Economy

Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, January 9th at 10 AM EST, when I will be discussing the economic and financial market outlook for 2019 and answering your questions. Best regards, Peter Berezin, Chief Global Strategist Highlights The lack of major financial and economic imbalances in the U.S., as well as the Fed’s ability to moderate the pace of rate hikes, reduce the risk of a vicious cycle where tighter financial conditions lead to slower economic growth and even tighter financial conditions. The scope for central banks to cut rates is more limited outside the United States. Imbalances are also greater abroad. Nevertheless, the news is not all bleak, with the recent rebound in China’s credit impulse being a case in point. We turned more bullish on risk assets following December’s post-FOMC equity sell-off. A moderately overweight position in global equities over a 12-month horizon is currently justified. While we continue to favor the U.S. over other bourses in dollar terms, our conviction level in this regional bias has decreased. Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. Outside Japan, global government bond yields will also increase in 2019. We are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. We are also taking profits on our March-2019 EEM ETF put for a gain of 104%. Feature Merry Crisis And A Happy New Fear Santa arrived early this year. The plunge in stocks allowed investors to buy some of the world’s premier companies at a mouthwatering 20%-to-30% discount to what they would have paid just a few months earlier. What a gift! Needless to say, most investors would not regard last month’s stock market performance in such a favorable light. But why not? One answer is that investors must mark their portfolios to market. Thus, even if the decline in equity prices raised future returns, it still implied a decline in present net worth. Yet, this cannot be the whole explanation, because if all investors expected stocks to bounce back quickly, they would not have sold in the first place. Clearly, many investors must have come to the conclusion that the stock market would not only go down but stay down. However, this presents a puzzle. The economic environment did not change that much in the weeks leading up to the October sell-off. Growth has slowed more recently (Chart 1), with this morning’s disappointing ISM manufacturing report being the latest example, but this appears to have been mainly a response to the souring market climate rather than the cause of it. Chart 1Tighter Financial Conditions Have Led To Slower Growth Reverse Causality? This raises an intriguing possibility: What if the drop in stock prices and jump in credit spreads that began in late September hurt expectations of economic growth by enough to justify a further discount in risk asset valuations? Such a “Financial Conditions Index (FCI) doom loop” is not just a theoretical construct. The last two U.S. recessions were both the products of burst asset bubbles — first the dotcom bubble and then the housing bubble. Could such a self-fulfilling vicious cycle be erupting again? If so, any rally in stocks or credit should be sold into, just as was the case in both 2001 and 2007. U.S. Fairly Resilient To A Doom Loop Fortunately, there are two reasons to think that such an outcome will not reoccur, at least not in the United States. First, as Box 1 explains, an FCI doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. That does not appear to be the case today. Unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart 2). Cyclical spending – the sum of residential investment, business capex, and expenditures on consumer durable goods – is also far below prior business-cycle peaks as a share of GDP (Chart 3). Chart 2The U.S. Private Sector Is A Net Saver Chart 3U.S. Economy: Cyclical Spending Is Still Restrained Despite recent releveraging in some categories, U.S. household debt has continued to decline in relation to the size of the economy. The ratio of personal debt-to-disposable income is now 34 percentage points below pre-crisis levels (Chart 4). Chart 4Household Leverage Is Below Its Peak U.S. corporate debt has moved in the opposite direction. Nevertheless, while the ratio of U.S. corporate debt-to-GDP has climbed to a record high, it is still quite low by global standards (Chart 5). Perhaps more importantly, corporate debt is generally held by non-leveraged institutions. If corporate defaults were to rise unexpectedly, the losses to lenders would not pose the same systemic risk to the financial sector as mortgage defaults did during the Global Financial Crisis. Chart 5U.S. Corporate Debt Is High, But It Is Higher Elsewhere The Fed’s Reaction Function It is not surprising that the stock market sell-off accelerated in early October following Fed Chairman, and failed golfer, Jay Powell’s comment that interest rates were “far from neutral.” We think that worries that the Fed will tighten too quickly are misplaced. Yes, monetary policy operates with “long and variable lags.” However, financial conditions, which lead growth, can be observed in real time (Chart 6). Chart 6Global Financial Conditions Have Tightened Most of the tightening in financial conditions since late September has been due to falling equity prices. Our baseline scenario envisions a gain of roughly 10% in the S&P 500 in 2019. A rebound in stocks of this magnitude will reverse most of the recent FCI tightening, thereby allowing the Fed to raise rates three times this year. But if equities continue to sag, the Fed will scale back further monetary tightening or even cut rates. The mere possibility of such a policy response reduces the odds of an FCI doom loop. A Mixed Bag Outside The U.S. The economic outlook is murkier outside the United States. Economic and financial imbalances are greater in the EM space and parts of Europe. Non-U.S. central banks also have less scope to respond to adverse shocks, either because of fears that looser monetary policy will spark capital outflows (as is the case in many emerging markets) or because of the presence of the zero-bound constraint on interest rates (as is the case in the euro area and Japan). Nevertheless, the situation is not that bad. EM assets have been fairly resilient over the past few months, at least in comparison to their developed economy counterparts (Chart 7). China’s credit impulse has actually perked up, an indication that while credit growth is falling, it is doing so at a slower pace. Chart 8 shows that the Chinese credit impulse is highly correlated with global industrial commodity prices. We still expect global growth to slow in the first half of 2019, but at this point, much of the slowdown has been discounted in asset markets. With that in mind, we are raising the stop on our short AUD/JPY trade to 10% and instituting a profit target of 15%. Chart 7EM Assets Have Been Outperforming Recently   Chart 8The Increase In China's Credit Impulse Bodes Well For Industrial Commodity Prices The Perils Of Discrete Decision-Making One of the annoyances of being an investment strategist is that you often feel compelled to take discrete views on where the markets are heading. Are you bullish, bearish, or neutral? Actually, it is usually just bullish or bearish because most people regard neutral views as lacking in conviction and insight. This incentive structure is counterproductive. Not only does it cause analysts to turn a blind eye to incoming data that may challenge their thesis, it disregards how professional investors actually operate. Successful investors scale into positions as the market gets cheaper and scale out as it becomes more expensive. Trying to time the bottom (or the top) with exact precision is futile. With that in mind, we are going to tweak the way we make recommendations going forward in order to improve transparency, accountability, and accuracy. Rather than simply stating whether we are bullish, bearish, or neutral, we will assign the main asset classes a subjective score between zero and one hundred, with 0-to-40 being bearish, 40-to-60 being neutral, and 60-to-100 being bullish. We will adjust the score in every publication. To add analytic rigor to this framework, we will also compare our subjective model score with that of our MacroQuant model. Where Things Now Stand We downgraded global equities last June, but moved back to overweight following December’s post-FOMC meeting sell-off, as valuations reached that rather blurry line at which a modest equity overweight was warranted. Our subjective score for global equities currently stands at 65%, above the model’s estimate of 50%. Our moderately bullish view reflects our expectation that global growth will stabilize by mid-year and monetary policy will remain accommodative, even if the Fed raises rates by more than what the markets are currently discounting. Tempering our enthusiasm is the recognition that the business cycle is getting long in the tooth – especially in the U.S. – and that global equity valuations, while far cheaper than they were a few months ago, are still significantly less favorable than they were near past market bottoms (Chart 9). Chart 9Global Equity Valuations Have Improved Regionally, we continue to favor U.S. stocks over other developed markets, and DM over EM more broadly. However, our conviction level on this view is not high, and we are prepared to revise it if it looks like global growth is accelerating, an outcome that would limit any further dollar strength (our subjective dollar score currently stands at 70%, below the model’s estimate of 92%). Reflecting our expectation of decent global equity returns in 2019 and our waning conviction to be underweight EM, we are taking profits on in our March-2019 EEM ETF put for a gain of 104%.  Please note that our view on EM is more optimistic than that of Arthur Budaghyan, BCA’s chief emerging markets strategist, who continues to see considerable downside risks to EM assets. For now, Treasury yields are likely to rise in an environment where U.S. growth is strong enough to enable the Fed to continue raising rates. We assign the 10-year yield a score of 30%, which is close to our model estimate of 32%. Accordingly, we are removing our long June-2019 Fed funds futures contract hedge, and we are now solely outright short the December-2020 contract. Core European bond yields will increase, reflecting diminished excess capacity in the euro area and the end of ECB net asset purchases. U.K. yields should also grind higher, as the odds of a soft Brexit (or no Brexit) improve. Only in Japan will yields remain contained, thanks to the BoJ’s ongoing yield curve control regime. We do not expect spread product to have a banner year, but the current yield pick-up should be sufficient to ensure that risky credit outperforms cash. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Box 1 The Analytics Of Doom Loops When will a tightening in financial conditions stemming from lower equity prices and higher borrowing costs lead to a vicious circle of slower economic growth and even tighter financial conditions? The answer depends on how sensitive economic growth is to financial conditions in relation to how sensitive financial conditions are to growth. Figure 1 shows two equilibrium schedules, one for the economy (EE) and one for asset markets (AA). Both schedules slope downward. The EE schedule is downward-sloping because easier financial conditions boost growth. If growth is too strong given the prevailing level of financial conditions, economic activity will slow (Panel A). The AA schedule is downward-sloping because equity prices tend to fall and credit spreads rise when growth slows. If equity prices are too high and credit spreads are too narrow for a certain level of growth, then financial conditions will tighten (Panel B). Suppose economic growth is not very sensitive to changes in financial conditions, perhaps because imbalances in the economy are limited (Panel C). Then changes in financial conditions will be fleeting: A decline in equity prices or a widening in credit spreads will not hurt growth very much, allowing the stock market and credit market to quickly normalize. In contrast, suppose that economic growth is very sensitive to financial conditions, so much so that the EE schedule is flatter than the AA schedule. In this case, the economy will be vulnerable to self-reinforcing booms and busts (Panel D). In particular, a small random jump from U to UI will send the economy careening towards a doom loop of ever-weaker growth and tighter financial conditions.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights The often-quoted 60% urbanization rate understates the extent of China’s industrialization. China is much more industrialized than generally perceived: the country’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This entails a slower rate of industrialization and urbanization going forward. Both rural-to-urban labor migration and expansion of existing cities will slow significantly over the next decade. Transforming rural areas into urban without migration will become the major form of urbanization over the next decade. Investment themes: Demand for urban property will slow considerably, while agricultural machinery sales may have sustainable growth ahead. Feature The scale of urbanization in China over the past two decades has been unprecedented in human history. China’s urban population has increased by 460 million from 1995 to 2017, outnumbering the total population of the U.S. and Japan combined. The extraordinary urbanization process, fundamentally driven by the country’s rapid and widespread industrialization process, had led to a massive migration of laborers from rural to urban areas, and in turn significant expansion of cities and a huge boom in the Chinese real estate market. Where is China now in terms of its industrialization and urbanization path? Will further urbanization be able to continue to support very high productivity growth as well as demand for its already bubbly property market? This report takes a closer look at the country’s progress of industrialization and urbanization. Industrialization Versus Urbanization Urbanization commonly refers to the increase in the proportion of people living in urban areas. For China, the National Bureau of Statistics (NBS) has two sets of data measuring the country’s urbanization rate – one uses the number of people who have resided in an urban area1 for at least six months within the period of one year, and the other uses the number of people who have only registered non-agricultural hukou.2 However, neither measure reflects the country’s industrialization level. Industrialization is defined as the transformation of an agrarian economy into an industrial one. One way to measure it is the share of employment in non-agricultural3 sectors of total employment. Based on this measure, China’s industrialization process is already reasonably advanced. Chart 1 shows that while only about 60% of the population lives in an urban area, as defined by the NBS (this is the often-cited measure by economists and strategists), World Bank data show that China’s industrialization rate is currently 82.5% – i.e., over 80% of jobs in China are already in non-agricultural sectors. This underscores that China’s development path is more advanced than is generally perceived by investors. Chart 1China: More Industrialized Than Perceived China’s urbanization rate cannot capture the fact that there are many non-agricultural jobs held by people living and working in areas administratively classified as rural. Therefore, the 60% urbanization rate understates the extent of China’s industrialization, and overestimates potential upside in future growth. The nation is already reasonably advanced in terms of moving labor from agriculture to non-agriculture industries. This conclusion is reinforced by comparing China with developed economies (the U.S., Japan and South Korea) based on standard urbanization rates and based on our measure of industrialization: The latter points to a much smaller gap between China and advanced countries than the former (Charts 2 and 3). Chart 2China Vs. Advanced Economies: A Much Smaller Gap In Industrialization Measure... Chart 3…Than In Standard Urbanization Measure China’s industrialization rate at 82.5% is similar to South Korea in the early-1990s (Chart 4, top panel). If in next 10 years China’s industrialization progresses in line with the South Korean experience during 1991-2001, this will mean China’s industrialization pace – defined as an annual increase in the industrialization rate – will slow materially to 0.6 percentage points per year over the next decade, from 1.4 percentage points per year over the past decade (Chart 4, bottom panel). Chart 5 demonstrates the close correlation between the pace of industrialization and real per capita GDP growth in both China and South Korea. What is clear from the chart is that as the pace of industrialization decelerates, per capita real income growth will slow further.   Chart 4Korean's Roadmap: Falling China's Industrialization Pace Ahead Chart 5Industrialization Pace Vs. Real Per Capita GDP Growth: Closely Correlated Indeed, industrialization has allowed massive rural-to-urban labor migration as well as enormous expansion of existing cities. Due to the high base, the pace of industrialization has already been slowing, and will continue to do so. Consequently, China’s industrialization-driven urbanization will also continue to lose steam, with ramifications for the economy and its various sectors. We discuss below each of the specific factors that are likely to contribute to China’s future urbanization path, and then conclude the report with the attendant implications for Chinese real estate and agricultural machinery sales. Falling Rural-To-Urban Migration Industrialization generally leads to urbanization by establishing manufacturing factories and generating job opportunities, which in turn induces the movement of agriculture labor to cities. Hence, rural-to-urban migration, triggered by industrialization, is typically the main driver of rising urbanization. Currently, rural-to-urban migration is falling, which is a negative signal for the pace of future urbanization. In China, the rural-to-urban migration process is indeed slowing – i.e., the number of new migrant workers moving from rural areas to cities has already decreased nearly by half, from an average of 9.3 million per year over 2009-2012 to 4.8 million per year over 2013-2017. If we exclude migrant workers aged 50 and above, the number of migrant workers (a stock variable) actually contracted last year (Chart 6). Chart 6The Number Of Young Migrant Workers: Actually Contracted In 2017 Several points suggest that the rural-to-urban migration process will likely progress at an even slower pace going forward: Declining industrial employment: Employment in industrial sectors has contracted across the board, implying less demand for migrant workers (Chart 7). Employment has contracted in all 30 industrial subsectors that the NBS monitors, and 29 of them currently have fewer employees than five years ago. Higher automation in factories, the government’s de-capacity reforms in some industries with excessive capacity (i.e., coal, steel, aluminum, cement and so on), and some labor-intensive industries (i.e. textiles) shifting to other low-labor-cost countries (i.e. Vietnam, Pakistan, Bangladesh, etc.) are all factors that have contributed to the reduction in industrial employment. Chart 7Declining Industrial Employment Aging migrant workers: The average age of migrant workers has already risen from 34 in 2008 to 39.7 last year, with 21.3% of total migrant workers now aged 50 and above. As they continue to age over the next five to 10 years, our sense is that a considerable proportion of these older migrant workers will likely move back out of urban areas because of the existence of a family support network in their villages/rural townships. Shrinking youth population in rural areas: China’s rural population has declined by 33% from its peak of about 860 million in 1995 to 577 million in 2017 (Chart 8, top panel). All else equal, the lower rural population base alone will result in smaller rural-to-city migration compared to the previous two decades. More importantly, as substantial numbers of the working-age population left their rural homes for cities, the proportion of elders in the rural population has significantly increased, while the proportion of young people has drastically decreased. The current 19-and-under cohort will be the major source of future rural-to-urban migration over next five to 10 years. Based on the NBS data, in rural areas the share of the population aged 50 and over rose to 33% in 2017, much higher than the 25% of the population aged 19 and younger. This contrasts with 18% and 36%, respectively, back in 1997. The increasing proportion of elders and the declining proportion of the young population segment in rural areas implies smaller rural-to-city migration scale going forward. Chart 8Rural-To-Urban Migration Will Continue To Decline Changing preferences of the rural population: In recent years, the agricultural hukou has become much more valuable than in the past. In China, the government always assigns a piece of land for farming to a person with an agricultural hukou when he or she is born. This does not apply to a person with a non-agricultural hukou. As the central government’s policy focuses more on rural development, more non-farming job opportunities will likely be created in the rural areas. Services that in the past could only be enjoyed in urban areas are now spreading into rural areas as well, suggesting farmers who have either kids or elder parents to take care of will be more willing to stay in rural areas. If we use the annual change in the rural population as an indicator to predict the scale of rural-to-urban migration, the migration started in 1996 and peaked in 2010, and will decline going forward (Chart 8, bottom panel). Bottom Line: The scale of rural-to-urban migration will likely continue to diminish in the next five to 10 years. Slower City Area Expansion China’s industrialization-driven urbanization is not only driven by rural-to-urban labor migration, but also by the process of expanding and developing existing urban areas. In Western parlance, this factor would be described as the intense development of the territories surrounding the core of a “metropolitan area.” By establishing manufacturing factories, developing public facilities (roads, highways, subways, schools, hospitals, recreation centers, etc.), and constructing residential/commercial buildings to accommodate massive influxes of migrant workers in the rural areas surrounding cities, these territories have quickly expanded and have been transformed into urban areas4 over the past two decades. Statistics show that the “city area” in China has expanded 150% since 2000, almost twice the 77% rate of growth in the urban population during the same period (Chart 9, top panel). Chart 9Overdevelopment Of City Area Expansion In these now formerly rural areas, local governments often bought land from local farmers and then either sold the land to real estate developers to construct new residential properties or commercial buildings or used the land to develop public facilities. As a result, living conditions and economic development in these rural areas have become “urban-like.” Looking forward, over the next five to 10 years, we believe city area expansion will slow considerably (Chart 9, bottom panel). First, local governments have already taken on massive debt to fund city area expansion over the past two decades, as part of an attempt to demonstrate the success of their economic development plans to the central government (which is usually measured by GDP). However, circumstances have changed. China’s central government now expects local governments to generate “high-quality” and environmentally-sustainable economic growth – and they are unlikely to measure the performance of local government officials simply based on GDP. In addition, containing debt/leverage (including that of SOEs and local governments) is a priority for the central government, implying that debt-fueled city area expansion is unlikely to continue. Moreover, Beijing has already shifted its policy focus from city-area expansion to rural-in-situ urbanization (discussed below). Bottom Line: Past overdevelopment and constraints on local governments suggest that city-area expansion in China will slow considerably in the next five to 10 years, constraining the country’s urbanization pace. Rising Rural-In-Situ Urbanization Going forward, the major driver of urbanization in China will be greatly different from the previous 30 years. Over the next five to 10 years, China’s urban population growth will be driven more by the rural-in-situ urbanization (urbanization without people migration) by transforming rural areas into urban. This is in contrast to urbanization through rural-to-urban labor migration and city-area expansion. The rural-in-situ urbanization – transforming townships/villages directly into towns – has become a policy focus of the central government. The Chinese central government released its first national urbanization plan in March 2014 and announced the “Rural Revitalization Strategic Plan 2018-2022” in September. Both strategic blueprints emphasize the goal of “rural-in-situ urbanization” over the next five to 10 years, to be achieved by building up villages directly into towns. There are currently about 7,000 specialty towns planned or under construction, and it seems more are on the way. However, given already high local government debt and lack of funds for a sizeable proportion of Chinese local governments, we believe a considerable portion of the development of these specialty towns will miss their initial expectations. We expect the rural-in-situ urbanization to be the major force of further urbanization in China (Chart 10). As noted above, the shifting demographic structure of China’s rural areas and the changing preferences of the rural population will also facilitate the rural-in-situ urbanization. Meanwhile, with the government’s policy support, disposable income per capita in rural areas will likely continue to grow faster than in urban areas, which may also help induce rural farmers to remain in rural areas (Chart 11). Chart 10Rising Rural-In-Situ Urbanization Chart 11Rural Vs. Urban: Higher Disposable Income Per Capita Growth Bottom Line: Over the next decade, China’s urbanization will be driven more by the rural-in-situ urbanization (without people migration) by transforming rural areas into urban. Rising “Organic” Urban Population Growth As a final point, “organic” urban population growth (births minus deaths) will likely account for a larger share of China’s rising urban population in the future. A larger urban population base, improving birth rate due to the end of the one-child policy and longer life expectancy (76.3 in 2016 vs. 74 in 2005) will result in a rising urban population going forward (Chart 12). Chart 12Rising "Organic" Urban Population Growth However, unaffordable housing and rising household debt levels (Chart 13) are generating pressure on new families, suggesting the demographic dividend of removing the one-child policy may be smaller than hoped. As a result, a rising urban-area population is unlikely to offset the slowing urbanization factors noted above. Chart 13Household Leverage: China And U.S. Structural Headwinds For Chinese Household Consumption Growth Growing Reluctance To Have More Kids Bottom Line: We believe China’s urban population growth will drift below 2.5%, the lowest in the past 30 years (Chart 14). Chart 14China's Urban Population Growth Will Drift Lower Investment Implications A declining pace of industrialization and changing forms of urbanization will have the following ramifications: Falling rural-to-urban labor migration points to diminishing property demand from migrant workers. This is structurally bearish for the Chinese residential real estate market, given that most residential construction has occurred in urban areas (Chart 15). Investors holding housing units in urban areas in expectations of rampant price appreciation due to continuous large-scale rural-to-urban migration will be disappointed in the long run. Chart 15Chinese Property Demand: Gloomy Outlook An emphasis on rural-in-situ urbanization suggests the government is aiming to improve the living conditions of rural households to enable them to live more similar to urban households. For income per capita in rural areas to rise faster, their productivity growth should grow more rapidly. To raise productivity in the agricultural sector, the government is aiming to implement farmland reforms as proposed by the “Rural Revitalization Strategic Plan 2018-2022.” The objective is to enable either the private sector or public sector to collate many small pieces of farmland into large ones. Large tracts of farmland will in turn allow for an improvement in productivity by applying modern agricultural techniques and machinery. Hence, we believe agricultural machinery sales may have sustainable growth ahead. The aging population and rising number of newborns suggest growth in healthcare, childcare and eldercare will outperform the real estate and raw materials sectors over the long run. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com   Footnotes 1      The definition of urban area and rural area in China is based on the country’s administrative divisions defined by the government. In China, cities and towns are recognized as urban areas while townships and villages are considered to be rural areas. 2      The Hukou system is a governmental household registration process to define residence in mainland China. It determines a person’s access to housing, education, medical treatment, and social welfare in a city. 3      All sectors other than the agricultural sector (farming, fishery, forestry and animal husbandry). 4      There is no clear definition or standards for the transformation of rural areas to urban areas. In general, a rural area, where has become more developed in terms of economic development, more connected to the city or town in terms of transportation and public facility access, and the residents’ living condition is more like the urban residents, is more likely to be re-defined as urban area by the local government. CYCLICAL INVESTMENT STANCE