Economy

Dear Client, There will be no US Investment Strategy next week as we take our summer vacation. We will return on Monday, September 6th. We wish everyone a happy and safe conclusion to the summer. Best regards, Doug Peta Highlights Economy – COVID-19 and the official and individual responses to it continue to exert considerable influence over economic activity: We expect that labor force participation and employment will rise as people return to the workforce, provided that resurgent infection rates don’t provide a new reason to stay on the sidelines. Markets – Financial asset valuations are elevated, but a de-rating catalyst may not emerge any time soon: Massive infusions of fiscal aid and a Fed that is determined to err on the side of being too easy should support the fundamental backdrop, even as the Delta variant runs wild in communities with low vaccination rates. Strategy – Be alert, but stay the course unless policy makers change direction or their measures lose their force: We continue to expect that risk assets will outperform Treasuries and cash. Feature Labor Day, just two weeks away, will mark the unofficial end of summer in the United States and this year the end of August will mark its own milestone: eighteen months of the pandemic. COVID-19’s year-and-a-half residency has been filled with uncertainty and misdirection, but it now seems clear that it will be staying for good. It is disheartening to concede that we will have to accommodate an unwanted malign presence, especially when we seemed to be on the verge of cornering and trapping it. The emotional letdown may have accounted for the slide in consumer confidence, but it is important to note that the virus we’ll be living with indefinitely has morphed from a peril to a nuisance. One constant amidst the pandemic confusion has been the federal shock-and-awe campaign to protect the economy from its ravages. The Fed went big immediately, cutting the fed funds rate to zero, instituting $120 billion of monthly securities purchases and unveiling a range of novel programs to ease financial stresses. Before the first month was out, Congress passed the gigantic CARES Act package, raining money down on the unemployed and households in all but the top quartile of the income distribution. It followed up with a more modest stopgap measure in late December before embarking on the largest round of economic impact payments this spring. The net effect has been to do more than enough to buffer the economy from the pandemic and push any potential hangover beyond the range of our twelve-month investment timeframe. Away from the constant of the policy efforts, however, there is much that is uncertain about key elements of the economic and market outlook. We do not have a definitive answer about what the future holds for the labor market, consumption, or equity valuations. For each topic we consider what is known, what is unknown and list the series we’ll be monitoring to assess whether our base case is on track. We remain constructive on financial markets and the economy, though we recognize that our conviction levels must be lower given the lack of close empirical comparisons to the current backdrop. We will shift with the data series if they move in ways that convincingly challenge our base-case scenarios. The Work Force Known Factor(s): The pandemic has driven a reduction in labor force participation. After catching up from the cyclical damage inflicted by the Global Financial Crisis, the share of people age 16 and above who are working or looking for work has once again fallen well off its implied demographic pace (Chart 1, top panel). GDP and S&P 500 earnings are making new highs, but labor force participation is still down by 2%, after having fallen a whopping 4.9% at the April 2020 trough (Chart 1, bottom panel). Labor force participation typically slips during recessions, but the pandemic’s peak-to-trough decline was more than five times the decline experienced during the GFC, which held the previous record. Chart 1The Pandemic Washed Away A Chunk Of The Work Force Unknown Factor(s): The explosion in unemployment while communities were sheltering in place was a foregone conclusion, and it’s easy to see how people might have slipped out of the labor force as they withdrew from jobs that lost their luster. There are more job openings than unemployed people now, though (Chart 2), and there are still 3.2 million fewer people in the labor force than there were before the pandemic. The persistence of high unemployment and low participation is a mystery that no study has fully explained. The most frequently cited hypotheses involve generous unemployment insurance (UI) benefits, difficulty securing care for children or adults, and fear of infection. Chart 2The Labor Market Is Unusually Tight We are skeptical of claims that supplemental UI benefits and the additional cushion provided by the three rounds of direct payments to households are a principal driver. $3,200 per adult ($1,200 in Round 1, $600 in Round 2 and $1,400 in Round 3) is nice but it won’t replace even $10 hourly wages for more than a couple months. UI benefits can’t be blamed for the low participation rate (you can’t collect them if you drop out), and their impact on the unemployment rate may also be less than it’s been cracked up to be. We found a very weak negative relationship between state-level replacement rates (the value of average UI benefits relative to average compensation) and changes in state unemployment rates while the most generous $600 weekly federal UI benefit supplement was in effect (Chart 3). Chart 3State Unemployment Rates Were Indifferent To Replacement Rates July’s state unemployment rates were inconclusive on the question of whether exiting the federal supplemental UI benefit program reduced unemployment. The 25 states that ended their participation early (Chart 4, top panel) saw a smaller decline in their average unemployment rate than the 26 (including Washington, DC) that remain in the program (Chart 4, bottom panel), but the early-exit states had a lower starting average unemployment rate. Of the 18 states that had statistically significant month-on-month unemployment rate declines, 8 have already exited the supplement UI benefit program and 10 remain. Of the 39 states with statistically significant employment gains, 17 have already exited the supplement UI benefit program and 22 remain. We expect the end of augmented benefits in early September will give the labor market a modest boost, but curtailing benefit supplements does not appear to be a silver bullet for reducing unemployment or increasing participation. Chart 4Much Ado About Nothing Chart 5Fewer Care Options, Fewer Workers We suspect family care burdens have been more of a drag on participation and/or exiting the unemployment rolls. Young children attending school remotely had to have adult supervision, sidelining adults who could not work remotely. Similarly, many workers who relied on outside providers to care for adult family members during the day found themselves unable to work or petrified of exposing their homebound loved ones to the virus if they did. Family care burdens regularly fall more heavily on females than males and the greater decline in aggregate female participation (Chart 5, top panel) and across the below prime-age (second panel), prime-age (third panel) and above prime-age (bottom panel) categories suggests care issues are restraining employment. Infection fears likely waned with the development of effective vaccines and their initially rapid distribution, but the spread of the Delta variant may have rekindled them, especially in areas with low vaccination rates. It will take progress in vaccinating the reluctant and the dissemination of antibodies via new infections to hasten the peak in the Delta wave, which should align with a peak in infection fears. What We’re Watching: Net nonfarm payrolls gains; labor force participation; COVID-19 infections, hospitalizations and deaths; vaccinations; schools’ ability to host in-person learning; ongoing data from states exiting the federal UI benefit; approval of vaccines for children under 12. Consumption Chart 6More Came In, Less Went Out Known Factor(s): Increased income from fiscal transfers and decreased spending from activity constraints have allowed households to amass $2.3 trillion of excess pandemic savings (Chart 6). Some of the savings went to pay down outstanding debt, with households cutting their credit card balances by 14% before slowly starting to build them back up over the last few months (Chart 7). The combination of less debt and low rates has pushed debt-service burdens to their lowest level in four decades (Chart 8). Powered by savings, financial market gains and home price appreciation, household net worth grew at its fastest five-quarter rate ever from 1Q20 through 1Q21. Chart 7Households Actively De-levered During The Pandemic Chart 8Plenty Of Room To Service New Debt Unknown Factor(s): Changes in household net worth lead changes in personal consumption expenditures by two quarters, though 2020 consumption fell way short of the level predicted by the best-fit regression line. We do not know how much of last year’s consumption was lost to the pandemic and how much was merely deferred. We also don’t know where the savings rate will stabilize going forward or how much it might overshoot to the downside before settling into its new longer-run range. Simply put, we don’t know how much households will spend from their newly accumulated stash. We do know, however, that the savings rate fell steadily from the mid-seventies, when the baby boomers began entering their prime working years, to the onset of the GFC (Chart 9). In recent client meetings we have made the conservative assumption that half of the $2.3 trillion of excess savings will be spent by the end of 2022. That would amount to a tailwind equivalent to 5% of a year’s GDP and keep the US growing at well above trend in 2021 and 2022. It remains to be seen, however, how much of their excess savings households will spend and when. Chart 9The Savings Rate Will Come Down What We’re Watching: Household income, consumption, savings rate, credit card and other consumer loan balances, borrower performance, lender willingness, spending on services and spending on goods. Asset Prices Known Factor(s): Ample and immediate monetary and fiscal accommodation put a floor under financial asset prices at the beginning of the pandemic. Thanks to the policy actions, stock prices have soared, investment grade and high yield bonds have delivered solid excess returns and home prices have surged (Table 1). The S&P 500 has risen 36% on a fundamental boost from an 18% increase in forward four-quarter earnings estimates and a valuation boost in the form of a 15% forward multiple expansion (Chart 10). Investment grade and high yield spreads have tightened to near their all-time lows (Chart 11) while trailing and forecasted defaults are low and rating upgrades are outpacing rating downgrades. Table 1Riskier Assets Are Having A Great Pandemic Chart 10Fundamentals Have Taken The Baton From Valuation Unknown Factor(s): We have argued that the next four quarters’ S&P 500 earnings estimates, which project a 1.9% decline from last quarter’s annualized run rate, will have to be revised higher to align with expected nominal annualized GDP growth near 9% in the second half of this year and 6% in the first half of next year. The future direction of forward earnings multiples is a much harder call, as it is largely a function of sentiment. It is also influenced by investors’ asset allocation options, and it does not look to us like TINA is going to be dislodged any time soon, as caution at the major developed world central banks will keep interest rates from gaining much upward momentum and a surfeit of liquidity will keep fixed income spreads tight. We argued with high conviction in a recent Special Report that housing poses no immediate threat to US financial stability because banks have no more than modest exposure to residential mortgages and the loans they have made are eminently sound. We stand by that view and further note that home prices are well supported in the near term by tight supplies and limited new construction activity. Finally, mortgage rates are extremely low and though we expect they will rise, we think they will do so at a slow, grinding pace throughout the second half and across 2022. What We’re Watching: Corporate earnings, interest rates, mortgage availability, flows into and out of risky assets, Fed guidance and anything bearing on risk appetites. Chart 11Don't Look For Further Capital Gains On Bonds Investment Implications Investors’ default position seems to be to assume that policy interventions will be exposed as artifice and elevated valuations will soon deflate. Neither has happened yet, however, and it doesn’t look like either will over the next twelve months. The Fed’s measures will have an extended influence because the fed funds rate will likely be zero until at least late 2022, monetary policy works with a lag and it will be a while before policy settings become truly restrictive. As for the fiscal transfers, they’ve largely been squirreled away as excess savings and their effect will only be felt as they’re consumed and/or funneled into financial markets. We don’t see elevated valuations retreating without a catalyst, given the ocean of liquidity in the US and the rest of the major developed economies. The money has to go somewhere as rapidly accelerating home prices around the world attest. Upward pressure on asset prices, especially for homes, has been a reliable source of instability but we don’t yet have concerns in the US, where mortgages have been extended to highly rated borrowers and the banking system has comparatively little exposure to residential loans. We are not saying multiples (or spreads) will remain elevated (tight) forever. We believe that today’s high prices will suppress long-term returns. Conditions look favorable for the next twelve months, however, and we think investors should take advantage of them before the longer-term adverse consequences emerge to weigh on returns. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

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.