect the bipartisan infrastructure bill from the partisan social welfare reconciliation bill this autumn. This will require a major concession from House Speaker Nancy Pelosi. Otherwise both bills could collapse and with them the Democratic Party’s fortunes. Biden and moderate Democrats that face competitive races in 2022 will demand a quick victory before moving onto the less popular part. Investment Takeaways Value stocks are re-testing their cycle lows against growth stocks (Chart 11). The Delta variant and global growth jitters continue to weigh on this trade. Chart 11S&P Value Re-Tests Lows Versus Growth The S&P 500’s “Big Five” are rallying and outperforming the other 495 companies once again (Chart 12). Chart 12S&P 5 Recovery Versus 495 We expect politically induced volatility throughout the fall but we also expect it to be resolved in new and reflationary legislation. Signs that Biden’s legislation will pass should enable cyclical sectors and value stocks to recover, though the pandemic, global growth, and Chinese stability may prevent them from outperforming defensive sectors and growth stocks. A new set of hurdles will face markets if Republicans regain the House and halt fiscal easing from 2022-24. However, they will not be rewarded by voters if they create a fiscal or economic crisis, implying that the proactive fiscal turn in public opinion will prevail over the long run. If Biden’s legislation fails then it suggests that US fiscal policy is dysfunctional even under single-party control. This would heighten the deflationary tail risk and force us to reassess our macro and policy outlook. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes 1 See Senator Joe Manchin, “Why I Won’t Support Spending Another $3.5 Trillion,” Wall Street Journal, September 2, 2021, wsj.com. 2 Richard Rubin, “Progressives’ Tax-The-Rich Dreams Fade As Democrats Struggle For Votes,” Wall Street Journal, September 5, 2021, wsj.com. 3 The three special House elections are: Florida’s 20th District, previously Democratic held; Ohio’s 11th District, previously Democratic held; Ohio’s 15th District, previously Republican held. 4 See Mark V. Tushnet, “Constitutional Hardball,” John Marshall Legal Review 37 (2004), pp. 523-53, scholarship.law.georgetown.edu.
Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE). This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2 Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday. Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation. Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at 56%. Chart 6 Chart 7 Footnotes 1 Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2 Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3 Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021. 4 Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Regulatory changes affecting Chinese platform companies are structural – rather than transitory – in nature. These companies might become quasi-SOEs and could be used by the government to achieve its national and geopolitical objectives. China’s regulatory clampdown will produce structurally lower corporate profitability and, thereby, reduce equity valuations for Chinese TMT companies. Chinese policymakers have begun easing monetary and fiscal policies. Money and credit growth will likely bottom in December or so. However, as in H2 2018 and H1 2019, policy will be eased only gradually. During this period EM ex-TMT stocks and industrial metal prices performed poorly. Mainstream EM (countries outside North Asia) will continue suffering from weak growth and rising political volatility, warranting a higher risk premium. The risk-reward tradeoff for EM financial markets is poor. Feature Over the past several days, I have held calls and roundtables with clients located in the EMEA region. In this report, we will share our answers to the most common client questions. Many clients were asking if the selloff in Chinese platform companies is nearing its end or whether much more weakness is to be expected. It is not surprising that with the Hang Seng Tech index down 35% from its February highs, there is great temptation to engage in bottom fishing. So, we start with questions relating to this topic. Chart 1Is This Time Different For Chinese TMT Stocks? Question: In 2018, the regulatory clampdown on Tencent and other video game companies lasted several months and created a major pullback in their share prices (Chart 1). However, authorities ultimately removed restrictions and these stocks rallied to new highs. Do you expect the same dynamics to emerge this time around? And if not, why? We are witnessing a structural regime shift in the Chinese government’s approach toward platform companies. These changes are much more profound and long lasting than those in 2018. They herald structurally lower corporate profitability and equity multiples for Chinese TMT companies. For these stocks, a bounce from oversold levels is possible over the near term and it could be sharp. However, the rebound will be short-lived, i.e., a cyclical or secular rally is unlikely. Investors – who have not sold – should use this rebound to pare back exposure to Chinese TMT stocks. Chart 2Chinese SOEs: Lackluster Share Price Performance Going forward, these platform companies will be managed in a similar fashion to Chinese state-owned enterprises (SOEs): with the interest of the entire nation in mind, and shareholder interests will take a back seat. China’s SOEs trade at very low multiples and their share prices have been treading water since 2009 (Chart 2). The secular bull market in Chinese TMT share prices is over and more de-rating is likely for the following reasons: Chinese platform/new economy companies possess unique big data that are important to the country’s development. Protecting big data becomes a priority in an era of US-China geopolitical confrontation and amid the elevated risk of cyber attacks. As a result, it is essential for the Chinese government to control companies that possesses big data. Limiting foreign shareholders’ access and decision making in regard to big data is also imperative. We do not believe that Chinese authorities will ever allow these new economy companies to operate as freely as they have in the past. Given platform company importance to both the domestic economy and geopolitical confrontation with the US, we will not be surprised if the government eventually establishes effective control over these platform companies – probably via its affiliated entities. Many of these platform companies are natural monopolies or oligopolies and their profitability should be regulated by authorities according to free market economic textbooks. We discussed this point in the recent report titled Chinese TMT Stocks: A Bad Dream Or A New Reality? Please click on the link to open the report. Going forward, return on equity will be lower than in the past for these stocks, heralding lower valuation multiples. Stocks of many Chinese platform companies trade in the US and are largely owned by US/international (non-Chinese) investors. Neither US nor Chinese authorities want to see shares of Chinese TMT companies trade in the US, albeit for completely different reasons. Chinese authorities want these companies to release little information to their foreign shareholders, especially regarding big data. In turn, the US securities regulator is keen for US investors not to be exposed to the risks of owning Chinese stocks for two main reasons: (1) these companies do not disclose full information and (2) China’s government meddles with the management of these enterprises. Given that authorities from both countries do not support the trading of Chinese stocks in the US, odds are high that the trading of Chinese TMT companies will move from the US to Hong Kong. Moreover, US authorities may recommend US funds avoid owing Chinese stocks. In short, increased government control over Chinese TMT companies and rising geopolitical tensions between the US and the Middle Kingdom may prompt many foreign investors to reduce their exposure to these stocks. This will have negative ramifications on their share prices. Chart 3Little Volatility Spillover From Offshore Into China's Onshore Markets Question: Don’t you think Chinese authorities may reverse their regulatory clampdown given that Chinese share prices have already dropped a great deal and further weakness could hurt investor and business sentiment? Chinese authorities will not reverse regulatory tightening on platform companies. If investor and business confidence on the mainland is hurt materially, regulators will reduce the intensity of their reforms but will not reverse them. Importantly, the carnage has so far been limited to Chinese offshore financial markets (Chart 3). Neither the onshore equity indexes, nor onshore corporate bonds have sold off much (Chart 3). The majority of platform companies are listed offshore and plunging share prices hurt foreign shareholders more than domestic retail and institutional investors. There is little reason for Chinese policymakers to worry about losses among foreign investors so long as the carnage does not spread to onshore markets. Question: Why would Chinese authorities damage their largest and most successful companies in the new economy sectors? Are they not critical amidst the US-China confrontation? Chinese policymakers understand the importance of platform companies to the country’s domestic growth outlook as well as its geopolitical ambitions. This explains why Chinese authorities seek to establish effective control over decision making in these companies. We elaborated on the strategic importance of big data above. Also, the largest platform companies, such as Alibaba, Tencent and Meituan, have in recent years been acquiring stakes in numerous businesses in Southeast Asia. Beijing might be thinking of using these platform companies to raise its geopolitical influence over other Asian nations and beyond. Many Asian nations will play a prominent role in the US-China confrontation. Whether they side with China or the US will affect the balance of geopolitical power in the region. In this context, having control over soft infrastructure (payment and data systems, among others) in these Asian economies will give Beijing a chance to influence their geopolitical choices, thereby giving China an advantage over the US. Therefore, the Chinese central government might be aiming to establish an effective control over these companies’ strategic decisions. In such a case, shareholder interests will take a back seat in these companies. Question: What about common prosperity initiatives and policies that the Chinese leadership has unveiled in recent weeks? Why now? President Xi will be elected for his third term in the fall of 2022. This constitutes a major political precedent in the Middle Kingdom’s modern history. President Xi wants to secure his support from the bulk of the population. Common prosperity policies entail income and wealth distribution from high-income to middle- and low-income households. Chart 4 and Chart 5 illustrate that there has so far been no equalization of income and wealth distribution. Chart 4China: Income Disparity Has Not Been Narrowing Chart 5Wealth Concentration Remains High In China It is imperative for President Xi to achieve a meaningful change in income and wealth distribution in the next 12 months before his third term. President Xi’s power stems not from the top 10% of the population but from the remaining (and less wealthy) 90%. Hence, there will be little easing in the push toward common prosperity. If anything, the pace of these initiatives could escalate going forward. As a part of the common prosperity initiatives, companies with excess profitability will be compelled to perform a national duty in the form of financing social programs or providing donations. Large platform companies have already begun making large donations. This trend will intensify in the months ahead. In brief, profits will be distributed away from shareholders of these companies in favor of the general well-being of society. The positive is that low- and middle-income consumer spending in China will be supported by income transfer from companies and wealthy individuals. As a result, investors should favor the companies that sell to low- and middle-income households. Chart 6Chinese Growth Stocks Are Not Yet Cheap Going forward, the model of SOEs in China or Russia will be applicable to Chinese platform companies. SOEs in China, Russia and other EM countries often perform national duties at the expense of shareholders. Not surprisingly, their stocks have been trading at much lower multiples than private companies. Presently, Chinese TMT/growth stocks trade at a trailing P/E ratio of 33.5 (Chart 6). We do not expect platform companies’ P/E ratio to drop to the level of SOEs. However, a trailing P/E ratio of 33.5 for China’s TMT companies is still high given: the uncertainty around future business models; a lack of clarity around (still evolving) new regulation; government involvement in their management; the prioritization of national and geopolitical objectives over shareholder interest. Chart 7Mind These Gaps Question: Isn’t the slowdown in China’s business cycle already well known and priced in related financial markets? Yes, it is well known but we do not think it has been priced in China-exposed plays. There are several market relationships and indicators that lead us to believe so. Both panels in Chart 7 illustrate that industrial metals prices have diverged from the Chinese manufacturing PMI and onshore government bond yields. The latter two variables project the Chinese business cycle. Such a decoupling is unsustainable given that China accounts for 55% of global industrial metal consumption. We continue to expect meaningful downside in industrial metals prices which would hurt EM countries exporting commodities. China’s credit and fiscal spending impulse leads its business cycle by nine months and suggests that economic data will be weakening until Q2 2022 (Chart 8). Finally, net EPS revisions for EM-listed companies remain elevated (Chart 9). Chart 8China's Business Cycle Will Continue Decelerating Well Into Q1 2022 Chart 9EM EPS Growth Expectations Have Not Yet Been Downgraded That said, one sentiment indicator that has dropped significantly and is now near its level during previous EM equity lows is the Sentix European investor sentiment index on EM equities (Chart 10). Chart 10European Investor Sentiment On EM Stocks Is Back To Its Previous Lows Net-net, the risk-reward tradeoff for EM equities and credit markets is not yet attractive. Chinese TMT stocks are vulnerable for reasons discussed above while EM financial markets exposed to China’s old economy are at risk due to decelerating Chinese economic growth. Question: When will authorities in China ease policy? What does it imply for Chinese and EM financial markets? Shouldn’t investors buy China/EM assets now in anticipation of macro policy easing in China? Yes, China has already started easing credit and fiscal policy and will ease more in the coming months. Chart 11 reveals that banks’ excess reserves at the PBOC have turned up and they lead the credit impulse by six months. In turn, the Chinese credit impulse in turn leads EM share price cycles by nine months (Chart 12). Chart 11China's Credit Impulse Will Bottom In Late 2021 Chart 12EM Equities Are Not Yet Out Of The Woods All in all, even though Chinese policymakers have begun easing credit and fiscal policy, financial markets leveraged to the mainland’s old economy could still suffer as growth continues to disappoint in the months to come. Chart 13Chinese Easing In H2 2018 And H1 2019 Did Not Help Much EM Stocks And Metal Prices Importantly, policy easing will be implemented gradually, as in H2 2018 and H1 2019. During this period EM ex-TMT stocks and industrial metal prices performed poorly despite policy easing in China (Chart 13). Question: Given improvements in vaccine availability worldwide, will EM countries close their vaccination gap with developed countries in the coming months? If yes, wouldn’t it allow their economies to catch up, and their financial markets to outperform their DM peers? EM vaccination rates will rise as vaccines become available to developing countries. However, mainstream EM vaccination rates will still remain below those of advanced economies. This gap is due to higher levels of mistrust toward governments in developing countries than in advanced ones. Therefore, the pandemic will continue capping economic activity in mainstream EM. Importantly, the lack of fiscal stimulus, monetary policy tightening and weak banking systems in mainstream EM (i.e., excluding China, Korea and Taiwan) herald weak income and domestic demand growth in these economies. Years of poor income growth and lasting pandemic damage have caused political volatility to flare-up in some countries such as Colombia, Peru, Brazil, South Africa and Malaysia. This trend will likely continue foreshowing a higher risk premium in EM financial markets. Question: What is your inflation outlook for mainstream EM (excluding North Asia)? Will inflation continue to surprise to the upside and will their central banks hike rates enough so that their currencies do not depreciate? We discussed the inflation dynamics and the outlook for local rates for EM in the August 12 report. While commodity price inflation will subside, renewed currency deprecation is the key risk to the inflation outlook in mainstream EM. EM currencies will depreciate because China’s continued slowdown is bearish for EM currencies but bullish for the greenback. The basis is that the US sells little to China while EM are exposed to the Chinese business cycle. Also, domestic demand in mainstream EM will disappoint. That, along with rising political volatility, is negative for their currencies. Finally, high local rates in mainstream EM have often coincided with currency depreciation rather than appreciation. Question: What is the biggest risk in your view? The biggest risk to our view has been and remains TINA (There Is No Alternative). We have strong conviction on fundamentals but very little conviction on fund flows. Given that DM equity and credit markets are expensive and their government bond yields are very depressed, portfolio capital can go into EM financial markets that offer lower valuation than their DM counterparts even though they are not cheap in absolute terms. Our methodology is that fundamentals drive flows in the medium- to-long term. However, with the global financial system flush with liquidity, the importance of fundamentals has declined in recent years. Therefore, we are cognizant that EM markets might not sell off a lot and could bottom at a higher level than warranted by fundamentals. Still, we expect more downside in the coming months because fundamentals are much worse than most investors realize. Chart 14EM Credit Will Continue Underperforming Their US Peers Question: What is your recommended strategy across EM equities, currencies, and fixed-income markets? Global equity portfolios should continue underweighting EM, a recommendation from March 25, 2021. Within the EM equity universe, our overweights are Korea, India, China (preferring onshore to offshore equities), Mexico and Chile. Our underweights are Brazil, Colombia, Peru, South Africa, Turkey, the Philippines and Indonesia. The risk-reward tradeoff for EM currencies remains poor. We continue shorting a basket of BRL, CLP, COP, PEN, ZAR, TRY, PHP, THB and KRW versus the US dollar. Within local markets we overweight Mexico, Russia, Korea, Malaysia, India, China and Chile. Regarding sovereign and corporate credit, we have downgraded EM credit versus US credit on March 25 and this strategy remains intact (Chart 14). The lists of our overweights, underweights and the ones warranting neutral allocation in EM equity, domestic bonds and credit portfolios are presented below and can always be found on the EMS website. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights Our willingness to spend money depends on which ‘mental account’ it occupies. Once windfall income enters our ‘savings mental account’, we will not spend it. Hence, the pandemic’s windfall income receipts will have no sustained impact on spending, or on inflation. This means that US monetary tightening will be later and shallower than the market is pricing. As we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples). Fractal analysis: The US dollar, and base metals versus precious metals. Feature Chart of the WeekNo Tsunami Of Spending Despite Excess Income Many people claimed that the war chest of savings that global households accumulated during the pandemic would unleash a tsunami of spending. Well, it didn’t. For example, US consumer spending remains precisely on its pre-pandemic trend (Chart I-1 and Chart I-2). This, despite stimulus checks and other so-called ‘transfer payments’ which boosted aggregate household incomes by trillions of dollars. Indeed, paste over 2020, and you would be forgiven for thinking that there was no pandemic! Chart I-2No Tsunami Of Spending Despite Excess Income Of course, households that lost their livelihoods during the pandemic, and thus became ‘liquidity constrained’, did spend the lifeline stimulus payments that they received. Yet in aggregate, households did not spend the excess income received during the pandemic. Moreover, the