Economy

Highlights Biden’s initial political capital is moderate-to-strong according to our Political Capital Matrix. He will pass his American Rescue Plan and one or two budget reconciliation bills over the next 18 months. Investors will need to discount the impact of tax hikes eventually.  The Democrats’ second impeachment of President Trump is a distraction but the party will not let it derail their legislative agenda. The bipartisan power-sharing agreement in the Senate will keep the filibuster in place for now (though not permanently). This does not affect the most market-relevant aspects of Biden’s policies, at least not in 2021, but beyond that it is an open question.  The stock rally is stretched, so prepare for volatility in the near term. But over the long run continue to prefer stocks over bonds, cyclicals over defensives, and value over growth stocks. Feature The US equity rally is getting frothy even as President Joe Biden kicks off his administration with a flurry of executive orders. Financial exuberance stems from combined monetary and fiscal stimulus that will provide a positive backdrop for risk assets for most of this year. Still, most of the good news is priced so we expect volatility to revive in the short run. The BCA Equity Capitulation Indicator is nearing the highest points of its historic range, which is typically a signal for a 10% equity correction or more (Chart 1). Not all indicators point decisively to a bubble that will pop imminently but several suggest that a bubble is being formed.1 The policy backdrop of fiscal largesse combined with an ultra-dovish Fed makes it easy to see why some parts of the market are getting manic. In this context, the Biden administration’s regulatory and tax agenda will become a negative catalyst in the short run even though its big spending will secure the economic recovery, which is positive in the long run. Chart 1Mania Unfolding Biden’s First Executive Orders Biden’s initial decrees brought zero surprises so far. He rejoined the Paris climate agreement, canceled the Keystone XL pipeline, suspended new oil and gas leasing on federal land, reversed President Trump’s border emergency and immigration curbs, ordered federal workers to wear masks, and directed the federal government to “Buy American.” The energy sector suffered the brunt of Biden’s initial regulatory salvo but the relative performance of energy stocks did not drop as much as financials, where Biden’s regulatory risks are less immediate. Biden’s policies are negative for health care stocks but they suffered least from what was a general setback for value plays in the context of a small bounce in the dollar and fears about global growth weakness stemming from the pandemic which has not yet been quelled. Large caps in all three of these sectors are underperforming small caps, suggesting that Biden’s new regulations and looming tax hikes are not driving the markets – at least not yet (Chart 2). Rather these cyclical small caps stand to benefit from the administration’s large spending plans, which include the $1.9 trillion American Rescue Plan currently being negotiated (Table 1). These plans are highly likely to pass as explained below.    Chart 2Biden's Executive Orders: No Surprises So Far Table 1Biden’s American Rescue Plan (With Previous COVID Relief) Going forward, Biden’s regulatory onslaught will bring negative surprises eventually as it expands and deepens but these will not counteract the stronger tailwinds of the vaccine and fiscal spending. Democrats have yet to invoke the Congressional Review Act, which enables them rapidly to reverse the regulations that the Trump administration ordered just before leaving office.2 The regulatory risk is greater for health care and energy than it is for financials and tech, though the latter two are not void of risk. Health care is the Democrats’ top priority outside of pandemic relief and economic recovery. (See Appendix for our updated political risk matrix by sector.) While the market can look through Biden’s regulatory threat, at least for now, it cannot look through the impact of higher taxes on corporate earnings forever. Over the next two months House Democrats will start revealing details of their budget proposals, which could serve as a negative catalyst for the overstretched equity rally. Other negative catalysts from an ambitious new administration are also possible with a market at such dizzy heights. Secretary of Treasury Janet Yellen has discouraged raising taxes initially but investors know that taxes will go up sooner or later. Moreover the specific legislative vehicle for Biden to push his agenda – “budget reconciliation” – requires tax hikes to offset spending increases. Thus if Democrats initiate a reconciliation bill in February or March then it will imply at least some revenue offsets, even if the biggest tax increases are saved for the second reconciliation bill for FY2022. Bottom Line: Value stocks have taken a breather but will continue to outperform over the cyclical 12-month time horizon. Looming Democratic tax proposals are more likely to serve as a near-term negative catalyst for the overstretched equity rally than Biden’s regulatory onslaught, which will take time to be felt. We are sticking with value over growth stocks due to the extremely accommodative fiscal and monetary policy setting. The Filibuster Preserved (For Now) A critical check on lawmaking in the Senate, the filibuster, has been preserved – at least for the moment. This is positive news for markets as it lowers the odds of major legislative surprises this year. The filibuster enables senators to block normal legislation through endless debate. Sixty senators are needed to invoke “cloture” and bring debate to a close. Otherwise the bill goes nowhere. With the Senate divided evenly at 50-50 seats between the two parties, Biden’s agenda will now depend on any bills that can garner 10 Republican senators, plus two “budget reconciliation” bills for fiscal 2021-22. Reconciliation bills only require a simple 51-seat majority in the Senate. Eliminating the filibuster will remain a risk over the long run. It was only preserved because two centrist Democratic senators, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, declared that they would not vote to abolish it. This prompted Republican Senate Minority Leader Mitch McConnell to drop his chief demand, that the filibuster be kept, in his negotiations with Democratic Majority Leader Chuck Schumer toward an agreement for the two evenly divided parties in the Senate to share power. Now a power-sharing agreement is in place so the legislative process can begin, albeit within the filibuster’s guardrails. Notice that Schumer never conceded to McConnell that the filibuster would be preserved. And two Democrats is not very many. Later these centrists may succumb to party pressure, say amid Republican obstructionism of a voting rights bill, to eliminate the filibuster. The last time the Senate was evenly divided, after the 2000 election, the power-sharing agreement only lasted six months, from January to June 2001. A single retirement or death could turn the balance. Moreover since Democrats have the option of two reconciliation bills first, the filibuster is not a substantial check on them until 2022 or beyond, at which point the centrists could fall under sustained pressure.3 Bottom Line: Preserving the filibuster provides a source of stability – it reduces policy uncertainty and polarization. It restricts Biden’s agenda largely to his major initiatives: entrenching the Affordable Care Act, expanding infrastructure spending, partially repealing Trump tax cuts, and various other tax-and-spend measures known to investors. It lowers the chance that financial markets will be blindsided in 2021 by a sweeping new legislative initiative – for example, the Green New Deal – or radical redistributive schemes. While markets will need to discount the tax hikes they will be able to recover more quickly than if they also expected a stream of unpredictable legislation from a Senate unshackled from the filibuster. Stimulus And The Tax Hike Timeline The American Rescue Plan could pass in February at the earliest or April at the latest. If at least 10 Republican senators cooperate then it will fly through Congress. The advantage of this bipartisan route is that it would achieve an early Biden objective while still leaving Democrats with two full chances to pass reconciliation bills covering fiscal 2021-22. The economic recovery would be on sure footing thereafter, giving Biden more room to maneuver (Charts 3 and 4). Chart 3Is More Stimulus Necessary? Bipartisan talks are under way. Senator Joe Manchin of West Virginia set up talks with about 15 other senators and three White House aides, including National Economic Council director Brian Deese, toward revising and passing the rescue plan.4 Winning over ten Republicans is a tall order but GOP senators are aware that the pandemic is still going and even Republican voter opinion favors more relief. So far Democrats have not allowed any compromise in the size of the deal but that could change to get 60 votes, since they can always make up the difference through reconciliation later. The rescue plan is unlikely to be passed before Trump’s second impeachment trial begins on February 8, however. If 10 Republicans cannot be found, the Senate will be slowed down by juggling reconciliation and impeachment. Trump’s first impeachment took 49 days, leaving the average at 65 days (Table 2). It will keep the Senate busy at least through mid-March. Chart 4More Checks Coming For Households? Table 2Impeachment Takes At Least A Month Since Democrats are highly unlikely to win over 17 Republicans to convict Trump of inciting insurrection, the impeachment could be a policy mistake. Democrats are determined not to let slide the opportunity to position themselves as the arch defenders of democracy. Acquitting Trump would put several prominent Republicans on record endorsing him even after his alleged interference with the peaceful transition of power. However, impeachment will not be allowed to derail Biden’s agenda. The Democratic Party controls both processes. The Senate can wrap up the trial if it becomes an obstacle. Diagram 1 presents the timeline for these events to occur. The implication is that March 14, when the latest expansion of unemployment benefits starts to expire, will serve as a deadline for Biden’s rescue plan. Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Budget reconciliation takes seven months on average but it only took three months in 2017, which is the proper analogy for today. Even if tax hikes are passed in Q2 there is an open question as to when they would take effect (Diagram 2). Prudent investors should be prepared for a retroactive January 1, 2021 effective date, even if it is more likely that they will kick in on January 1, 2022 to give the economy more time to recover. Again, taxes pose a risk to the rally. Diagram 2How Long Does It Take To Pass A Budget Reconciliation Bill? If Republicans do not cooperate on Biden’s rescue plan then Democrats will cite it as obstructionism from the beginning, despite Biden’s call to unity, and it will play into any future efforts to eliminate the filibuster. But those will likely center on the period after the two reconciliation bills. Bottom Line: As the House Democrats begin to draft their first budget resolution, to initiate the reconciliation process, tax hikes will come more into focus. The near-term upside risk is that Democrats skip taxes in the first bill and save it for later. But there will have to be at least some revenue raisers in any reconciliation bill. So a near-term pullback is entirely reasonable to expect. We would be buyers on the dip given the extremely accommodative fiscal and monetary backdrop. Introducing Our Political Capital Index To assess any government’s capability – namely its ability to alter the policy setting that affects the economy and financial markets – we need to measure its political capital or grounds of support. To this end we have constructed a Political Capital Index to measure the strength and capability of US ruling parties and presidencies (Table 3). Table 3Political Capital Index The Political Capital Index shows a series of political and economic indicators, as of the latest available data (December or January), as well as the change since Biden’s election in November.5 Below we describe the political and economic categories of political capital that we chose and the data we use to represent them: Political Strength: The most basic measure of political capital is President Biden’s margin of victory in the popular vote (4.4%) and Electoral College vote (306/538), the number of days he has been in power, his party’s Congressional majorities, and the Supreme Court’s ideological leaning. These components will last for two-to-four years and can only be changed by new elections or deaths (Table 4). Even a president elected in a landslide would see his political capital decay over time. The sooner the next election, the less political capital the ruling party has. The president and Congress will have more trouble passing legislation just before the election and will be more careful about what they do pass to avoid punishment at the ballot box. Any difficult economic policies or reforms will tend to be done at the beginning of the term, as political capital is still abundant and the next election is not a clear and present danger. President Biden has moderate political capital. His popular victory was solid, his electoral victory was the same as President Trump’s, but his congressional majorities are weak. His initial legislative efforts should be assumed to pass but aside from his rescue plan and one or two reconciliation bills he will not be able to get much else done. Table 4Political Capital: White House And Congress Household Sentiment: Household sentiment is the origin of political capital since households are voters. We measure it through presidential net approval ratings, both in general and in handling the economy, as well as through consumer confidence (Chart 5). Household sentiment changes easily – it can drive policies and react to them. Even if the economy is objectively improving, sentiment can remain downbeat if politicians fail to communicate their policies, which could cost them the election. Measures that improve household pocketbooks or welfare are more popular than those that impose structural changes like taxes and regulation. But reforms are possible when a politician has sufficient political capital, or when a worse outcome would follow from doing nothing. Biden will start with a higher approval rating than President Trump but his average approval is not much higher at present and consumer confidence has ticked down as a result of the pandemic. His economic stimulus should create an improvement in household sentiment in the coming year. Chart 5US Households: Still Downbeat Business Sentiment: Business sentiment is another important element of political capital. Businesses that are confident about the economy’s prospects will spend on capex, new orders, and new hires, and they will also deplete their inventories (Table 5). Animal spirits respond to spending, taxation, regulation, and trade – all areas where politicians have some control. Table 5Political Capital: Household And Business Sentiment Policymakers can run down business sentiment by enacting painful policies for business, in favor of government or households or personal whim – or they can pass business-friendly policies to boost animal spirits. Businesses cannot vote like households but they have a powerful influence over politicians through lobbyists and political donations and a powerful influence on voters through employment. Higher animal spirits encourage new employment, which improves household welfare, thus boosting political capital. Biden is starting out fairly strong with respect to business sentiment, with the exception of the service sector, which is still beaten down by the pandemic. This is an area where his political capital could decay over time. Big business was happy to get rid of Trump’s trade war but now it faces larger government encroachment. This risk is flagged by small businesses, which are already highly distrustful of new taxes and regulation (Chart 6). Chart 6US Business Sentiment Chart 7Measures Of Polarization Political Polarization: Starkly divided populations and governments are often gridlocked or obstructionist, preventing policies from getting approved or implemented (Chart 7). Our polarization proxy measures the difference in approval of the sitting president according to party, while our economic polarization measure does the same for economic sentiment. Structural polarization is a low-frequency data series from political science literature that measures whether House members and senators tend to vote with the “party line” or “reach across the aisle.”6 The Philly Fed Partisan Index also measures the degree of political disagreement among politicians at the federal level. A highly polarized environment ensures that there will be strong opposition to any policy put forward by lawmakers and a higher likelihood of reversal by the next governing party. This leads to erratic policymaking and policy uncertainty among households and businesses. Lower polarization increases the durability of policies. Fiscal Policy: The government sector contributes to political capital through fiscal policy, especially fiscal thrust (the change in the cyclically adjusted primary budget deficit) (Table 6). An expansionary fiscal policy affords policymakers greater latitude – especially in times and places where inflation is not a public concern. It can also be an effort by the ruling party to boost its political capital when it is low, or when an election looms. The Biden administration is lucky to start off with a new business cycle, as Obama did in 2009, but the large dose of fiscal support today will become a fiscal drag by 2024 so the long-term effectiveness of today’s “pump priming” will be essential. Table 6Political Capital: The Economy And Markets Economic Conditions: Economic conditions are arguably the most important component of political capital. We included several objective measures of household wellbeing such as unemployment, inflation, gasoline prices at the pump, and wage growth. If voters have seen their quality of life improve under the current set of leaders then they are more likely to vote to continue their windfall. To judge whether a party will be re-elected, it is critical to know whether household wellbeing has changed since the last election. High unemployment, high inflation, high economic uncertainty, and high bankruptcy levels point to struggling voters who are more likely to take their grievances to the ballot box. By the same token, leaders will struggle to get anything done if voters are beset with these ills. Asset Markets: Asset markets play at least some role in determining political capital. Most voters are not highly exposed to the stock market, though they care about their pension fund. Most voters are highly exposed to the property market. A euphoric stock market will not necessarily buoy the political capital of a president or ruling party, as demonstrated by the recent election: President Trump’s approval was closely linked to the stock market, which also restrained his actions, yet a rallying market did not get him re-elected. A market crash will always hurt policymakers, especially if it happens just before an election. We watch the stock market primarily as a downside risk to the ruling party’s political capital rather than upside. Bottom Line: Our Political Capital Index is how we will monitor President Biden’s and the Democratic Party’s capability in the coming months and years. The administration begins with moderate political capital but it is likely to improve on economic recovery, which will be secured through control of Congress and the purse strings. Our confidence that Biden’s American Rescue Plan and one or two reconciliation bills will pass stems from this assessment. This means a large spending program and tax hikes are highly probable and investors should prepare for them. Investment Takeaways Signs of mania – from Bitcoin to TESLA to GameStop – have gripped the market as the combined effect of ultra-dovish monetary and fiscal policy is priced. This process can continue beyond reasonable expectations. Nevertheless we are prepared for near-term volatility and a correction at any time. The rollout of the COVID-19 vaccine faces inevitable bumps and the pandemic is still triggering government lockdown measures and consumer caution – though these will improve over time. Biden’s regulatory agenda and especially looming tax hikes will also spur some risk aversion in the near term as the House Democrats begin preparing a reconciliation bill. Overcoming the hurdle of Trump’s impeachment will free up the Senate to move forward on reconciliation as well, which means tax hikes will fall under the market’s radar sooner or later. A regular bill could be passed in February without new taxes but otherwise a reconciliation bill will pass as early as April and include at least some new taxes, even if they take effect next year. We would still use the opportunity to buy into any further weakness in value plays relative to growth plays (Chart 8). Fundamentally the economy is set to improve this year, the pandemic is set to subside, and the policy support will be reinforced and expanded as necessary. Chart 8A Setback For Growth Versus Value Chart 9Equity Correction Looms The reflation trade is technically over-extended, investors are complacent, and some profit-taking is due. The extremely depressed put-to-call ratio tracks well with the US dollar index, both of which are showing signs of life (Chart 9). We would fade a rebound in the dollar, however, as the Democratic Party’s policies will ensure widening twin deficits (budget and trade deficits) even as the Fed demonstrates its commitment to its new goal of allowing an inflation overshoot to make up for past undershoots.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1Political Risk Matrix Table A2Biden’s Cabinet Position Appointments   Footnotes 1     See BCA Research US Equity Strategy, “Overdose?” January 25, 2021, bcaresearch.com. 2     The Congressional Review Act of 1996 enables Congress to speed up the removal of regulations that were adopted recently, in this case since August 21, 2020. The process requires both houses of Congress to repeal a regulation but the Senate cannot prevent repeal via filibuster. The Trump administration used the law aggressively to remove several of President Barack Obama’s outgoing regulations. See Jonathan H. Adler, “Will Democrats Learn To Love The Congressional Review Act?” Reason, January 23, 2021, reason.com.  3    Democrats are explicitly interested in repealing the filibuster, as Biden and Senate Majority Leader Chuck Schumer have indicated (not to mention former President Obama who characterized it as a relic of the racist Jim Crowe era). 4    See Ed O’Keefe et al, “16 senators from both parties meet with White House on COVID-19 relief plan,” CBS News, January 25, 2021, cbsnews.com; Aamer Madhani and Lisa Mascaro, “White House Begins Talks With Lawmakers On COVID-19 Relief,” Associated Press, January 25, 2021, apnews.com.  5    Biden’s term technically began on January 20 but voters in 2024 will judge the president and ruling party based on whether they are better off than they were four years ago, i.e. when they last made a major judgment. 6    See Jeffrey Lewis, Keith Poole, Howard Rosenthal, et al, at voteview.org.  

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Chart 4…And Occur Alongside Strong Economic Recovery Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2  Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification