Economy

Feature June’s economic data and second-quarter GDP indicate that China’s economic recovery may have peaked. Slight improvements in some sectors, including manufacturing investment, exports and consumption, were offset by slowing in China’s old economy, such as infrastructure and real estate. A softening economy will weigh on Chinese corporate profits in 2H21. Inflation in Producer Price Index (PPI) has likely peaked, but it remains far above its historic average. Downstream industries may benefit from low interest rates and slightly less inflationary pressures on input prices, however, their profit growth has rolled over given weakening domestic demand and base effect. Industrial profits will shift downward in 2H21, meanwhile China’s macro policy will probably disappoint investors. Last week’s GDP’s numbers show that small-to-medium enterprises (SMEs) and private-sector businesses bore the brunt of rising global commodity prices and a slow recovery in domestic household consumption and services. The data, coupled with recent policy moves, support our view that China’s leadership is focused on helping vulnerable segments of the economy rather than boosting domestic demand by broadly easing policies (Chart 1). Nonetheless, the authorities may resort to easing policy later in 2021 if export growth weakens significantly in the second half of the year. A series of Reserve Requirement Ratio (RRR) and/or interest rate cuts, increased infrastructure project approvals, and/or looser real estate regulations, will signal that China’s ongoing policy tightening cycle has ended. In recent weeks both Chinese onshore and offshore stocks slipped further in absolute terms and relative to global benchmarks (Chart 2). We continue to recommend that investors remain cautious on Chinese stocks, at least through Q3. Chart 1No Broad Easing Yet Chart 2Investors Still Cautious On China's Economy And Policy   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Q2 GDP: Recovering At A Slower Pace China’s official GDP growth, on a year-over-year basis, slowed to 7.9% in Q2 from 18.3% in Q1 (Chart 3, top panel). While Q2’s weaker reading reflects the base effect in the data, it was slightly below the market’s expectation of 8.0-8.5%. Moreover, on a sequential basis (quarter-over-quarter), Q2’s seasonally adjusted GDP growth was one of the slowest in the past decade (Chart 3, bottom panel). These figures and the underlying data highlight that China’s economic growth momentum, which historically lags the credit impulse by six to nine months, has peaked (Chart 4). However, in 1H21, China aggregate output still grew by a 5.5% average annual rate during the same period over the past two years, well within Chinese policymakers’ target of above 5% growth needed to maintain a stable economy.  Meanwhile, the bifurcation in China’s economic recovery continues.  While robust external demand for Chinese goods helped to underpin manufacturing output, the sector’s profit growth has lagged upstream industries. Moreover, state-owned enterprises (SOEs) are experiencing soaring profit growth whereas SMEs have struggled with rising global commodity prices and sluggish domestic consumption as discussed below. We expect that the pace in credit growth deceleration will moderate in 2H21 and interest rates will stay at historically low levels. However, the authorities are unlikely to loosen macro policies until more signs of economic weaknesses emerge. Chart 3Q2 GDP: Slowing From An Elevated Level Chart 4Chinese Economic Growth Should Soften Further In 2H21   Robust Exports, Sluggish Manufacturing Investment Chart 5Subdued Manufacturing Investment Recovery Despite Robust Exports China’s export growth in June beat market expectations, despite shipping disruptions at major ports in Guangdong province due to a resurgence in COVID-19 cases. However, the recovery in manufacturing investment was muted through most of 1H21 even though export growth was resilient (Chart 5). There are several reasons for the sluggish recovery: the RMB’s rapid appreciation in the first five months of 2021, rising inflation and the limited pricing power that Chinese exporters gained in the first half of the year likely impeded their profits and curbed their propensity to invest (Chart 6). Total export values in USD significantly outpaced those in RMB terms, suggesting that the profit gains by Chinese exporters were offset by the strengthening local currency (Chart 7). Chart 6Rapid RMB Appreciation Will Weigh On Industrial Profits Chart 7Divergence Between Exports In USD versus RMB Furthermore, manufacturers in mid-to-downstream industries have been unable to fully pass on rising input costs to domestic consumers, which is evidenced in the faster growth of manufacturing output volume compared with price increases. It contrasts with the previous inflationary cycles, where surging prices for manufactured goods surpassed output volume (Chart 8A & 8B). Chart 8AChina's Manufacturing Recovery: Stronger Volume Than Prices Chart 8BMuted Profit Margin Recovery In Manufacturing Compared With Mining June’s improvement in manufacturing investment may not advance into 2H21 without added policy support. The nearly 2% depreciation in the RMB against the dollar in recent weeks will alleviate some pressure on exporters’ profit margins. However, export prices in USD also started to weaken (Chart 9). In addition, June’s manufacturing PMI and a Chinese business school survey,1 reported a deterioration in business conditions among smaller businesses. The weaker sentiment will depress manufacturing investments since China’s manufacturing sector is dominated by private and smaller businesses (Chart 10). Chart 9Chinese Export Prices In USD Are Rolling Over Chart 10Deteriorating Business Sentiment Will Depress Manufacturing Investments Recent policy measures to keep a low interest-rate environment will help the export and manufacturing sectors by reducing operating costs. The measures are also in keeping with China’s shift from boosting its service sector to maintaining a steady share of manufacturing output in its domestic economy (Chart 11). Chart 11Maintaining A Steady Share Of Manufacturing Output In China's Economy   Policy Tightening In The Old Economy Continues Chart 12Investments In Real Estate Have Lost Steam Infrastructure investment growth slowed further in June. Investments in real estate, which drove China’s economic recovery in the second half of 2020, are also losing momentum (Chart 12). The slowdown, engineered by policymakers, will likely endure for the rest of the year. Bank loans to real estate developers tumbled to a cyclical low (Chart 13). In addition, deposit and advance payments, the main source of funds for real estate projects, nose-dived along with home sales (Chart 14).  Chart 13No Signs Of Looser Financing Regulations In Property Sector Chart 14Falling Home Sales Will Further Depress Real Estate Investments Chart 15Sharp Pullback In New Infrastructure Project Approvals This Year Infrastructure project approvals by the Ministry of Finance remain on a downward trend (Chart 15). Last week, China’s Banking and Insurance Regulatory Commission (CBIRC) announced a new rule to stop financial institutions from lending to local government financing vehicles (LGFV) that hold off-balance sheet government debt. LGFVs are largely used by provincial governments to borrow from banks to help fund infrastructure projects. Regulations targeting the real estate sector will further dampen real estate investments in the second half of this year. Land purchases and housing starts, both leading indicators for real estate investment, have declined since February. Excavator sales and investment in construction equipment also deteriorated sharply (Chart 16). Given that housing prices remain elevated, we do not expect real estate regulations to shift to an easier tone.  The deceleration in China’s old economy is reflected in imports. While the value of imports remains strong, the volume has slowed, which suggests that the surge was due to soaring commodity prices (Chart 17, top panel). In particular, the growth in China’s imports of copper and steel, on a year-over-year basis and in volume terms, contracted in June (Chart 17, bottom panel). Chart 16Construction Activities Set To Slow Further Chart 17Falling Import Volume   The Key To A Consumption Recovery Retail sales picked up slightly in June following two consecutive months of decline.  However, retail sales remain below their pre-pandemic level (Chart 18). Labor market dynamics and household income growth, which stayed sluggish through 1H21, hold the key to the speed and magnitude of a recovery in consumption this year (Chart 19). Chart 18Sluggish Recovery In Household Consumption Chart 19A Lackluster Consumption Recovery Due To Slow Recovery in Household Income Household precautionary savings, which remain elevated compared with their historical norms, have depressed the propensity to spend (Chart 20). While the overall unemployment rate in China’s urban centers has steadily declined this year, the rate of jobless young graduates (ages 16-24) picked up and is nearly three percentage points higher than its historical mean (Chart 21). However, the high unemployment among graduates will not encourage policymakers to stimulate the economy. The number of new graduates in both 2020 and 2021 is larger than the historical average, while the growth in new job creation has nearly recovered to that of the pre-pandemic years (Chart 22). Chart 20Households' Propensity For Precautionary Savings Remains Elevated Chart 21Rising Unemployment Rate Among Younger Workers Moreover, labor market slack among young graduates seems to be concentrated in the services sector, and this sector’s improvement is dependent on China’s domestic pandemic situation and inoculation rates rather than on stimulus (Chart 23). Chart 22Urban Job Creation Growth Still On The Mend Chart 23Interruptions In Service Sector Recovery Due To Lingering COVID Cases   Elevated Inflation, Downshifting Industrial Profits Chart 24China's PPI May Have Reached A Cyclical Peak... China’s domestic inflationary pressures eased slightly in June with a small decline in both consumer and producer prices. The input price component of the manufacturing PMI, which normally leads the PPI by about three months, dropped sharply last month, which indicates that the PPI may have reached its cyclical peak (Chart 24). However, producer price inflation will likely remain elevated in the second half of the year. Although global industrial metal prices have rolled over since May, they remain at their highest level since 2011 (Chart 25). A rapid deceleration in Chinese credit growth and weakening demand in 2H21 will remove some pressure in the sizzling hot commodity market, but global supply-side constraints will limit the downside in raw material prices, at least through the next six months. Therefore, diminishing inflationary pressures on the PPI will only slightly reduce input costs for China’s mid-to- downstream manufacturers, which have been unable to pass on rising commodity prices to domestic consumers (Chart 26). As discussed earlier, Chinese export prices in both USD and RMB terms have also rolled over. Chart 25...But Global Commodity Prices Are Still Elevated Chart 26Absence Of Inflation Pass-Through Given that price changes are more important to corporate profits than volume changes, Chinese mid-to-downstream industries will continue to face downward pressure on their profit margins. Profit growth in mid-to-downstream industries consistently lagged their upstream counterparts in the past 12 months (Chart 27). Moreover, state-holding enterprises, which dominate upstream industries, have seen a 150% jump in profit growth from a year ago, while the rate of profit gains among privately owned industrial companies tumbled this year (Chart 28). Chart 27A Faster Mean Reversal In Profit Growth Among Private Companies Chart 28A Faster Mean Reversal In Profit Growth Among Private Companies Chinese policymakers will probably focus on addressing imbalances in China’s industrial sector and economy by supporting SMEs and the private sector. Meanwhile, industrial profit growth will decline in 2H21 from its V-shaped recovery last year, given weakening domestic demand and the waning base effect. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes 1The CKGSB (Cheung Kong Graduate School Of Business) Business Conditions Index (BCI) comprises four sub-indices: corporate sales, corporate profits, corporate financing environment and inventory levels. Equity Sector Recommendations Cyclical Investment Stance

Highlights US Treasuries: Peaking global growth expectations and the growing spread of the Delta variant are challenging the “reflation and reopening” narrative that drove bond yields higher in Q1 of this year. Underlying growth, however, is likely to stay above-trend in most developed economies over the next 1-2 years, leading to tighter labor markets, increased domestic inflation pressures, and less dovish central banks - especially in the US. We continue to recommend an overall below-benchmark duration position in global bond portfolios, with an underweight stance on US Treasuries, on a strategic (6-24 month) basis. New Zealand: House prices, inflation, and the overall economic backdrop justify the RBNZ’s recent hawkish shift. However, government bond and interest rate swap markets have not fully priced in how quickly, and how far, the RBNZ can hike during the upcoming tightening cycle. As a play on further RBNZ hawkishness, we are entering a new recommended tactical trade: a 2-year/5-year yield curve flattener in New Zealand government bonds. Feature Dear Client, We will be taking a summer break over the next two weeks to recharge our batteries for what is shaping up to be an eventful time for global financial markets over the remaining months of 2021. Next week, you will be receiving a report written by our Chief US Bond Strategist, Ryan Swift. The following week, there will be no Global Fixed Income Strategy report published. We will return to our normal publishing schedule on Tuesday, August 10. Best Regards, -Rob Robis The World’s Most Important Asset Price We spent much of last week talking with clients (still virtually, sadly) in the US and Europe. In all the meetings, the first - and in some cases, only - topic of discussion was how to interpret the fall in longer-maturity US Treasury yields over the past few months. With the benchmark 10-year US yield hitting the lowest level since February earlier this week, breaching the 1.20% level, the message from the Treasury market will remain very much top of mind for investors - and for us, too - especially with bond yields in other countries also following US yields lower. Chart 1 The falling trend in US yields can be attributed to a number of factors, some of which are more legitimately bond bullish than others. Investors are increasingly convinced that global growth momentum has peaked, including in the US. While the global manufacturing PMI is still at the highest levels seen over the past decade, our global leading economic indicator (LEI) is rolling over from a very high level (Chart 1). The plunge in the global LEI diffusion index suggests that the dip in the global LEI is broad based across all the countries in the LEI (Chart 1, middle panel). This is not a sign that growth is slowing now, though, given the long lags between the swings in the diffusion index and the LEI, and between the LEI and actual economic growth. Importantly, US leading indicators like the Conference Board LEI are not rolling over and continue to signal that US growth will remain solid over the next 6-12 months. US consumer and business confidence are still upbeat, labor demand remains robust and corporate profits are growing smartly in the Q2 earnings data available so far. US growth will inevitably decelerate from the overheated pace of Q2 that was boosted by the rapid reopening from pandemic restrictions. Yet the US economy will continue to expand at an above-trend pace into 2022 – especially with an extra boost from fiscal stimulus - that is likely to tighten US labor markets and keep the Fed on the path towards bond-bearish tapering and, eventually, rate hikes by the end of next year. The renewed pickup in COVID-19 cases in the US could damage that positive narrative on US economic confidence. The uptick in the Delta variant raises the risk of a new wave of economic restrictions, even with nearly half the US population now fully vaccinated (Chart 2). To date, the latest surge in cases has not resulted in significant surges in hospitalizations and deaths in the US and, more importantly, the UK where the Delta variant has spread far more rapidly. If the hospitalization figures were to accelerate, investors would likely interpret that as a sign that a) vaccine efficacy against the variants is not as robust as for the original strain of the virus; and/or b) the next wave of COVID has arrived before the US could achieve herd immunity. At the moment, there is little political will to impose a new wave of growth-crushing - and bond bullish – economic restrictions in the US, especially with case numbers still low compared to previous waves of the virus amid ample vaccine supplies. Even in New York City, the epicenter of the first wave of the pandemic in the US in 2020 and one of the last major cities to reopen, the mayor said this week that a return to a mask-wearing mandate was not on the table (the city’s preference is to push for more of the unvaccinated to get their jabs to fight the variant). Lower US bond yields also reflect a growing belief that the rise in US inflation will prove to be transitory, as the Fed expects. Headline CPI inflation in the US reached 5.4% in June on a year-over-year basis, but was an even faster 8.8% on a 6-month annualized basis (Chart 3). Soaring US inflation rates have been dismissed by many as simply a function of temporary supply squeezes and favorable base effect comparisons versus the pandemic-fueled price collapses in Q2/2020. Yet the longer the inflation acceleration continues, the more the narrative will shift from “transitory” to “persistent” inflation, especially if inflation also keeps moving higher outside the US as well. Chart 2Delta Variant: Highly Contagious, But Not Lethal Investors, and the Fed, will not be able to assess if the US inflation surge is truly a short-lived phenomenon until at least 2-3 more inflation data prints are available. Chart 3Is This 'Transitory' Inflation? This means the “transitory or not” question will linger until the September inflation data is available in mid-October. What will be critical is the mix of US inflation. If more domestically generated inflation rates – rents, wages, etc. – accelerate, that would result in overall US inflation being driven more by stickier core inflation rather than surging non-core inflation fueled by rising commodity prices. That implies a higher floor for headline inflation, and a more bond-bearish challenge to the “transitory” narrative as the Fed would be even more emboldened to begin dialing back monetary accommodation sooner, or faster, than the current forward guidance. Beyond the fundamentals, the Treasury market continues to work off the technically oversold condition that developed in the first quarter of 2021, leading to short-covering that is pushing yields lower. The 10-year Treasury yield became extremely stretched versus the underlying trend in yields, defined by the 200-day moving average, with survey and positioning data showing large short positioning and below-benchmark duration exposures among bond investors (Chart 4). As the factors underpinning the US “reflation trade” in Q1 have come into question in Q2, speculators have covered much of the huge short positioning that built up in the 30-year Treasury, according to the CFTC (bottom panel). However, the JP Morgan survey of client duration positioning still shows a large number of clients are running duration exposures below that of their benchmark, suggesting that real money investors have not yet capitulated even as Treasury yields have moved lower. In a report published back in June, we looked at previous episodes where the 10-year US yield became stretched versus its underlying trend over the past two decades.1 We concluded that it could take until at least August before the 10-year Treasury worked off its oversold condition, defined as the yield returning to its 200-day moving average using daily closing prices, based on the average length of those past episodes. The US 10-year yield is now below its 200-day moving average of 1.28%, but it is still too soon to declare this oversold episode over given the still large underweight duration position visible in the JP Morgan survey. Some reduction in that tilt will be necessary before longer-term Treasury yields can begin to climb again. Summing it all up, the uncertainty over global growth momentum, the Delta variant, and the underlying pace of US inflation will likely keep Treasury yields under some downward pressure, especially with short positioning not yet completely cleaned out. We suspect that it will take a reacceleration of US employment growth before US Treasury yields can begin to move higher once again. That would not begin to be visible until at least the September payrolls data – a month when extended US federal unemployment benefits expire and children return to in-person learning at school, freeing up some of the supply bottlenecks in US labor markets. Our base case scenario is that the current pickup in COVID-19 cases will not derail the US economic recovery from the pandemic. A tightening US labor market and stickier-than-expected US realized inflation will lead the Fed to announce in December a tapering of its asset purchases starting in January 2022. A shift to a less dovish Fed, and eventual rate hikes beginning at the end of 2022 after tapering is complete, will be the driver of the next upleg in US Treasury yields. Looking outside the US, our Central Bank Monitors continue to highlight that developed economy central banks are all under cyclical pressure to begin dialing back the massive monetary accommodation put in place to fight the temporary economic shock of COVID-19 (Chart 5). Yet pricing in Overnight Index Swap (OIS) markets highlight the diverging messages from policymakers. Chart 4USTs Still Working Off Oversold Condition Chart 5A Clear Message From Our Central Bank Monitors A rate hike is now expected before year-end in New Zealand and by July 2022 in Canada (Table 1) “Liftoff” is now expected in January 2023 in the US, Australia and the UK; while rates are expected to remain unchanged until November 2023 in the euro area and February 2024 in Sweden. The bigger future issue for markets, however, is the pace of rate hikes given how little tightening is expected after liftoff. Table 1Bond Markets Are Vulnerable To Hawkish Monetary Policy Shifts OIS curves are only discounting a handful of rate hikes to occur by the end of 2024 in most countries. Beyond that, 5-year/5-year forward OIS rates – a good proxy for the so-called “terminal rate”, or how high rates will end up in the next tightening cycle – show that markets have downgraded their assessment of how high global interest rates can possibly go. With global growth likely to remain above trend over the next 1-2 years, the current surge in global inflation will likely not be as transitory as the Fed and other central banks expect, leading to a faster pace of monetary tightening than markets are discounting (outside of Europe and Japan) and a renewed move higher, on average, for global bond yields led by US Treasuries. Bottom Line: Peaking global growth expectations and the growing spread of the Delta variant are challenging the “reflation and reopening” narrative that drove bond yields higher in Q1 of this year. Underlying growth, however, is likely to stay above-trend in most developed economies over the next 1-2 years, leading to tighter labor markets, increased domestic inflation pressures, and less dovish central banks - especially in the US. We continue to recommend an overall below-benchmark duration position in global bond portfolios, with an underweight stance on US Treasuries, on a strategic (6-24 month) basis. New Zealand: Primed For Liftoff Recent news from New Zealand has confirmed the market pricing of the Reserve Bank of New Zealand (RBNZ) as one of the most hawkish central banks within the developed economies. We have been of the view that the RBNZ would be among the first to withdraw the monetary accommodation put in place because of the pandemic, and recommended that investors avoid New Zealand sovereign debt in our Special Report on global house prices earlier this year.2 Increasingly, that view is being borne out, with the RBNZ delivering a hawkish surprise last week by announcing an end to the Large-Scale Asset Purchase (LSAP) program by July 23. On the surface, New Zealand’s situation does not appear that different from other higher-yielding bond markets in the developed world such as the US, UK, Australia, and Canada. However, there are a number of factors that make higher interest rates more appropriate for this economy: An unsustainable housing market If nothing else, the RBNZ’s hawkish turn can be attributed to the country’s wildly unsustainable housing market (Chart 6). Nominal house prices have been in an unimpeded accelerating trend since mid-2019, and are now growing at a whopping 28% year-over-year as of June. The anecdotal stories of housing market frothiness in New Zealand are at times unbelievable, like the recent sale of a run-down house in an Auckland suburb, with no bathroom or toilet, for a whopping two million dollars.3 The housing boom has undoubtedly been caused by accommodative monetary policy, with mortgage rates reaching all-time lows during the pandemic. While the RBNZ has implemented macroprudential measures such as increased loan-to-value restrictions on mortgages, it will take a significant pickup in mortgage rates to truly curb the acceleration in house prices. Housing affordability – or, more accurately, unaffordability - has reached a point where a 20% down payment on the median national house price is equal to 223% of the median disposable income, according to the RBNZ (Chart 6, middle panel). A similar measure, the OECD’s house price-to-income ratio, is most elevated in New Zealand among the developed economies. The overheating housing market also poses a major financial stability risk. New Zealand also leads the pack when it comes to the housing exposure of commercial bank balance sheets (Chart 6, bottom panel). With nearly half of commercial bank balance sheets composed of housing loans, New Zealand’s financial system is especially susceptible to a housing downturn. The takeaway is clear - even in the absence of other factors, the housing situation alone would be enough to force the RBNZ to act. Inflation accelerating above target The RBNZ tapering decision came a mere two days before the release of a very strong CPI print for Q2/2021, with consumer prices rising 1.3% during the quarter and 3.3% on a year-over-year basis – the fastest pace since 2011 (Chart 7). The central bank had been expecting some near-term spikes in headline inflation owing to temporary supply shortfalls and high oil prices. However, the RBNZ does not see all inflation as “transitory” and acknowledges that rising capacity pressures and labor shortages could continue to push up inflation going forward Chart 6The RBNZ's Housing Headache Chart 7A Broad-Based Spike In NZ Inflation Inflation has also been broad-based, with both tradables and non-tradables inflation running above the upper band of the RBNZ’s 1-3% inflation target. Although the bank does, on net, favor a lower New Zealand dollar (NZD) for the export-driven New Zealand economy, the depreciation in the NZD could push up tradeables inflation further, making urgent action from the RBNZ all the more necessary. Also important are the sources of inflation. The housing basket was responsible for more than a third of the rise in prices in Q2 (Chart 8). With housing affordability now a politically fraught issue creating major headaches for the RBNZ, expect the bank to be extra-sensitive to this sort of inflation. Accelerating food prices also create the risk that the “sticker shock” of rapidly rising costs for everyday spending items pushes up consumer inflation expectations past the RBNZ target range. Chart 8Prices Are Rising For 11 Out Of The 12 Groups In The NZ CPI Basket Chart 9The RBNZ Is Running Out Of Bonds To Buy An asymmetric monetary policy backdrop The monetary policy backdrop in New Zealand also favors a withdrawal of stimulus, on the margin. After only sixteen months of quantitative easing, the RBNZ now owns nearly half of all the sovereign debt outstanding in the country. That is a level of ownership on par with the ECB, which has had a long-running asset purchase program, and far exceeds the shares held by peers such as the Fed and Bank of Canada (Chart 9). Had they not terminated purchases, the RBNZ would have been limited by the simple fact that there is not enough government bond issuance for it to buy up without starting to impair the liquidity of the bond market Looking beyond the end of the LSAP, the central bank may have to push policy rates considerably higher to contain inflation. At only 0.25%, the official cash rate is 165bps below the mean estimate of the neutral rate —the rate at which monetary policy would be neither restrictive or stimulative – derived from the RBNZ’s suite of quantitative models (Chart 10). There is also some uncertainty around this number, with the upper end of the range of estimates as high as 4.5%. This signals that the RBNZ could hike rates quite a bit without choking off the economy. Chart 10The Market Is Pricing In An Extremely Slow RBNZ Hiking Cycle In this context, market pricing in the New Zealand OIS curve, which discounts a very slow hiking cycle with the policy rate not expected to reach the median RBNZ neutral rate estimate until 2028, appears overly dovish. A buoyant economic backdrop Lastly, the RBNZ has arguably already satisfied its mandate to support the economic recovery coming out of the pandemic (Chart 11). Real GDP and aggregate employment are both above pre-COVID levels, while business and consumer confidence are continuing the recovery started last year. Yields have picked up across the New Zealand government bond curve, reflecting this improvement in growth and sentiment. Even though some pandemic restrictions remain in place, the vaccination program has shown steady progress and is likely to ramp up further as the government has just acquired a large shipment of the Pfizer vaccine. Looking at the broader picture, there appears to be little remaining justification for the RBNZ to remain as accommodative as it is right now. The economic recovery from the pandemic is largely complete and the upside inflation and financial stability risks are too important to ignore. After such an abrupt end to the RBNZ’s LSAP program, rate hikes are likely just around the corner. Yet with the OIS curve now discounting a full rate hike by October of this year, markets have adjusted to a sooner than expected RBNZ liftoff date. However, we believe that the New Zealand sovereign yield curve has not fully priced in how much the RBNZ - historically one of more active central banks that is not afraid to raise or lower interest rates aggressively - will need to tighten, and how flat the curve will get, once the rate hikes begin. Although the entire New Zealand government bond curve has already flattened somewhat, experience from previous hiking cycles shows that the curve usually continues to flatten well after rate hikes begin, usually reaching zero or inverting slightly by the time the RBNZ is done hiking rates. This is especially true for the yield curve between two and five years, which is the maturity range that is most sensitive to rate hike expectations (Chart 12). Chart 11The NZ Economy Has Recovered For The Most Part Chart 12Monetary Policy And The NZ Yield Curve Currently, the 2-year/5-year New Zealand yield curve is 22bps, leaving ample room for the curve the flatten further once the RBNZ begins to hike rates. Meanwhile, implied forward rates are currently priced for a re-steepening of the curve in the short term, making a 2-year/5-year flattener an especially attractive trade in New Zealand with the RBNZ set to tighten. This is also a “cleaner” play on monetary policy expectations over a cyclical horizon than, for example, a 2s/10s flattener where the longer-maturity yield could be boosted by higher inflation expectations (and where some flattening is already discounted in the forwards). Today, we are initiating a new recommended 2-year/5-year curve flattener trade in New Zealand using cash government bonds. This trade involves selling a 2-year bond, and using the proceeds to buy a combination of a 5-year bond and a 3-month treasury bill that has the same duration as the 2-year bond. This makes the trade both duration-neutral and “proceeds-neutral” by fully investing the cash from the sale of the 2-year bond. Details of the trade, including the duration weightings and specific bonds used, can be found in our Tactical Trade Overlay table on page 17. Bottom Line: House prices, inflation, and the overall economic backdrop justify the RBNZ’s hawkish shift. However, government bond and interest rate swap markets have not fully priced in how quickly, and how far, the RBNZ can hike during the upcoming tightening cycle. As a play on further RBNZ hawkishness, we are entering a new recommended tactical trade – a 2-year/5-year yield curve flattener in New Zealand government bonds.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Report, "A Summer Nap For Global Bond Yields", dated June 9, 2021, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Global House Prices: A New Threat For Policymakers", dated May 28, 2021, available at gfis.bcaresearch.com. 3https://www.theguardian.com/world/2021/jul/15/house-with-no-toilet-sells-for-2m-as-new-zealand-property-market-soars Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Metals prices are likely to suffer in the short term on the back of weakening Chinese demand and fading inflationary pressures. Accordingly, in our most recent Global Asset Allocation (GAA) Quarterly Outlook, we downgraded the AUD to underweight against the greenback. Bond yields, globally, are bound to rise moderately over the course of the coming 12 months. Australian yields, however, are likely to rise slower than those in the US. The RBA has been explicit in communicating what it would take to adjust its policy stance and is likely to lag behind other central banks in DM. We therefore recommend investors favor Australian government bonds in a global bond portfolio. Australian equities, now dominated by Financials rather than the Materials sector, would benefit from a rise in bond yields. However, a weaker AUD and declining metal prices warrant no more than a benchmark exposure to Australian equities within a global equity portfolio. Introduction Recently, clients have often been asking about Australia. The reasons seem clear. With a potential commodities “super-cycle” driven by a shift to renewable energy and electric vehicles (EVs), both the Australian economy and equities should be in a position to benefit. The reality, however, has been much less positive. Particularly the divergence between the core driver of the Australian market, industrial metals, and the performance of both equities and the currency over the past few years has been a concern (Chart 1). Over the past year and a half, Australian equities have underperformed the MSCI ACWI by 12.4% (Chart 2, panel 1). This underperformance was mainly due to the outperformance of the US. However, even against global markets excluding the US, Australian equities did not match the rise in commodity prices – particularly industrial metals (Chart 2, panel 2). Chart 1Despite The Rise In Metals Prices... Chart 2...Australian Equities Have Not Outperformed   Chart 3Financials Dominate Australian Equities The structure of the Australian market has changed over the past few years. The commodities boom and subsequent global liquidity boom over the past two decades have fueled a housing bubble in Australia and an unsustainable rise in household debt. As a result, Australian equities are no longer dominated by metals and mining stocks, but rather by banks (Chart 3). We structured this Special Report in a Q&A format, answering questions we think are most relevant for investors to assess both the short- and long-term outlook for Australia. We aim to provide an overview of the economy and draw some conclusions on how investors should be positioned. Our conclusions are as follows: Over the past year and a half, the Australian economy has shown how complementary actions between fiscal and monetary policy, as well as social restriction measures, can mitigate both economic and human damage. The Reserve Bank of Australia (RBA) will be in no rush to adjust its policy stance until wage growth is back to its 3% target. However, RBA officials risk running the economy hot in the meantime given that measures of employment are back to their pre-pandemic levels. The RBA is not likely to change its policy stance before reaching its wage growth and inflation targets and will probably lag behind other global central banks in tightening. In that case, investors should favor Australian government bonds in a global bond portfolio. Australian banks remain well-funded and in good health. But their excessive exposure to the housing sector puts them at grave risk if home prices collapse. Despite this, there seems to be a feedback loop where a decline in mortgage rates fuels further demand for loans, pushing up home prices. A slowdown in Chinese credit growth and economic activity will hamper commodity demand, weighing down on Australian equities. The longer-term outlook remains compelling for Australian equities and metals as we enter into a new commodities “supercycle” fueled by a transition to renewable and alternative energy. The Australian economy stands to benefit given that the country has high levels of both production and reserves of the minerals needed for this transition.   Q: How Does The Economy Look In The Short-Term? A: Australia can be regarded as one of the few countries that successfully navigated the pandemic with a minimal amount of damage, both to its population and economy. With swift measures to limit travel and implement social restrictions, the spread of the outbreak was curtailed to slightly over 30,000 total cases, representing only 0.12% of its population (Chart 4). On the other hand, its vaccination campaign has been much slower (at 38 doses administered per 100 people) than in other DM economies such as the US, UK, France, or Germany with 100, 120, 90, and 102 doses per 100 people, respectively. In the short term, this might not seem particularly damaging to the economy. However, if vaccination rates do not pick up rapidly, Australia’s international travel restrictions (which cannot sustainably be kept in place) will hamper economic growth and become a major drag on the tourism and education sectors (Chart 5, panels 1 & 2). Chart 4Government Policies Contained The Pandemic Outbreak... Chart 5...At The Expense Of Tourism Ample fiscal support – in the form of wage subsidies and business support through the JobKeeper program – mitigated the shortfall in household incomes (Chart 6). This provided a boost to both consumers and businesses with Q1 GDP growth coming in at 1.8% quarter-on-quarter (7.4% annualized). GDP expectations for the remainder of this year and next show a resilient strong momentum for Australian growth and domestic demand (Chart 7). Chart 6Fiscal Stimulus Supported Employment... Chart 7...And Overall Growth Chart 8Labor Market Back To Pre-Pandemic Levels...   The labor market recovery has been an excellent example of how fiscal support and lockdown measures complement each other. Most employment indicators have almost recovered or surpassed their pre-pandemic levels: The unemployment rate stands at 4.90%, compared to 5.13%, the underemployment rate is at 7.44%, compared to 8.60%. The total number of those employed is now above its pre-pandemic level, albeit still below the 2018-2019 growth trend (Chart 8).   Q: When Will The RBA Shift Its Policy Stance? A: The RBA has been explicit in communicating that changes in its policy stance hinge on Australian wage growth rising sustainably towards 3% – a level last reached in Q1 2013. Even with economic activity mostly restored, wage growth remains low at 1.49% (Chart 9). Our belief is that until that occurs, the RBA will probably maintain its accommodative stance. Our global fixed-income strategists, in a recent report, highlighted their belief that the RBA is likely to be less hawkish than markets currently expect – on both tapering and hiking rates. We agree with that assessment. Comments by RBA Governor Lowe earlier last month back our dovish belief: He stated that “The Board is committed to maintaining highly supportive monetary conditions to support a return to full employment in Australia and inflation consistent with the target…This is unlikely to be until 2024 at the earliest”. Market expectations nevertheless remain much more hawkish – pointing to a first rate hike by mid 2022 and almost 70 basis points of hikes by 2024 (Chart 10). Chart 9...However Wage Growth Remains Muted Chart 10Market Expects A Hawkish RBA...   Chart 11...And Is Already Pricing That Down The Curve Chart 12Inflation Remains Well-Below The RBA's Target This means that the RBA will probably risk running the economy hot for a while. With total employment back to its pre-pandemic level and other employment indicators closely behind, inflationary pressures, sooner or later, will begin to mount. Higher growth prospects and inflation risks are being discounted further down the curve (Chart 11). The June CPI print is likely to reflect a transitory short-term base effect and the RBA is mostly going to see through that. In the meantime, we would watch other broad inflation indicators to gauge for price pressures. Broader measures such as the trimmed-mean inflation index or median inflation remain subdued at 1.1% and 1.3%, respectively. The 10-year breakeven rate currently stands at 2.1%, within the RBA’s range of 2%-3%, highlighting the market’s belief that long-term inflation remains well under control (Chart 12). Bottom Line: The RBA is likely to maintain its dovish stance for longer than the market expects. A return to sustainable levels of wage growth and inflation will remain the top objectives and it is unlikely that policy will be reversed before they are achieved. Our global fixed-income strategists laid out a checklist of what would make the RBA turn less dovish. So far, only 1 out of 5 items on their list (the recovery in private-sector demand) signals the need for a more hawkish stance. The remaining items signal no imminent pressure on the RBA to adjust policy (Table 1). The RBA is also wary of the currency appreciating if it took a more hawkish stance ahead of other central banks (e.g., the Fed) and is therefore likely to switch policy only after other central banks do so (Chart 13). Accordingly, investors should favor Australian government bonds within a global bond portfolio. Table 1RBA Checklist Chart 13The RBA Will Be Wary Of A Rising AUD   Q: Are There Signs Of Improvement In The Banking Sector? A: Headline indicators of the health of the Australian banking sector paint a picture of a well-capitalized, highly funded, and profitable industry. Return on equity (ROE) has averaged 12.1% over the past decade. Capital adequacy and Tier 1 capital ratios stand at 14.5% and 18.2%, respectively – much higher than at the start of the Global Financial Crisis (GFC). The ratio of non-performing loans remains low and Australian banks’ reliance on leverage has also decreased (Chart 14). Chart 14Banks Look Healthy... Chart 15...But Remain Exposed To The Housing Sector... However, these indicators mask a major underlying risk. Banks remain heavily exposed to the housing market, with housing loans as high as 62% of banks’ gross outstanding loans and 40% of total assets (Chart 15, panel 1). Over the past decade and a half, banks have lent an average of A$56 of housing-related loans for every A$100 in total loans (Chart 15, panel 2).   Chart 16...Which Is Showing No Signs Of Slowing Down Chart 17Households Remain Heavily Indebted With interest rates falling over the past few decades, construction activity has boomed. Consequently, the demand for loans for new homes has been rising, leading home prices higher (Chart 16). This also meant that household debt levels have climbed and currently standing at a staggering 130% of GDP and 180% of disposable income (Chart 17).   So what does this mean for banks’ stock prices? The short answer is that absent a bursting of the bubble in house prices, banks should continue to fare well. Interestingly, the long-standing relationship between bond yields and banks’ relative stock price returns – one that works in other financial-heavy markets such as the euro area – did not hold in Australia, at least until recently. In fact, we find that, historically, Australian banks outperformed the broad market when bond yields were falling. This relationship changed post-GFC, most likely when inflation expectations became unanchored and trended lower – reflecting lower commodity prices (Chart 18). Bottom Line: Rising rates, reflecting better growth prospects and higher long-term inflation, should be a tailwind for bank stocks in the short term. Accommodative monetary policy will spur activity in the property market, propping up bank profits. This, however, puts banks at even greater risk when profitability starts to decline, NPLs rise and regulations tighten further. The latter risk is one we would highlight following RBA deputy governor Guy Debelle’s statement that monetary policy will not be used as a tool to curtail housing prices and that there are other tools to address that issue. Chart 18Rising Yields Will Be A Tailwind For Australian Equities   Q: How Does Chinese Policy Impact Australian Growth? A: China's role in global supply chains, as both a producer and consumer, has increased dramatically since the early 2000s. China’s demand for commodities generally and industrial metals in particular has grown over the past two decades from an average of 10% of total global demand to 50% for most metals (Chart 19). Australia stood to benefit, redirecting more and more of its metals’ production away from the rest of the world and towards China. For example, during the same period, the share of Australian iron ore exports to China increased fourfold (Chart 20). Chart 19China Is A Major Consumer Of Metals... Chart 20...And This Has Benefited Australia Over The Past Two Decades     However, this dynamic leaves the Australian economy very exposed to the Chinese business cycle – one that is heavily reliant on policymakers’ decisions on how much liquidity to inject into the economy. After strong credit and fiscal support throughout 2020, the Chinese authorities – wary of excessive leverage in the economy – have begun paring back stimulus which is likely to lead to weaker growth in the second half of the year and put downward pressure on metal demand (Chart 21). Chart 21Weakening Chinese Demand Will Hurt Metals In The Short-Term Heightened political tensions between Australia and China have also played a role. China recently imposed restrictions, including additional tariffs and bans, on Australian imports such as beef, wine, coal, and other goods. Consequently, Australian exports to China slowed. However, the goods not imported by China were absorbed by other economies – Australian export growth did not fall that much. It is unlikely that a new commodity-heavy marginal buyer will emerge in the short-term to replace Chinese demand. The recent rise in commodity prices reflected a return to economic activity, as well as inflationary fears, and supply, shipping, and logistical backlogs. These will ease in the short term, weighing on both the AUD and Australian equities.   Q: Can The Shift To Renewable Energy Spur Future Australian Growth? A: The shift to renewable energy and electrification – particularly in the transport sector – will occur sooner rather than later. Some commodity-exporting countries stand to benefit, and Australia is likely to be one. We previously highlighted that modeling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency and recycling rates, and the rate of conversion to renewables. Chart 22The Shift To Renewables Will Require More Resources... The mechanics of the future demand/supply relationship hinge on the following: Demand will rise during this energy transition period – simply due to the fact that the new clean energy systems require more minerals (such as copper and zinc) than the current traditional hydrocarbon-fueled energy system (Chart 22, panel 1). Electric vehicles (EVs) require about four and a half times more of certain commodities – particularly copper, nickel, and graphite – than conventional vehicles do (Chart 22, panel 2). Supply limitations, on the other hand, are what might propel metal prices even higher and lead the world economy into a new commodities “supercycle”. A study by the Institute for Sustainable Futures has shown that, in the most positive energy transition scenarios, demand for some metals will exceed supply, in terms of both available resources and reserves (Table 2). Table 2...Which Are Likely To Be In Short Supply For some of those metals, Australia is either among the top producers, or has the largest reserves. For example, Australia produces almost 45% and 12% of the world’s lithium and zinc, and has 22% and 27% of the world’s reserves. Looking at other metals, supply disruptions – particularly in economies where political, social, and environmental influences are an issue – might be the driver of further price rises. For example, Chile has the largest shares of global lithium reserves (~44%), and copper reserves (~23%), while South Africa has the largest share of global manganese reserves (~40%). Bottom Line: The transition to renewable energy is already underway and is likely to intensify. Forecast demand should outstrip supply and Australia stands to benefit given its large share of current production and/or reserves. How much will depend on the pace of renewable energy integration but miners are likely to be long-term winners.   Q: What Is The Outlook For The AUD? A: The Global Asset Allocation (GAA) service, in its latest Quarterly Outlook, turned negative on the AUD. The currency has historically had a high positive correlation with commodity prices and industrial metals prices, which in turn are very sensitive to Chinese demand (Chart 23). Given our outlook for metals in the short term (falling demand driven by slowing Chinese activity), we expect some weakening in the AUD over the coming 9-to-12 months (Chart 24). Chart 23The AUD Is Highly Correlated To Metal Prices... Chart 24...Which In Turn Are Highly Correlated To Chinese Activity Additionally, short-term weakness in the economy, caused by further lockdowns as Delta-variant COVID cases rise, is a risk since it might reduce domestic demand. From a valuation perspective, the AUD is slightly below its fair value (Chart 25). However, this on its own does not compel us to remain positive on the currency. We also consider other indicators such as investor positioning – which has reached a decade high, according to Citibank’s FX Positioning Alert Indicator (PAIN) (Chart 26). This indicator suggests that active FX traders hold substantial long positions in the AUD against the USD. Historically, this indicator has provided contrarian signals, with extreme optimism (pessimism) providing useful short (long) signals. Chart 25The AUD Is Close To Fair Value Chart 26Investors Are Long The AUD Bottom Line: Short-term weakness in the economy and a reversal in metal prices warrant caution on the currency. While valuations do not signal overbought conditions, investor positioning (a contrarian indicator) does.   Q: How Should Equity Investors Be Positioned? A: Our recent Special Report on whether country or sector effects drive equity performance showed that sector composition was relatively important in Australia, given the large difference in sector weightings relative to the global benchmark. Our analysis showed that cumulative Australian sector performance over the past two decades detracted from overall returns (Chart 27). Given that framework, and the relationship between the Australian economy and industrial metals, we find that Australian equity performance relative to the US mirrors the performance of global metal and mining relative to global tech stocks (Chart 28). This underperformance makes sense: Commodity prices have been in a structural downtrend throughout the past decade. Chart 27Country Vs Sector Effect Chart 28Australia / US = Metals / Tech Therefore, given our view of the outlook for metals, we would not want to shun Australian equities. The Global Asset Allocation (GAA) service is currently neutral the Australian market within a global equity portfolio, and underweight the Materials sector over the next 12 months. We believe this positioning makes sense given the slowdown in the Chinese economy and the improbability that another country will emerge as the alternative marginal buyer of commodities. The longer-term outlook is more compelling however, as the shift to decarbonization, renewables, and alternative energy gets underway. Conclusions In the short term metals prices are likely to suffer on the back of weakening Chinese demand (with no immediate substitute as a marginal buyer) as well as fading inflationary fears and an easing of supply/logistical issues. Our analysis shows that sector composition is a larger driver of Australian equity relative performance than country composition. While Australian equities – dominated by Financials – would benefit from a moderate rise in global bond yields, yields will rise more slowly in Australia than in the US and the AUD is likely to weaken. Over the next 12 months, investors should remain neutral on Australian equities within a global equity portfolio. The RBA is likely to lag other central banks in tightening policy. Investors should therefore favor Australian government bonds over other developed economies such as the US and Canada.   Amr Hanafy, Senior Analyst Global Asset Allocation amrh@bcaresearch.com