Economic Growth
Highlights A decline in the marginal propensity to spend out of both income and wealth over the past few decades generated a flood of excess savings. Facing a chronic shortfall of aggregate demand, central banks had no choice but to cut interest rates. This inflated asset prices. Looking out, the marginal propensity to spend should rise as household deleveraging pressures abate, retiring baby boomers shift from being savers to dissavers, and labor’s share of income increases. While rising bond yields will be a headwind to equities, continued above-trend global growth, upward earnings revisions, forthcoming Chinese fiscal stimulus, and a cresting in the number of new Delta variant cases all justify overweighting stocks on a 12-month horizon. A more cautious stance towards equities will be appropriate in two years’ time once stagflationary forces begin to assert themselves. The Keynesian Cross The “Keynesian Cross” is one of the first diagrams that students encounter in introductory macroeconomic courses (Chart 1). It simply plots Aggregate Expenditure (AE) versus output (Y). Chart 1The Keynesian Cross Aggregate expenditure consists of personal consumption, capital investment, government expenditure, and net exports: (1) If spending exceeds output, inventories will decline, causing firms to raise production. In contrast, if output exceeds spending, inventories will increase, prompting companies to cut production. Hence, the economy gravitates towards a level of output where inventories are stable; that is, where AE is equal to Y. Importantly, this level of production may or may not correspond to full employment. Introducing Asset Prices The Keynesian Cross model does not explicitly include asset prices. However, this can be easily rectified by postulating that spending depends on both income and wealth. For example, let us express consumption as: (2) In this equation, α is the marginal propensity to consume out of wealth (i.e., how much consumption rises for every dollar increase in wealth, W) while β is the marginal propensity to consume out of income, Y.1 An increase in asset prices will boost wealth, leading to more consumption. A Simple But Illuminating Identity Consider the case where inventories are stable. Substituting equation (2) into equation (1) and then dividing by Y yields: (3) The equation above is an identity. It does not say that a change in one term must lead to a change in another term in any causal sense of the word. All it says is that the terms on the right-hand side of the equation must add up to one. Suppose, for example, that α or β were to decline. If that were to happen, consumption would fall, leading to lower output. In order to restore output to its original level, either wealth would need to rise or some combination of investment, government spending, and net exports would need to increase. Upward Pressure On Savings There are at least three reasons to think that α and β have declined since the early 1980s: Chart 2US Household Debt Burdens Have Eased Significantly Over The Past Decade Deleveraging: The need for households in economies such as the US to repair their balance sheets in the aftermath of the Global Financial Crisis put upward pressure on desired savings, leading to a decrease in β. The inability to use the equity in one’s home to finance consumption also lowered α. To this day, outstanding home equity line of credit (HELOC) balances in the US are a shadow of their former selves (Chart 2). Demographics: Savings vary over the life cycle. In general, savings are highest between the ages of 35 and 60 (Chart 3). The percentage of households in developed economies in their peak savings years began to increase in the late 1970s. While the trend has reversed in recent years, the ratio of workers-to-consumers in most countries (the so-called “support ratio”) remains elevated (Chart 4). Inequality: Higher income households save a greater share of their incomes than lower income households. As Atif Mian, Ludwig Straub, and Amir Sufi documented at last week’s Jackson Hole symposium, the rise in income inequality since 1980 has pushed up desired savings, thus lowering β in the process (Chart 5). Likewise, there is evidence that wealthier households tend to spend less of every additional dollar of wealth than poorer households.2 To the extent that wealth inequality has also increased since 1980, α has declined. Chart 3ASavings Peak Around Middle Age (I) Chart 3BSavings Peak Around Middle Age (II) Chart 4AIncreased Desired Savings Corresponded To A Rise In Support Ratios (I) Chart 4BIncreased Desired Savings Corresponded To A Rise In Support Ratios (II) Chart 5Income Inequality Has Skewed The Composition Of Savings The Need For Policy Support The decline in α and β over the past few decades could have been offset by an increase in investment or net exports. Unfortunately, at least in the US, that never happened (Chart 6). The US trade deficit in goods and services stood at 3.9% of GDP in Q2 of 2021, the highest in 12 years. The non-petroleum trade deficit is at a record high. Investment spending also remains below the levels reached in the pre-GFC period. The shortfall in aggregate demand put pressure on policymakers to spur the economy. The results were somewhat mixed. Looking at the US, government spending on goods and services rose substantially during the Great Recession. However, spending then proceeded to fall to multi-decade lows as a share of GDP by 2019 (Chart 7). Transfer payments were also broadly stable as a share of GDP in the decade leading up to the pandemic. The Trump tax cuts reduced government revenue by around 1.7% of GDP. However, as we have noted in the past, the impact of the tax cuts on aggregate demand was fairly small. Chart 6US Private Sector Investment Remains Below Its Pre-GFC Peak While The Non-Petroleum Trade Deficit Is At A Record High Chart 7Fiscal Policy Has Been More Reactive Than Proactive In The US After surging during the pandemic, both direct government expenditure and transfer payments have come off their highs. Tax rates are also likely to rise for upper income earners and corporations. Nevertheless, with Congress set to pass a $550 billion infrastructure bill and a $3.5 trillion budget reconciliation bill, US fiscal policy will remain more stimulative over the next few years than it was in the pre-pandemic period. The same is likely to be true outside the US (Chart 8). Chart 8Fiscal Policy: Tighter But Not Tight Central Banks To The Rescue This brings us to monetary policy. In the post-GFC period, lower interest rates helped keep capital investment from falling more than it would have otherwise. In addition, lower rates discouraged savings, thus supporting consumption. And, with other central banks also cutting rates, the decision by the Fed to maintain low rates prevented the dollar from strengthening excessively. Beyond the direct benefits to the economy, lower rates increased the prices of long-duration assets such as equities and homes. This raised W in the equations above. The resulting “wealth effect” stoked consumer spending, while also encouraging new investment (particularly in real estate). Excess Savings Should Diminish Looking out, there are a few reasons to think that α and β will begin trending higher, leading to more spending and less need for ultra-accommodative monetary policies: Chart 9Wealth Accumulation Through The Ages Deleveraging pressures have abated. In the US, the ratio of household debt-to-disposable income has returned to pre-housing bubble levels. Debt-servicing costs are at a multi-decade low. Baby boomers are leaving the labor force. They hold over half of US household wealth, considerably more than younger generations (Chart 9). As baby boomers transition from being net savers to net dissavers, national savings will fall. Chart 10A Tight Labor Market Eventually Bolsters Wages Governments are working to mitigate income inequality. Not only are redistributionist policies increasingly in vogue, but policymakers are trying to run economies hot. Historically, a tight labor market has curbed income inequality, while driving up workers’ share of overall income (Chart 10). Upside For Bond Yields, Both Near And Far Bond yields in the major economies likely hit a generational low last summer. Yields should rise over the coming years, first as slack diminishes, and later as structural forces reduce the amount of excess savings sloshing around the global economy. In the near term, a cresting of the Delta variant wave will prop up Treasury yields. While the number of new cases in the US continues to rise, the second derivative has turned for the better. A heat map shows that the weekly growth in new cases has slowed substantially in most US states (Chart 11). Chart 11The Delta Variant Wave Is Fading In The US Globally, the Delta variant wave is abating (Chart 12). The transmission rate has clearly peaked within the G7 (Chart 13). The number of cases has begun to fall in recent hot spots such as Indonesia and Thailand. And, after rising above 100, the 7-day average of new cases in China has fallen back to 30. Chart 12The Delta Wave Is Cresting Chart 13The Covid Transmission Rate Is Falling Again The tapering of bond purchases by the major central banks should also lift yields. Canada began tapering this past April. BCA’s fixed-income experts expect the Fed to start paring back purchases by the end of this year, with the ECB and BoE following suit in early 2022. We do not expect bond markets to become unhinged. Central banks would strongly push back against an excessive rise in yields. Nevertheless, a move in the US 10-year Treasury yield to 1.8% by early next year seems reasonable. Stocks Can Withstand Rising Bond Yields… For Now Chart 14Equity Valuations and Real Bond Yields Have Tended To Move In Tandem Equity valuations have broadly tracked real bond yields over the past few years (Chart 14). While higher yields will weigh on equity prices, there are a number of remaining tailwinds for stocks: Growth will remain above trend in the foreseeable future: Bloomberg consensus estimates foresee the global economy growing at an above-trend pace well into next year (Table 1). We agree with this assessment, and in fact, see upside risks to consensus growth forecasts. In particular, Chinese growth is likely to accelerate later this year as credit growth rebounds and fiscal spending increases. Local governments used less than 40% of their annual debt issuance quotas as of the end of July. Typically by that time of the year, they have used 70% of their quotas. Table 1Global Growth Will Remain Above Trend Well Into Next Year Forward earnings estimates will continue to drift higher: Analysts are usually too optimistic. As a result, they normally have to cut estimates over the course of the calendar year. This year has been different (Chart 15). In early July, analysts expected S&P 500 companies to generate about $45 in EPS in Q2. In the end, they generated about $53. Earnings are projected to decline in absolute terms in Q3 and remain below Q2 levels until the second quarter of next year, when they are anticipated to grow by a meagre 3.5% year-over-year (Table 2). As earnings estimates move up, stock prices will rise, even if P/E multiples move sideways. Chart 15Unusually, Analysts Have Been Revising Earnings Estimates Higher This Year Table 2US Earnings Estimates Have Upside Rising inflation expectations will lift nominal bond yields more than real yields: Investors expect inflation to come down rapidly over the coming months (Chart 16). The 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s comfort zone of 2.3%-to-2.5% (Chart 17).3 We think that US inflation will fall fast enough over the next few quarters to allow the Federal Reserve to maintain a fairly accommodative monetary stance, but not as fast as markets are discounting. Chart 16Investors Expect Inflation To Fall Rapidly From Current Levels The global equity risk premium remains elevated: We measure the equity risk premium (ERP) by subtracting the real 10-year bond yield from the forward earnings yield.4 Based on this measure, the global ERP stands at 634 bps (Chart 18). At the peak of the stock market boom in 2000, the global ERP was barely positive. Even in the US, where valuations are more stretched than abroad, the ERP stands at 574 bps. Remarkably, this is almost exactly where the ERP was in May 2008. An increase in the US 10-year Treasury yield to 1.8% by early next year – representing roughly a 50 basis-point increase from current levels in nominal terms and even less in real terms – would still leave US stocks attractively priced relative to bonds. Chart 17Below The Fed's Comfort Zone In summary, investors should remain overweight global equities on a 12-month horizon. A more cautious stance towards stocks will be appropriate in two years’ time once stagflationary forces begin to assert themselves. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Chart 18The Global Equity Risk Premium Remains Elevated Footnotes 1 Note that Gross Domestic Product should theoretically equal Gross Domestic Income. Thus, Y can denote either income or output. 2 For example, in a sample of five euro area economies, the European Central Bank found that the marginal propensity to consume out of wealth is higher for households at the lower end of the wealth distribution. 3 The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. 4 It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
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 China’s credit tightening may have surpassed maximum strength. Monetary policy will remain accommodative and fiscal policy will become more supportive in the rest of the year. However, overall regulatory oversight is still restrictive, limiting the scope of reflationary effects on the economy. There were signs that the “cross-cyclical” approach – a new catchphrase from the July Politburo meeting - emerged even before the start of the pandemic. The current policy backdrop resembles the situation in 2H2018. China’s new “common prosperity” plan, which sets up guidance for long-term policy direction, will likely have cyclical implications. Chinese investable stocks are in oversold territory and will probably rebound in the near term. In the next 6 to 12 months, however, we remain cautious given the lack of a catalyst to revive investor sentiment. Feature Chart 1Chinese Stocks Are Oversold In Absolute Terms China’s economic momentum has slowed, while regulatory crackdowns show no signs of dissipating. Meanwhile, Chinese investable stocks in absolute terms have slumped into technically oversold territory (Chart 1). Global investors are looking at fiscal and monetary policy easing for clues to what may be next. A shift in policy direction from restrictive to reflationary will help to shore up market sentiment and the outlook for the economy. Fiscal policy implementation in 1H21 was tighter than budgeted, leaving room for more support in 2H21. The PBoC’s unexpected reserve requirement ratio (RRR) cut in early July may have been a signal that policy tightening has ended. In short, China’s financial tightening has most likely passed its peak strength. Chart 2Valuations Are Almost Back To 2018 Lows We have no doubt that China will announce some compensatory measures in the coming months in response to rising downward pressures on the domestic economy. However, we continue to hold the view that the bar for a fresh round of material stimulus is higher today than it was in the past. The policy focus pivoting from a countercyclical to cross-cyclical adjustment, the rising emphasis on common prosperity, and the ongoing regulatory clampdowns in an array of industries, all limit the extent to which authorities can deploy the expected magnitude in infrastructure spending and bank lending. Therefore, we continue to recommend investors remain underweight Chinese stocks versus their global peers – a stance we have maintained since earlier this year – despite cheapened relative valuations in Chinese equities (Chart 2). Shifting To A Cross-Cycle Approach China’s policy shift to a cross-cyclical stance has gained more market attention since the late-July Politburo meeting. However, there were signs that the cross-cyclical approach emerged even before the start of the pandemic. Chart 3Size Of Stimulus Was Already Getting Smaller During the height of the 2018/19 US-China trade war, policymakers responded to the economic shocks from imposed import tariffs with much more measured stimulus than in previous cycles (Chart 3). President Xi repetitively used the “Long March” analogy during the trade war, warning Chinese citizens to prepare for protracted hardship stemming from conflict with the US.1 The metaphor had important market implications because the attitude was fundamental to how the government handled the cyclical slowdown in 2018/19. Despite aggressive RRR and policy rate cuts in the second half of 2018, authorities maintained tight restrictions on bank lending and local government spending. Consequentially, aggregate credit growth continued to slide through end-2018 (Chart 4). Furthermore, authorities became uneasy about the sharp rise in the rate of credit expansion in Q1 2019. Following a public spat between the Premier Li Keqiang and the central bank, bank lending slowed sharply in the rest of the year. As a result, the improvement in infrastructure investment growth was small and short-lived. Despite an acceleration in local government bond issuance in 2H18 and Q1 2019, infrastructure investment growth remained on a structural downward trend throughout most of 2018 and 2019 (Chart 5). Chart 4China: A Deja Vu Of 2018-2019? Chart 5Improvement In Infrastructure Investment Was Short-Lived In 2019 Chart 6Financial De-Risking Mode Is Still On The current policy backdrop resembles the situation in 2H2018: while the central bank has kept interest rates at historically low levels and preemptively cut the RRR rate in July, lending standards remain tight and shadow bank credit continues to shrink (Chart 6). In the past Chinese authorities stimulated substantially following exogenous shocks, but did not stimulate much when business cycle was slowing in an orderly manner. A resurgence of domestic COVID cases and the severe flood in central China in July and August represent exogenous shocks and occured when the economy was losing steam. Hence, there are higher odds authorities will provide some support in response to these exogenous shocks. However, the recurring battle against COVID and lingering tensions with the US have likely prompted Chinese top leadership to extend their cross-cycle strategy. Officials may feel that a modest easing in both monetary and fiscal policies will be sufficient to offset the current economic weakness without overstimulating the economy. Bottom Line: A cross-cycle policy approach means not only responding early to small shocks with piecemeal stimulus to stabilize growth but also limiting the scope of stimulus and preparing for “protracted battles”. The response from Chinese leaders during the trade war with the US in 2018/19 may be a roadmap for policy direction in the next 12 months. Cyclical Implications From “Common Prosperity” President Xi Jinping laid out a plan for “common prosperity”, a guideline for the country’s national policy in the coming decades, at the August 18th Central Committee for Financial and Economic Affairs. Most of the plan’s objectives have 2035 deadlines and will be achieved gradually in multiple phases.2 However, in the next 12 months and leading to the 20th National Party Congress in the fall of 2022, we expect the authorities to accelerate some reform agendas that are consistent with the 14th Five-Year Plan (2021-2025). A key area that may gain momentum is increasing labor income and household consumption share in national output. Both labor compensation and household consumption as a share of GDP improved from 2011 to 2016, but the progress stalled in recent years and further deteriorated last year in the wake of the pandemic (Chart 7). Policy decision makers can reverse the falling share by either boosting income/consumption or lowering the share of capital formation in the national output, or a combination of both. Regulatory tightening in the property market has reduced investment growth in the sector, which accounts for 66% of the country’s total fixed-asset formation (Chart 8). We expect policy restrictions to continue curbing real estate investment in the rest of the year and into 2022, further shrinking the share of capital formation in the aggregate output.3 Chart 7China's Economic Rebalancing Progress Has Stalled In The Past Five Years Chart 8Policymakers Are Moving Away From The 'Old Economy' Pillars Chart 9Recovery In Household Income And Consumption Has Significantly Lagged Other Sectors Recovery in household income and consumption has significantly lagged other sectors in China’s recent economic rebound (Chart 9). In addition to short-term, pandemic-related factors, household consumption has been sluggish due to China’s long-standing imbalanced income distribution. Given that China will be under more pressure to deliver economic progress in 2022, boosting wage growth and consumption will help to facilitate both the nation’s cross-cyclical economic strategy and President Xi’s longer-term reform plan for income and wealth redistribution. If successfully implemented, a rebalancing of labor income and consumption as a share of the national aggregate will have long-term economic benefits. However, for investors with a cyclical time frame, the transition will likely have the following implications on the market: Policymakers will keep a large fiscal budget deficit and increase spending in public services and social welfare, but there will be more pressure on the central government to keep local government debt in check. The increased fiscal burden also means that while the government will provide subsidies for households and key new-economy industries, policy at margin may move away from boosting investment in traditional infrastructure and construction (Chart 10). Chart 10Traditional Infrastructure Investment Will Remain Subdued Empirical research shows that lower-income households have a higher marginal propensity to consume.4 Last year China refrained from meaningful stimulus to incentivize consumption. In contrast, the statement from the August 18th meeting indicated the focus is on securing living standards and wages among lower-income households. Common prosperity related policies may boost consumption of staples and some durable goods but will likely discourage splurging in high-end luxury goods and services. Large corporations and high-net-worth individuals will be expected to share social responsibility and the cost of reducing income inequality, either through higher and stricter tax burdens, raising minimum wages for employees, and/or donations. Bottom Line: The “common prosperity” theme will mostly entail long-term policy initiatives, but it may also have some cyclical market repercussions. Investment Recommendations Chart 11Tactical Bounce Gave Way To Cyclical Downturn In Previous Cycles We do not rule out the possibility of a tactical (within the next three months) / technical rebound in Chinese stocks. Our August 4th report discussed how prices managed to rebound strongly within 90 days of the policy-triggered market riots in both 2015 and 2018. However, the rallies quickly faded and stocks fell to new lows (Chart 11). Prices bottomed when policy decisively turned reflationary. For now, the risks to Chinese equities are largely to the downside. Although there are some remedial measures to ease monetary and fiscal policies, officials have not sent a clear signal to ease on the regulatory front. Conversely, there are two scenarios that could prompt us to upgrade Chinese stocks to either neutral or overweight in both absolute and relative terms. Chart 12No Clear Signal Chinese Policymakers Will Ease On The Regulatory Front The first scenario is that the economy does not slow further and a modest policy easing is sufficient to stabilize the economic outlook. This may happen if strong global economic growth and demand continue to support China’s export and manufacturing sectors, while domestic household consumption improves. In this case, the downside risks on the overall economy would abate, but the gradual underlying downtrend in China's old economy would be intact. We would need an additional reflationary tailwind, such as a boost from fiscal spending or a reversal of industry policy tightening, to upgrade Chinese stocks to overweight. We have argued in the past that housing appears to be the best candidate; the catalyst is missing at the moment (Chart 12). In the second scenario, Chinese policymakers may determine that the downside risks to growth are unacceptably large given existing slowdowns in the industrial and service sectors, and decide to temporarily reverse course on structural reforms. We will watch for indications of a shift in attitude. For now, we think that China’s leadership has a higher pain threshold than in the past, suggesting that this outcome is not yet probable. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1"Xi Jinping calls for ‘new Long March’ in dramatic sign that China is preparing for protracted trade war", South China Morning Post. 2"Xi stresses promoting common prosperity amid high-quality development, forestalling major financial risks", Xinhua, English.news.cn 3We use fixed-asset investment (FAI) as a proxy for gross fixed capital formation (GFCF) because the National Bureau of Statistics of China does not publish the GFCF breakdown by sectors. GFCF comprises FAI, less the purchase of existing fixed assets, land and some minor items. Historically, the two series have closely tracked each other. 4"The Stimulative Effect of Redistribution", Federal Reserve Bank of San Francisco Market/Sector Recommendations Cyclical Investment Stance
Highlights 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 US crude oil output will continue its sharp recovery before leveling off by mid-2022, in our latest forecast (Chart of the Week). The recovery in US production is led by higher Permian shale-oil production, which is quietly pushing toward pre-COVID-19 highs while other basins languish. Permian output in July was ~ 143k b/d below the basin's peak in Mar20, and likely will surpass its all-time high output in 4Q21. Overall US shale-oil output remains ~ 1.1mm b/d below Nov19's peak of 9.04mm b/d, but we expect it to end the year at 7.90mm b/d and to average 8.10mm b/d for 2022. We do not expect US crude oil production to surpass its all-time high of 12.9mm b/d of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means larger shares of free cashflow will go to shareholders, and not to drilling for the sake of increasing output. While our overall balances estimates remain largely unchanged from last month, we have taken down our expectation for demand growth this year by close to 360k b/d and moved it into 2022, due to continuing difficulties containing the COVID-19 Delta variant. Our Brent crude oil forecasts for 2H21, 2022 and 2023 remain largely unchanged at $70, $73 (down $1) and $80/bbl. WTI will trade $2-$3/bbl lower. Feature Chart 1US Crude Recovery Continues Global crude oil markets are at a transition point. The dominant producer – OPEC 2.0 – begins retuning 400k b/d every month to the market from the massive 5.8mm b/d of spare capacity accumulated during the COVID-19 pandemic. For modeling purposes, it is not unreasonable to assume this will be a monthly increment returned to the market until the accumulated reserves are fully restored. This would take the program into 2H22, per OPEC's 18 July 2021 communique issued following the meeting that produced this return of supply. Thereafter, the core group of the coalition able to increase and sustain higher production – Kuwait, the UAE, Iraq, KSA and Russia – is expected to meet higher demand from their capacity.1 There is room for maneuver in the OPEC 2.0 agreement up and down. We continue to expect the coalition to make supply available as demand dictates – a data-dependent strategy, not unlike that of central banks navigating through the pandemic. This could stretch the return of that 5.8mm b/d of accumulated spare capacity further into 2H22 than we now expect. The pace largely depends on how quickly effective vaccines are distributed globally, particularly to EM economies over the course of this year and next. US Shale Recovery Led By Permian Output While OPEC 2.0 continues to manage member-state output – keeping the level of supply below that of demand to reduce global inventories – US crude oil output is quietly recovering. We expect this to continue into 1H22 (Chart 2). Chart 2Permian Output Recovers Strongly The higher American output in the Lower 48 states primarily is due to the continued growth of tight-oil shale production in the low-cost Permian Basin (Chart 3). This has been aided in no small part by the completion of drilled-but-uncompleted (DUC) wells in the Permian and elsewhere. Chart 3E&Ps Favor Permian Assets Since last year’s slump, the rig count has increased; however, compared to pre-pandemic levels, the number of rigs presently deployed are not sufficient to sustain current production. The finishing of DUC wells means that, despite the low rig count during the pandemic, shale oil supply has not dipped by a commensurate amount. This is a major feat, considering shale wells’ high decline rates. Chart 4US Producers Remain Focused On Shareholder Priorities DUCS have played a large role in sustaining overall US crude oil production. According to the EIA, since its peak in June 2020, DUCs in the shale basins have fallen by approximately 33%. As hedges well below the current market price for shale producers roll off, and DUC inventories are further depleted, we expect to see more drilling activity and the return of more rigs to oil fields. We do not expect US crude oil output to surpass its all-time high of 12.9mm b/ of Jan20 by the end of 2023. Instead, exploration & production (E&P) companies will continue to prioritize shareholders' interests. This means only profitable drilling supporting the free cashflow that allows E&Ps to return capital to shareholders will receive funding. US oil and gas companies have a long road back before they regain investors' trust (Chart 4). Demand Growth To Slow We expect global demand to increase 5.04mm b/d y/y in 2021, down from last month's growth estimate of 5.4mm b/d. We have taken down our expectation for demand growth this year by ~ 360k b/d and moved it into 2022, because of reduced mobility and local lockdowns due to continuing difficulties in containing the COVID-19 Delta variant, particularly in Asia (Chart 5).2 We continue to expect the global rollout of vaccines to increase, which will allow mobility restrictions to ease, and will support demand. This has been the case in the US, EU and is expected to continue as Latin America and other EM economies receive more efficacious vaccines. Thus, as DM growth slows, EM oil demand should pick up (Chart 6). Chart 5COVID-19 Delta Variant's Spread Remains Public Health Challenge Chart 6EM Demand Growth Will Offset DM Slowdown Net, we continue to expect demand for crude oil and refined products to grind higher, and to be maintained into 2023, as mobility rises, and economic growth continues to be supported by accommodative monetary policy and fiscal support. If anything, the rapid spread of the Delta variant likely will predispose central banks to continue to slow-walk normalizing monetary policy and interest rates. Global Balances Mostly Unchanged Chart 7Oil Markets To Remain Balanced Although we have shifted part of the demand recovery into next year, at more than 5mm b/d of growth, our 2021 expectation is still strong. This is expected to continue next year and into 2023 although not at 2021-22 rates. Continued production restraint by OPEC 2.0 and the price-taking cohort outside the coalition will keep the market balanced (Chart 7). We expect OPEC 2.0's core group of producers – Kuwait, the UAE, Iraq, KSA and Russia – will continue to abide by the reference production levels laid out in 18 July 2021 OPEC communique. Capital markets can be expected to continue constraining the price-taking cohort's misallocation of resources. These factors underpin our call for balanced markets (Table 1), and our view inventories will continue to draw (Chart 8). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23Our balances assessment leaves our price expectations unchanged from last month, with Brent's price trajectory to end-2023 intact (Chart 9). We expect Brent crude oil to average $70, $73 and $80/bbl in 2H21, 2022 and 2023, respectively. WTI is expected to trade $2-$3/bbl lower over this interval. Chart 8Inventories Will Continue To Draw Chart 9Brent Prices Trajectory Intact Investment Implications Balanced oil markets and continued inventory draws support our view Brent and refined-product forward curves will continue to backwardate, even if the evolution of this process is volatile. As a result, we remain long the S&P GSCI and the COMT ETF, which is optimized for backwardation. We continue to wait for a sell-off to get long the SPDR S&P Oil & Gas Exploration & Production ETF (XOP ETF). 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 The US EIA expects natural gas inventories at the end of the storage-injection season in October to be 4% below the 2016-2020 five-year average, at 3.6 TCF. At end-July, inventories were 6% below the five-year average (Chart 10). Colder-than-normal weather this past winter – particularly through the US Midwest and Texas natural gas fields – affected production and drove consumption higher this past winter, which forced inventories lower. Continued strength in LNG exports also are keeping gas prices well bid, as Asian and European markets buy fuel for power generation and to accumulate inventories ahead of the coming winter. Base Metals: Bullish The main worker’s union at Chile's Escondida mine, the largest in the world, and BHP reached an agreement on Friday to avoid a strike. The mine is expected to constitute 5% of total mined global copper supply for 2021. China's refined copper imports have been falling for the last three months (Chart 11). Weak economic data – China reported slower than expected growth in retail sales and manufacturing output for July – contributed to lower import levels. Precious Metals: Bullish Gold has been correcting following its recent decline, ending most days higher since the ‘flash crash’ last Monday, facilitated by a drop in real interest rates. The Jackson Hole Symposium next week will provide insights to market participants regarding the Fed’s future course of action and if it is in fact nearing an agreement to taper asset purchases. According to the Wall Street Journal, some officials believe the program could end by mid-2022 on the back of strong hiring reports. This was corroborated by minutes of the FOMC meeting which took place in July, which suggested a possibility to begin tapering the program by year-end. While the Fed stressed there was no mechanical relationship between the tapering and interest rate hikes, this could be bearish for gold, as real interest rates and the bullion move inversely. On the other hand, political uncertainty and a potential economic slowdown in China will support gold prices. Ags/Softs: Neutral Grain and bean crops are in slightly worse shape this year vs the same period in 2020, according to the USDA. The Department reported 62% of the US corn crop was in good to excellent condition for the week ended 15 August 2021, compared to 69% for the same period last year. 57% of the soybean crop was in good-to-excellent shape for the week ending on the 15th vs 72% a year ago. Chart 10 Chart 11 Footnotes 1 Please see our report of 22 July 2021, OPEC 2.0's Forward Guidance In New Baselines, which discusses the longer-term implications of this meeting and the subsequent communique containing the OPEC 2.0 core group's higher reference production levels. It is available at ces.bcareserch.com. 2 S&P Global Platts notes China's most recent mobility restrictions throughout the country will show up in oil demand figures in the near future. We expect similar reduced mobility as public health officials scramble to get more vaccines distributed. Please see Asia crude oil: Key market indicators for Aug 16-20 published 16 August 2021 by spglobal.com. Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed In 2021 Summary of Closed Trades