Economy

Highlights Our willingness to spend money depends on which ‘mental account’ it occupies. Once windfall income enters our ‘savings mental account’, we will not spend it. Hence, the pandemic’s windfall income receipts will have no sustained impact on spending, or on inflation. This means that US monetary tightening will be later and shallower than the market is pricing. As we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples). Fractal analysis: The US dollar, and base metals versus precious metals. Feature Chart of the WeekNo Tsunami Of Spending Despite Excess Income Many people claimed that the war chest of savings that global households accumulated during the pandemic would unleash a tsunami of spending. Well, it didn’t. For example, US consumer spending remains precisely on its pre-pandemic trend (Chart I-1 and Chart I-2). This, despite stimulus checks and other so-called ‘transfer payments’ which boosted aggregate household incomes by trillions of dollars. Indeed, paste over 2020, and you would be forgiven for thinking that there was no pandemic! Chart I-2No Tsunami Of Spending Despite Excess Income Of course, households that lost their livelihoods during the pandemic, and thus became ‘liquidity constrained’, did spend the lifeline stimulus payments that they received. Yet in aggregate, households did not spend the excess income received during the pandemic. Moreover, the phenomenon is global – the savings rate in the UK has surged near identically to that in the US (Chart I-3). Chart I-3The Savings Rate Has Surged Everywhere The excess income built up during the pandemic did not unleash a tsunami of spending. Neither will it unleash a tsunami of future spending. We can say this with high conviction because we have seen the same movie many times before. Previous tranches of stimulus and transfer payments that boosted incomes in 2004, 2008, and 2012 (though admittedly by less than in 2020) had no lasting impact on spending. Whether We Spend Or Save Money Depends On Which ‘Mental Account’ It Occupies Why do windfall income receipts not trigger a tsunami in spending? (Chart I-4) Chart I-4Stimulus Checks Had No Meaningful Impact On Spending One putative answer comes from Milton Friedman’s Permanent Income Hypothesis. Contrary to the Keynesian belief that absolute income drives spending, Friedman postulated that income comprises a permanent (expected) component and a transitory (unexpected) component. And only the permanent income component drives spending. In the permanent income hypothesis, spending is the result of estimated permanent income rather than a transitory current component. Therefore, for households that are not liquidity constrained, a windfall receipt – like a stimulus payment – will not boost spending if it does not boost estimated permanent income. Nevertheless, this theory does require households to estimate their future permanent incomes, and it is debatable if households can do this. Stimulus and transfer payments that boosted incomes in 2004, 2008, 2012, and 2020 had no lasting impact on spending. We believe that a more real-world answer to how we deal with windfalls comes not from Economics but from the field of Psychology, and the theory known as Mental Accounting Bias. Mental accounting bias states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, so that a dollar in a current (checking) account is no different to a dollar in a savings account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings or investment accounts we will not spend. Hence, the moment we move the dollar from our current account into our savings or investment account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. More likely, it will be used to reduce household debt, and thereby constrain the broad money supply. In effect, part of the recent increase in public debt will just end up decreasing private debt, as happened in Japan during the 1990s (Chart I-5). Chart I-5In Japan, Public Debt Ended Up Paying Down Private Debt With no permanent boost to spending, the pandemic’s windfall income receipts will have no sustained impact on inflation. As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable While consumer spending remains precisely on its pre-pandemic trend, the sub-components of this spending do not. Specifically, spending on durable goods stands way above its pre-pandemic trend, while spending on services languishes below trend (Chart I-6). Chart I-6The Pandemic Distorted Spending Patterns This makes perfect sense. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. Therefore, consumers just shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods. But now that shift is reversing. In turn, these massive and unprecedented shifts in spending patterns explain the recent evolution of inflation. As booming demand for durable goods created supply bottlenecks, durables prices skyrocketed (Chart I-7). Chart I-7The Pandemic Distorted Prices Remarkably though, the 10 percent spike in US durable good price through 2020-21 was the first increase in an otherwise persistently deflationary trend through this millennium (Chart I-8). As such, it was a huge aberration and as Jay Powell pointed out last week in Jackson Hole: Chart I-8The Increase In Durables Prices Was A Huge Aberration “It seems unlikely that durables inflation will continue to contribute importantly over time to overall inflation.” Meanwhile, with services simply unavailable, their prices did not fall, given that the price of something that cannot be bought is a meaningless concept. Moreover, unlike for an unbought durable good, which adds to tomorrow’s supply, an unbought service such as a theatre ticket – whose consumption is time-sensitive – does not add to tomorrow’s supply. Hence, when unavailable services suddenly became available, the initial euphoric demand for limited supply caused these service prices also to surge. But excluding such short-lived euphoria in airfares, car hire, and lodging way from home, services prices remain well-contained. This reinforces our conclusion from the first section. The pandemic’s windfall income receipts will have no sustained impact on inflation. As Jay Powell went on to say: “We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2 percent inflation on a sustainable basis.” All of which means that US monetary tightening will be later and shallower than the market is pricing. Another important investment conclusion is that as we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. The abnormally high spending on durables has a long way to fall. Given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market, this will weigh on consumer discretionary sectors (Chart I-9). Chart I-9As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples) (Chart I-10). Chart I-10Underweight XLY Versus XLP Fractal Analysis Update Fractal analysis suggests that the dollar’s rally since late-Spring could meet near-term resistance, given the incipient fragility on its 65-day fractal structure (Chart I-11). Chart I-11The Dollar's Rally Could Meet Near-Term Resistance A bigger vulnerability is for the strong and sustained rally in base metals versus precious metals, which is now extremely fragile on its 260-day fractal structure (Chart I-12). We are already successfully playing this through short tin versus platinum, but are adding a new expression: short aluminium versus gold. The profit target and symmetrical stop-loss are set at 13.5 percent. Chart I-12The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights China’s credit tightening may have surpassed maximum strength. Monetary policy will remain accommodative and fiscal policy will become more supportive in the rest of the year. However, overall regulatory oversight is still restrictive, limiting the scope of reflationary effects on the economy. There were signs that the “cross-cyclical” approach – a new catchphrase from the July Politburo meeting - emerged even before the start of the pandemic. The current policy backdrop resembles the situation in 2H2018. China’s new “common prosperity” plan, which sets up guidance for long-term policy direction, will likely have cyclical implications. Chinese investable stocks are in oversold territory and will probably rebound in the near term. In the next 6 to 12 months, however, we remain cautious given the lack of a catalyst to revive investor sentiment. Feature Chart 1Chinese Stocks Are Oversold In Absolute Terms China’s economic momentum has slowed, while regulatory crackdowns show no signs of dissipating. Meanwhile, Chinese investable stocks in absolute terms have slumped into technically oversold territory (Chart 1). Global investors are looking at fiscal and monetary policy easing for clues to what may be next. A shift in policy direction from restrictive to reflationary will help to shore up market sentiment and the outlook for the economy. Fiscal policy implementation in 1H21 was tighter than budgeted, leaving room for more support in 2H21. The PBoC’s unexpected reserve requirement ratio (RRR) cut in early July may have been a signal that policy tightening has ended. In short, China’s financial tightening has most likely passed its peak strength. Chart 2Valuations Are Almost Back To 2018 Lows We have no doubt that China will announce some compensatory measures in the coming months in response to rising downward pressures on the domestic economy. However, we continue to hold the view that the bar for a fresh round of material stimulus is higher today than it was in the past. The policy focus pivoting from a countercyclical to cross-cyclical adjustment, the rising emphasis on common prosperity, and the ongoing regulatory clampdowns in an array of industries, all limit the extent to which authorities can deploy the expected magnitude in infrastructure spending and bank lending. Therefore, we continue to recommend investors remain underweight Chinese stocks versus their global peers – a stance we have maintained since earlier this year – despite cheapened relative valuations in Chinese equities (Chart 2).  Shifting To A Cross-Cycle Approach China’s policy shift to a cross-cyclical stance has gained more market attention since the late-July Politburo meeting. However, there were signs that the cross-cyclical approach emerged even before the start of the pandemic. Chart 3Size Of Stimulus Was Already Getting Smaller During the height of the 2018/19 US-China trade war, policymakers responded to the economic shocks from imposed import tariffs with much more measured stimulus than in previous cycles (Chart 3). President Xi repetitively used the “Long March” analogy during the trade war, warning Chinese citizens to prepare for protracted hardship stemming from conflict with the US.1 The metaphor had important market implications because the attitude was fundamental to how the government handled the cyclical slowdown in 2018/19. Despite aggressive RRR and policy rate cuts in the second half of 2018, authorities maintained tight restrictions on bank lending and local government spending. Consequentially, aggregate credit growth continued to slide through end-2018 (Chart 4). Furthermore, authorities became uneasy about the sharp rise in the rate of credit expansion in Q1 2019. Following a public spat between the Premier Li Keqiang and the central bank, bank lending slowed sharply in the rest of the year. As a result, the improvement in infrastructure investment growth was small and short-lived. Despite an acceleration in local government bond issuance in 2H18 and Q1 2019, infrastructure investment growth remained on a structural downward trend throughout most of 2018 and 2019 (Chart 5). Chart 4China: A Deja Vu Of 2018-2019? Chart 5Improvement In Infrastructure Investment Was Short-Lived In 2019 Chart 6Financial De-Risking Mode Is Still On The current policy backdrop resembles the situation in 2H2018: while the central bank has kept interest rates at historically low levels and preemptively cut the RRR rate in July, lending standards remain tight and shadow bank credit continues to shrink (Chart 6).  In the past Chinese authorities stimulated substantially following exogenous shocks, but did not stimulate much when business cycle was slowing in an orderly manner.  A resurgence of domestic COVID cases and the severe flood in central China in July and August represent exogenous shocks and occured when the economy was losing steam. Hence, there are higher odds authorities will provide some support in response to these exogenous shocks. However, the recurring battle against COVID and lingering tensions with the US have likely prompted Chinese top leadership to extend their cross-cycle strategy. Officials may feel that a modest easing in both monetary and fiscal policies will be sufficient to offset the current economic weakness without overstimulating the economy.   Bottom Line: A cross-cycle policy approach means not only responding early to small shocks with piecemeal stimulus to stabilize growth but also limiting the scope of stimulus and preparing for “protracted battles”. The response from Chinese leaders during the trade war with the US in 2018/19 may be a roadmap for policy direction in the next 12 months.  Cyclical Implications From “Common Prosperity”  President Xi Jinping laid out a plan for “common prosperity”, a guideline for the country’s national policy in the coming decades, at the August 18th Central Committee for Financial and Economic Affairs.  Most of the plan’s objectives have 2035 deadlines and will be achieved gradually in multiple phases.2 However, in the next 12 months and leading to the 20th National Party Congress in the fall of 2022, we expect the authorities to accelerate some reform agendas that are consistent with the 14th Five-Year Plan (2021-2025). A key area that may gain momentum is increasing labor income and household consumption share in national output. Both labor compensation and household consumption as a share of GDP improved from 2011 to 2016, but the progress stalled in recent years and further deteriorated last year in the wake of the pandemic (Chart 7). Policy decision makers can reverse the falling share by either boosting income/consumption or lowering the share of capital formation in the national output, or a combination of both. Regulatory tightening in the property market has reduced investment growth in the sector, which accounts for 66% of the country’s total fixed-asset formation (Chart 8). We expect policy restrictions to continue curbing real estate investment in the rest of the year and into 2022, further shrinking the share of capital formation in the aggregate output.3 Chart 7China's Economic Rebalancing Progress Has Stalled In The Past Five Years Chart 8Policymakers Are Moving Away From The 'Old Economy' Pillars Chart 9Recovery In Household Income And Consumption Has Significantly Lagged Other Sectors Recovery in household income and consumption has significantly lagged other sectors in China’s recent economic rebound (Chart 9). In addition to short-term, pandemic-related factors, household consumption has been sluggish due to China’s long-standing imbalanced income distribution.  Given that China will be under more pressure to deliver economic progress in 2022, boosting wage growth and consumption will help to facilitate both the nation’s cross-cyclical economic strategy and President Xi’s longer-term reform plan for income and wealth redistribution. If successfully implemented, a rebalancing of labor income and consumption as a share of the national aggregate will have long-term economic benefits. However, for investors with a cyclical time frame, the transition will likely have the following implications on the market: Policymakers will keep a large fiscal budget deficit and increase spending in public services and social welfare, but there will be more pressure on the central government to keep local government debt in check. The increased fiscal burden also means that while the government will provide subsidies for households and key new-economy industries, policy at margin may move away from boosting investment in traditional infrastructure and construction (Chart 10). Chart 10Traditional Infrastructure Investment Will Remain Subdued Empirical research shows that lower-income households have a higher marginal propensity to consume.4 Last year China refrained from meaningful stimulus to incentivize consumption. In contrast, the statement from the August 18th meeting indicated the focus is on securing living standards and wages among lower-income households. Common prosperity related policies may boost consumption of staples and some durable goods but will likely discourage splurging in high-end luxury goods and services. Large corporations and high-net-worth individuals will be expected to share social responsibility and the cost of reducing income inequality, either through higher and stricter tax burdens, raising minimum wages for employees, and/or donations. Bottom Line: The “common prosperity” theme will mostly entail long-term policy initiatives, but it may also have some cyclical market repercussions. Investment Recommendations Chart 11Tactical Bounce Gave Way To Cyclical Downturn In Previous Cycles We do not rule out the possibility of a tactical (within the next three months) / technical rebound in Chinese stocks. Our August 4th report discussed how prices managed to rebound strongly within 90 days of the policy-triggered market riots in both 2015 and 2018. However, the rallies quickly faded and stocks fell to new lows (Chart 11). Prices bottomed when policy decisively turned reflationary. For now, the risks to Chinese equities are largely to the downside. Although there are some remedial measures to ease monetary and fiscal policies, officials have not sent a clear signal to ease on the regulatory front. Conversely, there are two scenarios that could prompt us to upgrade Chinese stocks to either neutral or overweight in both absolute and relative terms. Chart 12No Clear Signal Chinese Policymakers Will Ease On The Regulatory Front The first scenario is that the economy does not slow further and a modest policy easing is sufficient to stabilize the economic outlook. This may happen if strong global economic growth and demand continue to support China’s export and manufacturing sectors, while domestic household consumption improves. In this case, the downside risks on the overall economy would abate, but the gradual underlying downtrend in China's old economy would be intact. We would need an additional reflationary tailwind, such as a boost from fiscal spending or a reversal of industry policy tightening, to upgrade Chinese stocks to overweight. We have argued in the past that housing appears to be the best candidate; the catalyst is missing at the moment (Chart 12). In the second scenario, Chinese policymakers may determine that the downside risks to growth are unacceptably large given existing slowdowns in the industrial and service sectors, and decide to temporarily reverse course on structural reforms. We will watch for indications of a shift in attitude. For now, we think that China’s leadership has a higher pain threshold than in the past, suggesting that this outcome is not yet probable.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1"Xi Jinping calls for ‘new Long March’ in dramatic sign that China is preparing for protracted trade war", South China Morning Post. 2"Xi stresses promoting common prosperity amid high-quality development, forestalling major financial risks", Xinhua, English.news.cn 3We use fixed-asset investment (FAI) as a proxy for gross fixed capital formation (GFCF) because the National Bureau of Statistics of China does not publish the GFCF breakdown by sectors. GFCF comprises FAI, less the purchase of existing fixed assets, land and some minor items. Historically, the two series have closely tracked each other. 4"The Stimulative Effect of Redistribution", Federal Reserve Bank of San Francisco Market/Sector Recommendations Cyclical Investment Stance