Economy

Highlights The bipartisan Infrastructure Investment and Jobs Act will increase US government non-defense spending to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s.   Democrats are increasingly likely to pass their ~$1.75 trillion social spending bill, with odds at 65%. The budget reconciliation process necessary to pass this bill is also necessary to raise the national debt limit by December 3, so Congress is unlikely to fail.    The Democratic spending bills will reduce fiscal drag very marginally in 2022-24 and will occasionally increase fiscal thrust thereafter. Republicans are unlikely to repeal much of the spending in coming years. Limited Big Government is a new strategic theme. The federal government is permanently taking a larger role in the economy – but this role will still be limited by voters, who do not favor socialism. Biden’s approval rating will stabilize at a low level. Immigration, crime, and especially inflation will determine the Democrats’ fate in the 2022 midterms. Gridlock is likely. The stock market has already priced the infrastructure bill and it will continue to rally on the rumor that reconciliation will pass. But growth has outperformed value, contrary to expectations. Feature Democrats in the House of Representatives finally passed the $1.2 trillion Infrastructure Investment and Jobs Act, which consists of $550 billion in brand new spending and $650 billion in a continuation of existing levels of spending to cover the next ten years. The legislation passed with 228 votes in the House, ten more than needed, due to 13 Republican votes, making it “bipartisan” (Chart 1). The contents of the bill are shown in Table 1. Republicans supported the bill because of its focus on traditional infrastructure – roads, bridges, ports – but they also agreed to more modern elements such as $65 billion on broadband Internet and $36 billion on electric vehicles and environmental remediation. Implementation of the bill will be felt in 2023-24, in time for the presidential election, as committees will need to be set up to identify and approve projects. Table 1Itemized Infrastructure Plan While $550 billion is not a lot in a world of multi-trillion dollar stimulus bills, nevertheless it makes for a 34% increase in federal non-defense investment to levels consistent with the 1980s-90s (Chart 2). The new government spending will amount to 3% of GDP per year over the next ten years, a non-trivial amount of stimulus even though the big picture of the budget deficit remains about the same (Chart 3). The passage of the infrastructure bill will increase, not decrease, the odds of Biden and the Democrats passing their $1.75 trillion social spending bill via the partisan budget reconciliation process. Subjectively we put the odds at 65% in the wake of infrastructure, although recent events suggest that the odds could be put even higher. While left-wing Democrats failed to link the infrastructure and social spending bills, as we argued, nevertheless the passage of infrastructure was a requirement for the key swing voter in the Senate, Joe Manchin of West Virginia. Manchin is negotiating on the reconciliation bill, suggesting he will vote for it, and he will ultimately capitulate because he will not want to be blamed for a default on the US national debt. The US will hit the national debt ceiling on December 3 and the only reliable means for the Democrats to raise the ceiling is reconciliation. The other critical moderate Democratic senator, Kyrsten Sinema of Arizona, seems to have capitulated, after securing a removal of corporate and high-income individual tax hikes from the bill. Far-left senators might make a last stand, holding up reconciliation and winning some last-minute concession. Six House Democrats refused to vote for the infrastructure bill (including New York House member Alexandria Ocasio-Cortez). However, progressives lost leverage after the Democrats’ losses in the off-year elections. Moreover the debt ceiling will force the hand of the progressives as well as the moderates. Any such hurdles will ultimately be steamrolled by the president and Democratic Party leaders. Combined with infrastructure, the net deficit impact of the infrastructure and reconciliation bills will range from $461 billion to $1 trillion (Table 2). Our scenarios vary based on how much credence we give to Democratic revenue raisers, since many of these are gimmicks and accounting tricks to make the bill look more fiscally responsible than it really is. At the most the US is looking at an increase in the budget deficit of less than 0.5% of GDP per year in the coming years. Table 2Biden Administration Tax-And-Spend Scenarios Investors should think of Biden’s legislative efforts as very marginally reducing fiscal drag rather than increasing fiscal thrust, at least in the short run. The budget deficit is normalizing after hitting unprecedented peacetime extremes at the height of the global pandemic and social lockdowns. The shrinking deficit subtracts from aggregate demand in 2022-2024. But the new spending bills will remove a small part of that drag during these years, as highlighted in Chart 4. More importantly the US Congress is signaling that fiscal policy is back in action and that fiscal retrenchment is a long way off. Over the long run, new spending will add marginally to fiscal thrust and aggregate demand, suggesting that the US government’s contribution to the economy will grow a bit in the latter part of the 2020s, namely if Democratic legislation survives the 2024 election. For the most part it probably will, as it is very difficult to repeal entitlements or slash government spending even with Republican majorities, as witnessed with the Affordable Care Act (Obamacare) in 2017. Chart 5Polarization Of Economic Sentiment Declining The polarization of economic sentiment – i.e. divergence in partisan views of the economy – has fallen since the pandemic and will likely continue to fall as the business cycle continues (Chart 5). Both presidential candidates offered infrastructure packages – they only differed on how to fund it. With the government taking a larger role in the economy – and yet the Republicans likely to rebound in future elections – the result is one of our new strategic themes: limited big government. The heyday of “limited government,” from President Ronald Reagan through George W. Bush, has ended. But the new popular and elite consensus in favor of “Big Government” can be overrated – the US political system is defined by checks and balances that will limit the pace and magnitude of the big government trend, and at times even seem to reverse it. Hence investors should think of US fiscal policy and government role in the economy as limited big government. Political Implications Of Bipartisan Infrastructure President Biden’s approval rating has collapsed since this summer when he suffered from perceptions of incompetence on both the delta variant of COVID-19 and the withdrawal from Afghanistan. Democratic infighting, which delayed the passage of his legislation, also hurt him (Chart 6). However, these are all passing narratives, with the exception of the incompetence narrative, which could become a lasting threat to Biden if not addressed. Biden’s signing of the infrastructure bill will stabilize his approval rating. Biden will probably end up somewhere between Presidents Obama and Trump. Voters will most likely upgrade their assessment of his handling of the economy over the coming year, at least marginally. But on foreign policy he will remain extremely vulnerable since he faces numerous immediate crises in coming years. American presidential disapproval has trended upwards since the 1950s of President Eisenhower. Disapproval peaks during recessions and wars. As the economy improves, Biden’s disapproval will fall, but foreign crises and wars are likely in today’s fraught geopolitical environment (Chart 7). A few opinion polls suggest that Republicans have taken the lead over the Democrats in generic opinion polling regarding support for the parties in Congress. These polls are outliers and may or may not become the norm over the next year. Democrats have fallen from their peaks but Republicans still suffer from significant internal divisions (Chart 8). Voters continue to identify mostly as political independents, with a notable downtrend in the share of voters who see themselves as Republicans or Democrats in recent years (Chart 9). Independent voters have marked leanings, right or left. While the leftward lean of independents has peaked, they are not leaning to the right. The infrastructure bill and even reconciliation bill will support Democratic identification. But the sharp rise in immigration, crime, and potentially persistent inflation will support Republicans. These last will become the critical political issues going forward. The democratic socialist or progressive agenda has already been checked by voters and Democrats can only double down on that agenda at their own peril. The infrastructure bill’s passage may give a boost to perceptions of Democratic odds of maintaining the Senate in the 2022 midterm elections – that question is still up in the air, even as the House is very likely to return to Republican control (Chart 10). Chart 9Independent Voters Still Rule An under-the-radar beneficiary of the bipartisan infrastructure bill is Congress itself. Since 2014, public approval of Congress has gradually recovered from historic lows. The level is still low, at 27%, but the upward trend is notable for suggesting that a fiscally active Congress gains popular approval (Chart 11). New social spending will also increase Congress’s image, first for “doing something,” and second for expanding the social safety net, which more than half of voters will approve.  Partisan gridlock after 2022 could reverse the trend, as Republicans may find or invent a reason to impeach President Biden in retribution for President Trump’s impeachments. But our best guess is that Congress will remain above its low point as long as fiscal support – limited big government – remains intact. Aggressive tax hikes or spending cuts, or a national debt default, could reverse the recovery of this institution. Investment Takeaways The infrastructure bill’s passage may have supported the recent rally in stocks but it is not the main driver. Infrastructure stocks had largely discounted the bill’s passage by spring and our BCA Infrastructure Basket has underperformed the broad market since then. In absolute terms, infrastructure stocks have reached new highs and show a rising trajectory (Chart 12). The infrastructure bill has not delivered as expected when it comes to sectors or investment styles. Cyclicals have outperformed defensives, as expected. But value stocks have hit new lows relative to growth stocks, contrary to our expectation this year (Chart 13). Chart 12Infrastructure Was Already Priced Chart 13Wall Street Looks Well Beyond Infrastructure External factors – namely China’s policy tightening and bumps in the global recovery – weighed on cyclicals and value plays, especially relative to Big Tech (Chart 14). Growth stocks have surged yet again on low bond yields, positive earnings surprises, and secular trends like innovation and digitization. The American economy looks robust as the year draws to a close. The service sector is recovering smartly from the delta variant. Non-manufacturing business activity is surging and new orders are exploding upward relative to inventories (Chart 15). Service sector employment has suffered from shortages. Chart 14External Factors Weigh On Infrastructure Plays Chart 15Service Sector Recovery Underway Inflation risks are trickling into consumer and voter consciousness as Christmas approaches and prices rise at the pump (Chart 16). The Democrats’ two big bills will mitigate the damage they face in next year’s midterm elections – the Senate is still in competition. But a persistent inflation problem will overwhelm their legislative accomplishments. Voters will connect the dots between large deficit spending and inflationary surprises (not to mention any Democratic changes that reinforce the extremely dovish stance of the Fed). The normal political cycle will count heavily against the Democrats in 2022 regardless of inflation. But voters simultaneously face historic spikes in immigration and crime – and the former, at least, will get worse and not better over the next 12 months. Predicting inflation is a mug’s game but wage growth suggests it will remain a substantial risk in 2022 – and the structural shift in favor of big government, even if it is limited big government due to the political cycle, is inflationary on the margin. Chart 16Voters Awakening To Inflation   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix  

Highlights Fed/BoE: Both the Fed and the Bank of England found ways to talk down 2022 rate hike expectations discounted in US and UK bond markets. This is only a temporary reprieve, however, as the near-term uncertainties over the persistence of cost-push inflation will eventually be overwhelmed by medium-term certainties of demand-pull inflation confirmed by tightening labor markets. Stay underweight US Treasuries and UK Gilts in global bond portfolios. US Treasury Curve: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022. Feature Chart of the WeekShifting Rate Expectations Driving Bond Yields As QE Fades Bond market uncertainty about future monetary policy moves is on the rise. Bond volatility has picked up, most notably at the front end of yield curves that are most sensitive to rate hike expectations which have been intensifying. Yet last week, the Federal Reserve and Bank of England (BoE) were able to talk bond investors off the ledge – at least, temporarily - by pushing back against expectations of multiple rate hikes in the US and UK in 2022. Central bankers in those countries are stuck in a difficult spot. Inflation is high enough to warrant some tightening of monetary policy. Yet there are lingering concerns over how long the current upturn in global inflation will last. Meanwhile, there are just enough questions on the underlying pace of economic momentum to require policymakers to see more data, especially in labor markets, before feeling comfortable enough to pull the trigger on actual rate hikes. We now see that happening first in the UK early next year, and in the US in late 2022. One thing that is certain is that the ups and downs of interest rate expectations – and the central bank forward guidance that influences them – will increasingly become the more dominant driver of bond yields and yield curve shape as global pandemic bond-buying programs get wound down (Chart of the Week). On that front, we see more potential for bond-bearish steepening in the UK and US over the next several months. The BoE: Another Bad Date With The Unreliable Boyfriend The UK financial press infamously dubbed the BoE “the unreliable boyfriend”, under the leadership of former Governor Mark Carney, for hinting at interest rate increases that never materialized. At last week’s Monetary Policy Committee (MPC) meeting, rates were kept unchanged in a 7-2 vote despite some intense signaling in recent weeks that a rate hike was imminent. Under current BoE Governor Andrew Bailey, this edition of the MPC is more like an indecisive spouse than unreliable boyfriend. On the one hand, there is a clear overshoot of UK inflation (and inflation expectations) that would justify a rate hike as soon as possible (Chart 2). The BoE’s new economic forecasts presented in the November Monetary Policy Report (MPR) called for headline CPI inflation to reach a peak of 5% in April 2022 – significantly higher than the 4% late-2021 forecast from the August MPR. On the other hand, high current inflation is already having a dampening effect on economic sentiment. The GfK index of UK consumer confidence is down -10% from the peak seen in July, despite diminishing concerns over COVID seen in public opinion polls (Chart 3, middle panel). A similar divergence is evident in the BoE’s Decision Maker Panel survey of UK Chief Financial Officers, which showed that uncertainty over future sales was somewhat elevated compared to diminished concerns about COVID and Brexit (bottom panel). Chart 2Fed/BoE Cannot Stay Dovish For Much Longer Chart 3High UK Inflation Raises Growth Uncertainty The BoE highlighted these divergences in economic sentiment series in the November MPR as examples of how high inflation, fueled by global supply chain disruptions and soaring energy prices, introduced uncertainty into the central bank’s forecasts. Even more uncertainty exists in the BoE’s ability to assess the amount of spare capacity, and underlying inflationary pressure, in the UK economy. The BoE dedicated a 9-page section of the November MPR to a discussion about estimating the growth of the supply-side of the UK economy, evidence of how difficult that process has become during the COVID era. The BoE concluded that the pandemic would end up reducing the level of UK potential supply by -2% from pre-COVID levels, even though the growth rate would return to a pre-pandemic pace of around 1.5% by 2023-24. This is a combination that makes setting monetary policy tricky. Reduced supply indicates that the UK economy has a smaller output gap with more inflationary pressure that would require higher interest rates. Yet sluggish growth in potential supply implies that the UK equilibrium interest rate is likely still very low, thus the BoE would not have to raise rates much to get policy back to neutral. This uncertainty over the size of the output gap in the UK economy will force to BoE to focus more on the labor market as the best “real-time” measure of spare capacity. On that front, the evidence is also difficult to interpret. The UK unemployment rate fell to 4.5% over the three months to August, the last available data before the UK government’s COVID furlough schemes, which protected worker incomes hit by COVID job losses, ended on September 30. The UK Office of National Statistics estimates that there were between 900,000 and 1.4 million UK workers furloughed in late September, representing a significant source of labor supply to be absorbed when the government income assistance ends. Thus, the BoE would need to see at least a month or two of post-furlough employment reports – not just job growth, but labor force participation - to assess how quickly those workers were being reabsorbed into the UK labor market. By the BoE’s own estimates, the impact of the furlough schemes, combined with the compositional issues arising from pandemic job losses being borne more by lower-wage workers, boosted UK wage growth by 2.2% (Chart 4, bottom panel). “Underlying” wage growth, net of those effects, is 0.6%, above the pre-COVID peak, suggesting a tightening labor market before the return of furloughed workers to the labor force. In the end, we see the BoE’s November non-hike as nothing more than a delay of the inevitable. While a December hike is possible, this would represent a “double tightening” of monetary policy with the current BoE quantitative easing program set to expire at year-end. The more likely date for a rate hike is now February. This would give the MPC a few months of post-furlough labor data to assess the amount of spare capacity in UK labor markets. We expect the data to show enough underlying health in labor demand relative to supply for the BoE to conclude that accelerating wage growth represents a more sustainable form of UK inflation in 2022 than energy prices or supply-chain disruptions were in 2021, justifying a move to begin hiking rates. We continue to recommend positioning for a steeper UK Gilt curve, focused on longer-maturities where yields were too low relative to even a moderate future BoE rate hike cycle (Chart 5). We entered a new tactical butterfly spread trade last week, going long the 10-year Gilt bullet versus a duration-neutral 7-year/30-year barbell – we continue to like that trade as a way to play for eventual BoE rate hikes in the first half of 2022. Chart 4BoE Needs More Employment Data To Confirm Wage Uptrend Chart 5Stay In UK Long-End Gilt Curve Steepeners Bottom Line: The Bank of England is still on a path to begin rate hikes, either in December or, more likely, February of next year. Stay underweight UK Gilts. Position For A Steeper US Treasury Curve The Fed announced last week that tapering would begin right away in November, in a move that has been hinted at since the summer. The monthly pace of purchases of Treasuries and Agency MBS will decline by $10 billion and $5 billion, respectively in November and also December. The Fed declined to commit to any specific tapering amounts beyond that, although it seems likely that the same monthly pace of reduction will continue in 2022. This would take the buying of Treasuries and MBS, net of maturing debt, to zero by June of next year, clearing the first necessary hurdle before the FOMC could contemplate a hike in the funds rate. A completion of the taper by June has been hinted at in the speeches of several Fed officials in recent weeks. This is a bit faster than the expected pace of tapering seen in the most recent New York Fed Primary Dealer and Market Participant Surveys from September (Chart 6), but should not be categorized as a hawkish surprise. There were also few bond-bearish signals on future policy moves hinted at by Fed Chair Jay Powell in post post-FOMC meeting press conference. Chart 7Upside Risk To UST Yields From A Tightening Labor Market Powell did note that it was still not clear how long the current supply chain/commodity price driven surge in inflation would persist into next year. The expectation, however, was that these forces would eventually subside and allow US inflation to return back to levels much closer to the Fed’s 2% target. Given the uncertainties in the timing of that peak and decline in US inflation, the Fed has limited ability to calibrate any post-taper rate hikes by focusing solely on inflation - especially with longer-term inflation expectations still at levels consistent with the Fed’s target. The Fed will continue to look at US labor market developments to determine the timing and pace of future rate hikes. The last set of FOMC economic projections compiled for the September meeting have the US unemployment rate falling to 3.8% next year, below the median FOMC estimate of full employment at 4%, with one 25bp rate hike penciled in for 2022. We can use that as a baseline assumption on what the Fed considers to be the level of “maximum employment” that would need to be reached before rate hikes could begin. The US unemployment rate fell to 4.6% in October, thus there is still some more to go before hitting that 3.8% rate hike threshold. Yet among the FOMC members, the estimates of full employment range from 3.5%-4.5%, so the October print did knock on the door of that range (Chart 7, middle panel). With US wage growth already showing signs of breaking out – the Atlanta Fed Wage Tracker hit a 14-year high of 14% in September (bottom panel), while the Employment Cost Index rose by a record quarterly pace of 1.3% in Q3 – the Fed will likely be under a lot of pressure to begin hiking rates soon after the taper is expected to end next June. Chart 8UST Curve Forwards Too Flat Vs. Likely Fed Rate Hikes We still see December 2022 as the most likely liftoff date, although a faster decline in unemployment could move that timetable forward. The bigger issue for the US Treasury market, however, is not the timing of liftoff but how fast the pace of hikes will be afterward. On that note, future rate expectations are still far too low. For example, according to the New York Fed’s Primary Dealer Survey, the fed funds rate is expected to average only 1.7% over the next ten years (top panel), a level that has proved to be a ceiling for the 10-year Treasury yield so far in 2021. Our colleagues at BCA Research US Bond Strategy recently made the case for expecting the US Treasury curve to bearishly steepen in the coming months. In their view, longer-maturity Treasury yield forward rates were too low compared to a fair value determined by the likely path for the funds rate that assumes rate hikes start in December of next year and rise by 100bps per year to a terminal rate of 2.08% (Chart 8). Interestingly, 2-year Treasury forward rates were in line with the projections of our US Bond Strategy team’s fair value framework. We fully agree with our US Bond colleagues on the likelihood of future Treasury curve steepening. This fits with our views on many developed market countries, not just the US, where longer-maturity bond yields were pricing in too few future rate hikes relative to what was likely to occur over the next few years. Even when taking a much longer perspective, the US Treasury curve looks too flat right now. Going back to the mid-1980s, the current 2-year/10-year US Treasury curve slope of just over 100bps has never been reached (in a flattening move) in the absence of actual Fed rate hikes (Chart 9). Chart 9UST Curve Has Never Been This Flat Without Some Actual Fed Rate Hikes This week, we are adding a new trade to our Tactical Overlay table to benefit from this expected move in the US yield curve, a US Treasury 2-year/10-year curve steepener (combined with a position in cash, or US 3-month treasury bills, to make the entire trade duration-neutral). We are also taking profits on our previous Tactical US curve flattening trade, which has returned 0.84% since initiation back in June. The exact securities and weightings for our new trade can be found in the Tactical Overlay Trades table below. Bottom Line: Longer-term US Treasury yields are priced too low relative to the likely peak in the fed funds rate in the next cycle. Position for a steeper US Treasury curve until Fed rate hikes are imminent, which will likely not be until Q4/2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations Duration Regional Allocation Spread Product Tactical Overlay Trades GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Dear Client, Next week I will be hosting and attending client events, both virtual and in person. Our next report, on November 24 will be a recap of my observations from the meetings with our clients. Best regards, Jing Sima China Strategist Executive Summary Chart Of The DayThe Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High     Producer price inflation in China will likely peak in the next two quarters, but inflation could remain elevated well into 2022. Chinese producers will continue to pass on inflation to domestic and foreign consumers. Core CPI is only a notch below its pre-pandemic level; rising energy and food prices, along with improved service sector consumption, will push up headline consumer prices next year. Lack of meaningful policy easing is creating an air pocket for China’s economy, with significant near-term risks for a faster-than-expected economic slowdown. We continue to prefer the CSI500 Index over the broader onshore market. Bottom Line: China’s business cycle has rapidly matured while inflation remains a risk. We are still underweight Chinese equities in a global portfolio. Within Chinese stocks, we continue to favor CSI500 Index which has a greater exposure to external demand. Feature Chart 1Persistently Negative Economic Surprises China’s economic conditions deteriorated in the third quarter. Chart 1 shows that the nation’s economic surprise index remains in deep contraction. However, the combination of power shortages and persistent supply-side price pressures has limited policy choices, particularly the traditional measures used to stimulate the economy. We are closely monitoring the BCA China Play Index and the relative performance of domestic infrastructure stocks versus global equities as proxies for reflation; neither is signaling a significant improvement (Chart 2). The outlook for Chinese stocks in the next 6 to 12 months remains dim. Chinese corporate profit growth has peaked, and input cost pressure on domestic producers may prove to be stickier than the market has currently priced in (Chart 3). Chart 2Reflation Proxies Are Not Signaling A Major Economic Upturn Chart 3Corporate Profit Growth Has Peaked Producer Price Inflation Remains A Near-Term Risk China’s producer price index (PPI) inflation may stay high longer than the market is expecting. Supply-side pressures and bottlenecks will abate, but perhaps not as fast as investors expect. Moreover, energy prices will likely remain elevated into 2022 and labor shortages in the urban areas will further exacerbate inflationary pressures. As discussed in a previous report, the surge in China’s manufacturing output and prices has been driven by strong US consumer demand for goods. Robust external demand this year occurred as China’s industrial sector had gone through years of capacity reduction and domestic de-carbonization efforts gained momentum.  Chart 4Expanding Mining Capacity Takes Time Capacity in the mining sector will expand in the next 6 to 12 months if the power crunch persists. However, the 2015/16 supply-side reforms significantly reduced China’s upstream industry’s capability to produce. Given the capital-intensive nature of upstream industries, expanding production output often takes a long time. Chart 4 shows the significant lag between mining’s higher product prices, which indicate rising demand and tighter supply, and improved output and investment in the sector.  The industrial sector’s capacity utilization rate remains elevated. China’s manufacturers can ramp up output more easily compared with mining enterprises. However, both manufacturing investment growth and output in volume have been falling (Chart 5). The wide gap between manufacturing input and output prices means that the profit margin among producers of manufacturing goods has been squeezed, giving them little incentive to expand business operations (Chart 6). Chart 5Manufacturing Investment Growth And Output Volume Have Been Falling Chart 6The Gap Between Chinese Manufacturing Input And Output Prices Reached Multi-Year High In addition, PPI inflation may be slow to decline for the following reasons: Coal futures prices have been clobbered since mid-October in the wake of government regulatory measures to curb speculation in the domestic commodity exchange market (Chart 7). However, the plunge does not solve the supply shortage issue. Coal prices at China’s major ports have been trending sideways and remain at historic highs (Chart 8). Chart 7Regulators Have Squashed Coal Price Speculations In Commodity Exchanges... Chart 8...But Coal Prices At Ports Remain High   Regulators have allowed electricity producers to boost prices by as much as 20% to industrial users. We estimate that a 20% increase in electricity prices can add anywhere from half to one percentage point to PPI. The recovery in the global service sector will provide support to oil prices (Chart 9). BCA’s Commodity and Energy Strategy service expects energy prices to soften in the next 12 months, but not by as much as the markets are discounting. Our latest forecast sets Brent crude oil at an average $81/bbl in 2021Q4, $80/bbl in 2022 (versus market expectations of $77/bbl) and $81/bbl in 2023 (versus market expectations of $71/bbl) (Chart 10). Chart 9Oil Prices Find Support From Recovery In Global Service Activity China’s domestic demand has weakened, particularly in the construction sector. Prices for steel rebar, iron ore and cooper have all rolled over and/or fallen sharply (Chart 11). Nonetheless, the prices remain well above pre-pandemic levels and policy-induced production cuts may limit the downside. Labor shortages in China’s urban areas have not improved. Reverse migration has increased since early last year when China imposed travel restrictions to contain domestic COVID transmission. Workers from rural areas opted to remain in their hometowns rather than return to work in urban areas. As of Q3 this year, there were still about 2 million fewer migrant workers than in the pre-COVID years, which has exacerbated an urban labor shortage that existed before the pandemic (Chart 12). Chart 11Commodity Prices In China Have Rolled Over, But Downside May Be Limited Chart 12Migrant Workers Are Slow To Return To Urban Jobs Bottom Line: PPI should peak in the next one to two quarters as supply bottlenecks ease and the base factor wanes. However, China’s industrial capacity and labor market remain tight. Producer inflationary pressures may sustain longer than investors expect. Passing On Costs To Consumers Chart 13Households Are Paying Higher Prices For Durable Goods And Daily Necessities The weakness in demand from Chinese households has kept consumer price inflation subdued so far this year. Nonetheless, Chinese producers have started to pass on supply-side cost pressures to consumers, both domestic and foreign. Rising raw material costs have pushed up the price of Chinese consumer durable goods, such as home appliances (Chart 13). Consumer prices for fuel have reached the highest level since the data collection started in 2016. The cost of consumer daily necessities is also climbing: households are paying more for utilities (water, electricity and fuel) compared with pre-pandemic years and prices are at 2013 highs. Escalating electricity prices will further strengthen inflationary pressures on the CPI. While residential electricity costs are strictly regulated in China and are unlikely to rise in the near future, price inflation passthroughs will be mainly via higher costs on both consumer goods and services. If the 20% increase in electricity costs among Chinese manufacturers is passed onto consumers, it could potentially push up the CPI by about 0.2 -0.4 percentage points. The cost of food and vegetables has also jumped since early October. Given the high likelihood of La Niña this winter, food inflation could further mount and potentially push the headline CPI close to the PBoC’s 3% inflation target next year. The recovery in China’s service sector has lagged due to domestic COVID flareups and subsequent lockdowns (Chart 14A and 14B). However, service CPI has recovered to above its pre-pandemic level, with strong rebounds in tourism and transportation (Chart 15). Given that China is accelerating vaccine boosters, an improvement in the domestic COVID situation next year could further support the service sector’s consumption and prices.   Chart 14AService Sector Recovery In China Has Lagged... Chart 14BService Sector Recovery In China Has Lagged... Chart 15...But Prices Have Not Chart 16Chinese Export Growth Remained Buyout Through October China’s exporters are passing on inflation to their foreign customers too. Newly released trade data highlights buoyant export growth through October (Chart 16). Even though goods consumption in the US will likely converge to its long-term trend next year, inventories are at multi-year lows while global industrial production growth remains well above trend (Chart 17). China’s export growth may stay strong in the next two quarters, as suggested by our regression-based modelling (Chart 18). Exporters have been charging US and global customers less than average prices (Chart 19). Robust demand for consumer and capital goods from the US and Europe should give China’s exporters sustained pricing power. Chart 17Extremely Low Inventories In The US Will Benefit Chinese Exports Chart 18Above-Trend Growth In Global Industrial Production Will Also Support Chinese Exports Bottom Line: China’s producers will continue to pass on inflation to their domestic and foreign customers. Chart 19Chinese Export Prices Are Below Global Average Chart 20Favor CSI500 Index Over A-Shares Investment Conclusions China’s authorities will unlikely use policy measures to cool domestic demand, but they will be constrained by lingering inflationary risks driven by external consumption and supply-side pressures in the next six months. Monetary and fiscal policies will ease to counter the slowdown in the economy, but reflationary measures will be gradual. We expect the money and credit impulse to bottom in Q4, but the rebound will be subdued. As such, domestic demand will remain sluggish and economic growth will likely decelerate faster than the onshore market has currently discounted. While we maintain a cautious stance on Chinese stocks in general, we continue to favor the CSI500 Index relative to the broader A-share market. External demand growth may remain above trend in the next six months. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market, and should still have some upside potentials. (Chart 20).   Jing Sima China Strategist jings@bcaresearch.com Market/Sector Recommendations Cyclical Investment Stance