phenomenon is global – the savings rate in the UK has surged near identically to that in the US (Chart I-3). Chart I-3The Savings Rate Has Surged Everywhere The excess income built up during the pandemic did not unleash a tsunami of spending. Neither will it unleash a tsunami of future spending. We can say this with high conviction because we have seen the same movie many times before. Previous tranches of stimulus and transfer payments that boosted incomes in 2004, 2008, and 2012 (though admittedly by less than in 2020) had no lasting impact on spending. Whether We Spend Or Save Money Depends On Which ‘Mental Account’ It Occupies Why do windfall income receipts not trigger a tsunami in spending? (Chart I-4) Chart I-4Stimulus Checks Had No Meaningful Impact On Spending One putative answer comes from Milton Friedman’s Permanent Income Hypothesis. Contrary to the Keynesian belief that absolute income drives spending, Friedman postulated that income comprises a permanent (expected) component and a transitory (unexpected) component. And only the permanent income component drives spending. In the permanent income hypothesis, spending is the result of estimated permanent income rather than a transitory current component. Therefore, for households that are not liquidity constrained, a windfall receipt – like a stimulus payment – will not boost spending if it does not boost estimated permanent income. Nevertheless, this theory does require households to estimate their future permanent incomes, and it is debatable if households can do this. Stimulus and transfer payments that boosted incomes in 2004, 2008, 2012, and 2020 had no lasting impact on spending. We believe that a more real-world answer to how we deal with windfalls comes not from Economics but from the field of Psychology, and the theory known as Mental Accounting Bias. Mental accounting bias states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, so that a dollar in a current (checking) account is no different to a dollar in a savings account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings or investment accounts we will not spend. Hence, the moment we move the dollar from our current account into our savings or investment account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. More likely, it will be used to reduce household debt, and thereby constrain the broad money supply. In effect, part of the recent increase in public debt will just end up decreasing private debt, as happened in Japan during the 1990s (Chart I-5). Chart I-5In Japan, Public Debt Ended Up Paying Down Private Debt With no permanent boost to spending, the pandemic’s windfall income receipts will have no sustained impact on inflation. As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable While consumer spending remains precisely on its pre-pandemic trend, the sub-components of this spending do not. Specifically, spending on durable goods stands way above its pre-pandemic trend, while spending on services languishes below trend (Chart I-6). Chart I-6The Pandemic Distorted Spending Patterns This makes perfect sense. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. Therefore, consumers just shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods. But now that shift is reversing. In turn, these massive and unprecedented shifts in spending patterns explain the recent evolution of inflation. As booming demand for durable goods created supply bottlenecks, durables prices skyrocketed (Chart I-7). Chart I-7The Pandemic Distorted Prices Remarkably though, the 10 percent spike in US durable good price through 2020-21 was the first increase in an otherwise persistently deflationary trend through this millennium (Chart I-8). As such, it was a huge aberration and as Jay Powell pointed out last week in Jackson Hole: Chart I-8The Increase In Durables Prices Was A Huge Aberration “It seems unlikely that durables inflation will continue to contribute importantly over time to overall inflation.” Meanwhile, with services simply unavailable, their prices did not fall, given that the price of something that cannot be bought is a meaningless concept. Moreover, unlike for an unbought durable good, which adds to tomorrow’s supply, an unbought service such as a theatre ticket – whose consumption is time-sensitive – does not add to tomorrow’s supply. Hence, when unavailable services suddenly became available, the initial euphoric demand for limited supply caused these service prices also to surge. But excluding such short-lived euphoria in airfares, car hire, and lodging way from home, services prices remain well-contained. This reinforces our conclusion from the first section. The pandemic’s windfall income receipts will have no sustained impact on inflation. As Jay Powell went on to say: “We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2 percent inflation on a sustainable basis.” All of which means that US monetary tightening will be later and shallower than the market is pricing. Another important investment conclusion is that as we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. The abnormally high spending on durables has a long way to fall. Given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market, this will weigh on consumer discretionary sectors (Chart I-9). Chart I-9As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples) (Chart I-10). Chart I-10Underweight XLY Versus XLP Fractal Analysis Update Fractal analysis suggests that the dollar’s rally since late-Spring could meet near-term resistance, given the incipient fragility on its 65-day fractal structure (Chart I-11). Chart I-11The Dollar's Rally Could Meet Near-Term Resistance A bigger vulnerability is for the strong and sustained rally in base metals versus precious metals, which is now extremely fragile on its 260-day fractal structure (Chart I-12). We are already successfully playing this through short tin versus platinum, but are adding a new expression: short aluminium versus gold. The profit target and symmetrical stop-loss are set at 13.5 percent. Chart I-12The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The post-pandemic investment phase is just a continuation of the post-credit boom investment phase. This is because the pandemic has just accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends will structurally weigh on the profits of old economy sectors, consumer prices, and bond yields. At the same time, these trends are a continuing structural tailwind for the profits in those sectors that facilitate the shift to a more digital and cleaner world. Our high-conviction recommendation is to stay structurally overweight growth sectors versus old economy sectors… …and to stay structurally overweight the US stock market versus the non-US stock market. Fractal analysis: PLN/USD, Hungary versus Emerging Markets, and sugar versus soybeans. Feature Chart of the WeekUS And Non-US Profits Go Their Starkly Separate Ways Many people use the US stock market as a proxy for the world stock market. Intuitively, this makes sense, because the US stock market is the largest in the world, and the S&P 500 and Dow Jones Industrials are well-known indexes that we can monitor in real time. In contrast, world equity indexes such as the MSCI All Country World are less familiar and do not move in real time. Yet to use the US stock market as a proxy for the world stock market is a mistake. Although the US comprises makes up half of the world stock market capitalisation, the other half is so different – the non-US yan to the US yin – that the US cannot represent the world. As we will now illustrate. US Profits Have Doubled While Non-US Profits Have Shrunk Over the past ten years, US and non-US stock market profits have gone their starkly separate ways. While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011! (Chart of the Week) While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011. Of course, in any comparison of this sort, a key issue is the starting point. In this first part of our analysis, we are defining the starting point as the point at which profits had recouped all their global financial crisis losses. For both US and non-US profits this point was in March 2011 (Chart I-2 and Chart I-3). Chart I-2Comparing Profit Growth Since The Full Recovery From The Financial Crisis Chart I-3Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Because the issue of the starting point of the analysis is contentious, we will look at a much earlier starting point later in the report. But first, here are the decompositions of the US and non-US stock market moves from March 2011. US stock market profits are up 93 percent, while the multiple paid for those profits (valuation) is up 75 percent. Compounding to a total price gain of 235 percent (Chart I-4). Chart I-4US Profits Up 93 Percent, Valuation Up 75 Percent Non-US stock market profits are down -9 percent, while the multiple paid for those profits is up 38 percent. Compounding to a total price gain of a measly 25 percent (Chart I-5). Chart I-5Non-US Profits Down -9 Percent, Valuation Up 38 Percent The aggregate world stock market profits are up 24 percent, while the multiple paid for those profits is up 57 percent. Compounding to a total price gain of 94 percent (Chart I-6). Chart I-6World Profits Up 24 Percent, Valuation Up 57 Percent The Post-Credit Boom Phase Favours The US Over The Non-US Stock Market In the post-credit boom phase, several important features of stock market performance are worth highlighting. In absolute terms, valuation expansion has lifted US stocks by twice as much as non-US stocks, 75 percent versus 38 percent. Yet even the 75 percent expansion in the US stock market valuation has played second fiddle to the 93 percent expansion in US stock market profits. Absent valuation expansion, non-US stocks would stand lower today than in 2011. But for non-US stocks, whose structural profit growth has been non-existent, valuation expansion has been the only instrument for structural gains. Indeed, absent valuation expansion, non-US stocks would stand lower today than in 2011. And absent valuation expansion at a world level, the world stock market would lose three quarters of its ten-year gain. What can explain the startling performance differential between US and non-US stocks on both profit and valuation expansions? As we have argued before, most of the difference does not come from the underlying (US versus non-US) economies, but instead comes from the company and sector compositions of the stock markets. The US stock market is heavily over-weighted to global growth companies and sectors – such as technology and healthcare (Chart I-7) – which, by definition, have experienced structural growth in their profits. In contrast, the non-US stock market is heavily over-weighted to global old economy companies and sectors – such as financials, energy, and resources (Chart I-8) – whose profits have stagnated, or entered structural downtrends (Chart I-9). Chart I-7The US Stock Market Is Heavily Over-Weighted To Growth Sectors Chart I-8The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors Chart I-9Old Economy Sector Profits Have Gone Nowhere At the same time, when bond yields decline, companies whose profits are growing (and time-weighted into the distant future) see a greater increase in their net present values. Hence, companies in the global growth sectors have experienced a larger valuation expansion than those in the old economy sectors. In this way, the US stock market has outperformed the non-US stock market on both profit growth and valuation expansion. The key question is, will these post-credit boom trends continue? The answer depends on whether the post-pandemic world marks a new phase for investment, or whether it is just a continuation of the post-credit boom phase. The Post-Pandemic Phase Is A Continuation Of The Post-Credit Boom Phase Let’s now address the issue of the starting point of our analysis by panning out to 1990. This bigger picture from 1990 shows three distinct phases for investors (Chart I-10 and Chart I-11). Chart I-10Since 1990, There Have Been Three Distinct Investment Phases Chart I-11The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The first phase was the 1990s build-up to the dot com boom. This phase clearly favoured growth sectors, and thereby the US stock market versus the non-US stock market. The second phase was the early 2000s credit boom. This phase clearly favoured sectors that facilitated the credit boom or benefited from its spending – notably, the old economy sectors of financials, energy, and resources. Thereby it favoured the non-US stock market versus the US stock market. The third and most recent phase is the post-credit boom phase. This phase has flipped the leadership back to growth sectors as the absence of structural credit growth has stifled financials as well as the capital-intensive old economy sectors that had previously benefited from the credit boom. Additionally, the structural disinflation that has comes from weak credit growth has dragged down bond yields and – as already discussed – given a much bigger boost to growth sector valuations. Since 1990, there have been three distinct phases for investors: the dot com boom; the credit boom; and the post-credit boom. Now we come to the key question. Did 2020 mark the end of the post-credit boom phase and the start of a new ‘post-pandemic’ phase? On the evidence so far, the answer is an emphatic no. Crucially, there is no new credit boom. A still highly indebted private sector is neither willing nor able to borrow. And although public sector debt surged during the pandemic, governments are now keen to temper or rein in deficits. In any case, Japan teaches us that government borrowing – which is bond rather than bank financed – does nothing for the banks or the broader financial sector. An equally important question is, has the pandemic reversed the societal and economic trends of the post-credit boom phase? The answer is no. Quite the contrary, the pandemic has accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends are structurally disinflationary for the profits of old economy sectors as well as for consumer prices. Thereby, they will continue to weigh on bond yields. At the same time, the trends are a continuing structural tailwind for the profits in those sectors that facilitate and enable the shift to a more digital and cleaner world. While we are open to the evolving evidence, the post-pandemic investment phase seems an extension of the post-credit boom phase. This means that structurally, there is no reason to flip out of growth sectors back to old economy sectors. It also means that structurally, there is no reason to switch from US to non-US stocks. Fractal Analysis Update This week’s fractal analysis highlights three potential countertrend moves based on fragile fractal structures. First, the recent rally in the US dollar could meet near-term resistance given its weakening 65-day fractal structure. A good way of playing this would be long PLN/USD (Chart I-12). Chart I-12PLN/USD Could Rebound Second, the strong outperformance of Hungary versus Emerging Markets – largely driven by one stock, OTP Bank – has become a crowded trade based on its 130-day fractal structure. This would suggest underweighting Hungary versus the Emerging Markets index (Chart I-13). Chart I-13Underweight Hungary Versus EM Finally, the sugar price has skyrocketed as extreme weather has disrupted output in the world’s top producer, Brazil. Given that supply bottlenecks ultimately ease, a recommended trade would be to short sugar versus soybeans, using ICE versus CBOT futures contracts (Chart I-14). Set the profit target and symmetrical stop-loss at 8 percent. Chart I-14Short Sugar Versus Soybeans Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) Footnotes 1 See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2 Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.
Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story. Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent. Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations