Bubbles
Dear Client, In addition to our regular report, this week we are sending a Special Report written by my colleague Lucas Laskey from BCA Research’s Equity Analyzer service titled “Is The Reopening Trade Closed?”. The report discusses the state of the reopening trade through the lens of Equity Analyzer's factor model. I hope you find the report insightful. Additionally, please join us next week on Friday, May 7, 2021 at 10am EDT as I moderate a debate between my colleagues Arthur Budaghyan, BCA Research’s Chief Emerging Market Strategist, and Robert Ryan, Chief Commodity & Energy Strategist. Titled “A Debate On Commodities,” Arthur and Bob will discuss the outlook for commodities, touching on the trajectory both DM and China/EM growth will follow, the path for the US dollar, and other cyclical and structural forces currently shaping commodity markets. During the webcast, Arthur and Bob will highlight the areas they disagree on and the reasons behind their differing views. Best regards, Peter Berezin Chief Global Strategist Highlights Bitcoin is on a collision course with ESG. ESG interests will win out. Widespread adoption of cryptocurrencies, if it were to happen, would erode the purchasing power of traditional money, while robbing governments of billions of dollars in seigniorage revenue. Governments have already begun to take steps to thwart such an outcome. Restrictions on the use of cryptocurrencies will only increase over the coming years. The rollout of Central Bank Digital Currencies (CBDCs) represents an existential threat not only to cryptos, but potentially to credit card companies and online payment processors such as PayPal, Square, Venmo, WeChat Pay, and Alipay. Shorting cryptocurrencies, meme stocks, or any other high-flying asset is risky business. Fortunately, there is a way to flip the usual risk-reward from going short on its head. Rather than facing unlimited losses and a maximum gain of only 100% of the initial position, we outline a shorting strategy that caps the loss at 100% but allows for unlimited gains. Bitcoin’s Questionable ESG Record Crypto critics have often blamed cryptocurrencies for facilitating illicit transactions and enlarging the world’s carbon footprint. There is some truth to both claims. Motivated to avoid detection, online scammers, smugglers, and terrorists have been drawn to cryptocurrencies. Cryptos have also been used to evade capital controls and conceal wealth from the tax authorities. On the environmental side, Bitcoin mining now consumes more energy than entire countries such as Sweden, Argentina, and Pakistan (Chart 1). Moreover, about 70% of Bitcoin mining currently takes place in China, mainly using electricity generated by burning coal. A lot of the remaining mining occurs in countries such as Russia and Iran with questionable governance records. Chart 1How Dare You, Bitcoin Cryptos And Inequality One criticism of Bitcoin that is less frequently mentioned is its role in exacerbating wealth inequality. We are not just talking about the small number of “whales” who amassed huge fortunes by buying or mining Bitcoin shortly after it was created. If these whales sell their coins at today’s prices and the price of Bitcoin eventually crashes, those early investors will have ended up profiting at the expense of smaller investors who bought at the top. While such a transfer of income may be unsavory, it is not much different from what happens when someone sells a high-flying stock to the proverbial bagholder just as the stock is peaking. The more interesting question is what happens if Bitcoin prices do not crash. It might be tempting to think that in such a scenario, no one would be worse off. But that is incorrect. There would still be losers, and importantly, these losers would consist of people who never bought or sold Bitcoin in their lives. To see why, ask yourself who suffers from counterfeit currency. One possibility is shopkeepers who inadvertently accept counterfeit cash and find themselves stuck with worthless money. But even if the counterfeit money is never detected, there would still be losers: Fake money dilutes the value of genuine money, making everyone who holds the genuine money worse off. Crypto evangelists like to argue that cryptocurrencies offer protection against the “debasement of fiat money.” Ironically, the widespread adoption of cryptocurrencies could produce a self-fulfilling cycle that leads to just such an inflationary outcome. If enough people decide to swap fiat currencies for cryptos, the dollar and other fiat monies could become “hot potatoes.” The price of cryptos would rise in relation to dollars. Feeling more wealthy, crypto holders would spend some of their wealth on goods and services. As long as the economy is operating below potential, this would not be such a bad thing since increased spending would generate more output and employment. However, once the output gap disappears, more spending would result in higher inflation. The purchasing power of fiat currencies would decline. The Empire Strikes Back Will governments allow such a massive transfer of wealth from holders of fiat currencies to holders of crypto currencies to occur? It seems highly unlikely. In order to entice people to hold on to their fiat currency bank deposits, central banks would have to raise interest rates. Debt-strapped governments would not like that. Governments also generate significant revenue from their ability to print currency and then exchange it for goods and services. For the US, this “seigniorage revenue” is around $100 billion per year (Chart 2). No government will want to part with this revenue. A financial system where loans and deposits are denominated in cryptocurrencies would be highly unstable. Even if the supply of each individual cryptocurrency were capped, the rise and fall of competing cryptocurrencies could still result in large shifts in the aggregate cryptocurrency money supply. Moreover, wild swings in cryptocurrency prices, both versus fiat currencies and one another, could destroy any semblance of price stability. The value of bank loans made in Bitcoin or other cryptos would experience great fluctuations. Powerless to issue cryptocurrencies themselves, central banks would not be able to provide unlimited liquidity support to commercial banks as they do now. The situation would resemble the US in the late 19th century when myriad currencies competed with one another and the financial system veered from one crisis to another (Chart 3). Chart 2Governments Will Not Part With Seigniorage Revenue Chart 3An Inelastic Money Supply Historically Led To More Banking Crises What Is It Good For? One might argue that the ultimate aim of cryptocurrencies is not to displace fiat money. Okay, but if Bitcoin can never truly function as a medium of exchange or a unit of account, what exactly underpins its utility as a store of value? At least with gold, you get an extremely rare metal, forged in the collision of neutron stars billions of years ago, that has great aesthetic value. With cryptos, you get fairy dust. In past reports, we referred to Bitcoin as a “solution in search of a problem.” In retrospect, that characterization was much too charitable. Bitcoin is a problem in search of a problem. Whereas the Visa network can process over 20,000 transactions per second, the Bitcoin network can barely process five (Chart 4). Bitcoin transactions take 10 minutes-to-an hour to complete compared to just a few seconds for most debit or credit card transactions. The average fee for a Bitcoin transaction is around $30. This fee has been rising, not falling, over the past few years (Chart 5). Chart 4Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 5Bitcoin: The Cost Per Transaction Is Rising Look Out Below Table 1A Growing List Of Cryptocurrency Bans Cryptos are heading for a world of pain. ESG concerns will force companies to step back from their newfound infatuation with these magic beans. Meanwhile, governments will tighten the screws on cryptocurrencies while rolling out their own digital monies. As my colleague Chester Ntonifor pointed out last week, a growing list of countries have already moved to ban Bitcoin transactions (Table 1). In addition, most G10 central banks have outlined their own digital currency plans (Map 1). Not only will Central Bank Digital Currencies (CBDCs) squeeze out decentralised cryptocurrencies, they will also pose an existential risk to credit card companies and online payment processors such as PayPal, Square, Venmo, WeChat Pay, and Alipay. Map 1Many Central Banks Are Planning A Digital Currency The Risk Of Shorting Bitcoin These days, there is no shortage of ways to short Bitcoin. Many cryptocurrency platforms permit short selling. In addition, one can bet against Bitcoin through the futures market. To the extent that the fortunes of companies such as Coinbase are tied to the crypto market, one can also express a short view on cryptos through listed equities. Yet, shorting cryptos is a risky strategy. Cryptocurrencies do not have any intrinsic value. What you think a Bitcoin is worth depends on what others think it is worth and vice versa. At present, the value of all Bitcoins that have ever been issued is about $1 trillion. Eighteen cryptocurrencies have valuations exceeding $10 billion (Table 2). The market capitalization of all cryptocurrencies in circulation stands at $2 trillion. In contrast, the value of all the gold that has ever been mined is around $10 trillion (Chart 6). It is certainly possible that euphoric investors will push up the value of cryptocurrencies to the point that they are collectively worth more than all the gold in the world. Table 2Close To 20 Cryptos Have A Market Cap In Excess Of US$10bn Chart 6Gold Versus Cryptocurrencies To guard against this risk, one needs a prudent strategy for shorting not just high-flying cryptocurrencies, but any security whose price can rise significantly. Luckily, such a strategy exists. How To Short Without Losing Your Shorts Clients sometimes ask me what I invest my money in. The answer is that most of my liquid wealth is held in publicly traded US small cap stocks. I have been investing in this space for over two decades (prior to joining Goldman, I even wrote a blog about it). I used my knowledge of stock picking to develop an early version of BCA’s Equity Analyzer. David Boucher and his team have since transformed it into a powerful, state-of-the-art stock selection service. Table 3Don’t Be Like Melvin Shorting small cap stocks is risky business. To limit the risk, I have employed a strategy that flips the usual risk-reward from shorting on its head. Normally, when you short a stock, your gain is capped at 100% of the initial position whereas your potential loss is unlimited. With my shorting technique, your potential loss is capped at 100% while your potential gain is unlimited. To illustrate how the strategy works, let us consider shorting one particular overpriced “meme” stock that has been in the news a lot this year. I won’t single out the name of the company, other than to note that it begins with “G” and ends with “stop.” At the time of writing, this mystery stock was trading at $180 per share. Suppose you shorted 1,000 shares at that price. The basic idea is to then short 2% more shares if the price falls by 1% and cover 2% of your shares if the price rises by 1%. So, in this case, you would increase your short position to 1020 shares if the price were to fall to around $178 but cover 20 shares (leaving you with 980 shares short) if the price were to rise to $182. Table 3 shows the number of shares you would need to be short for any given price between $5 and $360. If the price of the shares were to fall to $10 (double what it was last August), the strategy would generate roughly $3,060,000 in profits.1 In contrast, if the price were to rise to $360 per share, the strategy would incur a loss of $90,000. Even if the price went to infinity, the most you would lose is $180,000. There are a number of challenges to implementing this strategy: 1) It requires frequent trading; 2) gap downs and gap ups in the price could meaningfully hurt the results; 3) it is not always possible to short a stock and even when it is, the borrowing costs could be high, etc. Nevertheless, as a “rule of thumb,” I have found this strategy to be extremely effective in mitigating risk. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Notice that the profit of $3,060,000 from going short 1,000 shares in the case where the price of the stock falls from $180 to $10 is equal to 17 times the initial short position of $180,000 (i.e., $3,060,000 divided by 180,000 is 17). This is exactly the same return that one would earn if one went long the stock and the price rose from $10 to $180. In this case, the profit would also be equal to 17 times the initial investment (i.e., $1,800,000-$100,000 divided by $100,000 is 17). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights The Federal Reserve’s ultra-dovish stance is not the only reason for markets to cheer. The US is booming, China is unlikely to overtighten monetary and fiscal policy, and Europe remains a source of positive political surprises. Still, the cornerstone of this cycle’s wall of worry has been laid: Biden faces a series of foreign policy challenges, the US is raising taxes, China is tightening policy, and Europe’s stimulus is not large enough to qualify as a game changer for potential GDP growth. Stay the course by maintaining strategic pro-cyclical trades yet building up tactical hedges and safe-haven plays. Feature Chart 1US Stimulus, Chinese Tightening, German Vaccine Hiccups The US is turning to tax hikes, China is returning to structural reforms, and Europe is bungling its vaccine rollout. Yet synchronized global debt monetization is nothing to underrate. Especially not in the context of a Great Power struggle that features a green energy race as well as a high-tech race. Governments are generating a cyclical growth boom and it is conceivably that their simultaneous pump-priming combined with a new capex cycle and private innovation could generate a productivity breakthrough. This upside risk is keeping global equity markets bullish even as it becomes apparent that construction has begun on this cycle’s wall of worry. The US dollar bounce should be watched closely in this context (Chart 1). After passing the $1.9 trillion American Rescue Plan Act, which consists largely but not entirely of short-term cash handouts (Chart 2), President Joe Biden’s policy agenda will now turn to tax hikes. Thus far the tax hike proposals are in line with Biden’s campaign literature (Table 1). It remains to be seen whether the market will “sell the news” that Biden is pivoting to tax hikes. After all, Biden was the most moderate of the Democratic candidates and his tax proposals only partially reverse President Trump’s tax cuts. Chart 2American Rescue Plan Act Table 1Biden’s Tax Hike Proposals On The Campaign Trail Nevertheless higher taxes symbolize a regime change in the US – it is very unlikely tax rates will go down anytime soon but they could go easily higher than expected in the coming decade – and the drafting process will bring negative surprises, as Treasury Secretary Janet Yellen highlighted by courting Europe to cooperate on a 12% minimum corporate tax and halt the global race to the bottom in taxes on multinational corporations. At the same time Biden’s foreign policy challenges are rising across the board: China is demanding a rollback of Trump’s policies: If Biden says yes, he will sacrifice hard-won American leverage on matters of national interest. If he says no, the Phase One trade deal will be null and void, as will sanctions on Iran and North Korea, and the new economic sanctions on Taiwan will expand beyond mere pineapples.1 Russia is recalling its US ambassador: Biden vowed to make Russia pay for alleged interference in the 2020 US election and sanctions are forthcoming.2 The real way to make Russia pay is to halt the construction of the Nordstream II natural gas pipeline, which reduces the leverage of eastern European democracies while increasing Germany’s energy dependence on Russia. But Germany is dead-set on that pipeline. If Biden levies sanctions the centerpiece of his diplomatic outreach to Europe will be further encouraged to chart an independent course from Washington (though the rest of Europe might cheer). North Korea is threatening to restart missile tests: North Korea is pouring scorn on the Biden administration for trying to restart negotiations.3 The North wants sanctions relief and it knows that Biden is willing to offer it but it may need to create an atmosphere of crisis first. China would be happy were that to happen as it could offer the US its good services on North Korea instead of concrete trade concessions. Iran is refusing to rejoin negotiations over the 2015 nuclear deal: Biden has about five months to arrange for the US and Iran to rejoin the 2015 nuclear deal. Beyond that he will enter into another long negotiation with the master negotiators, the Persians. But unlike President Obama from 2009-15, he will not have support from Russia and China … unless he sacrifices his doctrine of “extreme competition” from the get-go. It is not clear which of these challenges will be relevant to financial markets, or when. However, with US and global equities skyrocketing, it must be said that the geopolitical backdrop is not nearly as reassuring as the Federal Reserve, which announced on Saint Patrick’s Day that it will not hike interest rates until 2024 even in the face of a 6.5% growth rate and the prospect of an additional, yet-to-be passed $2 trillion in US deficit spending. Herein lies Biden’s first victory. He has stressed that boosting the American economy and middle class is critical to his foreign policy. He envisions the US regaining its global standing by defeating the virus, super-charging the economy, and then orchestrating a grand alliance of European and Asian democracies to write new global rules that will put pressure on China to reform its economy. “I say it to foreign leaders and domestic alike. It's never, ever a good bet to bet against the American people. America is coming back. The development, manufacturing, and distribution of vaccines in record time is a true miracle of science.”4 The pandemic and economic part of this agenda are effectively done and now comes the hard part: creating a grand alliance while China and Russia demonstrate to their neighbors the hard consequences of joining any new US crusade. The contradiction of Biden’s foreign policy is his desire to act multilaterally and yet also get a great deal done. The Europeans are averse to conflict with China and Russia. The Russians and Chinese are not inclined to do any great favors on Iran or North Korea. Nobody is opening up their economy – Biden himself is coopting Trump’s protectionism, if less brashly. Cooperation with Presidents Xi Jinping and Vladimir Putin on nuclear proliferation is possible – as long as Biden aborts his democracy agenda and his trade agenda. We continue with our pro-cyclical investment stance but have started building up hedges as we are convinced that geopolitical risk will deliver a rude awakening. This awakening will be a buying opportunity given the ultra-stimulating backdrop … unless it portends war in continental Europe or the Taiwan Strait. In the remainder of this report we highlight the takeaways from China’s National People’s Congress as well as recent developments in Germany. Our key views remain the same: China will not overtighten monetary/fiscal policy; Biden will be hawkish on China; Germany’s election may see an upset but that would be market-positive. China: No Overtightening So Far China concluded its National People’s Congress – the “Two Sessions” of legislation every year – and issued its 2021 Government Work Report. It also officially released the fourteenth five-year plan covering economic development for 2021-25. Table 2 shows the new plan’s targets as compared to the just expired thirteenth five-year plan that covered 2016-20. Table 2China’s Fourteenth Five Year Plan (2021-25) For a full run-down of the National People’s Congress we recommend clients peruse BCA’s latest China Investment Strategy report. From a geopolitical point of view we would highlight the following takeaways: The Tech Race: China added a new target for strategic emerging industry value added as percent of GDP – it wants this number to reach 17% by 2025 but there is nothing solid to benchmark this against. The point is that by including such a target China is putting more emphasis on emerging industries, including: information technology, robotics, green energy, electric vehicles, 5G networks, new materials, power equipment, aerospace and aviation equipment, and others. China’s technological “Great Leap Forward” continues, with a focus on domestic production and upgrading the manufacturing sector that is bound to stiffen the competition with the United States. China’s removal of a target for service industry growth suggests that Beijing does not want de-industrialization to occur any faster – another reason for global trade tensions to stay high. Research and Development: For R&D spending, previous five-year plans set targets for the desired level. For example, over the last five years China vowed to increase annual R&D spending to 2.5% of GDP. A reasonable expectation for the coming five years would have been a 3% target of GDP. However, this time the government set a target of an annual growth rate of no less than 7% during 2021-2025. The point is that China is continuing to ascend the ranks in R&D spending relative to the US and West in coordination with the overarching goal of forging an innovative and high-tech economy. Unemployment: China has restored an unemployment rate target. In its twelfth five-year plan Beijing aimed to keep the urban surveyed unemployment rate below 5% but over the past five years this target vanished. Now China restored the target and bumped it up slightly to 5.5%. This target should not be hard to meet given the reported sharp decline in urban unemployment to 5.2% already. However, China’s unemployment statistics are notoriously unreliable. The real takeaway is that unemployment will be higher as trend growth slows, while social stability remains the Communist Party’s ultimate prize – and any reform or deleveraging process will occur within that context. The Green Energy Race: China re-emphasized its pledge to tackle climate change, aiming for peak carbon emissions by 2030 and carbon neutrality by 2060. However, no detailed action plans were mentioned. Presumably China will not loosen its enforcement of existing environmental targets. Most of these were kept the same as over the past five years, except for pollution (PM2.5 concentration). Previously the government sought to reduce PM2.5 concentration by 18%. Now the target is set at 10% aggregate reduction, which is lower, though further reduction will be difficult after a 43% drop since 2014. Overall, China has not loosened up its environmental targets – if anything, enforcement will strengthen, resulting in an ongoing regulatory headwind to “Old China” industries. Military Power: Last week we noted that the government’s goals for the military have changed in a way that reinforces themes of persistently high geopolitical tensions. The info-tech upgrades to the People’s Liberation Army were supposed to be met by 2020, with full “modernization” achieved by 2035. However, last October the government created a new deadline, the one-hundredth anniversary of the PLA in 2027 (“military centenary goal”). No specific measures or targets are given but the point is that there is a new deadline of serious importance – an importance that matches the party’s much-ballyhooed centennial on July 1 of 2021 and the People’s Republic’s centennial in 2049. The fact that this deadline is only six years away suggests that a rapid program of military reform and upgrade is beginning. The official defense spending growth target of 6.8% is only slightly bigger than last year’s 6.6% but these targets mask the significance of the announcement. The takeaway is that the Chinese military is preparing for an earlier-than-expected contingency with the United States and its allies. What about China’s all-important monetary, fiscal, and quasi-fiscal credit targets? There is no doubt that China is tightening policy, as we highlight in our updated China Policy Tightening Checklist (Table 3). But will China overtighten? Probably not, at least not judging by the Two Sessions, but the risk is not negligible. Table 3A Checklist For Chinese Policy Tightening The government reiterated that money and credit growth should remain in a reasonable range in 2021, with “reasonable range” referring to nominal economic growth. Chinese economists estimate that the nominal growth rate will be around 8%-9% in 2021. The IMF projection is 8.1%, while latest OECD forecast is at 7.8%.5 Because China’s total private credit (total social financing) growth is inherently higher than M2 growth, we would use pre-pandemic levels as our benchmark for whether the government will tighten policy excessively: If total social financing growth plunges below 12%, then our view is disproved and Beijing is over-tightening (Chart 3). If M2 growth plunges below 8%, we can call it over-tightening. Anything above these benchmarks should be seen as reasonable and expected tightening, anything below as excessive. However, the Chinese and global financial markets could grow jittery at any time over the perennial risk of a policy mistake whenever governments try to prevent excessive leverage and bubbles. As for fiscal policy, the new quotas for local government net new bond issuance point to expected rather than excessive tightening. New bonds can be used to finance capital investment projects. The quota for total new bond issuance is 4.47 trillion CNY, down by 5.5% from last year. Though local governments may not use up all of the quota, the reduction is small. In fact, total local government bond issuance will be a whisker higher in 2021 than in 2020. The quota for net new bonds is only slightly below the 2020 level and much higher than the 2019 level. Therefore the chance of fiscal overtightening is small – and smaller than monetary overtightening. Chart 3China Policy Overtightening Benchmark Chart 4China’s Real Budget Deficit Is Huge China’s official budget balance is a fiction so we look at the IMF’s augmented net lending and borrowing, which reached a whopping -18.2 % of GDP in 2020. It is expected to decrease gradually to -13.8% by 2025. That level will be slightly higher than the pre-pandemic level from 2017-2019 (Chart 4).6 By contrast, China’s total augmented debt is expected to keep rising in the coming years and reach double the 2015 level by 2025. Efforts to constrain debt could lead to a larger debt-to-GDP ratio if growth suffers as a consequence, as our Global Investment Strategy points out. So China will tighten cautiously – especially given falling productivity, higher unemployment, and the threat of sustained pressure from the US and its allies. US-China: Biden As Trump-Lite Chinese and US officials will convene in Alaska on March 18-19. This is the first major US-China meeting under the Biden administration and global investors will watch closely to see whether tensions will drop. So far tensions have not fallen, highlighting a persistent and once again underrated risk to the global equity rally. Biden’s foreign policy team has not completed its review of China policy and Presidents Biden and Xi Jinping are trying to schedule a bilateral summit in April – so nothing concrete will be decided before then. Chart 5US-China: Beijing's Standing Offer The Biden administration is setting up a pragmatic policy, offering areas to engage with China while warning that it will not compromise on democratic values or national interests. China would welcome the opportunity to work with the Americans on nuclear non-proliferation, namely North Korea and Iran, as this would expend US leverage on an area of shared interest while leaving China a free hand over its economic and technological policies. China at least partially enforced sanctions on these countries in response to President Trump’s demands during the trade war and official statistics suggest it continues to do so. Oil imports from Iran remain extremely low while Chinese business with North Korea is, on paper, nil (Chart 5). If this data is accurate then North Korea’s economy has not benefited from China’s stimulus and snapback. If true, then Pyongyang will offer partial concessions on its nuclear program in exchange for sanctions relief. At the moment, instead of staging any major provocations to object to US-Korean military drills, the North is using fiery language and threatening to restart missile tests. This suggests a diplomatic opening. But investors should be prepared for Pyongyang to stage much bigger provocations than missile tests. In March 2010, while the world focused on the financial crisis, the North Koreans torpedoed a South Korean corvette, the Chonan, and shelled some islands, at the risk of a war. The problem under the Trump administration was that Trump wanted a verifiable and durable deal of economic opening for denuclearization whereas the North Koreans wanted to play for time, reduce sanctions, study the data from their flurry of missile tests during the Obama and early Trump years, and see if Trump would get reelected before offering any concrete concessions. Trump’s stance was not really different from Bill Clinton’s but he tried to accelerate the timeline and go for a big win. By Trump’s losing the election North Korea bought four more years on the clock. Chart 6US-China: Biden Lukewarm On China The Biden administration is willing to play for time if it gets concrete results in phases. This would keep North Korea at bay and retain a line of pragmatic engagement with Beijing. But if North Korea stages a giant provocation Biden will not hesitate to use threats of destruction like Clinton and Trump did. The American public is not much concerned about North Korea (or Iran) but is increasingly concerned about China, with a recent Gallup opinion poll showing that nearly 50% view China as America’s greatest enemy and Americans consistently overrate China’s economic power (Chart 6). Biden will not let grassroots nationalism run his policy. But it is true that he has little to gain politically from appearing to appease China. With progress at hand on the pandemic and economic recovery, Biden will devote more attention to courting the allies and attempting to construct his alliance of democracies to meet global challenges and to “stand up” to China and Russia. The allies, however, are risk-averse when it comes to confronting China. This is as true for the Europeans as it is for China’s Asian neighbors, who stand directly in its firing line. In fact, Europe’s total trade with China is equivalent to that of the US (Chart 7). The Europeans have said that they will pursue tougher trade enforcement through the World Trade Organization, which would tie the Biden administration’s hands. Biden and his cabinet officials insist that they will use the “full array” of tools at their disposal (e.g. tariffs and sanctions) to punish China for mercantilist trade policies. Chinese negotiators are said to be asking explicitly for Biden to roll back Trump’s policies. Some of these policies relate to trade and tech acquisition, others to strategic disputes. We doubt that Biden will compromise on the trade issues to get cooperation on North Korea and Iran. But he will have to offer major concessions if he wants durable denuclearization agreements on these rogue states. Otherwise it will be clear that his administration is mostly focused on competition with China itself and willing to sideline the minor nuclear aspirants. Our expectation is that Americans care about the China threat and the smaller threats will be used as pretexts with which to increase pressure and sanctions on China. Asian equities have corrected after going vertical, as expected. But contrary to our expectations geopolitics was not the cause (Chart 8). This selloff could eventually create a buying opportunity if the Biden administration is revealed to take a more dovish line on China, trade, and tech in exchange for progress on strategic disputes like North Korea. Any discount due to North Korean provocations in particular would be a buy. On Taiwan, however, China’s new 2027 military target underscores our oft-recited red flag. Chart 7EU Risk Averse On China Chart 8Asian Equity Correction And GeoRisk Indicators Bottom Line: Investors should stay focused on the US-China relationship. What matters is Biden’s first actions on tariffs and high-tech exports. So far Biden is hawkish as we anticipated. Investors should fade rumors of big new US-China cooperation prior to the first Biden-Xi summit. Any major North Korean aggression will create a buy-on-the-dips opportunity. Unless it triggers a war, that is – and the threshold for war is high given the Chonan incident in 2010. Germany: Markets Wake Up To Election Risk – And Smile This week’s election in the Netherlands delivered a fully expected victory to Prime Minister Mark Rutte’s liberal coalition. The German leadership ranks next to the Dutch in terms of governments that received an increase in popular support as a result of the COVID-19 crisis (Chart 9). However, in Germany’s case the election outcome is not a foregone conclusion. Chart 9German Leadership Saw Popularity Bounce As we highlighted in our annual forecast, an upset in which a left-wing bloc forms the government for the first time since 2005 is likelier than the market expects. This scenario presents an upside risk for equities and bund yields since Germany would become even more pro-Europe, pro-integration, and proactive in its fiscal spending. In the current context that would be greeted warmly by financial markets as it would reinforce the cyclical rotation into the euro, industrials, and European peripheral debt. Incidentally, it would also reduce tensions with Russia and China – even as the Biden administration is courting Germany. Recent state elections confirm that the electorate is moving to the left rather than the right. In Baden-Wurttemberg, the third largest state by population and economic output, and a southern state, the Christian Democrats slipped from the last election (-2.9%), the Social Democrats slipped by less (-1.7%), the Free Democrats gained (2.2%), the Greens gained (2.3%), and the far-right Alternative for Germany saw a big drop (-5.4%). In the smaller state of Rhineland-Palatinate the results were largely the same although the Greens did even better (Tables 4A & 4B).7 In both cases the Christian Democrats saw the worst result since prior to the financial crisis while the Greens tripled their support in Baden and doubled their support in the Palatinate over the same time frame. Table 4AGerman State Elections Show Voters’ Leftward Drift Continues Table 4BGerman State Elections Show Voters’ Leftward Drift Continues To put this into perspective: Outgoing Chancellor Angela Merkel and her coalition have seen a net 6% increase in popular support since COVID-19. The coalition, led by the Christian Democratic Union and its Bavarian sister party, the Christian Social Union, still leads national opinion polling. What we are highlighting are chinks in the armor. The gap with the combined left-leaning bloc is less than 10% points (Chart 10). Chart 10German Party Polling Merkel is a lame duck whose party has been in power for 17 years. She is struggling to find an adequate successor. Her current frontrunner for chancellor-candidate, Armin Laschet, is suffering in public opinion, especially after the state election defeats, while her previous successor was ousted last year. Other chancellor-candidates, like Friedrich Merz, Markus Söder, and Norbert Röttgen may find themselves to the right of the median voter, which has been shifting to the left. Merkel’s party’s handling of COVID-19 first received praise and now, in the year of the vote, is falling under pressure due to difficulties rolling out the vaccine. Even as conditions improve over the course of the year her party may struggle to recover from the damage, since the underlying reality is that Germany has suffered a recession and is beset by global challenges. While the Christian Democrats performed relatively well in the 2009 election, in the teeth of the global financial crisis, times have changed. Today the Social Democrats are no longer in free fall – ever since their Finance Minister Olaf Scholz led the charge for fiscal stimulus in 2019 – while third parties like the Free Democrats, Greens, and Die Linke all gained in 2009 and look to gain this year (Table 5). In today’s context it is even more likely that other parties will rise at the ruling party’s expense. Still, the Christian Democrats have stout support in polls and do not have to split votes with the far-right, which is in collapse. Table 5German Federal Election Results Show 2021 Could Throw Curveball For Ruling Party Therein lies the real market takeaway: right-wing populism has flopped in Germany. The risk to the consensus view that Merkel will hand off the baton seamlessly to a successor and secure her party another term in leadership is that the establishment left will take power (the Greens in Germany are essentially an establishment party). Chart 11German Bunds Respond To Macro Shifts, State Elections Near-term pandemic and economic problems have caused bund yields to fall and the yield curve to flatten so far this year (Chart 11). But that trend is unlikely to continue given the global and national outlook. Election uncertainty should work against this trend since the only possible uncertainty gives more upside to the fiscal outlook and bond yields. If the consensus view indeed comes to pass and the Christian Democrats remain in power, the election holds out policy continuity – at least on economic policy. Fiscal tightening would happen sooner under the Christian Democrats but it would not be aggressive or premature, at least not in the 2021-22 period. It is the current coalition that first loosened Germany’s belt – and it did so in 2019, prior to COVID-19. Germany’s and the EU’s proactive fiscal turn will have a major positive impact on growth prospects, at least cyclically, though it is probably too small thus far to create a structural improvement in potential growth. Fiscal thrust is negative over next two years even with the EU’s Next Generation Recovery Fund being distributed. A structural increase in growth is possible given that all of the major countries are simultaneously pursuing monetary and fiscal stimulus as well as big investments in technology and renewable energy that will help engender a new private capex cycle. But productivity has been on a long, multi-decade decline so it remains to be seen if this can be reversed. Geopolitically speaking, Germany’s and the EU’s policy shift arrived in the nick of time to deepen European integration before divisions revive. Integration is broadly driven by European states’ need to compete on a grand scale with the US, Russia, and China. But Putin, Brexit, and Mario Draghi demonstrate the more tactical pressures: Brexit discourages states from exiting, especially with ongoing trade disputes and the risk of a new Scottish independence referendum; Putin’s aggressive foreign policy drives eastern Europeans into the arms of the West; and the formation of a unity government in Italy encourages European solidarity and improves Italian growth prospects. The outlook for structural reforms is not hopeless. Prime Minister Draghi’s government has a good chance of succeeding at some structural reforms where his predecessors have failed. Meanwhile French President Emmanuel Macron is still favored to win the French election in 2022, which is good for French structural reform. The fact that the EU tied its recovery fund to reform is positive. Most importantly the green energy agenda is replacing budget cutting for the time being, which, again, is positive for capex and could create positive long-term productivity surprises. Of course, structural reform intensity slowed just prior to COVID, in Spain, France, and Italy. Once the recovery funds are spent the desire to persist with reform will wane. This is clear in Spain, which has rolled back some reforms and has a weak government that could dissolve any time, and Italy, where the Draghi coalition may not last long after funds are spent. If the global upswing persists and Chinese/EM growth improves, then Europe will benefit from a macro backdrop that enables it to persist with some structural reforms and crawl out of its liquidity trap. But if China/EM growth relapses then Europe will fall back into a slump. Thus it is a very good thing for Europe, the euro, and European equities that the US is engaged in an epic fiscal blowout and that China’s Two Sessions dampened the risk of overtightening. Incidentally, if the German government does shift, relations with Russia would improve on the margin. While US-Russia tensions will remain hot, German mediation could reduce Russia’s insecurity and lower geopolitical risks for both Russia and emerging Europe, which are very cheaply valued at present in part because they face a persistent geopolitical risk premium. Bottom Line: German politics will drive further EU integration whether the Christian Democrats stay in power or whether the left-wing parties manage a surprise victory. Europe will have to provide more fiscal stimulus but otherwise the global context is favorable for Europe. Investors should not be too pessimistic about short-term hiccups with the vaccine rollout. Investment Takeaways The US is stimulating, China is not overtightening, and German’s election risk is actually an upside risk for European and global risk assets. These points reaffirm a bullish cyclical outlook on global stocks and commodities and a bearish outlook on government bonds. It is especially positive for global beneficiaries of US stimulus excluding China, such as Canada and Mexico. It is also beneficial for industrial metals and emerging markets exposed to China over the medium term, after frenzied buying suffers a healthy correction. Any premium in European equities should be snapped up. However, the cornerstone has been laid for the wall of worry in this global economic cycle: the US is raising taxes, China is tightening policy, and Europe’s fiscal stimulus will probably fall short. Moreover a consensus outcome from the German election would be a harbinger of earlier-than-expected fiscal normalization. There is not yet a clear green light in US-China relations – on the contrary, our view that Biden would be hawkish is coming to pass. Biden faces foreign policy tests across the board and now is a good time to hedge against the inevitable return of downside risks given the remorseless increase in tensions between the Great Powers. Housekeeping A number of clients have written to ask follow-up questions about our contrarian report last week taking a positive view on cybersecurity stocks despite the tech selloff and a positive view on global defense stocks, especially in relation to cybersecurity. The main request is, Which companies offer the best value? So we teamed up with BCA’s new Equity Analyzer to highlight the companies that receive the best BCA scores utilizing a range of factors including value, safety, payout, quality, technicals, sentiment, and macro context – all relative to a universe of global stocks with a minimum market cap of $1 billion. The results are shown in the Appendix, which we hope will come in handy. Separately our tactical hedge, long US health care equipment versus the broad market, has stopped out at -5%. This makes sense in light of the pro-cyclical rotation. Health care equipment is still likely to outperform the rest of the US health care sector amid a policy onslaught of higher taxes, government-provided insurance, and pharmaceutical price caps. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Appendix Appendix Table ABCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Appendix Table BBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Appendix Table CBCA Research Equity Analyzer Casts Light On Best Defense And Cybersecurity Stocks Footnotes 1 China is asking for export controls that have hamstrung Huawei and SMIC to be removed as well as for sanctions and travel bans on Communist Party members and students to be lifted. See Lingling Wei and Bob Davis, "China Plans To Ask U.S. To Roll Back Trump Policies In Alaska Meeting," Wall Street Journal, March 17, 2021, wsj.com; Helen Davidson, "Taiwanese urged to eat ‘freedom pineapples’ after China import ban," The Guardian, March 2, 2021, theguardian.com. 2 "Putin on Biden: Russian President Reacts To US Leader’s Criticism," BBC, March 18, 2021, bbc.com. 3 Pyongyang is likely to test a new, longer range intercontinental ballistic missile for the first time since its self-imposed missile test moratorium began in 2018 after President Trump’s summit with leader Kim Jong Un. See Lara Seligman and Natasha Bertrand, "U.S. ‘On Watch’ For New North Korean Missile Tests," Politico, March 16, 2021, politico.com. 4 See ABC News, "Transcript: Joe Biden delivers remarks on 1-year anniversary of pandemic", ABC News, Mar. 11, 2021, abcnews.com. 5 Please see IMF Staff, "World Economic Outlook Reports", IMF, Jan. 2021, imf.org and OECD Staff, "OECD Economic Outlook, Interim Report March 2021", OECD, March 9, 2021, oecd.org. 6 Please see IMF Asia and Pacific Dept, "People’s Republic of China : 2020 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the People's Republic of China", IMF, Jan. 8, 2021, imf.org. 7 The other state elections coming up this year will coincide with the federal election on September 26, with one minor exception (Saxony-Anhalt). Opinion polls show the Christian Democrats slipping below the Greens in Berlin and the Social Democrats in Mecklenburg-Vorpommern. The Alternative for Germany is falling in all regions.
Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Chart 15...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The sharp rally in Chinese developer stocks this year reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. The positive re-rating has further to run. Tighter policy imposed by local governments will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Urbanization still provides a powerful tailwind for residential construction from a long-term perspective. Chinese housing market will continue to experience cyclical swings, but the powerful structural tailwind will make the cyclical downturn shallow and fleeting. Feature Chart 1A Sharp Re-Rating Of Developer Stocks Chinese real estate developer stocks have more than doubled so far this year, making them the best performing sector in the investable universe - easily outpacing even the world-beating Chinese technology sector (Chart 1). The recent moves in developer stock prices have become parabolic, which combined with recent measures by some major cities to further tighten housing transactions raises the odds of profit-taking and a technical correction in the near term. However, the sharp rally since the beginning of the year has largely been a mean-reverting positive re-rating process rather than an overshoot. Moreover, the latest housing tightening measures are unlikely to have a long-lasting impact on housing demand. Therefore developer stocks should continue to advance after a period of consolidation. Beyond the cyclical horizon, residential development will remain a long-term growth driver for Chinese business activity. Positive Re-Rating Has Further To Run Chart 2Improvement In Developers' Fundamentals It is tempting to dismiss this year's sharp rally in developer stocks as a speculative frenzy, as the dramatic boom in stock price has been accompanied by cooling property sales and moderating home prices amid regulatory tightening in various cities. In our view, the sharp rally in property stocks has been a powerful positive re-rating in multiples after being deeply depressed for several consecutive years. The bottom panel of Chart 1 shows strong multiples expansion of developer stocks since the beginning of 2017. The message here is that China's cyclical improvement in the past two years has led to an aggressive repricing of Chinese equities, particularly in some of the hardest hit sectors. Investors' overwhelming bearishness towards China's macro situation in previous years took a heavy toll on Chinese investable stocks. The market had essentially priced in a chaotic hard-landing scenario, which is now being reversed due to growth improvement. In recent years we have consistently argued that the risk premium embedded in Chinese equities was exceptionally high and ultimately unsustainable, and one of our major investment themes has been a "positive re-rating in Chinese equities" - a view that has been quickly validated. Moreover, developers' stock prices have also reflected some notable improvements in earnings and balance sheet fundamentals, which can also be observed among their domestically listed peers (Chart 2): Deleveraging: The median liabilities-to-assets ratio of developers has dropped notably from the peak of 2015. Destocking: Developers have been focusing on selling inventories, and have been cautious on new projects. The median inventory-to-assets ratio has dropped from a peak of 63% in late 2015 to below 50% currently. Stronger cash positions: Aggressive de-stocking and conservative expansion have also significantly improved developers' cash flows. Cash position as a share of total assets has improved significantly, returning to the all-time highs reached in 2010. Total profits have also recovered strongly with strengthening margins.1 In short, the rally in developer stocks reflects a combination of the unwinding of "doomsday" bets and notable improvement in fundamentals rather than a bubble formation. There is little froth in the marketplace just yet. In fact, property stocks still remain quite cheap based on some conventional valuation indicators - even after this year's sharp rally. Property stocks are trading at 13 times trailing earnings and nine times forward earnings, and are still trading at hefty discounts to bottom-up net-asset-value (NAV) estimates. This means the bull market should have more legs in the coming months. Will Policy Constraints Lead To Another Major Downturn? Recent policy tightening on the residential market clearly creates some headwinds for the sector, and policy risk has been a key factor driving developer stock prices in previous tightening cycles. Historically, the government's tightening campaigns have typically restricted land supplies and bank credit to developers, and have been combined with tighter lending standards and higher interest rates for mortgage borrowers - and even outright bans on household investment demand for residential properties in major cities. In the current tightening cycle that began early last year, regulations on developers have remained largely unchanged, while the rein on households has been much tighter. Mortgage interest rates have also begun to inch higher (Chart 3). In the latest round of tightening measures announced late last week, eight major cities tightened controls on home sales, with a ban on reselling of homes within two to five years of purchase. The government's tightening measures have already led to a moderation in both home sales and prices, as shown in Chart 3, and the impact needs to be closely monitored. For now, our view is that policy constraints will not lead to major negative surprises both for developer stock prices and overall construction activity. On the demand side, household residential demand has been exceptionally strong of late. The central bank's most recent survey showed that a record high percentage of households intend to buy a home in the near future, a dramatic turnaround since the beginning of 2016 (Chart 4). The reason for the surge in home-buying intentions is not clear - we suspect it is the combination of pent-up demand accumulated in previous years and the herd-following mentality that typically follows a period of rapid increase in home prices. On the supply side, developers' inventory de-stocking and stronger cash positions have improved their ability to deal with sales slowdowns. In fact, home sales have significantly outpaced housing completions since 2015, leading to a sharp decline in inventories. Even including floor space under construction, the sellable inventories-to-sales ratio has dropped to its lowest level since 2010 (Chart 5). In our view, the sharp decline in inventories has been a key reason for the rampant increase in home prices since early last year. Chart 3Housing Market Has Been Moderating Chart 4Booming Demand For Home Purchases Taken together, with no inventory overhang and strong demand, we expect the impact of the current episode of housing tightening to be limited. In fact, real estate investment has been pretty subdued in recent years, despite surging home sales and improvement in business confidence among developers (Chart 6). Previous housing tightening measures were often implemented after a prolonged period of construction boom, leading to a sudden halt in investment and construction activity. This time around, tighter policy will probably keep developers in dormancy, but a major downturn is highly unlikely simply because there is not much excess to begin with. Chart 5Housing Destocking Becomes Advanced Chart 6Real Estate Investment Will Unlikely Slump Anew It's The Supply Side, Stupid! It appears that Chinese policymakers as well as global investors have perpetual fears of a "housing bubble" in China. The authorities are deeply worried about potential housing excesses and the negative impact on macro stability. Investors share similar concerns, and chronically worry about the global repercussions of a Chinese housing bust. Some have taken aggressive bets against Chinese developers and other asset classes that are leveraged on Chinese construction activity. While there are some idiosyncrasies in the motives of every tightening cycle in recent years, there is one common theme: the authorities' repeated attempts to cool off the housing sector are deeply rooted in the belief that both residential supplies and home prices were excessive, and therefore tighter controls on both supply and demand were warranted. Remarkably, concerns about housing excesses began to emerge almost immediately after the residential sector was privatized and a housing "market" began to develop in the early 2000s. In a special report dated April 29th 2004 titled, "What Housing Bubble?",2 I disputed for the first time the then-prevailing view on Chinese housing excesses. Fast forwarded 13 years and China's urban landscape has changed profoundly - yet the arguments for a "housing bubble" have remained essentially unchanged: speculative demand, excess supply, parabolic price increases and extreme unaffordability. To some China watchers, the housing sector's remarkable resilience despite repeated policy attacks from the early 2000s was simply an accumulation of a bigger accident waiting to eventually happen. In our analysis in recent years, we have repeatedly emphasized that the supply side shortages have been a key reason for the massive increase in Chinese home prices. While the government's various tightening measures to restrict speculators and cool off demand are well warranted, harsh supply side restrictions during various tightening campaigns have proven counterproductive, as they have amplified supply shortages, creating even more upward pressure on prices. Indeed, the supply-side restrictions are fairly easy to observe. China's leadership is fundamentally concerned about self-sufficiency of agricultural products, and therefore is reluctant to sacrifice farmland for urban development. Moreover, land supplies zoned for residential construction have accounted for an increasingly smaller share of total land supply, due to competition from infrastructure, industrial and commercial projects (Chart 7). Similarly, land purchased by developers plateaued in the early 2000s, and has dropped substantially in recent years. As a highly levered business by nature, developers have also been constantly challenged by limited access to bank loans due to regulatory restrictions. Loans to developers account for about 7% of banks' total loan book, largely unchanged in the past decade despite the massive construction boom. Tight credit controls have forced developers to other "shadow" financing options, which are both costlier and less reliable than formal bank loans, further limiting their ability to bring new housing projects to market. The prevailing heightened concerns on residential excesses and tougher regulations have pushed real estate companies to increasingly shift to commercial and industrial property development. Residential accounted for almost 80% of total real estate development in the early 2000s; the share has dropped to below 70% in recent years (Chart 8). Finally, the government's ill-informed judgement on the degree of excessive supply and speculative demand in the residential sector also prevented them from formulating a multi-tier residential market. Rental residential properties owned by professional institutional investors are rare, and "renters" often suffer discrimination for some public services, making homeownership essentially the only way for new families to establish themselves in urban areas. Chart 7Residential Land Supply Has Been Shrinking Chart 8Residential Construction's Dwindling Importance From a big-picture point of view, China is still in the midst of a spectacular urbanization process. Residential development is not only part of the growth process, but also an essential component to accommodating the massive increase in the urban population. Mainstream media often hype about "ghost towns" but ignore the fact that millions of young migrant workers still reside in dorm rooms provided by employers in sub-standard living conditions. Adjusting for the increase in the urban population, China's new residential construction in recent years has been a lot smaller than in other countries such as Japan and Korea at the prime stage of their respective urbanization process, according to our calculations (Chart 9) - likely the critical reason why Chinese home prices have remained stubbornly high, despite numerous rounds of government crackdowns. Chart 9China's Construction Boom In Perspective Since last year it appears the Chinese authorities have been paying more attention to increasing residential housing supply by providing more funding for social housing projects and shanty town reconstruction, as well as increasing land supply for residential projects. Meanwhile, there are recent proposals to develop rental markets in some major cities, allowing developers to build solely for rental, rather than for sales. In our view, policies boosting residential supplies will be a lot more effective in improving housing affordability for urban citizens. All in all, after the massive boom in recent years, home prices in certain major cities certainly feel a lot more "bubbly" than any time before, and it is easy to make a bearish structural case, as many have been doing over the past decade. However, urbanization still provides a powerful tailwind for residential construction from a long-term perspective. The Chinese housing market will continue to experience cyclical swings, but powerful structural tailwinds will make the cyclical downturn shallow and fleeting, as repeatedly demonstrated in previous policy tightening cycles. Looking forward, construction will remain an important growth driver for China for decades to come. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Earnings Scorecard And Market Tea Leaves", dated September 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "What Housing Bubble?" dated April 29, 2004, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
The secular bond bull market is over. Safety is in a bubble. The shift from monetary to fiscal easing is the most likely candidate to prick the bubble in safety.
In this piece we revise our yield portfolio to increase its resilience to interest rate shocks.