Sectors

Special Report

Highlights The US fiscal outlook has deteriorated substantially over the past two decades, as a consequence of the fiscal response to both the global financial crisis and the COVID-19 pandemic. US government debt-to-GDP is now nearly as high as it was at the end of the Second World War, and is projected by the US Congressional Budget Office (CBO) to explode higher over the coming 30 years. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks. We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in a scenario where investors raise their expectations for the neutral rate of interest, a possibility that we discussed in last month’s report. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, we do not expect that rising interest rates pose a risk to stocks over the coming 6-12 months. Investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. In 2001, US government debt held by the public as a share of GDP stood at 31.5%, after having fallen roughly 16 percentage points from early 1993 levels. Today, as a result of both the global financial crisis and the COVID-19 pandemic, the debt to GDP ratio has risen to a whopping 100%, and is projected to rise meaningfully higher over the coming decades. Feature In this report we review the long-term US fiscal outlook in the wake of the pandemic, with a focus on the implications for interest rates. Some investors argue that extreme levels of government debt now virtually guarantee that interest rates will remain structurally low, and we test this claim alongside a scenario that limits the projected rise in the primary deficit. We find that US fiscal reform, when it eventually occurs, will likely be negative for health care stocks, whose fundamental performance has outstripped that of the broad equity market since the mid-1990s (reflecting pricing power that stands to be curtailed through regulation). We also note that even in a scenario where the US limits the size of its future primary budget deficit, net interest outlays will likely rise to elevated levels compared to history. A comparison with the Canadian experience in the 1990s suggests a structurally negative outlook for the US dollar, from an overvalued starting point. Finally, we note that the US fiscal outlook does not necessarily prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report,1 i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This scenario is not our base case view, but it is plausible and should actively be monitored by investors over the coming one to two years. For now, investors should remain cyclically overweight equities within a multi-asset portfolio, and should maintain a below-benchmark level of duration on a risk-adjusted basis. Debt Sustainability, And The CBO’s Baseline Projection When analyzing the US fiscal outlook, the Congressional Budget Office’s Long-Term Budget Outlook report is typically the reference point for investors. The report provides annual projections for the budget deficit and the debt-to-GDP ratio for the next three decades, as well as a breakdown of the projected deficit into its primary (i.e., non-interest) and net interest components. Charts II-1 and II-2 present the most recent baseline projections from the CBO, which clearly present a dire long-term outlook. The deficit and debt-to-GDP ratio are projected to be relatively stable over the next decade, but explode higher over the subsequent 20 years. In 2051, the CBO’s baseline projects that the budget deficit will be roughly 13% of GDP, with net interest costs accounting for approximately two-thirds of the deficit. Chart II-1The CBO’s Fiscal Outlook Is Extremely Negative Chart II-2In 2051, The CBO Projects A 13% Annual Budget Deficit In order to understand what is driving the CBO’s dire long-term budget and debt forecast, it is important to review the government debt sustainability equation shown below. The equation highlights that the change in a government’s debt-to-GDP ratio is approximately equal to 1) the primary deficit plus 2) net interest costs as a share of GDP, the latter being defined as the product of last year’s debt-to-GDP ratio and the difference between the average interest rate on the debt and the rate of GDP growth. Δ Debt-To-GDP Ratio ≈ Primary Deficit As A % Of GDP2 + (r-g)*(Prior Period Debt-To-GDP Ratio) Where: r = Average interest rate on government debt and g = Nominal GDP growth The equation highlights that expectations of a persistently rising debt-to-GDP ratio must occur either because of expectations of a persistent primary deficit, or expectations that interest rates will persistently exceed the rate of economic growth (or some combination of the two). This underscores why debt sustainability analysis often focuses on the primary budget balance, as a country’s debt-to-GDP ratio will be stable if no primary deficit exists and interest costs are at or below the prevailing rate of economic growth. Chart II-3 illustrates the source of the CBO’s projected rise in debt-to-GDP beyond 2031, by presenting the two components of the debt sustainability equation alongside the projected annual change in the debt-to-GDP ratio. The chart makes it clear that while the CBO is forecasting a sizeable primary deficit to continue, it is projected to grow at a slower pace than the debt-to-GDP ratio itself. The increasing rate at which the debt-to-GDP ratio is projected to grow in the latter years of the CBO’s forecast period is clearly driven by the interest rate component, meaning that “r” is projected to be greater than “g”. Chart II-4 presents this point directly, by highlighting that the CBO is forecasting the average interest rate on government debt to exceed that of nominal GDP growth in 2038, and to continue to exceed growth (by an increasing amount) thereafter. Chart II-3Decomposing The CBO's Projected Change In The Debt-To-GDP Ratio Chart II-4The CBO's Projections Rest, In Part, On Rates Eventually Exceeding Growth   Three Adjustments To The CBO’s Baseline We make three adjustments to the CBO’s baseline in order to assess how the US fiscal outlook shifts under an interest rate path that is different than that projected by the CBO. First, we adjust the CBO’s projected budget deficit over the coming few years based on deficit forecasts from our US Political Strategy service following the passage of the American Recovery Plan act.3 Chart II-5We Test The Effect Of An Initially Higher, But More Sustainable, Rate Path Next, we adjust the interest component of the total budget deficit based on a new path for short- and long-term interest rates that models a scenario in which the neutral rate of interest rises to, but not above, GDP growth (Chart II-5). In last month’s report we outlined a scenario in which this could feasibly occur,1 and the hypothetical path for interest rates shown in Chart II-5 thus incorporates both the negative budgetary impact of an earlier rise in interest rates and the positive budgetary impact of “r” never rising above “g”. We explicitly exclude any crowding out effect on long-term interest rates, based on the view that term premia are likely to remain muted in a world of low potential economic growth, unless a fiscal crisis appears to be imminent (see Box II-1). Box II-1 Arguing Against The CBO’s Crowding Out Assumption The CBO’s projection that interest rates will ultimately rise above the rate of economic growth rests on the view that increased government spending will absorb savings that would otherwise finance private investment (a “crowding out” effect). We agree that crowding out can occur over the course of the business cycle, especially in a scenario where increased government spending pushes output above its potential (creating a cyclical acceleration in inflation and eventually an increase in interest rates). But the CBO is assuming that high government debt-to-GDP ratios will crowd out private investment on a structural basis, and on this basis we disagree. First, Chart Box II-1 highlights that there is essentially no empirical relationship across countries between a country’s debt-to-GDP ratio and its long-term government bond yield. Japan is a clear outlier in the chart, but including Japan implies that the relationship is negative, not positive. Chart Box II-1There Is No Empirical Relationship Between Debt-To-GDP And Interest Rates In addition, given that central banks directly control interest rates at the short-end of the curve, a structural crowding out effect can only manifest itself in the form of an elevated term premium embedded in longer-term government bond yields. Our bet is that term premia are likely to stay low in a world of low falling nominal growth, as evidenced by the experience of the past decade.4 Finally, we model the impact of two changes, beginning in 2031, that would work towards reducing the primary deficit: an increase in average government revenue to 20% of GDP (its peak level reached in 2000), and a slower pace of increase on major health care program spending. Despite the fact that population aging will increase mandatory spending on social security and health care over the coming three decades, the CBO has highlighted that the majority of the increase in spending towards these programs is projected to occur due to rising health care costs per person (Chart II-6). We thus model the impact of medical care cost control by limiting the rise in net mandatory outlays on health care programs between 2021 and 2051 to roughly half of what the CBO baseline projects. This adjustment does not prevent mandatory spending on health care programs from rising, given the strong political challenges involved in limiting spending increases that are caused by an aging population. Chart II-6The US Structural Primary Balance Is Heavily Impacted By Medical Costs Charts II-7 and II-8 illustrate how these three adjustments impact the long-term US fiscal outlook. Relative to the CBO’s baseline projections, the American Recovery Plan (ARP) budget deficit forecasts from our US Political Strategy service imply that the debt-to-GDP ratio will be approximately three to four percentage points higher over the very near term, and roughly ten points higher over the long term. Chart II-7Even With Higher Rates, The Fiscal Outlook Is Meaningfully Less Bad… Relative to this new baseline, an increase in interest rates to, but not above, the projected rate of nominal economic growth increases the debt-to-GDP ratio by an additional ten percentage points (20 points higher versus the CBO’s baseline) in the middle of the forecast period, but it lowers the debt-to-GDP ratio over the longer run by eliminating the effect of outsized interest rates magnifying a persistent primary deficit. Still, the debt-to-GDP ratio is projected to rise to a whopping 207% of GDP by 2051 in this scenario, with a budget deficit in excess of 10% of GDP. The third adjustment shown in Charts II-7 and II-8 underscores the impact on the US fiscal outlook of actions aimed at reducing the primary deficit. Increases in government revenue and the prevention of rising health care costs per person results in the debt-to-GDP ratio that is 64 percentage points lower in 2051 than in our normalized interest rate scenario. The budget deficit in this scenario still increases to approximately 6% of GDP thirty years from today, but in this case most of the deficit is due to the net interest component rather than the primary deficit, meaning that the debt-to-GDP ratio would be increasing at a much slower rate if interest rates were no higher than the rate of economic growth. Chart II-8 highlights that net interest spending in this scenario would rise to 4.5% of GDP, which would be meaningfully higher than the prior high of roughly 3% in the late 1980s and early 1990s. Chart II-8...With Higher Taxes And Medical Cost Control Chart II-9A Meaningful, But Not Unprecedented, Rise In Net Interest Outlays But that is far from unprecedented or necessarily consistent with a fiscal crisis. Chart II-9 also shows that Canada’s public debt charges rose to 6.5% of GDP in the early 1990s without triggering a public debt crisis. It is true that Canada subsequently embarked on a painful fiscal consolidation program in order to reduce its public debt burden, but this, in part, occurred because of a cyclically-adjusted primary deficit of approximately 3% - twice as large as that projected for the US in 2051 in our adjusted scenario shown in Charts II-7 and II-8. Revenue And Health Care Cost Reform Our third adjustment to the CBO’s long-term budget outlook involved changes to revenue and health care cost control to reduce the US’ projected primary deficit. Are these adjustments achievable? In our view, the answer is yes: As noted above, our scenario modeled these changes taking place a decade from today, which allows for policymakers and stakeholders to have a substantial amount of time to act and adjust to these changes. On the revenue front, we noted above that US government revenue has reached 20% of GDP in the past, in the year 2000. Chart II-10 highlights that while raising taxes will likely reduce US competitiveness, the US maintains a sizeable tax advantage relative to other advanced economies, and that this was true prior to the tax cuts that took place under the Trump administration. On the health care cost front, Chart II-11 highlights that US healthcare expenditure is much larger as a share of GDP than other countries, which was not the case prior to the 1980s. Chart II-12 highlights that this cost difference is entirely due to inpatient (i.e., hospital) and outpatient (i.e., drug) costs. While it is not clear what form it will take, it seems likely that future reforms by policymakers to eliminate rising health care costs per person will occur and can be achieved. Chart II-10The US Government Can Afford To Raise Revenue Chart II-11The US Spends Much More On Health Care Than Other Countries   Chart II-12The US Significantly Outspends The World On Hospital And Drug Costs The key point for investors is not whether these changes should or should not occur, but whether there are any feasible scenarios in which spiraling government debt and interest payments are avoided without the Fed purposely maintaining monetary policy at levels persistently below the rate of economic growth – and thus risking major inflationary pressure. Our analysis above highlights that there are; the question is when policymakers will choose to act and in what form. A potential tipping point may be when US government spending on net interest as a % of GDP exceeds its prior high, which occurs in 2026 in the scenario modeled in Chart II-8. In a scenario where reforms fail to materialize or where financial markets force policymakers to act, a fiscal risk premium could certainly emerge in longer-term government bond yields, which could lead the Fed to maintain lower short-term interest rates than it otherwise would. But this scenario is only likely to emerge after interest rates converge towards rates of economic growth, as US government debt will remain highly serviceable for some time if "r" remains meaningfully lower than "g". Investment Conclusions There are three potential investment implications of our research. First, the fact that rising medical costs have such a significant impact on the CBO’s projections of the primary deficit implies that fiscal reform, when it eventually occurs, will be negative for US health care stocks. Chart II-13 highlights that US health care sector earnings have outperformed broad market earnings since the mid-1990s, and that the sector has consistently delivered an above-average return on equity. This historical performance likely reflects the sector’s pricing power, which stand to be curtailed through regulatory efforts in a world where rising health care costs per person collide with fiscal belt-tightening. Interestingly, Chart II-12 highlighted that US per capita spending on medical goods is not significantly higher than in other developed markets, suggesting that the health care equipment & supplies industry may fare better over a very long term time horizon than overall health care. Second, Charts II-7 and II-8 highlighted that even if the US does raise revenue as a share of GDP and limits excessive growth in medical costs, a primary deficit will still exist and net interest outlays will still rise to elevated levels compared to what has historically been the case. We noted that Canada experienced a higher public debt burden in the 1990s and did not suffer from a fiscal crisis, but Chart II-14 highlights that the fiscal situation did weigh on the Canadian dollar, which progressively traded 10-20% below its PPP-implied fair value level over the course of the 1990s. Thus, the implication is that eventual fiscal reform in the US may be structurally negative for the US dollar, from an overvalued starting point (panels 3 and 4 of Chart II-14). Chart II-13Eventual Fiscal Reform Will Likely Be Negative For Health Care Stocks Chart II-14The US Fiscal Outlook, Even With Some Reforms, Is Dollar-Negative   Finally, our scenario analysis highlights that very elevated levels of government debt do not guarantee that interest rates will remain structurally low, especially over the next decade when the US primary deficit is projected to remain relatively stable. For investors focused on forecasting the direction of 10-year Treasury yields from the perspective of valuation, it should be noted that the next decade is the relevant projection period for the Fed funds rate, not what occurs to net interest outlays in the two decades that follow. Over the very long run, it is true that there may ultimately be very strong political pressure on the Fed to keep interest rates below the prevailing rate of economic growth, as policymakers in 2030 will be able to avoid a structural adjustment to the primary deficit of roughly 1.1-1.3% of GDP for every percentage point that average interest rates on government debt are below nominal GDP growth. However, we noted above that this pressure is unlikely to build before the second half of this decade even in a scenario where interest rates rise significantly over the coming few years, and it remains an open questions whether the Fed will acquiesce to this pressure given its strong potential to fuel excess private sector leveraging. Over the coming one to two years, the key conclusion is that the US fiscal outlook is not likely to prevent an increase in interest rates over the coming few years in the hypothetical scenario that we described in last month’s report, i.e., an environment where the narrative of secular stagnation is challenged and investor expectations for the neutral rate rise closer to trend rates of economic growth. This remains a risk to our overweight stance towards risky assets and is not our base case view. But it does highlight the importance of monitoring long-dated rate expectations over the coming year, and argues, on a risk-adjusted basis, for a below-neutral duration stance within a fixed-income portfolio. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst Special Report "R-star, And The Structural Risk To Stocks," dated March 31, 2021, available at bca.bcaresearch.com 2 Presented in this fashion, a budget deficit (surplus) is recorded with a positive (negative) sign. 3 For more information, please see US Political Strategy report “Biden’s Pittsburgh Speech And Legislative Agenda,” dated April 1, 2021, available at usp.bcaresearch.com 4 Please see “Term premia: models and some stylised facts”, by Cohen, Hördahl, and Xia, BIS Quarterly Review, September 2008.

Highlights Clients countered our opinion that China’s economy has reached its cyclical peak. However, we have already incorporated the supporting facts into our analysis so they will not alter our cyclical outlook for the economy. The favorable external backdrop is a potential downside risk to China’s domestic economy, because the country’s pain threshold for reform is often positively correlated with global growth. We agree that an acceleration in local governments’ special-purpose bond issuance could boost infrastructure investment in the next six months, but we are skeptical about the magnitude of such support. China’s onshore and offshore stock markets remain firmly in a risk-off mode. For now, we recommend investors stay on the sidelines until some of the early indicators turn more bullish. Feature We spent the past week hosting virtual meetings with BCA’s clients in Europe and Asia. We presented our view that China’s economic recovery has likely peaked and escalating risks of a policy overtightening warrant an underweight position on Chinese stocks for the next six months. Most clients shared our concern that policymakers may keep financial and industry regulations more restrictive than the market is currently pricing in, leading to more downside surprises to risk asset prices. Clients also brought up a few opposing views which challenged our analytical framework. In this and next week’s reports we will highlight some of the counterpoints we discussed in these meetings. Interestingly, most of our clients - even ones who are more sanguine about China’s economic outlook - prefer to wait on the sidelines before jumping back into China’s equity market. They foresee sustained volatility in the coming months as the market continues to struggle between digesting high valuations and adjusting expectations for future earnings growth. Has China’s Economic Recovery Reached An Apex? The primary discussion centered around whether the strength in China’s economy has reached a cyclical peak. Q1 GDP points to slower sequential economic momentum from Q4 last year (Chart 1). Some of the high-frequency economic data also indicate that economic activity peaked in Q4 last year (Chart 2).  Chart 1Q1 Sequential Growth Was The Slowest In A Decade Chart 2Has Economic Activity Peaked? Chart 3Our Framework Suggests A Slower Growth Momentum Ahead The view fits perfectly into our analytical framework, which has worked well in the past decade. Historically, China’s credit formation has consistently led economic activity by about six to nine months. A turning point in the credit impulse occurred last October, which suggests that economic activity should start to slow in Q2 this year (Chart 3). However, our clients countered with the following arguments, which support a notion that sequential economic growth rate can still trend higher in the next six months: Aggregate demand in Europe and the US continues to improve, while the COVID-19 resurgence in major emerging economies, such as India and Brazil, has forced their production recoveries to pause. Thus, China’s exports will remain robust and should continue to make substantial contributions to the economy (Chart 4). Infrastructure spending could get a meaningful boost when local governments speed up issuing special-purpose bonds (SPB) in Q2 and Q3. Infrastructure investment growth was relatively weak in Q1, probably the result of a slower pace in credit growth and government expenditures (Chart 5). However, a delay in local government SPB issuance in Q1 this year means more support for infrastructure investment in the rest of the year (Chart 6). Chart 4Counterpoint #1: Chinese Exports Will Stay Strong   Chart 5Slower Credit Growth Led To A Subdued Q1 Infrastructure Investment Growth     Travel restrictions imposed during the Chinese New Year weighed heavily on the service sector in Q1 (Chart 7). If China’s domestic COVID-19 cases remain well controlled, then the trend could reverse and the pent-up demand for service consumption may usher in a significant improvement in Q2 when three major public holidays occur. The service sector accounts for more than half of China’s GDP, therefore, an improvement in this sector should significantly bolster future GDP growth. Chart 6Counterpoint #2: More LG SPBs, More Spending On Infrastructure Chart 7Counterpoint #3: Service Sector Activities Will Pick Up Our Analytical Framework The viewpoints expressed by clients have not changed our cyclical view of China’s economy, since our broad analysis of Chinese business cycle already incorporates the main points that clients raised. Additionally, data such as GDP growth figures are coincident and lagging indicators, and do not explain the direction of forward-looking financial markets. The authorities will shift their policy trajectories only if the data significantly deviate from expectations. We view Q1 GDP and underlying data broadly in line with Chinese leadership’s short- and medium-term economic growth targets and, therefore, will not lead to any policy adjustment. Chart 8If Demand For Chinese Exports Stays Strong, Reform Efforts Will Intensify To our clients’ point that strong exports ahead will support China’s overall GDP growth, we regard a favorable external backdrop as a potential downside risk to the domestic economy. The willingness of Chinese authorities to pursue painful reforms is often positively correlated with global growth (Chart 8). BCA has written extensively about how China has taken advantage of a stronger export sector by increasing the pace of domestic reforms and in the past has embarked on a multi-year reform plan that weighed on growth. At the beginning of this year, Chinese policymakers were set out to “keep credit growth in line with nominal GDP growth in 2021.” Nonetheless, policymakers’ targets for credit and nominal GDP growth rates could change during the year, contingent on their perception of the broad growth outlook and unemployment. Chart 9Both Credit And Economic Growth Rates Are Moving Targets And Subject To Policy Finetuning Even if policymakers keep the country’s leverage ratio steady in 2021, which is our base case view and assuming China’s nominal GDP grows by 11%, then the credit impulse (measured by the 12-month difference in total social financing as a percentage of GDP) will likely fall to about 28% of GDP, down from 32% of GDP in 2020 (Chart 9).  The rate of credit formation increased by 13.6% in the first three months from Q1 last year, above government’s target. We expect a further pullback in credit growth in the rest of the year, to bring the annual pace at or below 12%. Construction capex, which is sensitive to both credit creation and tightening regulations in the housing sector, will likely experience a slowdown. At more than 90% of GDP, China’s economy is mainly driven by domestic demand and a weakening in the domestic economy can more than offset positive contributions from a robust export sector. Infrastructure And Services We expect infrastructure investment will grow by 4-5% this year, which is in line with its rate of expansion in 2020. However, the sequential growth in the sector in Q2 – Q4 this year will be slower than during the same period in 2020 (Chart 10). We agree that a more concentrated issuance of local government SPBs in Q2 and Q3 could help to buttress infrastructure investment. However, SPBs made up only about 15% of overall infrastructure spending in the past three years, so we are dubious that SPBs can provide the crucial support. The rest of the gap for local governments to finance their spending on infrastructure projects will need to be filled through public-private partnerships (PPP) financing, government-managed funds’ (GMFs) revenues, government budgets and bank loans. Note that only non-household medium- and long-term (MLT) bank lending showed a positive impulse so far (Chart 11). While not all of MLT loans are used for infrastructure, they have a positive correlation with investments in infrastructure projects which are generally long term in nature. Chart 10Sequential Growth In Infrastructure Investment Will Be Slower Than In Q2 – Q4 Last Year Chart 11MLT Bank Loans Have Been Supportive To Infrastructure Spending... On the other hand, the contribution of PPPs to total infrastructure spending has been plunging in recent years due to tighter regulations aimed at controlling increased risks related to local government debt (Chart 12). Depressed revenues from land sales and extended corporate tax cuts this year will also curb the ability of local governments to finance infrastructure projects (Chart 13). Chart 12...But Public-Private Partnerships Have Become Too Small To Fill The Financing Gap Chart 13Government-Managed Funds Also Face Headwinds From Falling Land Sales Finally, although the service sector accounts for 54% of China’s GDP (2019 statistic), transport, retail and accommodation, which were hardest hit by COVID-19, accounted for less than 30% of China’s tertiary GDP. This compares with a slightly larger share of tertiary GDP from finance- and housing-related sectors (financial intermediation, leasing & business services, and real estate) –the sectors that have been thriving since the second half of last year when both the equity and housing markets boomed (Chart 14). Nonetheless, it is unreasonable to expect these areas to strengthen even more in an environment where the policy has shifted to contain risks in the financial and housing arenas. The net result to tertiary GDP growth is that the deterioration in finance- and real estate-related segments will likely offset an improvement in transport, retail and accommodation. Chart 14More Than 70% Of China’s Services Sector Is Finance And Real Estate Related Investment Conclusions The ultimate question we got from almost every client meeting was: What would make us turn bullish on Chinese stocks in the next 6 to 12 months?  Chart 15Changes In Domestic Policy Dominate Chinese Stock Performance Since most monthly and quarterly economic data do not provide enough market-moving catalysts, we rely on our assessment of the changes in policy direction, such as interbank liquidity conditions and excess reserves, in addition to overall credit growth (Chart 15). We will also continue to watch for the following signs before upgrading our tactical and cyclical calls from underweight to overweight: Chart 16 shows that cyclical stocks remain depressed relative to defensives in both onshore and offshore markets, underscoring investors’ concerns about China’s economy. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards policy support and economic growth. A technical breakdown in the performance of healthcare and utility stocks relative to investable stocks would be another bullish indicator (Chart 17). These equities have historically led China’s economic activity, core inflation and stock prices by one to three months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a meaningful economic upturn in China.   Chart 16Waiting For A Telltale Sign... Chart 17...Before Upgrading Chinese Stocks   Given that the above mentioned indicators remain firmly in a risk-off mode, we maintain our view that China’s economy has reached its peak, and policy has tightened meaningfully. Our cyclical underweight position on Chinese stocks, in both absolute terms and within a global portfolio, is warranted.   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Overweight We are currently overweight the S&P railroads index in anticipation of financial sector liquidity morphing into real economic growth and thus propelling domestic oriented railroad stocks. There is also another way easy monetary policy is boosting this transportation sub-industry's already high monopolistic stature: by providing cheap capital incentivizing mergers as is evident in the recent bidding war for KSU that pushed the stock higher by 35% in a month. Switching to macro data, and the message is equally upbeat. Both our macro earnings model and margin proxy – constructed using industry-level data – are sending a bullish message and corroborate that investors should remain overweight rails (see chart). Bottom Line: We reiterate our March 15 boost to overweight in the S&P railroads index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP.  

Stock market margin debt charts have been making the rounds on the sell-side’s research and popping in the blogosphere and social media platforms. Some pundits showed margin debt as a nine-month rate of change and others as a year-over-year percentage change. Correcting for this FINRA margin debt balance, we (and others) have shown it as a percentage of GDP, and all these iterations highlight that margin debt has gone parabolic. Our long held view remains that margin debt uptake is a coincident stock market indicator and has little to no leading properties, neither at tops nor at bottoms. However, correcting margin debt balances versus the stock market capitalization makes the most sense to us. Our data set goes back to the 1930s and the latest tick up in relative margin debt balances is just that a tick up. The chart shows that it hovers near the historical mean, and while it is picking up momentum it is nowhere near previous excesses especially the two most recent ones during the dotcom bubble and the GFC. Crudely put, in momentum terms, the rate of relative growth will have to more than double from the current print, and in level terms margin debt as a percentage of market capitalization will have to jump to near 2.5% (from 2% currently) before it is in clear overshoot territory (top panel). Bottom Line: While some near-term caution is warranted on the prospects of the broad equity market that remains fully valued, margin debt is not yet at levels that have marked previous danger zones. China’s looming slowdown, and the Fed’s taper are the two key macro risks we continue to closely monitor. ​​​​​​​  

Special Report

Highlights President Biden’s proposal to raise the capital gains tax rate from 20% to 43.4% is part of the American Families Plan, which at best has a 50% chance of passing before the 2022 midterm election. Biden will soon present the full outline of this $1 trillion bill. The legislative priority is the American Jobs Plan with infrastructure spending and corporate tax hikes. This bill has an 80% chance of passing by Christmas. If it passes by end of July, then the odds of passing the American Families Plan prior to the midterm will shoot up. But we expect it to take to November, which could render the families plan (and capital gains tax) a campaign issue for 2022. Republicans are much more likely to vote for infrastructure spending than tax hikes. Traditional infrastructure can be separated into a bipartisan bill with Republicans and passed along with a renewed highway authorization by September. This creates an alternate avenue for infrastructure. Democrats would still pass the rest of Biden’s American Jobs Plan via reconciliation, including corporate tax hikes, which will only be watered down a bit. We reiterate our recommendations in favor of the BCA Infrastructure Basket and the Biden Fiscal Advantage Equity Basket. Given the eight-year span of the US infrastructure proposals, we recommend a cyclical and structural overweight for these baskets. Feature President Joe Biden’s $2.3 trillion American Jobs Plan is shifting from the initial phase – “coordinated policy rollout” and media cheerleading – to the drawn-out process of congressional negotiation and voting. None of our core views on the bill have changed: we expect the bill to pass before the end of the year and to be similar to what Biden has proposed on both corporate tax hikes and spending. Some spending proposals can be offloaded, some tax hikes can be watered down, but the gist of the bill is known to investors. Scares over Biden’s proposed capital gains tax hike are premature as this bill must pass before Congress can turn to Biden’s second plan and individual tax hikes. In this special report with BCA’s US Equity Strategy, we update the status of the bill and then take a closer look at our BCA Infrastructure Basket. We recommend investors stick to this trade over a structural time horizon of 12 months-plus. Biden’s Bill Will Pass – Bipartisanship Is Possible But Separate Biden’s infrastructure plan will pass on a party-line vote through budget reconciliation. Republicans will reject tax increases; Democrats will muster all 50 of their caucus votes plus Vice President Kamala Harris. Procedurally, reconciliation has been cleared. The fiscal 2021 budget resolution will be revised and this will enable Democratic leaders to cram the infrastructure package into a new reconciliation bill, ostensibly to raise the debt ceiling, which is due to expire on July 31. Technical public debt default will loom in early fall to help the Democrats motivate stragglers to vote for the bill.1 Spending Compromises: The reconciliation process will keep the price tag of the bill from rising higher than the proposed $2.3 trillion, since it will mostly exclude “earmarks.” States will have to apply in a competitive bidding for funding for projects beginning sometime in 2022 rather than receive guarantees of special projects in exchange for their senator’s vote for the overall package. The headline price tag could be whittled down by about $1 trillion if a bipartisan deal is done. Biden’s proposal consists of $784 billion in traditional infrastructure, $647 billion in social welfare, $370 billion in green energy initiatives, $280 billion in tech initiatives, and $219 billion in business support (Chart 1). The Republicans might be willing to agree to most of the traditional infrastructure as well as some of the tech initiatives and business support (Chart 2). This means these measures could be removed from the bill and passed separately. This would leave the Democrats to pass the rest on their own, including corporate tax hikes, which they could do at earliest by the end of July and at latest by the end of December (Diagram 1). Or Democrats could pass the whole package alone. Chart 1American Jobs Plan Has $784Bn In Traditional Infrastructure Chart 2Republicans Support Roads And Bridges Diagram 1Timeline For Congress To Pass American Jobs Plan By End Of 2021 Tax Compromises: Much has been made of West Virginia Senator Joe Manchin’s claim that the corporate tax rate should not exceed 25%, as opposed to Biden’s preferred 28%. Manchin is not alone, however. Table 1 highlights other Senate Democrats who oppose a 28% rate. These decisive swing voters may get a reduction in the rate but we tend to doubt it will be modified much from the proposal. Corporate tax hikes are popular – including when presented as a responsible way to pay for infrastructure (Chart 3). A minimum corporate tax will play very well politically while the headline corporate rate can be toggled one or two percentage points to ensure the bill gets enough votes (Chart 4). Chart 3Independents Support Corporate Taxes For Infrastructure Chart 4Voters Favor Corporate Tax Hike And Minimum Tax Table 1Centrist Senators: Democrats Who Oppose A 28% Corporate Rate, Republicans Who Voted To Convict Trump Of Insurrection, And Others Bipartisan infrastructure spending is possible but separate. Republicans are at risk of getting steamrolled by Democrats in the coming years. Democrats have stolen back the lead on infrastructure, manufacturing, trade, and China, yet they are free of the taint of mishandling the pandemic. Most importantly they have gotten hold of the magic money tree (Modern Monetary Theory), which enables them to expand the social safety net in a historic way that could boost the fortunes of their own party and its underlying principle of Big Government for a decade or more. Thus the pressure will be high on Republicans to show that they can govern and compromise – and infrastructure is the policy on which it is least painful for the GOP to join them. Republicans could hive off traditional “roads and bridges” – as well as tech competition with China – into a separate bill that could go forward on a bipartisan basis. There is a separate opportunity to pass infrastructure spending because the federal highway funding authorization, the 2015 FAST Act, expires on September 30 (Chart 5). The need to reauthorize this law will force lawmakers to act, thus presenting an opportunity to top up funding for traditional infrastructure projects.2 But this merely highlights that infrastructure spending has multiple avenues. If partisanship prevails as usual then Democrats will drive through their bill anyway. Chart 5US Infrastructure Spending In Recent Decades The regular budget process will be gridlocked. The regular appropriations process for FY2022 will not be an avenue for increased spending. Limits on discretionary spending expire at the end of FY2021 so there are no limits on budget appropriations. But 60 votes are needed for appropriations. Republicans will be loath to assist Democrats on the normal budget while the latter achieve all their other priorities via reconciliation. The economy will not need extra spending. A continuing resolution – a stopgap measure that keeps appropriations at the same level as the previous year – is the likeliest outcome. Or a government shutdown, which might be useful for Republicans to rally their base after a demoralizing year, though it would hurt their standing among the general public. Biden’s $1 trillion American Families Plan will be presented on April 28. This bill could pass in H1 2022, if the American Jobs Plan passes by July, but it is just as likely to become the Democrats’ campaign platform for the 2022 midterms. This bill will require the House and Senate to draft a FY2022 concurrent resolution, which cannot be finalized prior to passing the FY2021 reconciliation bill for both parliamentary and budgetary reasons. The economy will be red hot and fiscal fatigue will be setting in. We stick with our subjective 50/50 odds of passage for this bill. This means that the market’s concern over the capital gains rate hike is premature. First, Democrats have been back-loading tax hikes to prioritize economic recovery – and minimize negative impacts prior to the midterm election – so there is no reason to expect the capital gains tax hike to be retroactive whenever the American Families Plan passes Congress. If Congress passes it in mid-2022 then it will most likely go into effect on January 1, 2023. Second, the capital gains rate itself will likely be watered down from Biden’s proposed 43.4% to something around 32%. The good news for investors is that Biden is proposing to keep the distinction between individual income and capital gains (thus preserving the “carried interest loophole”). The bad news is that he is also keeping the Obamacare surtax of 3.8% on capital gains for those making over $250,000 or more. The American Families Plan is not urgent for investors because it is less likely to pass than the American Jobs Plan – and Republicans could win the House in 2022. But if the latter passes by July then the odds of the former passing before the midterm will shoot up. The family plan also shows that there is an upside risk to the budget deficit outlook and inflation expectations (Chart 6). Chart 6Revised US Budget Deficit Projection Post-ARPA Investment Implications Of Biden’s Sweeping Infrastructure Package While both the CBO and IMF currently project that the fiscal impulse will turn negative in 2022 (a mid-term election year) following a modest decrease this year, government largesse has staying power (Chart 7). Chart 7Fiscal Easing… The populist shift in US politics will push government expenditures as a share of output to nose-bleed levels. Given the lack of adequate tax offsets, it will buttress government debt-to-GDP to levels last seen during WWII (Chart 8). True, debt sustainability largely depends on nominal GDP growth, but spendthrift politicians are unconcerned about paying back debt as interest rates are held low courtesy of an extremely accommodative Federal Reserve and (temporarily) well-behaved bond vigilantes. This is all welcome news for equities exposed to fiscal spending in general and for infrastructure-reliant shares in particular. Two weeks ago we matched different segments of Biden’s infrastructure proposal (Tables A1 and A2 in the Appendix) to eight ETFs and one stock that now comprise our Biden Fiscal Advantage equity basket (Chart 9).3 Today we reiterate our sanguine view on this basket – especially versus the NASDAQ 100, given the high concentration of tech stocks in these ETFs. Chart 8...And Debt Uptake Bode Well For Infrastructure Stocks Chart 9Stick With The Biden Fiscal Advantage Basket Importantly, Charts 7 & 8 highlight that a rising fiscal deficit and ballooning government debt are a boon for the BCA’s infrastructure stock basket both from a cyclical and structural perspective.4 Tack on the Fed’s 6.5% real GDP growth projections for calendar 2021 that are more or less in line with the Street’s economic expectations and even the shorter-term outlook brightens for these infrastructure-laden equities (real GDP forecast shown advanced, Chart 10). Chart 10Enticing Domestic Growth Already, the US ZEW Indicator of Economic Sentiment is soaring following up the path of the ISM manufacturing survey, corroborating that the US economy is firing on all cylinders (top panel, Chart 11). While the recent bond market selloff has gone on hiatus, it will likely prove short-lived. The US population is on track to reach herd immunity sometime this fall and by then inflation will be rearing its ugly head (bottom panel, Chart 11). As a result, the 10-year US Treasury yield should resume its ascent (middle panel, Chart 11). Chart 11Plenty Of Upside Left Historically, all these key macro indicators have been positively correlated with the relative share price ratio of BCA’s infrastructure equity basket and the current message is positive (Chart 11). Beyond the conducive domestic backdrop, likely in the back half of the year the rest of the world will also be on the cusp of getting back to normal – with China’s pace of deceleration being the sole question mark – heralding a synchronized global growth setting. Not only will the US twin deficits weigh on the greenback, but a looming commodity up-cycle is also a boon for hypersensitive commodity-exposed currencies. This dual boost coupled with the budding rebound in EMs is music to the ears of US infrastructure-reliant US conglomerates (Chart 12). Gelling everything together, our US and global capex indicators do an excellent job in encapsulating all of these moving parts. Chart 13 shows that both of our capital expenditure indicators are in V-shaped recoveries, with our global capex one probing multi-decade highs. Chart 12Alluring EM Growth Chart 13Heed The Bullish Message From Our Capex Indicators Bottom Line: The sweeping American Jobs Plan will bolster both the BCA infrastructure and BCA Biden Fiscal Advantage equity baskets. Given the multi-year span of this looming bill, we recommend a cyclical and structural overweight in both baskets.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1 Table A2 Footnotes 1       Paul M. Krawzak, “More questions than answers in parliamentarian’s budget opinion,” Roll Call, April 8, 2021, www.rollcall.com. 2       Jinjoo Lee, “Road Is Smoother Than Expected For Infrastructure, Biden Plan Or Not,” Wall Street Journal, March 24, 2021, wsj.com. 3      As a reminder, the ticker symbols we included in this Equity Basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. 4      We first created this basket in late-2018 comprising a range of industrials and materials indexes that should see a positive reaction to a spur in infrastructure demand; Table A2 in the Appendix at the end of this report updates all the constituents in our basket.  

Neutral (Downgrade Alert) Soft drinks have taken a beating recently and we are on the lookout for an oversold bounce before we go underweight this consumer goods sub-group, especially given our short-term cautious outlook. Our technical indicator also made a new 20-year low and is well below the level consistent with previous reversals, underscoring that a counter-trend bounce is a high probability event (bottom panel). On the earnings’ front, while KO’s and PEP’s earnings were on the bright side, leading macro indicators signal that investors will be better off to avoid this defensive consumer staples sub-index. Importantly, safe-haven soft drink stocks that tend to be very stable cash flow generators both in good times and in bad, fare worse during the early stages of an economic expansion. As growth transitions from scarcity to abundance, investors start to shed staples exposure including soft drinks (ISM shown inverted, middle panel). Bottom Line: The S&P soft drinks index is on our downgrade watchlist. The ticker symbols for the stocks in this index are: BLBG: S5SOFD – KO, PEP, MNST. For more details, please refer to this Monday’s Strategy Report.  

Highlights Higher copper prices will follow in the wake of China's surge in steel demand, which lifted Shanghai steel futures to an all-time high just under 5,200 RMB/MT earlier this month, as building and infrastructure projects are completed this year (Chart of the Week). Copper will register physical deficits this year and next, which will pull inventories even lower and will push demand for copper scrap up in China and globally. High and rising copper prices could prompt government officials to release some of China's massive state holdings of copper – believed to total some 2mm MT – if the current round of market jawboning fails to restrain demand and price increases. Strong steel margins and another round of environmental restraints on mills are boosting demand for high-grade iron ore (65% Fe), which hit a record high of just under $223/MT earlier this week. Benchmark iron ore prices (62% Fe) traded at 10-year highs this week, just a touch below $190/MT. We are lifting our copper price forecast for December 2021 to $5.00/lb from $4.50/lb. In addition, we are getting long 2022 CME/COMEX copper vs short 2023 CME/COMEX copper at tonight's close, expecting steeper backwardation. Feature Government-mandated reductions of up to 30% in steel mill operations for the rest of the year in China's Tangshan steel hub to reduce pollution will tighten an already-tight market responding to a construction and infrastructure boom (Chart 2). This boom triggered a surge in steel prices, and, perforce, in iron ore prices (Chart 3). As it has in the past, this sets the stage for the next leg of copper's bull run. Chart of the WeekSurging Steel Presages Stronger Copper Prices In our modeling, we have found a strong relationship between steel prices, particularly for reinforcing bar (rebar), and copper prices, as can be seen in the Chart of the Week. Steel goes into building and infrastructure projects at the front end (in the concrete that is reinforced by steel and in rolled coil products), and then copper goes into the completed project (in the form of wires or pipes). Chart 2Copper Bull Market Will Continue In addition to the building and construction boom, continued gains in manufacturing will provide a tailwind for copper prices, which will be augmented by the global recovery in activity 2H21. Chart 4 shows the relationship between nominal GDP levels and copper prices. What's important here is economic growth in Asia (including China) and ex-Asia is, unsurprisingly, cointegrated with copper prices – i.e., economic growth and industrial commodities share a long-term equilibrium, which explains their co-movement. Chart 3Steel Boom Lifts Iron Ore Prices Media reports tend to focus on the effects of Chinese government spending as a share of GDP – e.g., total social financing relative to GDP – to the exclusion of the economic, particularly when trying to explain commodity price movements. To the extent the Chinese government is successful in further expanding the private sector – on the goods and services sides – organic economic growth will become even more important in explaining Chinese commodity demand. Chart 4Global Economic Grwoth Will Boost Copper Prices In our copper modeling, we find copper prices to be cointegrated with nominal Chinese GDP, EM Asian GDP and EM ex-Asian GDP, along with steel and iron ore prices, which, from a pure economics point of view, is what would be expected. On the other hand, there is no cointegration – i.e., no economic co-movement or a shared trend – between these industrial commodity prices and total social financing as a percent of nominal China GDP. These models allow us to avoid spurious relationships, which offer no help in explaining or forecasting these copper prices. Chart 5Iron Ore, Copper Demand Will Lift With The "Green Energy" Buildout Chart 6Renewables Dominate Incremental New Generation Longer term, as we have written in past research reports, the transition to a low-carbon energy mix favoring distributed renewable electricity generation, more resilient grids and electric vehicles (EVs) will be a major source of demand growth for bulks like iron ore and steel, and base metals, particularly copper (Chart 5).1 Already, renewable generation represents the highest-growth segment of incremental power generation being added to the global grid (Chart 6). Copper Supply Growth Requires Higher Prices Copper supply will have a difficult time accommodating demand in the short term (to end-2022) when, for the most part, the buildout in renewables and EVs will only be getting started. This means that over the medium (to end-2025) and the long terms (2050) significant new supply will have to be developed to meet demand. In the short term, the supply side of refined copper – particularly the semi-refined form of the metal smelters purify into a useable input for manufactured products (condensates) – is running extremely low, as can be seen in the longer-term collapse of Treatment Charges and Refining Charges (TC/RC) at Chinese smelters (Chart 7). At ~ $22/MT last week, these charges were the lowest since the benchmark TC/RC index tracking these charges in China was launched in 2013, according to reuters.com.2 Chart 7Copper TCRCs Fall As Supplies Fall, Pushing Prices Higher The copper supply story also can be seen in Chart 8, which converts annual supply and demand into balances, which will be mediated by the storage market. The International Copper Study Group (ICSG) estimates mine output again registered flat year-on-year growth last year, while refined copper supplies were up a scant 1.5% y/y. Chart 8Physical Deficits Will Draw Copper Stocks... Consumption was up 2.2%, according to the ICSG's estimates, which expects a physical deficit this year of 456k MT, after adjusting for Chinese bonded warehouse stocks. This will mark the fourth year in a row the copper market has been in a physical deficit, which, since 2017, has averaged 414k MT. The net result of this means inventories will once again be relied on to fill in supply gaps, and global stockpiles, which are down ~25% y/y, and will continue to fall (Chart 9). With mining capex weak and copper ore quality falling, higher prices will be required to incentivize significant new investment in production (Chart 10). However, the lead time on these projects is five years in the best of circumstances, which means miners have to get projects sanctioned with final investment decisions made in the near future (Chart 11). Chart 9...Which After Four Years Of Physical Deficits Are Low Chart 10Higher Copper Prices Required To Reverse Weak Capex, Falling Ore Quality Chart 11Falling Lead Times To Bring New Mines Online, But Time Is Short Investment Implications Our focus on copper is driven by the simple fact that it spans all renewable technologies and will be critical for EVs as well, particularly if there is widespread adoption of this technology (Chart 12). We continue to expect copper supply challenges across the short-, medium- and long-term investment horizons. To cover the short term, we recommended going long December 2021 copper on 10 September 2020, and this position is up 39.2%. To cover the longer term, we are long the S&P Global GSCI commodity index and the iShares GSCI Commodity Dynamic Roll Strategy ETF (COMT), recommended 7 December 2017 and 12 March 2021 , respectively, which are down 2.3% and 0.8%. Chart 12Widespread EV Uptake Will Create All New Copper Demand At tonight's close, we will cover the medium-term opportunity of the copper supply-demand story developed above by getting long the 2022 CME/COMEX copper futures strip and short 2023 CME/COMEX copper futures strip, given our expectation the continued tightening of the market will force inventories to draw, leading to a steeper backwardation in the copper forward curve. The principal risks to our short-, medium- and long-term positions above are a global failure to contain the COVID-19 pandemic, which, we believe is a short-term risk. Second among the risks to these positions is a large release of strategic copper concentrate reserves held by China's State Reserve Bureau (aka, the State Bureau of Minerial Reserves). In the case of the latter risk, the actual holdings of the Bureau are unknown, but are believed to be in the neighborhood of 2mm MT.3 Bottom Line: We remain bullish industrial commodities, particularly copper. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Texas is expected to add 10 GW of utility-scale solar power by the end of 2022, according to the US EIA. Texas entered the solar market in a big way in 2020, installing 2.5 GW of capacity. The EIA expects The Great State to add ~ 5GW per year in the next two years, which would take total solar capacity to just under 15 GW. Roughly 30% of this new capacity is expected to be built in the Permian Basin, home to the most prolific oil field in the US. By comparison, the leading producer of solar power in the US, California, will add 3.2 GW of new solar capacity, according to the EIA (Chart 13). To end-2022, roughly one-third of total new solar generation in the will be added in Texas, which already is the leading wind-powered generator in the country. Wind availability is highest during the nighttime hours, while solar is most abundant during the mid-day period. Precious Metals: Bullish Palladium prices, trading ~ $2,876/oz on Wednesday, surpassed their previous record of $2,875.50/oz set in February 2020 and are closing in on $3,000/oz, as supply expectations continue to be lowered by Russian metals producer Nornickel, the largest palladium producer in the world (Chart 14). Earlier this week, the company updated earlier guidance and now expects mine output to be down as much as 20% this year in its copper, nickel and palladium operations, due to flooding in its mines. Palladium is used as a catalyst in gasoline-powered automobiles, sales of which are expected to rebound as the world emerges from COVID-19-induced demand destruction and a computer-chip shortage that has limited new automobile supply. In addition, production of platinum-group metals (PGMs) is being hampered by unreliable power supply in South Africa, which has forced the national utility suppling most of the state's power (> 90%) to revert to load-shedding schemes to conserve power. We remain long palladium, after recommending a long position in the metal 23 April 2020; the position is up 35.6%. Chart 13 Chart 14     Footnotes 1     Please see, e.g., Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020.  It is available at ces.bcaresearch.com.   2     Please see RPT-COLUMN-Copper smelter terms at rock bottom as mine squeeze hits: Andy Home published by reuters.com 14 April 2021.  The report notes direct transactions between miners and smelters were reported as low as $10/MT, in a sign of just how tight the physical supply side of the copper market is at present. 3    Please see Column: Supercycle or China cycle? Funds wait for Dr Copper's call, published by reuters.com 20 April 2021.    Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

On Tuesday, our 5% rolling stop on the long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade was triggered. We are obeying the stop and closing the trade for another 20.5% return on top of the previous 21.5%, which brings the total return to 42% in under 9 months. While we are not changing our 2021 overlapping theme of economic reopening that underpinned this trade, we are no longer content with the risk/reward tradeoff, and from a risk management portfolio perspective choose to obey our stop and step aside. Granted, if the share price ratio goes through a meaningful correction catalyzed by the dormant US 10-year Treasury yield, we will reopen this trade once again looking for a new leg higher. Bottom Line: Close the long “Back-To-Work”/short “COIVD-19 Winners” baskets pair trade for a gain of 20.5%, since the second inception, but stay tuned.  

While the Fed remains committed to ZIRP for the remainder of the year, already FOMC members started talking about talking about tapering. The next logical step is for tapering to become reality as the year draws to a close or early in 2022. Peering above the 49th parallel, the BoC yesterday opted to taper bond purchases, albeit slightly, and may offer a glimpse of what may also take root in the US in the not too distant future. True, tapering is a good thing as the Central Bank’s (CB) confidence is high that the economy is on a solid footing and no longer needs additional CB support, however if history is an accurate guide, equity investors will have to digest the tapering news once it becomes reality. The chart shows G4 CB liquidity as a 26-week change in the asset side of the balance sheet, and given that some of this excess liquidity seeps over to the US equity market, its withdrawal will likely prove tumultuous. Bottom Line: Near-term caution is warranted on the prospects of the broad equity market that remains fully valued. Please see the next US equity sector Insight.

Special Report

Highlights EM banks will underperform their DM peers in the next six months due to worsening relative NPL dynamics and shrinking net interest margins. EM banks will either continue experiencing rising NPLs and moribund loan demand due to restrictive lending rates or will have to reduce their lending rates, which will considerably shrink their net interest margins. In both scenarios, EM bank profits will be damaged. Besides, EM is facing an unfriendly macro cocktail of booming US growth and a slowing China. This could cause a capital exodus from EM in the coming months depressing EM currencies and precluding many central banks from cutting interest rates proactively. Feature Chart 1EM vs. DM Banks: More Underperformance Ahead We recommend initiating the short EM banks / long DM banks strategy. There has been a major technical breakdown in EM share prices versus DM peers (Chart 1). When discussing EM banks for the purpose of macro analysis, we separate Chinese, Korean and Taiwanese banks from their EM peers. The basis is that the banking systems in China, Korea and Taiwan1 face different cyclical and structural outlooks than in the rest of EM. Bank assets-to-GDP ratios are much more elevated and the monetary and fiscal policies have more flexibility in China, Korea and Taiwan than in EM. Chart 2Fiscal Thrust In EM And DM Reason #1: Higher NPLs In EM Than DM As a result of the pandemic lockdowns, bank NPLs have surged both in EM and DM. However, DM banks have begun to pare down the NPL provisions they had built over the past year. By contrast, NPLs in EM economies will linger due to persisting economic weakness. In fact, EM banks might need to boost their NPL provisions, further eroding their profits. DM policymakers have provided much more fiscal support to their economies than the governments in EM (ex-China, Korea and Taiwan). The fiscal thrust in these EM economies will be negative in 2021 while it is expected to be positive in the US and neutral in the euro area (Chart 2). Chart 3 shows the fiscal thrust across individual EM economies. The fiscal thrusts in Russia and Brazil are the most negative. In EM (ex-China, Korea, Taiwan), the prime lending rates have declined but are still high both in nominal terms (around 10%) and in real terms (6.5%) (Chart 4, top and middle panels). In our opinion, these levels of prime lending rates are restrictive for EM economies and will both inhibit loan demand and undermine debtors’ ability to service debt. Consistently, bank loan growth remains very muted in EM (ex-China, Korea, Taiwan) (Chart 4, bottom panel). Chart 32021 Fiscal Thrust In Individual EM Countries The pandemic is lingering in several developing countries and their vaccination efforts are trailing those of DM. Consequently, the pace and timing of a full economic recovery in EM will lag those in DM. Chart 5 illustrates that retail sales and auto purchases in EM (ex-China, Korea, Taiwan) remain lackluster. Chart 4EM Bank Lending Rates Are Restrictive Chart 5EM Ex-China, Korea And Taiwan: Domestic Demand Is Lackluster   Reason #2: Net Interest Margin Squeeze For EM Banks EM banks are facing a dilemma. They have a choice between: continuing to experience rising NPLs and moribund loan demand due to restrictive lending rates, which will also undermine bank profits; and/or significantly reducing their lending rates to spur new lending and to help debtors service their loans. In such a case, their net interest margins and profits will shrink. In a nutshell, the fact that borrowers are struggling despite lending rates being much lower than they have been in the past boils down to underlying productivity and return on capital. Both have downshifted considerably in EM (ex-China, Korea, Taiwan) economies. This was true before the pandemic erupted and is also true at present. Chart 6EM Banks: Net Interest Margin And EPS In brief, the only way for EM banks to avoid escalating NPLs is to reduce lending rates. Yet, the latter will erode their net interest margins and depress their profits. Chart 6 demonstrates that net interest rate margins have been an important driver of banks’ EPS growth and they currently point to weaker bank earnings. Notably, there is little room for EM (ex-China, Korea, Taiwan) central banks to cut their policy/short rates. Doing so could trigger a weakness in their currencies at a time when US growth is booming, and US bond yields are under upward pressure. Overall, any decline in prime lending rates will produce a net interest margin squeeze for banks in EM (ex-China, Korea, Taiwan). In China, authorities have been clear that they expect banks to reduce their lending rates for SMEs even though the central bank does not plan on cutting short-term rates. Such pressure on mainland banks will intensify as growth slows in H2 2021. Hence, Chinese banks are also experiencing a net interest margin contraction. Reason #3: An Unfriendly Macro Cocktail For EM Our major global theme for 2021 is an economic boom in the US and a slowdown in China. Such a global macro dynamic warrants a rebound in the US dollar and a pullback in commodities prices. The US economy will be booming in H2 2021 facilitated by the general reopening of the economy, massive fiscal stimulus, rising employment and income growth as well as the release of pent-up demand for services. The Chinese economy is about to decelerate, as foretold by the rollover in money and credit impulses (Chart 7). China’s slowdown will lead to a decline in commodities prices and EM currencies (Chart 8). Chart 7China Is Set To Slow Down Chart 8Commodities And EM Currencies Are At Risk   Finally, one of the best leading indicators for EM EPS has been China’s narrow money growth. Chart 9 demonstrates that the latest rollover in Chinese narrow money growth heralds a slowdown in EM EPS later this year. Chart 9China's Narrow Money Heralds EM EPS Slowdown In H2 EM’s business cycle is very sensitive to China’s growth because many emerging economies sell to China as much if not more than to the US. An impending slowdown in China will cause a meaningful setback in commodities prices and will depress terms of trade for many EM (ex-China, Korea, Taiwan) economies. In turn, a booming US economy will herald higher US bond yields. Together, these dynamics will likely precipitate a rebound in the US dollar. In sum, such a macro cocktail could cause a capital exodus from EM in the coming months, depressing EM currencies and precluding many central banks from cutting interest rates proactively. As a result, EM local currency bond yields will not fall much, especially in vulnerable EM countries. Chart 10EM Ex-China, Korea And Taiwan: Banks Perform Poorly When Local Yields Rise Chart 10 demonstrates that the rise in EM local currency yields (shown inverted on the chart) is typically negative for EM (ex-China, Korea, Taiwan) bank stocks. This is opposite to the dynamics in the US and in Europe where bank share prices rally when bond yields rise. Reason #4: Chinese Bank Stocks Remain A Value Trap Market cap of Chinese bank stocks represents 25% of the MSCI EM bank index. Hence, the performance of Chinese bank share prices contributes significantly to the MSCI EM bank stock index. Chinese commercial banks’ assets have expanded 1.5-fold since early 2009 (Chart 11). The overwhelming part of this expansion has been driven by loan origination, purchases of corporate bonds and various claims on local governments and their affiliated vehicles.  We have written often and at length that there is no link between trends in bank assets and national or household savings. Critically, banks do not intermediate deposits into loans or savings into credit. This holds true in all countries around the world. Following such an epic credit boom in China since 2009, one would typically expect creditors in general and banks in particular to undertake a profound cleansing of their balance sheets, and for the amounts involved to be colossal. However, Chinese banks have not yet done this on a meaningful scale. We estimate that banks have disposed – written-off and sold – RMB 9.4 trillion in loans since 2012, which is equivalent to 6.6% of all loans originated since January 2009 (when the credit boom commenced). In addition, banks’ NPL provisions remain very low at 3.4% of their loan book. In a nutshell, Chinese banks have not yet sufficiently cleansed their balance sheets and carry a lot of non-recognized bad loans/assets. Investors doubt the quality of the banks’ books. As a result, Chinese banks’ share prices have been in limbo over the last ten years (Chart 12, top panel). Chart 11Chinese Bank Assets: An Epic Boom Chart 12Bank Stocks Have Been In Limbo In China, Japan, Korea And Taiwan   Provided that this issue of mainland bank asset quality is well known, the government will not allow a full-fledged banking crisis. However, authorities will also not recapitalize banks without current shareholders experiencing losses. Overall, Chinese bank share prices might share the fate of Japanese bank stocks. The latter has been in a secular bear market even though Japan has never had an acute credit crisis (Chart 12, second panel). In a nutshell, Korean and Taiwanese bank share prices have also delivered very poor returns over the past 20 years, even though these banks have not had an acute crisis and the credit-to-GDP ratios in these economies have been rising (Chart 12, third and fourth panels). The upshot is that a rising credit penetration is not sufficient to produce value for bank shareholders. The quality of credit assets, profit margins and the starting points of both equity valuation and bank capital adequacy matter for forward returns on bank stocks. A Word On Bank Stock Valuations Chart 13EM Ex-China, Korea And Taiwan: Banks Price-To-Book Value Ratio Even though Chinese bank stocks trade at very low multiples – the price-to-book value (PBV) ratio is presently 0.6, the latter represents a value trap. For comparison, the PBV ratio is 0.5 in Korea and 1.2 in Taiwan. Excluding China, Korea and Taiwan, the EM bank PBV ratio is well below its historical mean (Chart 13). However, this aggregate conceals the wide disparity among EM banks. Chart 14 plots banks’ return on equity (RoE) over the past 12 months on the X-axis and their PBV ratio on the Y-axis. There is a clear positive correlation between RoE and the PBV ratio.   Chart 14A Comparative Valuation Matrix For Global Bank Stocks Combining bank equity valuations and country macro fundamentals, within the EM bank space we favor banks in India, Mexico, Korea, the Czech Republic, Russia (barring a major military conflict in Ukraine) and Singapore. On the other hand, the most vulnerable are bank share prices in Brazil, Peru, Turkey, the Philippines, Malaysia and Indonesia. Concerning Chinese banks, we continue advocating the long large banks/short small and medium bank stocks strategy. The rationale is that a lot of bad news is already discounted in large bank stocks and little in listed small and medium bank stocks. In particular, the PBV ratio is 0.7 for large banks and 1.3 for small and medium banks. More so than large banks, small and medium banks are at risk from the new asset management regulation that will be implemented by the end of this year. Investment Recommendations We initiate a short EM banks / long DM banks position. This is a medium-term strategy for the next six months. This strategy is consistent with our tactical underweight in EM stocks versus DM stocks that we recommended on March 25. From a structural perspective, we continue recommending a neutral allocation to EM within a global equity portfolio. Today we are also publishing a report on India that highlights near-term downside risks to this bourse due to surging COVID-19 cases. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential super-spreader events. As a result, we recommend that asset allocators with less tolerance for volatility tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Chart 15Move Peruvian Stocks From Neutral To Underweight Finally, Peruvian bank stocks have been plunging on the heels of left-wing candidate Pedro Castillo lead in the presidential electionspolls ahead of the second round on June 6th. Chart 15 shows that surging NPLs (shown inverted) herald more downside in bank share prices. Consequently, in the context of political uncertainty, rising NPLs and a potential decline in metal prices, we are downgrading Peruvian equities from neutral to underweight. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 We refer to Taiwan (Province of China) herein in the report as Taiwan.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations