Money/Credit/Debt
Highlights We cannot predict how China will manage Evergrande precisely but we have a high conviction that it will do whatever it takes to prevent contagion across the property sector. However, China’s stimulus tools are losing their effectiveness over time. The country is due for a prolonged struggle with financial and economic instability regardless of whether Evergrande defaults. A messy default would obviously exacerbate the problem. China’s regulatory crackdowns target private companies and will continue to weigh on animal spirits in the private sector. The government will be forced to use fiscal policy to compensate. The US’s and China’s switch from engagement to confrontation poses a persistent headwind for investor sentiment toward China. The new consensus that investors should buy into China’s “strategic sectors” to avoid arbitrary regulatory crackdowns is vulnerable to its own logic and to sanctions by the US and its allies. Feature China poses a unique confluence of domestic and foreign political risks and global markets are now pricing them. Property giant Evergrande could default on $120 million in onshore and offshore interest payments as early as September 23, or next month, prompting investors to run for cover. Is this crisis fleeting or part of a larger systemic failure? It is a larger systemic failure. We expect a slow-motion, Japanese-style crisis over the coming decade, marked with periodic bailouts and stimulus packages. We recommend investors stay the course: steer clear of China and stay short the renminbi and Taiwanese dollar. Tactically, stick with large caps, defensive sectors, and developed markets within the global equity universe. Strategically, prefer emerging markets that benefit from forthcoming Chinese (and American) stimulus. 1. A “Minsky Moment” Cannot Be Ruled Out The chief fear is whether the approaching default of Evergrande marks China’s “Minsky Moment.” Hyman Minsky’s financial instability hypothesis held that long periods of stable revenues lead to risky financial deals and large accumulations of systemic risk that are underpriced. When revenues cannot cover interest payments, a crash ensues followed by deleveraging. Minsky’s hypothesis speaks to debt crises in an entire economy, yet nobody knows for sure whether China’s economy has reached such a breaking point. China’s national savings rate stands at 45.7% of GDP and nominal growth exceeds the long-term government bond yield. However, a sharp drop in asset prices, especially in the property sector, could change everything, as it could lead to balance sheet recession among corporates and a fall in national income. Evergrande is supposed to make an $84 million interest payment on offshore debt and a $36 million payment on onshore debt this week, and after 30 days it would default. It owes $37 billion in debt payments over the next 12 months but only has $13 billion cash on hand (as of June 30, 2021). Authorities can opt for a full bailout or a partial bailout, in which the company defaults on offshore bonds but not onshore. They could even let the company fail categorically, though that would produce exactly the kind of precipitous drop in property asset prices that would lead to wider financial contagion. State intervention to smooth the crisis is more likely – and the government can easily pressure other companies into acquiring Evergrande’s assets and business divisions. Chart 1Yes, This Could Be China's Minsky Moment Chart 1 shows that China’s corporate debt-to-GDP ratio stands head and shoulders above other countries that experienced financial crises in recent decades, courtesy of our Emerging Markets Strategy. While China can undoubtedly bear large debts due to its savings, the implication is that China has large enough financial imbalances to suffer a full-fledged financial crisis, even if the timing is hard to predict. Household credit is also elevated at 61.7% of GDP, and the household debt-to-disposable-income ratio is now higher than in the United States. About two-thirds of China’s corporate debt is held by state-owned or state-controlled entities, prompting some investors to dismiss the gravity of the risk. However, financial crises often involve the transfer of debt from the state to private sector or vice versa. 59% of bond defaults in H1 2021 have involved state companies. Total debt is the main concern. Don’t take our word for it: China’s Communist Party has warned for the past decade about the danger of “implicit guarantees” and “moral hazard” that encourage financial excesses in the corporate sector. The Xi Jinping administration has tried to induce a deleveraging process since it came to power in 2012-13. Xi’s “three red lines” for the property sector precipitated the current turmoil. Even if Evergrande’s troubles are managed, China’s systemic risks will continue to boil over as its potential growth rate slows and the government continues trying to wring out financial excesses. Chart 2Policy Uncertainty, Financial Stress Can Rise Higher More broadly China is experiencing an unprecedented overlap of economic and political crises: The population is aging and labor force is shrinking; The economic model since 2009 has been changing from export-manufacturing to domestic-oriented, investment-driven growth; Indebtedness is spreading from corporates to households and ultimately the government; The governance model is shifting from “single-party rule” to “single-person rule” or autocracy; The population is reaching middle class status and demanding better quality of life; The international trade environment is turning from hyper-globalization to hypo-globalization; The geopolitical backdrop is darkening with the US and its allies attempting to contain China’s ambitions of regional supremacy. Almost all of these changes bring more risks than opportunities to China over the long haul. The need for rapid policy shifts provides the ostensible reasoning for President Xi Jinping’s decision not to step down but to remain president for the foreseeable future. He will clinch this position at the twentieth national party congress in fall 2022. The implication is that policy uncertainty will continue climbing up to at least 2019 peaks while offshore equity markets will continue to trend lower, as they have done since the onset of the US trade war (Chart 2). Credit default swap rates have so far been subdued but they are showing signs of life. A sharp rise in policy uncertainty and property sector stress would pull them up. Domestic equities (A-shares) have rallied since 2019 but we would expect them to fall back given China’s historic confluence of structural and cyclical challenges, which will create further negative surprises (Chart 2, bottom panel). 2. Beijing Will Provide Bailouts And Stimulus Ad Nauseum Evergrande’s future may be in doubt but Beijing will throw all its power at stopping nationwide financial contagion. True, a policy miscalculation is possible. A tardy or failed intervention cannot be ruled out. However, investors should remember that a clear pattern of bailouts and stimulus has emerged over the course of the Xi Jinping administration whenever a “hard landing” or financial collapse loomed. The government tightens controls on bloated sectors until the financial fallout threatens to undermine general economic and social stability, at which point the government eases policy. It is often forced to stimulate the economy aggressively. Chart 3 shows these cycles in two ways: China’s control of credit through the state-controlled banks, and the frequency of news stories mentioning important terms associated with financial and economic distress: defaults, layoffs, and bankruptcies. These three terms used to be unheard of among China watchers. Under the Xi administration, a higher tolerance of creative destruction has served as the way to push forward reform. The current rise in distress is not extended, suggesting that more bad news is coming, but it also shows that the government has repeatedly been forced to provide stimulus even under the Xi administration. Chart 3Xi Jinping Has Bailed Out System Three Times Already Could this time be different? Not likely. The American experience and the pandemic will also force China’s government to ease policy: China learns from US mistakes. The US lurched from Lehman’s failure into a financial crisis, an impaired credit channel, a sluggish economic recovery, a spike in polarization, policy paralysis, a near-default on the national debt, a surge in right- and left-wing populism, the tumultuous Trump presidency, widespread social unrest, a contested leadership succession, and a mob storming the nation’s capitol (Chart 4). This is obviously the nightmare of any Chinese leader and a trajectory that the Xi administration will avoid at any cost. Chart 4Lehman Brothers A Powerful Disincentive For China To Let Evergrande Fail Chinese households store their wealth in the property sector, so any attempt at policy restraint or austerity faces a massive constraint. Only a few countries are comparable to China with respect to the share of non-financial household wealth (property and land) within total household wealth. All of them are hosts of property sector bubbles, including the bubbles in Spain and Ireland back in 2007 (Chart 5). A property collapse would destroy the savings of the Chinese people over four decades of prosperity. Chart 5Property Is The Bedrock Of Chinese Households Social instability is already flaring up. Almost all China experts agree that “social stability” is the Communist Party’s bottom line. But note that the Evergrande saga has already led to protests, not only at the company’s headquarters in Shenzhen but also in other cities such as Shenyang, Guangzhou, Chongqing. Protests were filmed and shown on social media (posts have been censored). Protesters demanded repayment for wealth management products gone sour and properties they are owed that have not been built. This is only a taste of the cross-regional protests that would emerge if the broader property sector suffered. The lingering COVID-19 pandemic is still relevant. Investors should not underrate the potential threat that the pandemic poses to the regime. Severe epidemics have occurred about 11% of the time over the course of China’s history and they often have major ramifications. Disease has played a role in the downfall of six out of ten dynasties – and in four cases it played a major role. It would be suicidal for any regime to add self-inflicted economic collapse to a lingering pandemic (Table 1). Table 1Disease Threatens Chinese Dynasties – Not A Time To Self-Inflict A Recession Easing policy does not necessarily mean bringing out the “bazooka” and splurging on money and credit growth, though that is increasingly likely as the crisis intensifies. Notably the July Politburo statement specifically removed language that said China would “avoid sharp turns in policy.” In other words, sharp turns might be necessary. That can only mean sharp reflationary turns, as there is very little chance of doubling down on policy tightening. A counterargument holds that the Chinese government is now exclusively focused on power consolidation to the neglect of financial and economic stability. Perhaps the leadership is misinformed, overconfident, or thinks a financial collapse will better purge its enemies – along the lines of the various political purges under Chairman Mao Zedong. Wealthy tech magnates and property owners could conceivably challenge the return of autocracy. After all, the US political establishment almost “fell” to a rich property baron – why couldn’t China’s Communist Party? Political purges should certainly be expected ahead of next year’s party congress. But not to the point of killing the economy. The government would not be trying to balance policy tightening and loosening so carefully if it sought to induce chaos. It must be admitted, however, that the change to autocracy means that the odds of irrational or idiosyncratic policy have gone up substantially and permanently. Of course, the high likelihood that Beijing will provide bailouts and stimulus should not be read as a bullish investment thesis, even though it would create a pop in oversold assets. The Chinese system is saturated with money and credit, which have been losing their effectiveness in driving growth. Financial imbalances get worse, not better, with each wave of credit stimulus. Beijing is caught between a rock and a hard place. Hence stimulus comes only reluctantly and reactively. But it does come in the end because a financial crash would threaten the life of the regime and preclude all other policy priorities, domestic and foreign. 3. Yes, China’s Regulatory Crackdown Targets The Private Sector Global growth and other emerging economies will get most of the benefit once China stimulates, since China’s own firms will still face a negative domestic political backdrop. Bullish investors argue that the government’s regulatory tightening is misunderstood and overblown. The claim is that China is not targeting the private sector generally but only isolated sectors causing social problems. Costs need to be reduced in property, education, and health to improve quality of life. China shares the US’s and EU’s desire to rein in tech giants that monopolize their markets, abuse consumer data and privacy, and benefit from distorted tax systems. Most of these arguments are misleading. China does not have a strong record on data privacy, equality, social safety nets, rule of law, or “sustainable” growth (as opposed to “unsustainable,” high-debt, high-polluting growth). China actively encourages state champions that monopolize key sectors. Many developed markets have better records in these areas, notably in Europe, yet China is eschewing these regulatory models in preference for an approach that is arbitrary and absolutist, i.e. negative for governance. As for the private sector, animal spirits have been in a long decline throughout the past decade. This is true whether judging by money velocity – i.e. the pace of economic activity relative to the increase in money supply – or by households’ and businesses’ marginal propensity to save (Chart 6). The 2015-16 period shows that even periodic bouts of government stimulus have not reversed the general trend. Regulatory whack-a-mole and financial turmoil will not improve the situation. Chart 6Private Sector Animal Spirits Depressed Throughout Xi Era Chart 7Even Official Data Shows Consumer Confidence Flagging Surveys of sentiment confirm that the latest developments will have a negative effect (Chart 7). Cumulatively, the changes in China’s domestic and international policy context are being interpreted as negative for business, entrepreneurship, and economic freedom – notwithstanding the government’s claims to expand opportunity in its “common prosperity” plan. 4. The Withdrawal Of US Friendship Is A Headwind For China Chart 8Other Asians Sought US Friendship, Not Conflict, When Export Models Expired All of the successful Asian economies – including China for most of the past forty years of prosperity – have tried to stay on the good side of the United States. By contrast, China and the US today are shifting from engagement to confrontation and breaking up their economic ties (Chart 8). This is a problem for China because the US and to some extent its allies will seek to undermine China’s economy and its autocratic model as part of this great power competition. The rise in geopolitical risk is underscored by the Australia-UK-US (AUKUS) agreement, by which the US will provide Australia with nuclear submarines over the next decade. This was a clear demonstration of the US’s “pivot to Asia” and the fact that the US and China are preparing for war – if only to deter it. China’s return to autocracy and clash with the US and Asian neighbors is also leading to a deterioration of its global image, particularly over issues of transparency and information sharing. The dispute over the origins of COVID-19 is a major source of division with the US and other countries. Transparency is important for investors. The World Bank has discontinued its “Ease of Doing Business” rankings after a scandal was revealed in which China’s ranking was artificially bumped up. The last-published trend is still downward (Chart 9). Most recently China has stepped up censorship of its financial news media amid the current market turmoil, which makes it harder for investors to assess the full extent of property and financial risks.1 The US political factions agree on China-bashing if nothing else. The Biden administration has little political impetus to eschew tariffs and export controls. One important penalty will come from the Securities and Exchange Commission, which is likely to ban Chinese firms from US stock exchanges unless they conform to common accounting standards. Hence the dramatic fall in the share prices of Chinese companies listed via American Depository Receipts (ADRs), in both absolute and relative terms (Chart 10, top panel). This threat prompted China’s recent crackdown on its own firms that were attempting to hold initial public offerings on US exchanges. Chart 9US Conflict Exposes China’s Global Influence Campaign The Quadrilateral Forum – the US, Japan, Australia, and India – has agreed to link the semiconductor supply chain to human rights standards, foreclosing China’s participation in that supply chain. US semiconductor firms are among the most exposed to China but they have not suffered over the course of the US-China tech war, suggesting that US vulnerabilities are limited (Chart 10, bottom panel). Chart 10US Regulators Will Kick Chinese Firms While They Are Down The point is not to exaggerate the strength of the US and its allies but rather the costs to China of actively opposing them. The US has a difficult enough time cobbling together a coalition of states to impose sanctions on Iran over its nuclear program, not to mention forming any coalition that would totally exclude and isolate China. China is far more important to US allies than Iran – it is irreplaceable in the global economy (Chart 11). The EU and China’s Asian neighbors will typically restrain the US’s more aggressive impulses so as not to upset the global recovery or end up on the front lines of a war.2 Chart 11No Substitute For China In Global Economy This diplomatic constraint on the US is probably positive for global growth but not for China per se. American allies are still able to increase the costs on China for pursuing its own state-backed development path and geopolitical sphere of influence. Japan, Australia, and others are likely to veto China’s application to join the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), while the UK and eventually the US are likely to join it. Investors should view US-China ties as a headwind at least until the two powers manage to negotiate a diplomatic thaw, i.e. substantial de-escalation of tensions. A thaw is unlikely in the lead-up to Xi Jinping’s consolidation of power and the US midterm elections in fall 2022. Presidents Biden and Xi are still working on a bilateral summit, not to mention a more substantial improvement in ties. We doubt a diplomatic thaw would be durable anyway but the important point is that until it happens China will face periodic bouts of negative sentiment from the emerging cold war. Other Asian economies thrived under US auspices – China is sailing in uncharted waters. 5. Global Investors Cannot Separate Civilian From State And Military Investments The word on Wall Street is that investors should align their strategies with those of China’s leaders so as not to run afoul of arbitrary and draconian regulators. For example, instead of “soft tech” or consumer-oriented companies – like those that give people rides, deliver food, or make creative video games – investors should invest in “hard tech” or strategic companies like those that make computer chips, renewable energy, biotechnologies, pharmaceuticals, and capital equipment. There is no question that the trend in China – and elsewhere – is for governments to become more active in picking winners and losers. Industrial policy is back. Investors have no choice but to include policy analysis in their toolbox. However, for global investors, an investment strategy of buying whatever the government says is far from convincing. The most basic investment strategy in keeping with the Xi administration’s goals would be to invest in state-owned enterprises in domestic equity markets. So SOEs should have outperformed the market, right? Wrong. They were in a downtrend prior to the 2015 bubble, the burst of which caused a further downtrend (Chart 12, top panel). Similarly, the preference for “hard tech” over “soft tech” is promising in theory but complicated in practice: hard tech is flat-to-down over the decade and down since COVID-19 (Chart 12, middle panel). It has underperformed its global peers (Chart 12, bottom panel). China’s policy disposition should be beneficial for industrials, health care, and renewable energy. First, China is doubling down on its manufacturing economy. Second, the population is aging and health care is a critical part of the common prosperity plan. Third, green energy is a way of diversifying from dependency on imported oil and natural gas. However, the profile of these sectors relative to their global counterparts is only unambiguously attractive in the case of industrials, which began to outperform even during the trade war (Chart 13). Chart 12State Approved' Trades Still Bring Risks Chart 13Beware 'State Approved' Trades In Table 2 we outline the valuations and political risks of onshore equity sectors. Valuations are not cheap. Domestic and foreign risks are not fully priced. Table 2China Onshore Equities, Valuations, And (Geo)Political Risks There is a bigger problem for global investors, especially Americans: investing in China’s strategic sectors directly implicates investors in the Communist Party’s domestic human rights practices, state-owned enterprises, and national security goals. “Civil-military fusion” is a well-established doctrine that calls for the People’s Liberation Army to have access to the cutting-edge technology developed by civilians and vice versa. These investments will eventually be subject to punitive measures since the US policy establishment believes it can no longer afford to let US wealth buttress China’s military and technological rise. Investment Takeaways China may or may not work out a partial bailout for Evergrande but it will definitely provide state assistance and fiscal stimulus to try to prevent contagion across the property sector and financial system. Bad news in the coming weeks and months will be replaced by good news in this sense. However, the fact that China will eventually be forced to undertake traditional stimulus yet again will increase its systemic financial risks, in a well-established pattern. The best equity opportunities will lie outside of China, where companies will benefit from global recovery yet avoid suffering from China’s unique confluence of domestic and foreign political risks. We prefer developed markets and select emerging markets in Latin America and Asia-ex-China. Chinese households and businesses are downbeat. This behavior cannot be separated from the historic changes in the economy, domestic politics, and foreign policy. It is hard to see an improvement until the government boosts growth and the 2022 political reshuffle is over. American opposition is a bigger problem for China than global investors realize. Not only are the two economies divorcing but other democracies will distance themselves from China as well – not because of US demands but because their own manufacturing, national security, and ideological space is threatened by China’s reversion to autocracy and assertive foreign policy. Investing in China’s “hard tech” and strategic sectors with government approval is not a simple solution. This approach will directly funnel capital into China’s state-owned enterprises, domestic security forces, and military. As such the US and West will eventually impose controls. Investments may not be liquid since China would suffer if capital ever fled these kinds of projects. Both American and Chinese stimulus is looming this winter but the short run will see more volatility. We are closing our long JPY-KRW tactical trade for a gain of 4.4% Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 We have often noted in these pages over the past decade that multilateral organizations overrated improvements in China’s governance based on policy pronouncements rather than structural changes. 2 Still, tensions among the allies should not be overrated since they share a fundamental concern over China’s increasing challenge to the current global order. The EU is pursuing trade talks with Taiwan, and there are ways that the US can compensate France over the nullification of its submarine sales to Australia (most of which are detrimental to China’s security).
Several key financial assets are failing to send a strong signal and instead have been in a state of stasis. Abstracting from day-to-day moves, Treasury yields, the LMEX, and EUR/USD have not been on a clear trajectory since the beginning of July. Similarly,…
Highlights A lot of pessimism is embedded in the Aussie dollar, making it a potent candidate for a powerful mean-reversion rally. The key catalyst will be a reversal in COVID-19 infection rates which are holding the Aussie economy hostage. Marginally, there is good news on that front. On a terms-of-trade basis, the Australian dollar is very cheap. Falling commodity prices are a handicap, but the valuation margin of safety makes the AUD a safer bet on a reflationary theme. At the crosses, we are already long AUD/NZD, but AUD/JPY and AUD/CHF should be winners in the next six-to-nine months. Feature The Australian economy was on a strong recovery path before a resurgence in Covid-19 infections handicapped this improvement. Australian GDP recovered to pre-pandemic levels in Q1 and the latest Q2 release suggests the Australian economy was on the path to achieve escape velocity (Chart I-1). Chart I-1The Aussie Economy Has Recovered The bounce in the Australian dollar has mirrored the improvement in the economy. From a low of 55 cents in early 2020, the Aussie rose over 40% to a high of 80 cents in earlier this year. However, more recently, there has been a strong correction in the AUD, reflecting both domestic and global concerns about growth. The key question for investors is whether the decline in the Aussie represents an excessive move or heralds a more malignant outcome for the currency. In our view, if risk sentiment stays ebullient, then the Australian dollar will be a potent candidate for a coiled-spring rebound. However, on the downside, there has already been a lot of bad news priced into the Aussie, making the reward/risk picture more favorable (Chart I-2). The Delta Variant The Delta variant of Covid-19 is ravaging across most countries, and the Australian economy has been particularly susceptible. While in absolute terms, Australia’s infection rates are faring better than most developed markets, the momentum of the latest wave has knocked down a nascent boom in Aussie economic conditions (Chart I-3). Chart I-2The Aussie And Global Stocks Have Diverged Chart I-3The Delta Variant Is Ravaging Australia Sydney is now entering its third month of lockdown, and the state of Victoria has just extended mobility restrictions for another three weeks. However, the population is getting vaccinated quickly, with almost 40% having received two jabs. Should the current trajectory of vaccinations continue, Australia could fully lift restrictions on its citizens by the fourth quarter. It is noteworthy that Australia has been here before, and during the last two waves in March and August of last year, the country was able to weather the storm with lower vaccination rates. As such, the latest wave should prove transient, allowing economic conditions to normalize after a weak Q3. AUD And The Global Cycle As a premier commodity producer, the Australian economy is intricately linked to the global economic cycle, especially what happens in China. Chart I-4 shows that both the Caixin and National Bureau of Statistics manufacturing PMIs in China lead Australian manufacturing activity. With the majority of Australian exports going to China, it makes the Aussie economy very sensitive to Chinese domestic conditions. Our China Investment Strategy colleagues believe that fiscal policy will be eased going forward, while the tightening in monetary conditions is past its peak, especially in the face of Covid-19 and floods ravaging China. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. With the Chinese bond market becoming more and more liberalized, it is becoming a good proxy for monetary conditions in China. As such, the trend in bond yields has tended to lead Chinese imports. This suggests that Aussie exports should remain robust in the coming months (Chart I-5). Chart I-4How Long Will The China Slowdown Last? Chart I-5Easing Financial Conditions In China Chart I-6Chinese Policy And The AUD A similar pattern to March of last year might be repeated this year, should Covid-19 fears remain persistent. China led the pack vis-à-vis other countries by injecting stimulus much earlier on, which helped ease domestic financial conditions. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil rose higher, helping Australian export volumes. This time around, excess money supply in China is rebounding from extremely depressed levels. While the near-term trajectory suggests some more volatility for the Aussie, the cyclical outlook is improving (Chart I-6). A Terms-Of-Trade Boom Despite a slowing Chinese economy, commodity prices remain resilient. Australian terms-of-trade have outperformed that of other commodity-producing nations (Chart I-7). Australia is relatively competitive in supplying the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, pollutes less, and is in high demand in China. Similarly, Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months. Going forward, Australia’s terms-of-trade improvement is likely to continue. China’s clear energy policy shift away from coal and towards natural gas will buffet LNG export volumes. Also, given that reducing, if not outright eliminating, pollution is a long-term strategic goal in China, this will provide a multi-year tailwind for both cleaner ore and gas exports. The pattern of an improving terms-of-trade picture but deteriorating domestic fundamentals has placed the AUD in a tug-of-war scenario. One of the key primary drivers of the AUD exchange rate has been the basic balance, the sum of the current account and long-term capital flows. The basic balance is making secular highs, suggesting the AUD should be above its 2011 peak near 1.10 (Chart I-8). This suggests that room for mean reversion is substantive. Chart I-7A Boom In Aussie Terms Of Trade Chart I-8The AUD Has Lagged Terms Of Trade In a nutshell, Australia sports the best improvement in both trade and current account balances in the G10 over the last few years (Chart I-9). Investment in projects in the resource space are now bearing fruit, easing the external funding requirement. This has ended the 35-year-long deficit in the current account. A rising current account naturally increases the demand for the Australian dollar, which buffets the currency. Domestic Considerations And The RBA By most accounts, the Reserve Bank of Australia (RBA) has achieved its objectives. Most measures of inflation are near target, unemployment is close to NAIRU, and wages have bottomed and are marginally inflecting higher (Chart I-10). The next batch of numbers coming out of Australia will likely be weak, as the RBA will outline next week, but any weakness in the Aussie will represent a buying opportunity. Chart I-9A Record Surplus In Australias Basic Balance Chart I-10Fundamentals In The Aussie Economy Are On The Mend Taking a step back, the recovery in the Australian jobs market has been spectacular. Unemployment is at 4.6%, very close to NAIRU. Meanwhile, the participation rate has recovered to pre-pandemic levels as pandemic-aid schemes wear off. The Liberal-National coalition government was very proactive, especially with the “Job Seeker” and “Job Keeper” schemes, providing a valuable cushion for domestic economic conditions. With a very low government debt burden, there is obviously scope to expand the scheme further should conditions dictate. House prices are rebounding in a trajectory the RBA likes to see, driven by credit from owner-occupied housing (Chart I-11). This suggests that at least at the margin, house prices are being driven by domestic demand/supply fundamentals. The key takeaway is that relative to its commodity-currency peers, Australia is well along its house-price adjustment path, having been one of the first developed market countries to introduce macroprudential measures. This suggests that beyond the very near term, emergency policy settings are no longer appropriate for the Aussie economy. The RBA is likely to taper asset purchases from $A5 billion a week, to $A4 billion as telegraphed (Chart I-12), but there is scope for a hawkish surprise at next week’s meeting. Markets are already discounting an increasing path for interest rates starting next year, but not so relative to the US. This could change as the RBA responds to improving economic conditions. Chart I-11A Sustainable Increase In House Prices Chart I-12The RBA Could Unexpectedly Change Policy Settings Meanwhile, real rates are already more attractive in Australia compared to the US, especially at the short end of the curve. A Valuation Cushion The cherry on the cake for the Aussie is that it is cheap according to most of our valuation measures. As we highlighted in a recent report, trading the Aussie on a valuation basis alone has added significant alpha over the last several years. One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 20% (Chart I-13). Our intermediate-term timing models, published a fortnight ago, shows the Australian dollar as 9% cheap, or near one standard deviation below the mean. Our purchasing power parity (PPP) models point to a slight undervaluation in the Australian dollar. It also helps that speculators are very short the Aussie, which is bullish from a contrarian perspective (Chart I-14). Chart I-13The AUD Is Cheap Chart I-14Investors Are Short The AUD How Should Investors Position Themselves? AUD/USD will close its undervaluation gap in the medium-to-long term, as happens with most currencies. This will lift the AUD towards 85 cents. In the short term, long AUD/NZD and long AUD/JPY remain attractive bets for those not willing to take directional dollar bets. In our portfolio, we are already long AUD/NZD for the following reasons: The markets have already priced in a very hawkish RBNZ and a very dovish RBA (Chart I-15). Our bias is that as Covid-19 proves to be a global problem, there will be a renormalization in interest rate expectations. Terms of trade in Australia will continue to outperform that of New Zealand. AUD/NZD and relative terms of trade tend to move together (Chart I-16). Chart I-15AUD/NZD Remains A Buy Chart I-16Terms Of Trade And AUD/NZD AUD/NZD is very cheap on a historical basis. This level of valuation has provided strong support in the past (Chart I-17). Meanwhile, the Australian yield curve has steepened, albeit with some recent flattening, but banks have still underperformed the improvement in the interest rate term structure (Chart I-18). A bottoming economy will benefit banks, which make up almost 35% of the Australian MSCI index, and thus there could be renewed foreign inflows. Chart I-17AUD/NZD Is Cheap Chart I-18Stay Long Aussie Banks Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Data out of the US this week was mixed: The payrolls report was well below expectations. Non-farm payrolls came in at 235K, versus an expected increase of 733K. Both the labor force participation rate and average hourly earnings remained steady at 61.7% and 4.3% year-on-year, respectively. The ISM report was robust for August. The manufacturing PMI improved from 59.5 to 59.9. New orders rose from 64.9 to 66.7 The PCE deflator came it at 3.6% year-on-year, in line with estimates. The US dollar DXY index fell this week. The weak payrolls report reiterates the fact that risks from tighter monetary policy in the US are overstated. This was the conclusion from the Jackson Hole meeting last week, that saw a drop in both the US dollar and bond yields. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data remains robust: Core CPI came in at 1.6% year-on-year in August. Headline CPI was a more robust 3%. The final read from the Markit manufacturing PMI remained at a robust 61.4 in August. The services PMI did decline from 59.5 to 59. Retail sales increased by a robust 3.1% in July. The euro rose by almost 1% this week. Covid-19 cases seem to be rolling over in Europe while firing in other nations. This will increase support for the euro, as well as expectations the ECB could dial back monetary accommodation. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been on the strong side: Retail sales rose 2.4% year-on-year in July. The employment report was strong. The unemployment rate fell to 2.85 and the job-to-applicant ratio rose from 1.13 to 1.15. Housing starts rose 10% year-on-year in July. Capital spending for Q2 was 5.3% year-on-year, well above expectations. The yen was flat against the dollar this week. In an environment where global risk is ebullient, the yen tends to underperform other pro-cyclical currencies. This was very evident this week. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data out of the UK this week was encouraging: The Lloyds business barometer improved from 30 to 36. Nationwide home prices rose 11% year-on-year in August. The Markit services PMI was steady at 55 in August. The pound rose by 0.6% this week. UK will continue to benefit from higher vaccination rates, compared to the rest of the G10. That said, other pro-cyclical currencies, such as the AUD, could benefit from a robust vaccination campaign, outperforming GBP. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data is slated to slow, but the recent numbers have been encouraging: Private sector credit rose 4% year-on-year in August. Q2 GDP was a robust 9.6% year-on-year. Exports rose 5% month-on-month in July. The AUD was the best-performing currency this week, rising almost 2%. We discuss the AUD at length in this week’s front section. Our bias is that the AUD will benefit from easing monetary policy in China and high commodity prices. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The was scant data out of New Zealand this week: Building permits rose 2.1% month-on-month in July. CoreLogic house prices are inflecting 27% year-on-year in August. ANZ Business confidence slipped from -3.8 to -14.2 in August. The NZD was up almost 2% this week. We like the NZD cyclically, but our bias is that hawkish expectations from the RBNZ could be watered down, which could make the kiwi lag other commodity currencies like the Aussie. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data out of Canada this week has been weak: Q2 GDP missed expectations, falling 1.1% versus an expected increase of 2.5%. The Markit manufacturing PMI increased from 56.2 to 57.2 in August. Net trade deteriorated in July, but Canada is still booking a C$0.8bn surplus. The CAD rose by 0.7% this week. The backdrop for the loonie is positive as the Bank of Canada continues to taper asset purchases and remains on a path to increase interest rates. The upcoming election could also usher in more fiscal stimulus for Canada. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The data out of Switzerland this week was weak: The KOF indicator declined from 129.8 to 113.5 in August. This was well below expectations. CPI in August was slightly above expectations at 0.4% year-on-year for the core and 0.9% for headline. GDP for Q2 was in line with expectations, at 1.8% quarter-on-quarter. The Swiss franc was flat this week. The franc will continue to benefit from rolling bouts of volatility, but at the margin, it will lag the bounce in other currencies as global risk sentiment stays ebullient. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data out of Norway this week was positive: Credit growth improved 5.3% year-on-year in July The current account balance was a healthy NOK 93.2bn in June. The unemployment rate fell from 3.1% to 2.7%. The NOK was up around 1% this week. We are long Scandinavian currencies on a bet that the dollar will fall cyclically. Meanwhile, the Norges Bank has signaled they will increase interest rates ahead of both the Federal Reserve and the ECB. This will benefit real rates in Norway. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been improving: The Swedbank manufacturing and services PMI remained robust in August at 60.1 and 64.7 respectively. The August current account balance showed a healthy surplus of SEK 80.3 billion. The economic tendency survey for August came in at 121.1 from 119.8. Consumer confidence rose from 106.5 to 108.6 in August. The SEK was up almost 1% this week. There are many signs the Swedish economy is improving. This is paring back expectations of more stimulus from the Riksbank. We are short both EUR/SEK and USD/SEK as reflation plays. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades Footnotes
Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Chart 11Canada: Trudeau Takes A Calculated Risk In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Chart 17Refugees Will Not Change Game In German/French Elections Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights The post-pandemic investment phase is just a continuation of the post-credit boom investment phase. This is because the pandemic has just accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends will structurally weigh on the profits of old economy sectors, consumer prices, and bond yields. At the same time, these trends are a continuing structural tailwind for the profits in those sectors that facilitate the shift to a more digital and cleaner world. Our high-conviction recommendation is to stay structurally overweight growth sectors versus old economy sectors… …and to stay structurally overweight the US stock market versus the non-US stock market. Fractal analysis: PLN/USD, Hungary versus Emerging Markets, and sugar versus soybeans. Feature Chart of the WeekUS And Non-US Profits Go Their Starkly Separate Ways Many people use the US stock market as a proxy for the world stock market. Intuitively, this makes sense, because the US stock market is the largest in the world, and the S&P 500 and Dow Jones Industrials are well-known indexes that we can monitor in real time. In contrast, world equity indexes such as the MSCI All Country World are less familiar and do not move in real time. Yet to use the US stock market as a proxy for the world stock market is a mistake. Although the US comprises makes up half of the world stock market capitalisation, the other half is so different – the non-US yan to the US yin – that the US cannot represent the world. As we will now illustrate. US Profits Have Doubled While Non-US Profits Have Shrunk Over the past ten years, US and non-US stock market profits have gone their starkly separate ways. While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011! (Chart of the Week) While US profits have nearly doubled, non-US profits languish 10 percent below where they were in 2011. Of course, in any comparison of this sort, a key issue is the starting point. In this first part of our analysis, we are defining the starting point as the point at which profits had recouped all their global financial crisis losses. For both US and non-US profits this point was in March 2011 (Chart I-2 and Chart I-3). Chart I-2Comparing Profit Growth Since The Full Recovery From The Financial Crisis Chart I-3Comparing Valuation Expansion Since The Full Recovery From The Financial Crisis Because the issue of the starting point of the analysis is contentious, we will look at a much earlier starting point later in the report. But first, here are the decompositions of the US and non-US stock market moves from March 2011. US stock market profits are up 93 percent, while the multiple paid for those profits (valuation) is up 75 percent. Compounding to a total price gain of 235 percent (Chart I-4). Chart I-4US Profits Up 93 Percent, Valuation Up 75 Percent Non-US stock market profits are down -9 percent, while the multiple paid for those profits is up 38 percent. Compounding to a total price gain of a measly 25 percent (Chart I-5). Chart I-5Non-US Profits Down -9 Percent, Valuation Up 38 Percent The aggregate world stock market profits are up 24 percent, while the multiple paid for those profits is up 57 percent. Compounding to a total price gain of 94 percent (Chart I-6). Chart I-6World Profits Up 24 Percent, Valuation Up 57 Percent The Post-Credit Boom Phase Favours The US Over The Non-US Stock Market In the post-credit boom phase, several important features of stock market performance are worth highlighting. In absolute terms, valuation expansion has lifted US stocks by twice as much as non-US stocks, 75 percent versus 38 percent. Yet even the 75 percent expansion in the US stock market valuation has played second fiddle to the 93 percent expansion in US stock market profits. Absent valuation expansion, non-US stocks would stand lower today than in 2011. But for non-US stocks, whose structural profit growth has been non-existent, valuation expansion has been the only instrument for structural gains. Indeed, absent valuation expansion, non-US stocks would stand lower today than in 2011. And absent valuation expansion at a world level, the world stock market would lose three quarters of its ten-year gain. What can explain the startling performance differential between US and non-US stocks on both profit and valuation expansions? As we have argued before, most of the difference does not come from the underlying (US versus non-US) economies, but instead comes from the company and sector compositions of the stock markets. The US stock market is heavily over-weighted to global growth companies and sectors – such as technology and healthcare (Chart I-7) – which, by definition, have experienced structural growth in their profits. In contrast, the non-US stock market is heavily over-weighted to global old economy companies and sectors – such as financials, energy, and resources (Chart I-8) – whose profits have stagnated, or entered structural downtrends (Chart I-9). Chart I-7The US Stock Market Is Heavily Over-Weighted To Growth Sectors Chart I-8The Non-US Stock Market Is Heavily Over-Weighted To Old Economy Sectors Chart I-9Old Economy Sector Profits Have Gone Nowhere At the same time, when bond yields decline, companies whose profits are growing (and time-weighted into the distant future) see a greater increase in their net present values. Hence, companies in the global growth sectors have experienced a larger valuation expansion than those in the old economy sectors. In this way, the US stock market has outperformed the non-US stock market on both profit growth and valuation expansion. The key question is, will these post-credit boom trends continue? The answer depends on whether the post-pandemic world marks a new phase for investment, or whether it is just a continuation of the post-credit boom phase. The Post-Pandemic Phase Is A Continuation Of The Post-Credit Boom Phase Let’s now address the issue of the starting point of our analysis by panning out to 1990. This bigger picture from 1990 shows three distinct phases for investors (Chart I-10 and Chart I-11). Chart I-10Since 1990, There Have Been Three Distinct Investment Phases Chart I-11The Post-Pandemic Investment Phase Is A Continuation Of The Post-Credit Boom Phase The first phase was the 1990s build-up to the dot com boom. This phase clearly favoured growth sectors, and thereby the US stock market versus the non-US stock market. The second phase was the early 2000s credit boom. This phase clearly favoured sectors that facilitated the credit boom or benefited from its spending – notably, the old economy sectors of financials, energy, and resources. Thereby it favoured the non-US stock market versus the US stock market. The third and most recent phase is the post-credit boom phase. This phase has flipped the leadership back to growth sectors as the absence of structural credit growth has stifled financials as well as the capital-intensive old economy sectors that had previously benefited from the credit boom. Additionally, the structural disinflation that has comes from weak credit growth has dragged down bond yields and – as already discussed – given a much bigger boost to growth sector valuations. Since 1990, there have been three distinct phases for investors: the dot com boom; the credit boom; and the post-credit boom. Now we come to the key question. Did 2020 mark the end of the post-credit boom phase and the start of a new ‘post-pandemic’ phase? On the evidence so far, the answer is an emphatic no. Crucially, there is no new credit boom. A still highly indebted private sector is neither willing nor able to borrow. And although public sector debt surged during the pandemic, governments are now keen to temper or rein in deficits. In any case, Japan teaches us that government borrowing – which is bond rather than bank financed – does nothing for the banks or the broader financial sector. An equally important question is, has the pandemic reversed the societal and economic trends of the post-credit boom phase? The answer is no. Quite the contrary, the pandemic has accelerated the pre-existing shifts to a more remote way of working, shopping and interacting as well as the de-carbonisation of the economy. Combined with no new credit boom, these ongoing trends are structurally disinflationary for the profits of old economy sectors as well as for consumer prices. Thereby, they will continue to weigh on bond yields. At the same time, the trends are a continuing structural tailwind for the profits in those sectors that facilitate and enable the shift to a more digital and cleaner world. While we are open to the evolving evidence, the post-pandemic investment phase seems an extension of the post-credit boom phase. This means that structurally, there is no reason to flip out of growth sectors back to old economy sectors. It also means that structurally, there is no reason to switch from US to non-US stocks. Fractal Analysis Update This week’s fractal analysis highlights three potential countertrend moves based on fragile fractal structures. First, the recent rally in the US dollar could meet near-term resistance given its weakening 65-day fractal structure. A good way of playing this would be long PLN/USD (Chart I-12). Chart I-12PLN/USD Could Rebound Second, the strong outperformance of Hungary versus Emerging Markets – largely driven by one stock, OTP Bank – has become a crowded trade based on its 130-day fractal structure. This would suggest underweighting Hungary versus the Emerging Markets index (Chart I-13). Chart I-13Underweight Hungary Versus EM Finally, the sugar price has skyrocketed as extreme weather has disrupted output in the world’s top producer, Brazil. Given that supply bottlenecks ultimately ease, a recommended trade would be to short sugar versus soybeans, using ICE versus CBOT futures contracts (Chart I-14). Set the profit target and symmetrical stop-loss at 8 percent. Chart I-14Short Sugar Versus Soybeans Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields ##br##- Euro Area Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Indicators To Watch - Bond Yields ##br##- Asia Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations
Highlights Confidence vs. Inflation: Global bond yields are lacking direction at the moment. The variant is setting a near-term ceiling on bond yields while the medium-term floor is established by inflation. The inflation pressures – fueled by tightening global labor markets and persistent supply chain disruptions - will linger for much longer than the Delta surge. Investors should position for higher global bond yields, led by the US, on a medium-term basis. Canada: The Canadian economy is performing strongly as the nation is finally reopening after a poor initial vaccine rollout earlier this year. Next month’s federal election will likely result in a re-election of Justin Trudeau’s Liberals and a continuation of expansive fiscal policy. The Bank of Canada is on track to begin interest rate hikes in 2022 with inflation likely to remain higher for longer than the central bank projects. Remain underweight Canadian government bonds within global (USD-hedged) fixed income portfolios. A Tug Of War For Bond Yields Chart of the WeekThe Delta Surge Is Not That Bond Bearish Global bond yields are currently trapped in narrow ranges, pulled in opposing directions by two powerful forces. The spread of the Delta variant is raising worries about future economic growth. Yet central banks cannot signal dovish bond-bullish guidance in response because of persistently high inflation and rich financial asset valuations. The result is that real bond yields cannot decline deeper into negative territory because central banks are unable to signal easier future monetary policy. At the same time, inflation expectations cannot fall either because of high realized inflation and overly accommodative monetary settings. With global supply chains still disrupted by the pandemic and labor markets in many major developed countries tightening rapidly, the inflation side of this tug of war on bond yields will remain strong. This leaves the Delta variant as being most important in determining which side wins the war. The variant is proving to be much less deadly (so far) than past COVID waves on an aggregate global basis (Chart of the Week) thanks to vaccinations. However, there are notable differences in economic growth momentum that have opened up between countries where the variant has spread aggressively, especially if economic restrictions have been imposed. The preliminary services PMIs for August showed big monthly declines in the US and UK, where case numbers have surged, and Australia, where half of the population is under some form of lockdown to fight the spread of the variant. Delta-stricken Japan also saw a sharp drop in services activity in August. The services PMIs in Europe, however, dipped very modestly, in line with the subdued spread of the variant in euro area countries. Chart 2No Major Changes On Bond Markets From The Delta Variant While the variant appears to be having a noticeable impact on relative economic growth in the near-term, the relative performance of government bond markets in the developed world is a different story. When looking at the 2021 year-to-date relative returns of the major bond markets versus the Bloomberg Barclays Global Treasury index - in USD-hedged and duration-matched terms - the outperformers have been Germany (and euro area bonds, in general), Japan and Australia while the laggards have been the US, UK and Canada (Chart 2). Over the past month, however, when the global spread of the Delta variant has become front page news, there has been very little change in the relative bond returns outside of a modest pickup in the outperformance of Australia - one of our current overweight recommendations. A big reason why relative returns have remained stagnant is that monetary policy expectations have not changed much in response to the variant. Our 24-month discounters, which measure the amount of interest rate hikes over the next two years currently priced in overnight index swap (OIS) curves, are essentially at the same levels that prevailed in early July in the US, Europe, the UK, Canada, Australia and Japan. With little change in future interest rate expectations between countries, amid stable inflation expectations, there is no impetus driving changes in relative government bond market performance. Other financial markets are also taking the spread of the variant in stride, especially in the US. Forward looking US economic sentiment measures like the University of Michigan consumer expectations index and the Philadelphia Fed Business Outlook survey all showed sharp declines in the preliminary August readings. Yet US equity markets continue to hover near all-time highs, US high-yield spreads remain near pandemic lows and the VIX index is below 20 (Chart 3). Perhaps one reason why risk assets are holding in well despite the worries over the variant is that the news outside the US has been more upbeat. Consumer confidence in Canada and the UK remains solid (Chart 4), with the latter also seeing a huge upside surprise in retail sales volumes in August according to the Confederation of British Industry’s survey of retailers. Even in Australia, with widespread lockdowns, consumer confidence remains well above the 2020 pandemic lows. Chart 3Delta Variant Hitting US Economic (Not Market) Confidence Chart 4Lockdowns Are Bad For Confidence (And Vice Versa) Delta developments in China are also turning more positive, with new reported cases now at zero after a surge that began in July. There are even reasons for optimism in the US, where COVID-19 reproduction rates in most of the Southern states – the epicenter of the US Delta surge – have fallen below 1, suggesting a declining pace of transmission of the virus.1 The overall hit to global growth from the Delta variant will likely be modest, leaving the inflation side of the tug of war on global bond yields as the winner, particularly in countries that are seeing a broad-based increase in inflation that will be difficult for central bankers to ignore. In the US, UK, Canada and New Zealand – our least-preferred bond markets within the developed world - both realized consumer price inflation and the growth of house prices are soaring at the same time (Chart 5). Unsurprisingly, the central banks in those four countries have either tapered bond purchases – all the way to zero in the case of the Reserve Bank of New Zealand (RBNZ) – or are preparing the markets for tapering as the US Federal Reserve has been doing in recent weeks. Policymakers in those four countries will be watching to see if the latest uptrend in inflation starts to drive up longer term inflation expectations by enough to warrant a monetary policy response. In the US, the University of Michigan consumer survey shows that one-year-ahead expected inflation has climbed to 4.6%, compared to a more subdued 3.% expected inflation rate over the next five years (Chart 6). In Canada, the Q2/2021 Survey of Consumer Expectations produced by the Bank of Canada (BoC) shows that both one-year and five-year inflation expectations are 3.1% - just above the upper limit of the BoC inflation target range – although the longer-term measure is off the highs seen in 2020 (we discuss Canada in greater detail later in this report) Chart 5Difficult For Central Banks To ##br##Ignore This Chart 6Will Short-Term Inflation Expectations Bleed Into The Long-Term? Inflation expectations in the UK, according to the YouGov/Citigroup survey, are 3.1% in the short-term (and rising) and a higher 3.4% in the longer term. In New Zealand, the RBNZ’s inflation survey shows both short-term (1-year) and longer-term (5-year) inflation expectations have increased to 3% and 4%, respectively. Chart 7Inflation Expectations Still Moderate In Europe, Japan & Australia Importantly, market-based expectations extracted from breakevens on 10-year inflation-linked bonds in those four countries are somewhat more subdued than the survey-based expectations measures. This means that central bankers can be patient on moving towards tapering and eventual interest rate hikes until the concerns over the Delta variant have passed. However, lingering global supply chain disruptions, alongside tightening labor markets, represent inflationary risks that will force the Fed, the Bank of England (BoE), the BoC and RBNZ to begin dialing back monetary accommodation over the next year. We still anticipate that the RBNZ will hike rates this fall in response to booming New Zealand house prices, while the Fed will begin tapering its bond buying next January and will start hiking rates in Q4/2022. Both the BoC and BoE will fully taper QE and lift interest rates in 2022, with the BoC likely to move first in the first half of the year. In the euro area, Japan and Australia – where we are currently recommending overweight government bond allocations on a USD-hedged basis – the latest uptrends in both house prices and realized inflation have not translated into overshooting inflation expectations (Chart 7). The ECB, Bank of Japan and Reserve Bank of Australia are not expected to tighten policy in any form (taper or rate hikes) through at least the end of 2022. Net-net, we do not see the spread of the Delta variant as a reason to make changes to our strategic recommended country allocations on global government bonds. Bottom Line: Global inflation pressures – fueled by tightening labor markets and persistent supply chain disruptions - will linger for much longer than the Delta surge. Investors should position for higher global bond yields, led by the US, on a medium-term basis. Also, favor countries where inflation pressures are less entrenched (Europe, Japan and Australia) versus nations with more broad-based inflation visible in both consumer prices and house prices (the US, UK, Canada and New Zealand). Canada: The BoC Is Still On The Path To Tighten Perhaps no country has suffered greater extremes with regards to COVID-19 in 2021 than Canada. A slow vaccine rollout at the start of 2021 placed Canada behind the US and other developed market countries in terms of dialing back pandemic restrictions imposed last year. The low rate of vaccinations allowed a harsh third wave of COVID to take place this past spring, further delaying Canada’s exit from lockdowns. Since then, Canada has flipped the script with a spectacularly rapid vaccination campaign. Two-thirds of the population is now fully inoculated and the country has rapidly emerged from lockdowns, spurring a stronger economy much more resilient to the rapid spread of the Delta strain seen in Canada’s southern neighbor. Our view on Canadian fixed income markets has also evolved alongside pandemic developments over the course of this year. In a Special Report published back in February, we concluded that the BoC would likely need to begin withdrawing the extraordinary monetary easing measures put in place in response to the pandemic sooner than most other developed market central banks.2 This would justify cutting our recommended stance on Canadian government debt from neutral to underweight. The slow initial vaccine rollout delayed that decision until late April, when we pulled the trigger on that downgrade.3 Chart 8The Economic Future Looks Bright In Canada At the time, our shift to a bearish stance on Canada rested on several pillars: Better news on the vaccination front, which would give a lift to consumer and business confidence Booming house prices, fueled by negative real interest rates, raising financial stability risks in a country with an already overheated housing market Additional fiscal stimulus announced by the ruling Liberal government, dramatically reducing the fiscal drag that was expected in 2021. Since our downgrade, the BoC has already cut the pace of its quantitative easing (QE) asset purchases in half, after allowing other pandemic emergency liquidity programs to expire earlier in the year. Interest rate markets are now pricing in a full 25bp rate hike in Canada by August 2022, with 115bps of cumulative hikes discounted by the end of 2024. Only Norway and New Zealand are expected to lift rates sooner, and by more, than the BoC within the developed markets universe. Yet that is still a very slow and shallow expected path for Canadian interest rates, given the substantial tailwinds to economic growth in Canada (Chart 8). Canadian consumers have a strong base to support spending. Nominal household disposable income growth remains solid at 9% on a year-over-year basis and the household saving rate is still elevated at 13% after peaking at 27% during the COVID recession in 2020. The BoC’s Q2 Survey of Consumer Expectations noted that 40% of respondents reported that their savings were higher than usual because of pandemic, and that those that did accumulate excess savings planned to spend 35% of those funds over the next two years. This implies that Canadian consumers still hold plenty of cash to spend, and that pent-up demand coming out of lockdowns will support a solid pace of consumption. Moreover, continuously recovering labor market conditions will also contribute to a solid pace of domestic demand. Even though the recovery of employment to date has been uneven across different sectors and worker backgrounds, Canadian firms are reporting robust hiring plans and increased intensity of labor shortages - leading firms to plan for wage increases - according to the BoC’s Q2/2021 Business Outlook Survey. This indicates that the Canadian labor market will likely tighten further over the next 6-12 months, further supporting consumer incomes, confidence and spending. The Business Outlook Survey also reported that overall business sentiment was at the highest level in the history of the series, with a net 36% of firms– just off the record high of 40% in Q1/2021 – reporting stronger capital spending intentions. Thus, business investment catching up after the COVID pause will also help boost overall Canadian economic growth. Importantly, the Delta variant does not pose the same near term risk to growth as is the case in the US and other countries. The number of new COVID cases and related hospitalizations is a fraction of what was seen as recently as the third pandemic wave earlier this year (Chart 9). The rapid pace of vaccinations is clearly providing a buffer to the spread of the variant in Canada, with 74% of Canadians having had at least one vaccine dose and 66% of the population fully vaccinated. While there is solid upward momentum in Canadian growth, the same can be said for Canadian inflation. Headline CPI inflation climbed to 3.7% in July, while core inflation jumped to 2.8% (Chart 10), both the highest pace seen since 2003. Not all of that increase is due to base effect comparisons versus a year ago, as the monthly increases in both headline (+0.6%) and core (+0.4%) were strong. Chart 9Vaccinations Have Made A Huge Difference In Canada Chart 10Canadian Inflation Momentum Is ##br##Not Slowing As discussed earlier in this report, survey-based measures of Canadian consumer inflation expectations show that this surge in inflation is perceived to be temporary, with shorter-term expectations rising but longer-term expectations slowing. There is a lack of worry in the Canadian inflation-linked bond markets, as well, with breakeven inflation rates hovering near the midpoint of the BoC’s 1-3% inflation target range. This presents a potential problem for the BoC, and the Canadian bond market, if the current surge in inflation does not prove to be temporary. The BoC’s August Monetary Policy Report (MPR) included a detailed breakdown of the contribution to Canadian inflation by spending category (Chart 11). While energy costs were a major driver of the year-over-year increase in inflation, components that were exposed to supply constraints – like motor vehicles and other durable goods – accounted for nearly one-half of the level of year-over-over inflation over the past three months. The CPI elements that were linked to increased demand as the economy reopened from lockdowns – like spending in restaurants – represented a much smaller share of current inflation. Chart 11Lingering Supply Constraints Are A Major Upside Inflation Risk Thus, while energy price inflation is likely to cool off somewhat on a year-over-year basis over the next 6-12 months, Canadian inflation could remain surprisingly sticky at levels above the BoC target band if supply disruptions persist for longer. Canadian businesses are already facing higher input costs, and it is inevitable that firms will offer higher wages in order to attract workers while demand keeps rising in a tightening labor market. In the end, all these increased costs will continue to be passed on by firms to consumers, putting upward pressure on Canadian Dollar – especially with both the BoC and IMF projecting Canada’s output gap to steadily narrow and be fully closed in the second half of 2022. Risks from the upcoming federal election Prime Minister Justin Trudeau has called a snap federal election for September 20. The timing of the election seems odd on the surface, given Trudeau’s poor approval ratings and the lingering uncertainties of COVID-19. The Canada Geopolitical Risk Indicator constructed by our colleagues at BCA Research Geopolitical Strategy shows that there is a high level of domestic political risk in Canada, largely due to the underperformance of the Canadian dollar versus improving Canadian economic variables (Chart 12). However, in the current context of the pandemic, with all the associated uncertainty, this high risk is translating in favor of the incumbent Liberal Party, rather than calling for regime change. Chart 12An Interesting Time To Call An Election In Canada The likely reason is that the COVID crisis was exogenous and polling shows that voters are at least content with ruling party’s handling of the situation. Current polls have the Liberals with a modest lead over the opposition Conservatives (Chart 13). The far-left New Democratic Party (NDP) is in third place, even though its leader has the highest approval rating of the three major party leaders. Chart 13Trudeau Is Taking A Calculated Risk Trudeau is taking a gamble with this election to try and retake the parliamentary majority he lost in the 2019 election that resulted in a minority Liberal government. Trudeau has framed the election as a chance to “finish the fight” against COVID-19, and as a referendum on his government’s handling of the pandemic. Yet the broad Liberal party platform is also positioned well, based on Canadian voter preferences. Current opinion polls show that the most important issues among Canadian voters are climate change, health care and housing (Chart 14). COVID-19 itself is actually well down the list, as are government deficits and taxes – issues that the Conservatives are relentlessly focused on. Trudeau has skillfully read the tea leaves and positioned his party well on issues most Canadians care most about, unlike his main opposition party (Table 1). Furthermore, Trudeau has co-opted many of the policy planks of the NDP, allowing the Liberals to gain potential votes from more left-leaning voters. At a time when voters want to reassert the role of government in tackling collective challenges, this is a favorable place to be. Chart 14Canada: Most Important Issues Facing The Country Table 1The Liberal Agenda Lines Up With Top Voter Priorities The likely election result will be another Liberal victory, with the party expanding its minority and having a legitimate shot at winning a majority. This also means that the Canadian fiscal policy is likely to remain supportive for growth over the next few years. Stay Underweight Canadian Government Debt Given all the positive momentum and upside risks to economic growth, house prices, inflation and government spending, the BoC is likely to continue on its current path towards fully tapering asset purchases and eventually starting to lift interest rates as soon as mid-2022 (Chart 15). This would be faster than the liftoff date currently discounted in the Canadian OIS curve. The pace of rate hikes discounted is also very shallow, and the risks are tilted towards the BoC doing more tightening than the market is expecting over the next couple of years. We continue to recommend a below-benchmark duration stance in Canada, and a strategic underweight allocation to Canada within global government bond portfolios with the BoC likely to be one of the more hawkish developed market central banks over the next 12-18 months (Chart 16). We also advocate positioning for a bearish flattening of the Canadian yield curve given the potential for hawkish surprises from the BoC. Chart 15The BoC's Policy Stance Has Already ##br##Turned Chart 16Stay Cautious On Canadian Government Bond Exposure Bottom Line: The Canadian economy is performing strongly as the nation is finally reopening after a poor initial vaccine rollout earlier this year. Next month’s federal election will likely result in a re-election of Justin Trudeau’s Liberals and a continuation of expansive fiscal policy. The Bank of Canada is on track to begin interest rate hikes in 2022 with inflation likely to remain higher for longer than the central bank projects. Remain underweight Canadian government bonds within global (USD-hedged) fixed income portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Estimates of the COVID-19 effective reproduction rate in US states, calculated by public health researchers at Harvard and Yale universities, can be found here: https://covidestim.org/ 2 Please see BCA Research Foreign Exchange Strategy and Global Fixed Income Strategy Report, " Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at gfis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Report, "Some Bond Bearish Tales From Both Sides Of The 49th Parallel", dated April 20, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns