Sectors
In this Sector Insight report, we come back to the issue of “how much inflation is too much” for equities. The short answer is – equities don’t mind inflation as long as the Fed does not mind it either. Chart 1 shows historical analysis of forward SPX returns (both real and nominal) using different inflation ranges as a starting point. Empirically, CPI prints of below 3% do not weigh on market performance. However, once inflation rises above the 3-4% range, it causes a notable slowdown in returns, and above the 4% mark, it results into negative expected forward returns. Chart 2 is a scatterplot of trailing PE multiples vs core CPI prints. This chart confirms our initial conclusion that an inflation sweet spot for the equity market is around 2-3% core CPI range: this is the range where equity multiples expand the most. It is also clear from the chart that any higher core CPI values become a headwind for equities. The implication is that the negative forward expected return that we showed on Chart 1 comes from the multiple contraction. Chart 1Moderate Inflation Does Not Have An Adverse Effect On The Performance Of Equities Chart 2High Levels Of Inflation Are Associated With Multiple Contraction Equities are a real asset, and rising inflation does not have a negative effect on the earnings, as most companies are able to pass cost increases to their customers, and strong earnings growth translates into robust equity returns. Inflation is a concern for equity investors only from one angle: higher inflation may provoke the Fed to raise rates, and higher rates do have an adverse effect on the performance of equities. Bottom Line: Our view remains that inflation surge was transitory, but we do believe that the inflation will stay elevated for a while. Yet, if it does not exceed the 3% mark, there will be no negative repercussions for equities if the Fed stays patient.
Foreword Today we are publishing a charts-only report focused on the S&P 500 and its sectors. Many of the charts are self-explanatory; to some we have added a short commentary. As with the styles Chart Pack, published a month ago, the sector charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to underpin sector allocation decisions. We also include performance, valuations, and earnings growth expectations tables for all the styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We plan to update it monthly, alternating sector and style coverage. Overarching Investment Themes Macro Economic surprise index is flagging while Q2-21 earnings surprises are unprecedented. Much of the good economic news has been priced in and the Citigroup Economic Surprise Index is hovering around zero (Chart 1A). Most of the economic indicators have turned, confirming that the surge in growth has run its course and the macroeconomic environment is normalizing. Covid-19 fears are resurfacing: The spread of the Delta variant is unlikely to trigger another lockdown, but consumers may curtail their activities out of fear of infection, adversely affecting demand for goods and services. However, for now, we are sanguine about this risk. Investors expect inflation to roll over: Investors’ inflation fears are dissipating, attested by the falling 5Y/5Y inflation breakevens (Chart 1B). Indeed, it appears that the debate on the persistence of inflation has been won by the “inflation is transitory” camp. Yet, we won’t be surprised if inflation surprises on the upside (no pun intended). Chart 1AGood Economic News Has Been Priced In Chart 1BMost Investors Are Now Convinced That Inflation Will Be Transitory Labor shortages are starting to dissipate: On the labor front, companies are still struggling to fill job openings. However, there are signs that the labor market is healing, with more and more workers interested in returning to the labor force (Chart 2). Inventories will be replenished, spurring investment: Post-pandemic economic recovery is still plagued by the mismatch between supply and demand. Supply-chain disruptions and shortages fail to meet pent-up demand of consumers eager to spend “helicopter drop cash” and accumulated savings. As a result, inventories have been drawn down, chipping away 1.1% from GDP growth. In fact, they are at all-time lows: Non-farm inventories to final sales have dropped lower than they were during the GFC (Chart 3). Low inventories will have to be replenished, resulting in further gains in investment and providing a boost to industrial activity going forward. Chart 2More Workers Are Interested In Returning To The Labor Force Demand for services will continue to exceed demand for goods: Last, but not least, consumers have money to spend but are shifting away from goods and toward services and experiences. Consumer expenditure on goods is above trend and has recently turned down, while spending on services is still below pre-pandemic levels, and rebound is still running its course (Chart 4). Chart 3Inventories Are At All Time Low Chart 4Real Spending On Services Is At PrePandemic Levels: Room For Further Rebound Valuations And Profitability The US stock market remains expensive: The S&P 500 is trading more than two standard deviations above the long-term average. However, there are pockets of reasonably priced, albeit unloved, stocks within the S&P 500: Telecom (11x forward earnings), Health Care (17x), Energy (14x), and Financials (14x). Earnings continue to crush expectations: While equities are expensive, they are redeemed by the strong showing of earnings and sales growth reported for Q2-2021. The scale of earnings beats relative to analyst expectations is spectacular: Running at nearly 20%, or more than two standard deviations above the historical average (Chart 5). Chart 5Earnings Surprises Are Unprecedented Earnings growth is normalizing: Earnings have increased 90% over the lackluster Q2, 2020. Compared to Q2-2019 as a baseline quarter, earnings are up 22%, pointing to normalization going forward. Earnings growth will become a tailwind for the outperformance of equities into the balance of the year and will help the S&P 500 to grow into its big valuation “shoes”. Margins are expanding despite inflation: Many sectors are able to grow earnings and recover margins despite increases in costs of raw materials and labor, thanks to their strong pricing power, i.e., ability to pass on higher input costs to their customers (Chart 6A). Sectors with the highest pricing power are: Communications Services, Consumer Discretionary, Industrials, Energy and Materials. They are the best inflation hedges. Chart 6ACompanies' Profitability Is Improving To Pre-Pandemic Levels Uses Of Cash Cash to be disbursed to shareholders: Share buybacks and other shareholder-friendly activities are on the rise again and are expected to gain steam this year and next. This is supported both by strong earnings growth, healthy balance sheets, and regulatory headwinds to any potential M&A activity due to the anti-trust stance of the current administration Capex is about to make a comeback: Capex is still lagging across most sectors. A pickup in capex will signal that the post-pandemic recovery is firmly on track, and companies are comfortable investing in future growth. However, there are early signs that that is about to change. Philly Fed survey shows that over 40% of respondents are planning to increase their capex expenditure (Chart 6B). Chart 6BCapex Increases Are On The Way Investment Implications Overweight sectors and industry groups exposed to consumer services spending (airlines, hotels, leisure) and be selective about consumer goods and retailing industry groups: Real PCE for goods has turned down toward the trend line. Exceptions are areas of the market with well-publicized shortages such as Autos and Parts. Overweight Industrials – US manufacturing has limited capacity, onshoring is a new trend, inventories need to be replenished, and capex intentions are on the rise. Overweight Health Care – growth slowdown favors this defensive sector, which also benefits from a backlog of demand for medical procedures and services. Reflation trade is out of the picture, now that inflation fears have abated and the Delta variant preoccupies investors. For that, we still favor Growth over Value. Yet, we watch this allocation closely, to time rotation once Covid-19 fears dissipate, rates pick up and inflation surprises on the upside. With valuations high, and forward returns expectations lackluster, we favor sectors likely to delivery healthy cash yield: Financials, Health Care, Energy, and Technology. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com S&P 500 Chart 7Macroeconomic Backdrop And Earnings Surprise Chart 8Profitability Chart 9Valuations And Technicals Chart 10Uses Of Cash Communication Services Chart 11Macroeconomic Backdrop Chart 12Profitability Chart 13Valuations And Technicals Chart 14Uses Of Cash Consumer Discretionary Chart 15Macroeconomic Backdrop Chart 16Profitability Chart 17Valuations And Technicals Chart 18Uses Of Cash Consumer Staples Chart 19Macroeconomic Backdrop Chart 20Profitability Chart 21Valuations And Technicals Chart 22Uses Of Cash Energy Chart 23Macroeconomic Backdrop Chart 24Profitability Chart 25Valuations And Technicals Chart 26Uses Of Cash Financials Chart 27Macroeconomic Backdrop Chart 28Profitability Chart 29Valuations And Technicals Chart 30Uses Of Cash Health Care Chart 31Health Care: Sector vs Industry Groups Chart 32Profitability Chart 33Valuations And Technicals Chart 34Uses Of Cash Industrials Chart 35Macroeconomic Backdrop Chart 36Profitability Chart 37Valuations And Technicals Chart 38Uses Of Cash Information Technology Chart 39Macroeconomic Backdrop Chart 40Profitability Chart 41Valuations And Technicals Chart 42Uses Of Cash Materials Chart 43Macroeconomic Backdrop Chart 44Profitability Chart 45Valuations And Technicals Chart 46Uses Of Cash Real Estate Chart 47Macroeconomic Backdrop Chart 48Profitability Chart 49Valuations And Technicals Chart 50Uses Of Cash Utilities Chart 51Macroeconomic Backdrop Chart 52Profitability Chart 53Valuations And Technicals Chart 54Uses Of Cash Table 1Performance Table 2Valuations And Forward Earnings Growth Recommended Allocation Footnotes
Highlights Investors have grown enamored with online retailers (AMZN), payment processing companies (V, MA, PYPL, SQ), and social media companies (FB, SNAP). All three sectors are likely to experience headwinds over the next 12 months as life returns to normal following the pandemic. Looking further out, market saturation, increased competition, and heightened regulation all pose risks to these sectors. Internet companies in general, and social media firms in particular, will face increased scrutiny not just for their monopolistic practices, but for the mental harm they are causing young people. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. We think there is a 50/50 chance that governments will start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Global Growth Will Remain Above Trend Investors are worried about growth again. Globally, the number of Covid cases is on the rise due to the proliferation of the Delta variant (Chart 1). The ISM manufacturing index dropped to 59.5 in July, down from a high of 64.7 in March. Both of China’s manufacturing PMIs have fallen, with the new orders component of the Caixin index dipping below the 50 line. The European PMIs have also come off their highs (Chart 2). Chart 1Number Of Covid Cases On The Rise Globally Due To The Delta Variant Chart 2Manufacturing PMIs Are Off Their Highs Growth concerns have registered in financial markets (Chart 3). After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.22%. Cyclical equity sectors have underperformed defensives. Growth-sensitive currencies such as the Swedish krona and the Australian dollar have weakened. We are more upbeat about global growth prospects than the consensus. As the experience of the UK demonstrates, there is little will to impose lockdowns in countries with ample access to vaccines. Strict social distancing restrictions remain a fact of life in countries lacking adequate vaccine supplies. However, the situation should improve later this year as vaccine production increases (Chart 4). Chart 3Financial Markets Trim Growth Expectations Chart 4Over 10 Billion Vaccine Doses Will Be Produced This Year Households in developed economies are sitting on US$5 trillion in excess savings, half of which reside in the United States (Chart 5). Inventories are at record low levels, which should support production over the coming quarters (Chart 6). Chart 5Households Flush With Excess Savings Chart 6Record Low Inventories Will Provide A Boost To Production Chinese policy should turn more stimulative, as the recent cut to bank reserve requirements foreshadows. With credit growth back down to 2018 lows, policymakers can afford to give the economy some juice. The 6-month credit impulse has already turned up (Chart 7). From Goods To Services While global growth should remain well above trend for the next 12 months, the composition of that growth will shift in ways that could meaningfully affect equities. As Chart 8 illustrates, aggregate US consumption has returned to its pre-pandemic trend. However, spending on goods is 11% above trend while spending on services is still 6% below trend. Chart 7Chinese Policy Is Turning More Stimulative Chart 8The Divergence Between Goods And Services Spending Households typically cut spending on durable goods during recessions, while services serve as the ballast for the economy. The opposite happened during the pandemic. As the global economy recovers, goods spending will slow while services spending will stay robust. This is critical for online retailers such as Amazon, which derive the bulk of their e-commerce revenue from selling goods. Even after its disappointing Q2 earnings report, analysts still expect Amazon to grow e-commerce sales by 17% in 2022 (Chart 9). Such a goal may be difficult to achieve, given that core US retail sales currently stand 13% above their trendline (Chart 10). Chart 9AAnalysts’ Great Expectations May Be Dashed (I) Chart 9BAnalysts’ Great Expectations May Be Dashed (II) Chart 10AUS Retail Spending Is Well Above Trend (I) Chart 10BUS Retail Spending Is Well Above Trend (II) Chart 11Screen Time Is Moderating If e-commerce spending slows, shares of payment processing companies could disappoint. Likewise, social media companies could suffer as people start going out more often. After spiking during the height of the pandemic, growth in data usage has returned to normal (Chart 11). Long-Term Risks Looking beyond the post-pandemic recovery, all three equity sectors face structural challenges that are not being fully discounted by investors. The first is market saturation. Close to three-quarters of US households have Amazon Prime accounts. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Competition is another challenge. Companies such as Amazon, Facebook, and Google dominate their respective markets. As they look for further growth, they will invariably invade each other’s turf. The result might benefit consumers, but it is unlikely to help the bottom line if it means more competitive pressures. Moreover, it is not just competition from within the tech industry that may disrupt incumbent firms. Consider payment processors. Like most other central banks, the Fed is planning to launch its own digital currency. Widely available, free-to-use Central Bank Digital Currencies (CBDCs) could thwart the ability of Visa and MasterCard to skim 2%-to-3% off of every transaction. Regulatory Pressures In recent years, tech companies have faced increased scrutiny over their alleged monopolistic practices. In contrast to Chinese tech firms, which have fallen under the thumb of the authorities, US companies have been able to evade harsh measures. Just last month, a US federal court judge dismissed a case filed by more than 40 state attorneys general arguing that Facebook’s acquisitions of Instagram and WhatsApp had harmed competition. In the past, evidence that companies were setting prices well above marginal costs could be used to build a case for anti-trust enforcement. Such cases are more difficult to argue today because so many online services are given away for free. Nevertheless, governments are likely to become more adept in pursuing regulatory actions. Rather than focusing simply on pricing policies, regulators are increasingly looking at the ways big tech companies use vendor data in the case of Amazon and user data in the case of Facebook and Google to maintain market dominance. Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted earlier this year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019. The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 1). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies. Table 1American Views On Big Tech A Drug Worse Than Nicotine? Social media companies are among the most loathed within the tech sector. A Pew Research Center study conducted last year revealed that more than six times as many Americans had a negative opinion of social media as a positive one (Chart 12). The public’s disdain for social media is increasingly going beyond traditional concerns over privacy. As psychologists Jonathan Haidt and Jean Twenge recently argued in the New York Times, there is growing evidence that the pervasive use of social media is harming the mental health of the nation’s youth. The share of students reporting high levels of loneliness has more than doubled in both the US and abroad over the past decade (Chart 13). Chart 12Social Media Increasingly Vilified Chart 13Alone In The Crowd In 2019, the last year for which comprehensive data is available, nearly a quarter of girls between the ages of 12 and 17 reported experiencing a major depressive episode over the prior year, up from 12% in 2011 (Chart 14). Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. Just like cigarettes are heavily regulated due to their addictive qualities, the same could happen to social media. Facebook and most other social media companies already restrict access to those under the age of 13, although enforcement is generally spotty. We assign a 50/50 chance that governments start restricting social media usage only to adults over the age of 18 by the end of the decade, a move that could decimate the sector. Priced For Perfection The seven companies in the three high-flying sectors mentioned in this report trade at 91-times forward earnings compared to the S&P 500’s aggregate multiple of 22. They also trade at an average price-to-sales ratio of 16 compared to 3.2 for the broader market (Chart 15). Chart 14The Rise In Depression Rates Coincided With Increased Social Media Usage Chart 15Trading At A High Multiple To Sales Such valuations can be justified only if these companies grow earnings-per-share by nearly 30% per year over the next five years, as analysts currently expect (Chart 16). However, as noted above, that may be too high a hurdle to clear. Higher bond yields represent another threat to valuations. Growth stocks are much more sensitive to changes in discount rates than value stocks. Chart 17show that tech stocks have generally outperformed the S&P 500 over the past four years whenever bond yields were falling. We expect bond yields to rebound over the coming months, with the 10-year yield rising to 1.8% by early next year. Tech is likely to lag the market in that environment. Chart 16Long-Term Growth Estimates May Be Too Optimistic For These High-Fliers Chart 17Higher Bond Yields Could Hurt Tech Stocks Trade Update Our long EM equity trade got stopped out last Tuesday before recouping some of its losses in subsequent days. We continue to expect EM stocks to bounce back later this year. That said, in keeping with this report, we see more upside for “traditional” EM sectors such as banks, industrials, energy, and materials than for EM tech (especially Chinese tech). Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
With two thirds of the S&P 500 companies reported Q2-2021 earnings, it becomes abundantly clear that the US experienced a rigorous economic revival in the second quarter of this year. Combination of loose fiscal and monetary policy, economic reopening, pent up demand and well-to-do US consumer and global growth acceleration are just some of the factors underpinning robust top- and bottom-line growth. Analysts keep revising their forward estimates higher, not lower as earnings season was rolling on – a rather unusual phenomenon (see chart). Zooming into the sector data is also instructive. On the earnings’ front, the Consumer Discretionary and the Financials sectors are leading the market surprise factor higher with 31% and 25% growth respectively. 96% of the technology companies and 95% of the financial companies have beaten the analyst targets, suggesting that expectations were rather low despite the upgrades. In comparison, 78% and 73% of companies beating expectation in the Materials and Energy sectors, look measly. At the same time, Materials are the clear cyclical laggards with a surprise factor of 7%. These results are consistent with our equity investment themes: China slowdown: Underweight Materials as demand for metals is waning Consumers flush with cash: Overweight the Consumer Discretionary sector Rate stabilization: Overweight growth sectors and underweight value (growth sectors, such as Technology and Communications Services are ahead of the value sectors, such as Materials, Energy and Utilities) Economic growth peaking at the end of Q2-2021: Financials outperforming as geared to economic growth acceleration. Bottom Line: With more than 2/3 of S&P 500 reported, the earnings season will likely finish on a high note.
In yesterday’s Sector Insight report we looked at the implications of the termination of the US national eviction ban. However, just as we went to print, the news has hit the tape that the CDC announced a new 60-day eviction moratorium in the areas with high levels of COVID-19 infections. These areas, covered by the eviction ban, account for 80% of the US counties and 90% of the US population. De facto, this moratorium is national, just as the one before. While there are doubts about the legitimacy of this new law, it will take a while to dispute it in courts. Also, while time will tell if there are extensions of this eviction ban, for now, all the benefits of ending the moratorium that we outlined in the previous report, are on hold.
Last weekend, the national eviction moratorium, put in place during the pandemic, expired. While our hearts go out for the affected families, wearing our economists’ hats, we consider the termination of the eviction ban a likely positive for the US economy, and the US equities. The US is experiencing a red-hot job market with companies struggling to fill positions. End of eviction moratorium may be a necessary catalyst for more workers joining the work force. Indeed, interest in online recruitment postings is picking up (see chart). Ability to fill in open positions will put a lid on the rising wages and contain a vicious cycle of inflation. Investment implication of this development is a further boost to home improvement stocks (HD, LOW) and residential REITS. Evictions will help vulnerable landlords, responsible for real estate taxes, mortgage payments, utilities, and repairs, avoid bankruptcies by finding solvent tenants. Landlords will spend again preparing houses and apartments for a changeover, contributing to the economic growth. Rent prices will increase, in response to ubiquitous housing shortages, and boosting performance of REITs. The likely passage of a bipartisan infrastructure bill and a larger infrastructure-and-social-welfare bill through Congress will expand the social safety net, supporting victims of evictions. Bottom Line: The termination of the national eviction ban is a small net positive for the home improvement and residential REITs equity industries.
Highlights Last week’s market gyrations do not mark the end of China’s structural reforms. The country’s macro policy setting has shifted to allow a higher tolerance for short-term pain in exchange for long-term gain. Chinese policymakers will temporarily put the brakes on its reform agenda if policy measures threaten domestic economic stability; a spillover from the equity market rout to the currency market and private-sector investment will be a pressure point for the authorities. Messages from last week’s Politburo meeting were only marginally more positive than in April. While policymakers seem to be paying more attention to the economic slowdown, they do not appear to be in a rush to rescue the economy. We present three scenarios describing how the equity markets and policy may develop in the coming months. In all the scenarios, investors should avoid trying to catch a falling knife. Feature July was an extraordinarily difficult time for Chinese stocks and last week’s steep slide intensified as a slew of announced regulatory changes spooked market participants (Chart 1). Chart 1Chinese Stocks Had A Tough MonthWe have repeatedly outlined the risks to Chinese equities in the past month. Since the PBoC cut the reserve requirement ratio in early July, the negative impact on the financial markets from tightening industry policies has outweighed the limited positive effects from a slightly more dovish central bank policy stance. Chart 2Chinese TMT Stock Prices Were Hammered Is now a good time to buy Chinese stocks? Multiple compressions have made Chinese equities, particularly the hard-hit technology, media & telecom (TMT) stocks in the offshore market, appear cheap compared with their global counterparts (Chart 2). In this report we present three scenarios how China’s equity market and policies will likely evolve. In our view, more than a week of stock selloffs will be needed for policymakers to halt reforms. Furthermore, even if the pace of reforms eases and policymakers start to reflate the economy, it will likely take between 6 and 12 months for stock prices to find a bottom. In light of escalating uncertainty over China’s financial market performance, the China Investment Strategy and Global Asset Allocation services will jointly publish a Special Report on August 18. We will examine how global investors can improve the risk-reward profile of their multi-asset portfolios with exposure to Chinese assets. Three Scenarios While the regulatory landscape is unclear, we can draw on previous experience to analyze how China’s equity market and policy directions may evolve. In the first scenario, which is our baseline case, the economy would weaken, but would not cross policymakers’ pain threshold. There would be marginal policy easing action to alleviate market anxiety and monetary policy would be slightly loosened along with polices on some non-core sectors, such as infrastructure investment. In this scenario, structural reforms could continue for another 6 to 12 months, as suggested by colleagues at the BCA Geopolitical Strategy services. Investors should resist the urge to buy on the dip. Investors would be kept on edge by a confluence of a slowing economy (even though the slowdown is measured) and heighted regulatory oversight. The market would oscillate between technical rebounds when macro policy eases and selloffs when industry regulations tighten. There are two reasons why the pace of regulatory tightening will not moderate in the near term. First, China’s economic policy has shifted from setting an annual economic growth target to multi-year planning. This allows policymakers to have a higher tolerance for near-term distress in exchange for long-term benefits. Despite a deep dive in stock prices last week, China’s bond and currency markets have been stable relative to the market gyrations in both 2015 and 2018 (Chart 3A and 3B). Furthermore, the newly released PMIs and recent economic data show that the China’s economic activity is weakening, but the speed of softening seems to be within the policymakers’ comfort zone (Chart 4). Chart 3AChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 3BChinese Bond And Currency Markets Have Been Relatively Calm Despite Equity Market Selloffs Chart 4Economic Pain Has Not Crossed Policymakers' Threshold Secondly, the new rules imposed on industries - ranging from internet, property, education, healthcare to capital markets - are part of China’s long-term structural reform agenda outlined in the 14th Five-Year Plan (FYP). As China transitions from building a "moderately prosperous society" by 2020 to becoming a "great modern socialist nation" by 2049, the country’s policy priority has shifted from a rapid accumulation of wealth to addressing income inequality and social welfare for average households. The policy objective is not only to close regulatory loopholes and end the disorderly expansion of capital and market shares, but also assign a larger weight of social equality and responsibility to the private sector’s business practices. The pace in achieving this overarching goal will only moderate when China’s economy and financial markets show meaningful signs of stress. The second possibility would be if policymakers fail to restore investors’ confidence. Foreign and domestic investors would reassess China’s policy directions and reprice the outlook for corporate profit growth. Market selloffs would continue, like in 2015 and 2018 following policy shocks,1 equity market gyrations would spill over to the currency market through capital outflows and real economic sectors through dwindling investment (Chart 5). In this scenario, Chinese policymakers would likely abandon their reform agenda, at least temporarily, and decisively shift policy to reflate the economy (Chart 6). Chart 5Financial Market Panic Spilled Over To Other Sectors In Both 2015 and 2018... Chart 6...Triggering Decisive Reflationary Policy Responses A third scenario would be if China is challenged by the external environment, either due to a significant increase in geopolitical conflicts or a widespread resurgence of new COVID cases. Both aspects would pose sizable downside risks to China’s economic activity. The risks would force authorities to shift to an easier stance and slow the pace of domestic reforms. Chart 7It Took 6 To 12 Months (And Sizable Stimulus) For Stock Prices To Bottom Out In the second and third scenarios, the rout in the equity market would likely deepen in the near term, before prices bottom in response to a halt in regulatory crackdowns and a decisive turn to reflationary measures. As illustrated in Chart 7, in both 2015 and 2018, it took 6 to 12 months and significant stimulus for Chinese stock prices to bottom in absolute terms. Bottom Line: Our baseline scenario suggests a continuation of structural reforms. Investors should refrain from jumping into the market until there are firm signs that regulatory tightening is over and reflationary measures have started. Key Messages From The Politburo Meeting Last week’s much-anticipated Politburo meeting, chaired by President Xi Jinping, adopted a slightly more dovish tone towards macroeconomic policy than in April, but also indicated that the leadership will stick to its long-term reform agenda. The stance was mildly positive for the overall economy and financial markets. Macro policies in some non-core sectors, such as infrastructure investment, will likely ease at the margin during the rest of the year. However, the meeting’s statement warned “a more complex and challenging external environment” lies ahead, which indicates that heightened concerns over geopolitical tensions will only exacerbate regulatory oversights in data and national security. Regarding fiscal policy in 2H21, the authorities seem to be growing more concerned about growth outlook. The meeting mentioned that fiscal support should make “reasonable progress” later this year and early next year. The pace of local government special purpose bond (SPB) issuance will pick up in Q3 and into Q4. However, we maintain our view that without a significant rise in bank credit growth, an acceleration in SPB issuance will only provide a moderate boost to local infrastructure spending. The reference to cross-cycle policy adjustment from the meeting readout is also in line with our view that policymakers may save their fiscal ammunition for next year when the economy comes under greater downward pressure. Odds are rising that the authorities will allow a frontloading of SPBs in Q1 2022 before the National People’s Congress in March next year. The statement also notably mentioned that government officials shall “ensure the supply of commodities and stabilize prices" and called for a more rational pace in carbon reduction. We think this message implies a temporary easing of production curbs in some heavy industries, such as steel, coal, and possibly a further release of strategic reserves of industrial metals (Chart 8A and 8B). The supply-side policy shift should add downward pressure on global industrial prices in addition to the ongoing slowdown in demand from China (Chart 9). Chart 8ASome Backpaddling Likely In Decarbonization Progress Chart 8BSome Backpaddling Likely In Decarbonization Progress Chart 9Downward Pressure On Commodity Prices From China's Weakening Demand And Rising Domestic Production Meanwhile, the meeting repeated the "three stabilization” policy, which targets stabilizing land prices, housing prices and property market expectations. This sends a strong signal that policymakers are unwilling to soften the tone on restrictions in the housing market. Bottom Line: The July Politburo meeting’s messaging was only modestly more dovish than three months ago. Investment Implications Chinese offshore stocks have fallen by 26% from their February peak, compared with approximately 14% for onshore stocks. The offshore TMT stocks are approaching their long-term technical resistance, measured by the three-year moving average in prices (Chart 10). While the magnitude of last week’s stock price decline seems excessive relative to previous market selloffs, the multiple compression reflects considerable uncertainty surrounding the outlook for China’s policy direction. New antitrust regulations in China are intended to limit the monopolistic business practices of internet companies. As a result, these companies’ operational costs will rise and profit growth will decline, and their valuations will converge with those of non-TMT companies. The trailing P/E ratio in Chinese investable TMT stocks is still elevated, making the equities vulnerable to further regulatory tightening and multiple compressions (Chart 11). Chart 10Chinese TMT Stocks: On The Verge Of Breaking Below Their Technical Resistance... Chart 11...But Still Vulnerable To Further Multiple Compression Jing Sima China Strategist jings@bcaresearch.com Footnotes 1On August 11, 2015, the PBOC surprised the market with three consecutive devaluations of the Chinese yuan, knocking over 3% off its value. On April 3, 2018 former US President Donald Trump unveiled plans for 25% tariffs on about $50 billion of Chinese imports. Market/Sector Recommendations Cyclical Investment Stance
Highlights The countertrend yield rally is near its end. Despite the deteriorating Chinese credit impulse, the outlook for global growth remains robust. An ample global liquidity backdrop, an inventory restocking cycle, and an upbeat capex outlook will increase aggregate demand and global capacity utilization. In this context, safe-haven bonds have sufficiently rallied. German yields will rise too, because the European yield curve will steepen. European banks will benefit from this trend. Investors should buy European momentum stocks and sell growth stocks. Investors should favor industrial equities and Sweden. Feature On April 12 of this year, we warned that a countertrend rally in bonds was increasingly likely. The decline in the Chinese credit impulse and the increasingly oversold state of Treasuries created the perfect conditions to generate disappointments in a lopsided market. As a corollary, we grew worried about our equity positioning, which calls for a large exposure to pro-cyclical stocks. Consequently, we recommended investors hedge this portfolio bias with some defensive bets. On July 20, Treasury yields fell to as low as 1.13%. Did this level mark the end of the Treasury rally? The bulk of the decline is behind us, and investors with a 12- to 18-month investment horizon should resume shortening portfolio duration. In Europe too, German yields are likely to trend higher. As a result, European financials and momentum stocks should generate significant outperformance in the coming quarters. Industrial equities are also set to shine, which will benefit the Swedish market, our favorite. Should I Stay Or Should I Go? The near-term outlook for Treasuries is currently more complex than it was in April, when forces lined up neatly to warn of an imminent pullback in yields. Technical indicators show that the oversold conditions that prevailed this spring have mostly cleared up. In April, the BCA Composite Technical Indicator for Treasuries reached its most oversold level in more than 20 years, which provided a very reliable buy signal (Chart 1). Now that the 10-year yield has reclaimed its 40-week moving average, the technical indicator is back to neutral. Normally, when bonds are in a cyclical bear market, which is BCA’s House View, the indicator rarely dips significantly into overbought territory. Meanwhile, the Marketvane Bullish Sentiment survey stands at 60%, which indicates that bonds are once again favored by many newsletters, traders, and investors. Chinese credit growth continues to send a bond-bullish signal (Chart 2). Slowing credit growth could hurt Chinese capex, which in turn has the potential to slow the demand for capital at the global level. This risk could still decrease global yields. Chart 1Bonds Are Not Oversold Anymore... Chart 2...But China Still Consistutes A Risk Chart 3A Synchronous Global Upswing The global economic recovery remains sufficiently broad-based to compensate for the risk of a Chinese slowdown. Our Global Synchronicity Indicator shows that manufacturing PMIs among the world’s major economies are all expanding (Chart 3), which usually elevates yields. This is especially important today, because the far-reaching and generalized nature of the current recovery gives more scope to the global economy to withstand a Chinese economic deceleration. Bottom Line: The variables that called for lower yields in early April are currently sending a mixed message. “Go!” The Global Business Cycle Responds Outside of China’s TSF impulse, most economic variables point toward higher yields. Chart 4Financial Liquidity Lifts The Business Cycle Global liquidity conditions remain consistent with higher growth and thus also with rising global interest rates. BCA’s US Financial Liquidity Index still stands near record highs and confirms that the Global Leading Economic Indicator (LEI) will remain at elevated levels (Chart 4). As a result, we expect the current fall in the Global LEI Diffusion Index to be short lived. Any softening in global growth, therefore, will prove to be transitory. Markets are forward looking. The recent decline in yields anticipated the deceleration in the Global LEI. Long-term rates will also increase before the LEI firms anew. Excess money growth tells a similar story. Historically, an expansion of the global money supply in excess of the demand for credit sends a strong signal that global economic activity is well supported by reflationary policies. It forecasts above-trend industrial production growth, robust international trade and rising global export prices. Currently, excess money growth in the US, Eurozone and Japan has overtaken its post-GFC high and is consistent with higher US and German yields (Chart 5). Global capacity utilization also points toward higher yields. Our US Composite Capacity Utilization indicator is back in the neutral zone after a steep decline in 2020. Furthermore, US industrial capacity utilization is currently back above its structural trend. Most importantly, capacity utilization should be evaluated at the global level. Even when slower-growing economies such as the Euro Area and Japan are included, global capacity utilization is improving enough to be consistent with rising yields (Chart 6). Chart 5Excess Money Points To Higher Yields Chart 6Rising CAPU Lifts Yields Capacity utilization should climb higher in the coming quarters as the world experiences an inventory re-stocking cycle. The US, with its rich data, provides a good example. The sales-to-inventory ratio is at an extremely elevated level and is climbing very rapidly (Chart 7). Meanwhile, the level of inventories is still 1% below its pre-pandemic peak, while GDP overtook it previous high in the second quarter, and business sales are 11% above their 2018 high. The recent rise in inflation highlights the inability of companies to fulfil demand for their goods and services and, consequently, the need to restock. Hence, we expect companies to increase their inventory spending, which will add to demand and to capacity utilization as the adjustment process takes place. Capex will also lift capacity utilization and put upward pressure on yields. US capex intentions are rising swiftly as firms are unable to meet demand (Chart 8, top panel). Our Japanese Capex Indicator reiterates this message, while the European Commission’s Investment Surveys are also recovering (Chart 8 bottom panels). Historically, capex intentions are an excellent, leading indicator of actual investments, hence, the recent poor capex numbers will not last. Chart 7Restocking Ahead! Chart 8Climbing Capex Intentions Everywhere Greater global cash flow growth is also consistent with higher capex. The growth in EBITDA among global companies has bottomed, and it is currently around 14%. Incidentally, this suggests that capex among quoted firms around the world should expand in the second half of the year by a similar amount (Chart 9). Ultimately, robust cash flows finance expansion plans and also send a strong signal to corporate boards that the environment is ripe for investment spending. Already, capital goods orders are strengthening, which confirms the signal from both the capex surveys and profits. This strength portends very strong private capex numbers in the coming quarters and thus, a greater level of demand in the economy (Chart 10). Chart 9Rising Cash Flows Lead To Higher Capex Chart 10Strong Global Orders Public infrastructure plans will create the final boost to global capex. $550 billion of the Biden administration’s infrastructure plan is getting close to bipartisan approval, and the budget reconciliation process might still result in an even bigger package before yearend. In Europe, the EUR800 billion NGEU plan that has been approved by all the EU’s national parliaments also includes large infrastructure spending envelopes to deploy over the coming five years. This context suggests that yields are unlikely to decline much further from current levels, since the oversold conditions that prevailed in March have been purged. Chart 11 shows that specific events are needed to prompt a greater 90-trading day collapse in yields than the one just registered. In 2019 and 2020, the Fed was cutting rates. Today, it is gearing up to raise them. In 2010 and 2011, the European sovereign debt crisis was hurting global growth and creating massive deflationary risks. In 2015, China was mired in deep deflation and devalued the RMB, which exported these negative pressures around the world and lowered yields. By late 2018, the yield curve was moving toward an inversion, which signaled that monetary policy was too tight. Today, none of these conditions are present and, consequently, the odds of a greater decline in yields are low. Chart 11Yields Have Moved Enough Bottom Line: The broad-based nature of the global recovery will limit the decline in yields. Global liquidity conditions remain extremely accommodative, global capacity utilization is improving, and inventories and capex spending will add to demand in the coming quarters. In this context, the recent decline in yields corrected this spring’s oversold condition in the bond market sufficiently. Investment Implications Bonds Investors with an investment horizon of more than six months should reduce their portfolio duration and remove hedges protecting against higher yields. The low in Treasury yields is likely to stay around 1.1%. The exact timing of the rebound is imprecise, and yields could churn for a brief period and retest their recent lows, but the balance of risks points toward a much greater probability of higher yields in the coming six to twelve months, and a limited probability of significantly lower yields from current levels. In fact, the CRB-to-gold ratio, often shown by BCA’s US bond strategists, clearly favors higher yields (Chart 12). Higher yields are not inconsistent with BCA’s view that the current inflation spike is transitory. TIPS yields are at a record low. As global growth recovers and the Fed moves closer to removing some accommodation, real yields will increase (Chart 13, top panel). Meanwhile, 5-year/5-year forward inflation breakeven rates remain well below the 2.5%-to-3% zone that prevailed prior to 2014, when long-term inflation expectations were still well anchored (Chart 13, bottom panel). The Fed is actively aiming to push this inflation expectation measure higher. Chart 12The CRB/Gold Ratio Points To Higher Yields Chart 13TIPS Yields Will Rise Chart 14The European Yield Curve Will Steepen German yields have some upside too, even if the ECB will lag well behind the Fed in terms of both ending its QE program and lifting interest rates. The ECB policy rate mostly anchors the short end of the curve, and the large European excess savings warrant lower Bund yields than those of T-Note. However, the nominal and real terminal rates embedded in the German curve remain lower than at the apex of the European sovereign debt crisis and are extremely low compared to the US. As a result, the European yield curve will steepen, which is confirmed by the comparative strength of the earnings revisions of Europe’s cyclical equity sectors (Chart 14). Equities An environment in which yields rise again should favor financials, industrials, and momentum stocks at the expense of growth stocks. In Europe, banks and financials will be the prime beneficiaries of higher yields. Historically, higher German Bund yields are associated with an outperformance of banks relative to the broad market, because a steeper yield curve boosts net interest margins (Chart 15). European banks also have scope for some re-rating. There is little case to significantly upgrade the sectors’ expected long-term profitability significantly, considering that the European economy remains replete with an excessively large capital stock. Nonetheless, at a price-to-book ratio of 0.6 or 55% below that of US banks and 67% below the European broad market, European banks are also priced as risky investments. However, European NPLs have declined significantly, and the public sector support during the pandemic will limit how high NPLs can rise (Chart 16, top panel). Moreover, European banks are much better capitalized than they once were, which further decreases their riskiness (Chart 16). Additionally, the ECB has allowed banks to pay dividends again. Finally, the fiscal risk sharing created by the NGEU funds and continued bond purchases by the ECB will cap the upside for peripheral yield spreads, which will limit the odds of the emergence of the kind of doom-loop that once plagued the European banking system. UK bank stocks look particularly attractive. Chart 15European Banks Have Upside Chart 16Less Risky The massive underperformance of European momentum stocks relative to growth stocks is also likely to reverse (Chart 17). As Chart 18 shows, momentum stocks currently trade at an exceptionally large discount to both growth stocks and the European broad market. Most importantly, momentum equities tend to outperform growth stocks in the wake of a rise in German yields (Chart 19). This sensitivity to yields is currently accentuated by the sector bias of momentum stocks. Relative to growth stocks, momentum equities greatest overweights are financials, industrials and materials (Table 1), three sectors that thrive on higher interest rates. Meanwhile, their largest relative underweights are consumer staples and healthcare, two sectors with strong defensive characteristics that benefit from lower yields. Chart 17Bomned Out Momentum Stocks... Chart 18...Have Become Very Cheap Chart 19Momentum Stocks Outperform When Yields Rise Table 1Sector Biases: Momentum Vs Growth Stocks Chart 20The Capex Outlook Favors Industrials Finally, we recommend investors move more aggressively into industrial equities. Industrials are the best-placed sector to benefit from the rise in global capex and the excess money supply growth. As Chart 20 highlights, even if the rate of growth of global capital goods orders decelerates, industrials should outperform the European broad market as long as the rate of growth remains positive. Nonetheless, the sector’s outperformance could moderate because it has become more expensive than the broad market. However, a stronger profitability compensates for this negative. As a corollary, we continue to favor Swedish equities because of their 38% weight in industrials and 27% allocation to financials. Moreover, their superior return on equity and profit margins, as well as the EUR/SEK’s downside potential, add to Sweden’s allure. The largest risk for industrials remains the slowdown in the Chinese credit impulse. However, the upbeat picture for DM capex and inventory growth counters this negative side. We continue to recommend some hedges against this risk. When it comes to our Sweden overweight, we still advise selling Norway, a position that has worked out well. We also still like selling consumer discretionary equities / long European telecoms to protect portfolios against a greater-than-anticipated global slowdown. Bottom Line: Global safe-haven yields are unlikely to decline significantly from current levels. Instead, they will rise meaningfully in the coming quarters, even in Germany. Consequently, investors with an investment horizon greater than six months should curtail their portfolio duration once again. Higher yields will also benefit European bank equities. We also recommend investors buy European momentum stocks and sell growth stocks. Finally, European industrials are set to shine compared to the rest of the European market, which will give a fillip to Swedish stocks, our favored European market. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Currency Performance Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar