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Executive Summary US Deficits Will Rise Before They Fall No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation The Inflation Reduction Act combined with the Chips and Science Act will add $88 billion to the budget deficit through FY2027. The two bills would only reduce the deficit by $11.1 billion by 2031. The deficit that year will be $2 trillion.    Hence Congress’s latest actions add to the deficit in the short run and are effectively deficit-neutral over the long run. That is not disinflationary.  Gridlock is still the likeliest outcome of the midterm elections. That is disinflationary for 2023-24 because fiscal policy freezes. Whether gridlock will persist after 2024 is unknown. Federal investments in US computer chips and renewable energy could enhance productivity over the long run. That could well be disinflationary … but the magnitude and timing are unknown. Overall, US social spending, industrial spending, defense spending, and government intervention are rising as the nation-state responds to social unrest and geopolitical conflict. Inflation will depend on many things, but this policy trend is not disinflationary. Close Recommendation (Tactical) Closing Level CLOSING DATE Return Long US Treasuries Vs. TIPS 1.3768 AUG 12, 2022 1.53%   Bottom Line: Close long US Treasuries relative to TIPS. But stay long the US dollar. Biden’s legislative victories underscore our strategic themes of Limited Big Government and Peak Polarization – and are not disinflationary.  Feature President Biden’s approval rating ticked up to 40% after a series of policy wins, including the passage of the Inflation Reduction Act and the Chips and Science Act. These bills reinforce our strategic theme of Limited Big Government, i.e. a rising role for the state within the US’s free market context. When Biden unveiled his anti-inflation agenda back in June we argued that his only real options to reduce inflation before the midterm elections hinged on other people: namely the Federal Reserve, the Saudis, the Iranians, and also Capitol Hill. With regard to Congress, we expected Democrats to pass a budget reconciliation bill. We saw that they were repackaging this bill as an “inflation reduction” measure to improve their election prospects. But we argued that it would not fight inflation in any substantive way.1 Now that the bill is on the way to Biden’s desk, it is only fair to ask: What will be the impact? Will it reduce inflation or not? The short version is no. The bill does not stand alone but is part of the Biden administration’s “last-ditch effort” to pass two major bills before the midterms. These two laws are deficit-neutral at best but slightly stimulative in the short run – and hence marginally inflationary. These laws could prove disinflationary over the long run, as investments in semiconductors and renewable energy should drive innovation. But that is hard to predict. We are optimistic on that front but for the foreseeable future the effects are neutral or inflationary. To understand this view, we need to review BCA’s stance on inflation overall and then discuss the legislation. The BCA View On Inflation BCA sees this year’s inflationary bout as both a cyclical and a structural phenomenon. The cyclical rise in inflation stemmed from the pandemic and the ensuing economic stimulus. This cycle is peaking now. Commodity prices are moderating and goods spending has fallen two-thirds of the way back to where it stood prior to the pandemic, suggesting that inflation will take a step back. At very least inflation has stopped skyrocketing (Chart 1). Yet the structural drivers of inflation will persist. Chart 1Inflation Rolls Over ... For Now Inflation Rolls Over ... For Now Inflation Rolls Over ... For Now The long-term inflation thesis hinges first and foremost on global population trends. Fewer prime-age workers as a share of the population means that the price of a prime-age worker goes up. It also hinges on the decline in the global glut of savings, the rise of mercantilism and trade protectionism (i.e. hypo-globalization), and the conclusion of household deleveraging in the wake of the 2008 crisis. Structurally looser fiscal policy – soft budgets – also plays a role. The decay of the liberal world order since 2008 financial crisis entails that western governments face the combined threats of social unrest at home and great power competition abroad. These governments’ answer is to take a more active role in the economy to appease popular wrath, improve energy security, and bulk up national defense. The result will be larger deficits. Larger budget deficits reduce the savings available to the private sector and constrain future supply, feeding into inflation. The result is that, in the United States, the neutral rate of interest will likely prove to be higher than expected, monetary conditions will be looser than expected in real terms, and hence the economy will overheat. At least until central banks and fiscal authorities impose austerity.  Bottom Line: Inflation is a cyclical and structural phenomenon in the United States. Cyclically inflation is starting to moderate as various factors from the pandemic and fiscal stimulus wear off. But structurally inflation will be a persistent problem due to population aging, the end of the savings glut, hypo-globalization, geopolitical conflict, and a rising government role in the economy. New Laws Do Not Cut The Deficit Until 2027 At Best Now we can put the Biden administration’s policy into context. The stagflationary cyclical backdrop poses a severe challenge for the ruling Democratic Party. Midterm elections are only three months away and yet headline inflation is still running at 8.5% and core inflation is rising unabated at 5.9% year-on-year. The median voter suffers from high inflation in the form of falling real income and wages. Yet the Democratic legislative agenda has focused on increasing spending, which adds to inflation.  If US gasoline prices continue to moderate, the median household’s inflation expectations will come down – and that is a positive short-term development for Democrats (Chart 2). That is why President Biden went to Saudi Arabia with his tail between his legs to beg for more crude oil production. That is why he is trying to do a deal with Iran too (though there our view is pessimistic). That is why he has urged Europe to wait until after the midterm to implement full oil sanctions on Russia. Hence also the Senate repackaged the -$4 trillion “Build Back Better” spending splurge as a +$300 billion “Inflation Reduction” fiscal reform. But will the Inflation Reduction Act truly reduce inflation? Will it affect the cyclical or structural drivers mentioned above?  Chart 2Inflation Expectations Moderating Inflation Expectations Moderating Inflation Expectations Moderating The title of the bill alone should prompt investors to be skeptical. The bill does not meaningfully reduce budget deficits. According to the Democratic Party it will generate $300 billion in savings over 10 years, mostly as a result of capping drug costs that Medicare pays to hospitals on behalf of about 64 million Americans. However, the Committee for a Responsible Federal Budget provides a more realistic scenario in which the savings amount to $160 billion, or about half as much as advertised (Table 1).2 The CBO estimates the bill will reduce the budget deficit by $100 billion over 10 years, one third of the official selling point. Table 1What Is Inside The Inflation Reduction Act Of 2022? No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table 2 shows the CBO’s baseline estimates of the US budget deficit outlook as of July 2021, May 2022, and August 2022 (i.e. the latter with the new legislation). The trend line with the reconciliation bill is virtually indistinguishable from the May estimate (Chart 3). Table 2US Budget Balance Projections Before/After The Inflation Reduction Act No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart 3What Deficit Reduction? No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table 3 shows the specific change in the budget deficit for each year, illustrated in Chart 4. The bill modestly reduces the deficit in 2023 but increases the deficit in subsequent years until 2028. When the bill’s savings peak at $41 billion in 2031, they will shave off 2% of the $2 trillion deficit. Table 3Change In US Deficit Due To Inflation Reduction Act And Chips And Science Act No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation In other words, the deficit reduction will not occur until after the 2028 election – by which time it will be swamped by other political and economic factors. In addition, the bipartisan Chips and Science Act will add $47.5 billion to the budget deficit through FY2026 and $79.3 billion through FY2031. Combining them shows that Congress is still adding to spending despite today’s 5.9% core inflation reading – while delaying the miniscule deficit reduction until the latter part of the decade. Credit should be given to the Democrats for offsetting their new spending with revenue increases. But in realistic terms Congress’s latest actions are deficit-neutral at best. The question was how to pay for the desired spending rather than how to impose budget consolidation. Austerity is politically impractical in the context of left-wing and right-wing populism. Chart 4US Deficits Will Rise Before They Fall No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation The new fiscal spending makes sense given the strategic predicament that the US faces. But it should flag to investors that the only real fiscal discipline on the horizon will come after the midterm election, when Congress is gridlocked and fiscal policy is basically frozen. Bottom Line: The Inflation Reduction Act combined with the Chips and Science Act will add about $88 billion to the budget deficit through FY2027. The two bills only reduce the growth of the budget deficit by $11.1 billion by 2031. They will not reduce investors’ inflation expectations over the next five years. Cyclical inflation expectations will fall for other reasons – such as Fed rate hikes, the slowdown in global growth, and looming gridlock. Reducing Drug Prices And EV Prices Is Not Generally Disinflationary What about the sector effects of the Inflation Reduction Act? Could they be disinflationary? The bill raises a minimum corporate tax rate of 15% to pay for renewable energy subsidies, it bulks up the Internal Revenue Service’s tax collecting capabilities to pay for an expansion of Obamacare subsidies, and it empowers Medicare to negotiate pharmaceutical prices, creating revenue savings for the federal government.   Theoretically caps on drug prices will push prices down, while subsidies to buy electric vehicles (EV) will incentivize Americans to buy those cars and expand the domestic EV supply chain. Hence Democrats can at least claim to be reducing drug price inflation and arguably EV price inflation. Drug price caps are popular and could increase social stability. Electric car subsidies are less popular but tap into demands for domestic manufacturing and action on climate change. Neither will generate substantial opposition in the voting booth. However, the general level of prices will not fall as a result of these sector-specific interventions. Spending on motor vehicles is around 4.2% of total personal consumption expenditure (Chart 5, first panel). Spending on prescription drugs is around 3.2% of total personal consumption expenditure (Chart 5, second panel). Hence the bill could at maximum affect 7.4% of total consumer spending. But only certain drugs will face price caps and only EVs will be subsidized, so the effect is even narrower than that. Spending on cars grew by 1.7% between 2003-20, in line with economic growth. Drug spending grew faster, in line with an aging society, at 2.9% over the same period (Chart 6). Normally the contribution to inflation is negligible for cars but higher-than-average for drugs. True, after Covid-19 car prices surged while drug prices fell below average, but that process should normalize (Chart 7).  Chart 5The Role Of Cars And Drugs In Inflation The Role Of Cars And Drugs In Inflation The Role Of Cars And Drugs In Inflation Chart 6Growth Of Car And Drug Spending Growth Of Car And Drug Spending Growth Of Car And Drug Spending Chart 7Change In Car And Drug Prices Change In Car And Drug Prices Change In Car And Drug Prices Only 20 drugs will be eligible for Medicare negotiation per year. The top 20 drugs amount to around 18% of the pharmaceutical market. The new government-negotiated prices will begin to take effect in 2027. The effect will be to dampen domestic manufacturers’ incentive to produce generics, leading to supply constraints or substitution effects (e.g. imports). Hence overall drug prices will not fall as much as expected. The US lacks universal healthcare coverage, so price controls represent an economic transfer between corporations or between corporations and government – not between corporations and consumers. Capping drug prices will benefit insurers directly and consumers only indirectly. The profit will change from the hands of Big Pharma to Big Insurance (managed healthcare providers) (Chart 8). Incidentally big insurers will also benefit from the bill’s expansion of the Obamacare subsidies. Of course, Obamacare enrollees will see a marginal increase in disposable income – especially lower-income individuals, who have a higher propensity to consume. This is positive from the perspective of social stability but likely to be inflationary, not disinflationary. Lower insurance premiums mean more spending cash. Chart 8Big Insurance Versus Big Pharma Big Insurance Versus Big Pharma Big Insurance Versus Big Pharma As for the bill’s green subsidies, EVs account for about 5.6% of cars sold. Subsidies will encourage the production of EVs and accelerate the growth of EV market share. The point is to make EV prices competitive with other cars since EVs are more costly to make, especially if they are to be made domestically. Non-EVs may have to lower their prices but, as we have seen, car inflation is not a major contributor to general inflation, at least not in normal times. Of course, no electric vehicles will qualify for the new rebate immediately. The law requires a large share of qualifying electric cars to be manufactured in North America, or at least not to be produced in “countries of concern” such as China. China is still the leader in making critical components of EVs, especially batteries. Such policies are not conducive to the most efficient manufacturing methods and lowest consumer prices. Rather they seek to shift supply chains to allied countries or to “onshore” them within the United States for strategic reasons, even at a higher cost to consumers. As such the new law reflects the US’s newfound populism, economic nationalism, industrial policy, and trade protectionism. It epitomizes the connection between great power competition and hypo-globalization, prioritizing supply chain resilience at the expense of economic efficiency. That makes sense from a national security point of view but is not likely to be disinflationary – quite the opposite. The bipartisan Chips and Science Act will dovetail with these measures to revive US industrial policy, steer capital into priority projects, and encourage domestic investment. This law and the climate change subsidies are federal investments that should boost productivity and enhance the supply side of the economy. We are optimistic over the long run regarding the productivity enhancements that could accrue from the government’s historic shift to re-initiate these kinds of investments. The space program in the 1960s may be too optimistic but it is still analogous. The US is already in the midst of Cold War II.  If a major breakthrough in renewable energy eventually occurs that is tied to investments from the Inflation Reduction Act, then it will justify the bill’s anti-inflation moniker. But that remains to be seen. In the meantime, these investments will quicken US economic activity when the economy is already at full employment and inflation is running hot. Bottom Line: Cars do not contribute much to inflation in normal times and this bill gives subsidies to make electric cars in the US, which is not optimal for costs. Drugs contribute positively to inflation but Medicare caps will not lower drug prices until 2027 and general price effects are debatable. Overall, social unrest and great power competition are leading to greater government involvement in the economy, which is marginally inflationary. Economic Slowdown Is Disinflationary What will be the effect of this legislation on the midterm election campaign? Economic sentiment improved over the past month, even among Republicans. That led to a drop in polarization for the right reasons, i.e. a resilient economy, rather than the wrong reasons, i.e. the universal loathing of inflation (Chart 9). Polarization will stay near peak levels during the 2022-24 election campaign but the bipartisan Chips Act, the Biden administration’s adoption of hawkish foreign policy on trade and China, and the administration’s attempt to pursue at least a deficit-neutral approach to the budget reinforce our “Peak Polarization” theme. Long-term US policy consensus is developing beneath the still extreme polarization in the short term. Business activity is improving, which has contributed to the equity rally on the basis that the Fed is achieving a “soft landing” (Chart 10). We expect a hard landing due to the combination of negative macro and geopolitical factors but the latest data brings a positive surprise. Chart 9Economic Sentiment Ticks Up ... Even Among Republicans Economic Sentiment Ticks Up ... Even Among Republicans Economic Sentiment Ticks Up ... Even Among Republicans Chart 10Business Activity Improves Business Activity Improves Business Activity Improves In the short term, Biden and the Democrats will benefit from passing legislation (“getting things done”) and piggybacking on the fact that inflation is rolling over and the economy is showing some positive surprises. Biden’s approval rating is showing signs of stabilizing, albeit at a low level (Chart 11). The two parties are neck and neck in congressional ballot, with Democrats taking back the lead again from Republicans (Chart 12). If this trend continues it will mitigate the Democrats’ losses in the midterms. The Senate is competitive. Chart 11Biden’s Approval Will Perk Up At Least Somewhat No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart 12US Parties Neck And Neck In Generic Congressional Ballot No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation If inflation rolls over, real wages will improve, which will boost consumer confidence and, if it comes by October, could  help the Democrats further (Chart 13). Chart 13Uptick In Real Wage Would Boost Consumer Confidence Uptick In Real Wage Would Boost Consumer Confidence Uptick In Real Wage Would Boost Consumer Confidence Still, Democrats are likely to lose the House of Representatives in the midterms, as the ruling party usually loses seats and Democrats only have a five-seat margin. In other words, we would fade the emerging “Blue Sweep” risk (i.e. risk that Democrats keep control of both houses of Congress). A sweep is possible but unlikely, especially because many of Biden’s foreign policy problems can still come back to haunt him before the midterm. Two consecutive quarters of negative GDP growth usually results in an official recession. The jury is still out. Bankruptcies are ticking up and unemployment has nowhere to go but up (Chart 14). The stagflationary environment will probably persist through the midterm. Biden will face a rocky road to re-election. Chart 14Yet Unemployment And Bankruptcy Will Rise Yet Unemployment And Bankruptcy Will Rise Yet Unemployment And Bankruptcy Will Rise Investment Takeaways Inflation expectations began to roll over due to the global slowdown, the drop in commodity prices, and the Fed’s rate hikes, but structural factors suggest inflation will remain a problem over the long run. The Inflation Reduction Act will not be implemented in time to have any effect on prices in 2022. It will slightly reduce the budget deficit next year but expand the deficit from FY2024-27. Combined with the Chips and Science Act the effect is slightly stimulative or inflationary until FY2028 at earliest.   The bill increases policy uncertainty ahead of the midterms. Democrats will be able to take credit for any moderation of inflation through October and hence the election will become more competitive. But the election outcome is still highly likely to be congressional gridlock. Gridlock is disinflationary in 2023-24 because it implies that fiscal policy will shift to neutral – or even that real deficit reduction will occur if Biden compromises with a partially or wholly Republican congress. Structurally the US suffers from an imbalance of savings and investment. The global savings glut more than filled the gap and prevented inflation for several decades. Now the society is aging, the savings glut is depleting, globalization is retreating, and governments need to maintain spending to address high domestic and foreign challenges. US policy is forming a new consensus (“Peak Polarization”) that includes a larger role for government within the US context (“Limited Big Government”) in order to fight against social instability and geopolitical threats. The result is inflationary or at least not disinflationary. A high-tech and/or green energy productivity boom is possible and would combat the structural drivers of inflation. We are optimistic but the disinflationary impact is not forthcoming immediately and much remains to be seen.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com   Footnotes 1     Specifically we argued that the bill would be “mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms.” We also implied that the act would probably not correct the US’s long-term rise in budget deficits as a share of GDP. 2     The difference has to do with the Affordable Care Act (Obamacare). Obamacare subsidies were expanded during the pandemic. The reconciliation bill will spend about $100 billion on extending the subsidies by three years. But it will be politically difficult for future congresses to revoke these subsidies. Hence the CBO assumes they will become permanent.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A3US Political Capital Index No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A5BPolitical Capital: Household And Business Sentiment No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation Table A5CPolitical Capital: The Economy And Markets No, The Inflation Reduction Act Will Not Reduce Inflation No, The Inflation Reduction Act Will Not Reduce Inflation  

Executive Summary Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Inflation is not about oil, food or used car prices. Looking at prices of individual components of a consumer basket is akin to missing the forest for the trees. Despite the latest drop in US headline inflation, various core CPI measures continue trending up and registered considerable month-on-month rises in July. Wages and, more specifically, unit labor costs are the true measure of genuine and persistent inflation. US wage growth is very elevated, and the pace of unit labor cost gains has surged to a 40-year high. The conditions for sustainable and persistent disinflation in the US are not yet present. US inflation will prove to be much stickier and more entrenched than many market participants presently believe. The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. The mainland’s property market breakdown is structural, not cyclical. Excesses are very large, and problems are snowballing, rendering the enacted policy stimulus insufficient. Bottom Line: US core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap global risk asset prices and put a floor under the US dollar.  We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. Feature The bullish macro narrative circulating in the investment community is that conditions for a cyclical rally in global risk assets have fallen into place. Specifically: US inflation will drop sharply as US growth has crested and commodity prices have plunged; The Fed is nearing the end of a tightening cycle; China has stimulated sufficiently, and its economy is about to recover, which will boost economic conditions among its trading partners in general and EM in particular. These assumptions along with the fact that the S&P 500 index has found support at a 3-year moving average – a proven line of defense – suggest that US share prices have likely bottomed (Chart 1). Are we witnessing déjà vu of the 2011, 2016, 2018 and 2020 market bottoms? Chart 1Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? Déjà Vu? Is 2022 Like The 2011, 2016 And 2018 Bottoms In The S&P 500? We have reservations about all of the above fundamental conjectures. We elaborate on these reservations in this report. On the whole, we contend that the current environment is different, and the roadmaps of all post-2009 equity market bottoms are not necessarily currently applicable. BCA’s Emerging Markets Strategy team believes that (1) US consumer price inflation is much more entrenched and will prove stickier than is commonly believed; and (2) the Chinese property market’s breakdown is structural, not cyclical; hence, the recovery will not gain traction easily.  Is This The End Of The US Inflation Problem? Not Quite This week’s US inflation data confirmed that headline CPI inflation has probably peaked: prices in several categories plunged. However, inflation is not about oil, food or used car prices. Chart 2 reveals that historically there have been several episodes whereby core inflation remains elevated despite plunging oil prices. Chart 2US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices US Core Inflation Does Not Always Follow Oil Prices Looking at price dynamics among the individual components of the CPI basket is akin to missing the forest for the trees. Inflation is a very inert and persistent phenomenon. Underlying inflation does not change its direction often and/or quickly. That is why we believe that it is premature to celebrate the end of the US inflation problem. A few observations on this matter: Despite the drop in US headline inflation, various core CPI measures − like trimmed-mean CPI, median CPI and core sticky CPI − all continue trending up and registered substantial month-on-month rises in July (Chart 3). The range of core inflation based on these annual and month-month annualized rates is between 4-7%. In brief, the rate of genuine/sticky inflation is well above the Fed’s 2% target. Given its unconditional commitment to bringing inflation down to 2%, the Fed will continue hiking interest rates ceteris paribus. Chart 3US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High US Core CPI Measures Are Still Very High Chart 4US Wages Growth Has Been Surging US Wages Growth Has Been Surging US Wages Growth Has Been Surging   We continue to emphasize that wages and, more specifically, unit labor costs are the true measures of persistent and genuine inflation. We have written at length about why wages and unit labor costs are more important to inflation than oil or food prices. US wage growth is very elevated and is accelerating (Chart 4). Unit labor costs, calculated as hourly wages divided by productivity, have also been surging to a 40-year high (Chart 5, top panel). Chart 5Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation Unit Labor Costs, Not Oil Prices, Are The Key To US Core Inflation The reason for this very strong wage growth and swelling unit labor costs is the very tight labor market. The bottom panel of Chart 5 demonstrates that labor demand is still outpacing labor supply by a wide margin. Hence, wage inflation will not subside until the unemployment rate rises meaningfully. Bottom Line: Conditions for sustainable and persistent disinflation in the US are not yet present.  Inflation will prove to be much stickier and more entrenched than many market participants presently believe. Core inflation lingering above 4% and easing financial conditions will compel the Fed to continue hiking rates. This will cap risk asset prices and put a floor under the US dollar.   China: Is This Time Different? If one believes that China’s current business cycle is similar to all previous ones seen since 2009, odds are that a buying opportunity in China-related financial markets is at hand. Chart 6 illustrates that the credit and fiscal spending impulse leads the business cycle by about nine months. Given that this impulse bottomed late last year, a trough in the Chinese business cycle is due. Chart 6Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? Is A Recovery In China's Business Cycle Imminent? It is always risky to suggest that this time is different. Nevertheless, at the risk of being wrong, we contend that a combination of (1) property markets woes, (2) an impending export contraction, and (3) the dynamic zero-COVID policy will reduce the multiplier effect of current stimulus measures. Hence, a meaningful recovery in economic activity will likely fail to materialize in the coming months. The challenges facing the mainland property market are now well known. Yet, excesses are very large, and problems are snowballing, making policy stimulus insufficient. In particular: Authorities are contemplating bailout funds for property developers in the range of RMB 300-400 billion to enable them to complete housing that has been pre-sold. This is not sufficient financing for overall property construction. Table 1How Large Are Property Developers Bailout Funds? Déjà Vu? Déjà Vu? Table 1 illustrates that these amounts are equal to just 3-4% of annual fixed-asset investment in real estate excluding land purchases, 1.5-2% of total financing of developers, and 3-4% of the advance payments that property developers received for pre-sold housing in 2021. Property developers will not be receiving any cash upon the completion and delivery of presold housing units because they were paid in advance. Hence, without liquidating their other assets, homebuilders cannot repay the bailout financing. Consequently, only state financing can work here because, from the viewpoint of providers of this financing, this scheme de-facto means throwing good money after bad. The property industry in China is extremely fragmented. This makes bailouts difficult to organize and execute. There are officially about 100,000 property developers in China. The overwhelming majority of them are not state-owned companies. Plus, the two largest property developers, Evergrande (before defaulting) and Country Garden, had only 3.8% and 3.3% of market share respectively in 2020. The failure of homebuilders to complete and deliver pre-sold housing units could unleash a death spiral for them. In recent years, 90% of housing units have been pre-sold, i.e., buyers made advance payments/prepayments, often taking out mortgages (Chart 7, top panel). Witnessing the inability of developers to deliver on presold units, a rising number of people may decide to wait to buy. The largest source of developers’ financing – advance payments for pre-sold housing units – might very well dry up. This source has accounted for 50% of real estate developers’ total financing in recent years (Chart 7, bottom panel). In brief, a vicious cycle is possible. The lack of financing for homebuilders bodes ill for construction activity (Chart 8). Chart 7China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers China: Housing Presales And Pre-Payments Are Critical To Developers Chart 8Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Lack Of Homebuilder Financing = Shrinking Construction Activity Chart 9Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Chinese Property Developers Are Extremely Leveraged Besides, property developers are very leveraged with an assets-to-equity ratio close to nine (Chart 9). They have grown accustomed to borrowing heavily to accumulate real estate assets. They have been starting but not completing construction (Chart 10, top panel). We have been referring to this phenomenon as the biggest carry trade in the world. The bottom panel of Chart 10 shows two different measures of residential floor space inventories held by property developers. One measure subtracts completed floor space from started floor space, and another one deducts sold floor space from started floor space. On both measures, residential inventories are enormous. In theory, they could raise funds by selling their real estate assets. However, if they all try to sell simultaneously, there will not be enough buyers, and asset prices will plunge, which could lead to a full-blown debt deflation spiral. The last time the real estate market was similarly distressed in 2014-15, the central bank launched the Pledged Supplementary Lending (PSL) facility. This was effectively a QE program to monetize housing. This was the reason why housing recovered strongly in 2016-2017. There is currently no such program up for discussion. On the whole, odds are that the current property market breakdown is structural, not cyclical. Financial markets – the prices of stocks and USD bonds of property developers – convey a similar message and continue to plunge (Chart 11). Chart 10Excessive Property Inventories Excessive Property Inventories Excessive Property Inventories Chart 11No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices No Green Light From Property Stocks And Corporate Bond Prices Chart 12There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate There Has Been No Recovery In China Without A Revival in Real Estate Without an improvement in the housing market, a meaningful business cycle recovery is unlikely in China. Chart 12 illustrates that all recoveries in the Chinese broader economy since 2009 occurred alongside a revival in property sales. The importance of the property market goes beyond its size. Rising property prices lift household and business confidence, boosting aggregate spending and investment. The sluggish housing market and falling house prices will impair consumer and business confidence. This, along with uncertainty related to the dynamic zero-COVID policy, will dent consumer spending and private investments. Finally, the upcoming contraction in Chinese exports will dampen national income growth. Taken together, the multiplier effect of stimulus in the upcoming months will be lower than it has been in previous periods of stimulus. There are two areas that will see meaningful improvement in the coming months: infrastructure spending and autos. BCA’s China Investment Strategy service discussed the outlook for auto sales in a recent report. Chart 13Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment Green Shoots In China's Infrastructure Investment On the infrastructure front, there has been mixed evidence of an improvement in activity. The top and middle panels of Chart 13 demonstrate that Komatsu machinery’s operational hours and the number of approved infrastructure projects might be bottoming. However, the installation of high-power electricity lines has fallen to a 15-year low (Chart 13, bottom panel).   As we elaborated in last month’s report, the new financing/stimulus for infrastructure development will not result in new investments. Rather, it will by and large offset the drop in local government (LG) revenues from land sales this year. In short, there is little new stimulus for infrastructure beyond what was approved in the budget plan earlier this year. Bottom Line: The recovery in China will be U- rather than V-shaped, with risks tilted to the downside. Investment Recommendations Our bias is that the rebound in global risk assets could last for a few more weeks. The basis is that investor positioning in risk assets was very light when this rebound began. Plus, falling oil prices could reinforce the idea among investors that US inflation is no longer a problem. Looking beyond the next several weeks, the outlook for global and EM risk assets is dismal. Markets will realize that the Fed cannot halt its tightening with core inflation well above 4-5%. Hawkish Fed policy and contracting global trade will boost the US dollar and weigh on cyclical assets. We continue to recommend an underweight allocation to EM in global equity and credit portfolios. Consistently, we are also reluctant to chase EM currencies higher. EM local bonds offer value, as we have argued over the past couple of months, but for now we prefer to focus on yield curve flattening trades. We continue betting on yield curve flattening/inversion in Mexico and Colombia and are long Brazilian 10-year domestic bonds while hedging the currency risk. In addition, we recommend investors continue receiving 10-year swap rates in China and Malaysia.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategic Themes (18 Months And Beyond) Equities Cyclical Recommendations (6-18 Months) Cyclical Recommendations (6-18 Months)