Equities
Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Chart 1Wave Dynamics Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet Chart 2The Economy Is Not Out Of The Woods Yet The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later. It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB Chart 3A Careful ECB This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro Chart 4A Murky Outlook For The Euro Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities Chart 5German Yields Are Key To Value Stocks And Italian Equities Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Chart 6Europe’s Quality Deficit Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Chart 7Will The Cyclicals Outperformance Resume? The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Chart 8Favor Financials These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Chart 9Small-Caps Are Nearly There Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round. 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According to BCA Research’s Counterpoint service, this year’s sell-off in the interactive entertainment sector provides a good entry point for long-term investors. In the future, a typical day will be divided into three. A third we will spend sleeping and…
Almost two years ago, the Fed and other Central Banks (CBs) flooded the market with liquidity in an attempt to help the global economy and the financial sector to battle the pandemic. One of the unintended consequences of the said liquidity flood was a rally in the most speculative parts of the US equity market, such as small caps growth technology stocks, which are akin to lottery tickets and attract a disproportionate share of retail flows. Today, the situation could not be any different with more CBs tightening policy, the Fed discussing an accelerated taper program, and the market pricing in three rate hikes in 2022. Consequently, investors are now shedding their exposure to the most speculative assets with BTC, ARKK, and small caps growth being in an outright bear market. Given that we are still in the early innings of the tightening cycle, things are likely to get worse before they get better. Bottom Line: As global growth decelerates over the coming quarters, the Fed will be the final nail into the retail-heavy speculative assets’ coffin (see chart).
Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). Chart 3Social Restrictions Short Of Lockdown Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened) Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place Chart 13EM: Political Risk High But Governments Not Recapitalized Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22). Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound. We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks. -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail. Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2 Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar
Dear Clients, This is the final publication for the year, in which we recap some of the key economic developments this month. Our publishing schedule will resume on January 6, 2022. The China Investment Strategy team wishes you a very happy and safe holiday season and a prosperous New Year! Best regards, Jing Sima China Strategist Feature Recently released data show China’s economy is weakening despite easing monetary policy and power-supply constraints. Our credit impulse – measured by the year-on-year change in total social financing as a share of GDP – inched up in November (Chart 1, top panel). Given that the indicator leads economic activity by about six to nine months, we maintain the view that China’s economy will not bottom until Q2 next year. Chinese stocks, driven by business cycle, will remain under downward pressures in the next three to six months (Chart 1, middle and bottom panels). On the policy front, the PBoC announced a 50bps cut in the reserve requirement ratio (RRR) rate taking effect in mid-December. Last week’s Central Economic Work Conference (CEWC) signaled that stabilizing the economy will be the government’s core policy objective for 2022. However, we believe that policymakers will be data dependent and will only allow an overshoot in credit growth when the slowdown in the economy gathers pace in early 2022. Thus, investors should maintain an underweight allocation to Chinese equities relative to global stocks, at least for the next three to six months, until credit growth significantly improves. Chart 1Downside Risks Remain High For Chinese Stocks Until The Econmomy Troughs Chart 2Chinese Internet Stocks Are Not Cheap Chinese investable stocks, particularly internet companies, will continue to face geopolitical and regulatory headwinds in the next 12 months. Chinese tech stocks sold off this year, but they are not cheap (Chart 2). Economic weakness in the onshore market in the next three to six months may trigger more selloffs and further multiples compressions in Chinese investable stocks. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Cuts To The RRR And Relending Rates: Not Game Changers Chart 3RRR Cut Is Not A Game Changer Following the RRR cut announcement in early December, the PBoC announced a 25bps decrease in the relending rate targeting agriculture and small businesses (Chart 3). The measures sent an easing signal in response to mounting downside risks in the economy. However, their impact on credit growth will likely be limited for the following reasons: First, the PBoC indicated that the RRR cut will release around RMB1.2 trillion in liquidity to the banks. From that amount, RMB950 billion will be used to replace maturing Medium-term Lending Facility (MLF) this month, which leaves only RMB250 billion for new liquidity injection. Chart 4Business Conditions For SMEs Deteriorated Faster Than For Larger Businesses Secondly, the PBoC is trying to prevent a jump in market-based rates in the next two quarters. Demand for liquidity is usually high due to tax season by year-end plus a front-loading of local government bond (LGB) issuance. Moreover, the Chinese New Year in Q1 2022 will further boost demand for liquidity. Thirdly, the targeted relending rate drop is intended to lower the borrowing costs of small-medium enterprises (SMEs) whose profitability has been challenged by rising input costs and sluggish consumer demand (Chart 4). Loan demand from small enterprises, as shown in the PBoC survey, peaked much earlier and tumbled more rapidly than their larger peers (Chart 4, bottom panel). The rate cut has decreased the possibility of a broadly based decline in interest rates in the near-term. China’s Credit Growth May Have Bottomed, But The Rebound Is Moderate Chart 5Below-Expectation Credit Growth In November China’s aggregate credit growth ticked up slightly in November. The modest advance mainly reflects an acceleration in LGB issuance. Chart 5 highlights that excluding LGB financing, China’s credit impulse remains on a downward trend. LGBs will be frontloaded in Q1 2022 before the March National People’s Congress sets the full-year quota for LGBs. However, without a meaningful rebound in bank loan growth, the effects of LGB issuance on infrastructure investment will be limited and short-lived, as occurred in Q1 2019 (Chart 6). Shadow banking, which historically has had a tight correlation with infrastructure investment, continued to slide in November to an all-time low. Infrastructure project approval also does not show any signs of strengthening (Chart 7). Chart 6Improvement In Infrastructure Investment Will Be Limited Without An Acceleration In Loan Growth Chart 7Key Indicators Show Weak Signs Of Revival In Infrastructure Spending Weak demand for bank loans from corporations dragged down credit growth in November as evidenced by softening growth in medium- and long-term corporate loans (Chart 8). Both corporate financing needs and investment willingness continued to wane, implying that corporate demand for bank lending may not turn around soon despite recent monetary easing (Chart 8, bottom panel). In addition, marginal easing measures in the property market have not worked their way into the sector. Bank loans to real estate developers plummeted to all-time lows last month, while trust loans contracted significantly in November, which indicates that financing conditions for real estate developers have not improved (Chart 9). Chart 8Loan Demand Remains Weak And Unlikely To Turn Around Imminently Chart 9Deepening Contraction In Trust Loans Indicates Deteriorating Financing Conditions For Real Estate Developers Easing Of Property Restrictions Will Marginally Benefit The Housing Market Last week’s Politburo meeting and the CEWC both proposed to promote affordable rental housing and support reasonable housing demand. Loan growth to government-subsidized social welfare housing has been decelerating since 2018 and started to contract this year (Chart 10). It will likely strengthen next year amid policy support, but from a very low level and at a modest rate. In addition, although social welfare housing loans account for around 40% of bank loans to real estate developers, they are only about 6% of developers’ total source of funding as of 2020. We expect more policy finetuning in the coming months, which may help slow the pace of deterioration in real estate developers’ financing conditions. Real estate developers’ financing from banks may bottom on the back of government’s intervention, but the improvement in total funds to developers will be gradual without mortgage rate cuts and a pickup in home sales (Chart 11). Meanwhile, the downward trend in housing completion will be sustained in the coming months (Chart 11, top panel). Chart 10Bank Loans To Social Welfare Housing Will Likely Improve Modestly Amid Policy Support Chart 11Less Funding = Reduced Completions And Investments Housing prices in most Tier-one and Tier-two cities continued to move down through November. Data for high-frequency floor space sold show that housing demand continued to abate last month despite a modest uptick in household mortgage loans (Chart 12). Home sales will remain depressed as buyers expect more discounts in housing prices and real estate tax reforms loom. Falling prices and constraints in developers’ financing will continue to weigh on housing starts, given the strong positive correlation between property starts and housing prices (Chart 13). Chart 12Demand For Housing In November Showed Little Signs Of Revival Chart 13Housing Starts Are Highly Correlated With Prices The Rebound In November’s PMI Does Not Signal A Bottom In China’s Economy Chart 14China's PMI Rebounds Amid Supply-Side Improvement The NBS manufacturing PMI returned to above the 50-expansionary threshold in November, but the rise reflects a near-term supply-side improvement related to the power shortage rather than a demand-driven recovery (Chart 14). China’s overall business conditions and domestic demand are still worsening, indicating that the rebound in the manufacturing PMI may be short-lived. The production subindex jumped by three and half percentage points in November from October, reflecting re-started operation of heavy-industry enterprises that were halted amid electricity shortages in September and October. Robust global demand for China’s manufactured goods supported a strong reading in November’s new export orders subindex. However, domestic demand remains lackluster. A proxy for the new domestic orders derived from the PMI reached its lowest level since February 2020 (Chart 14, bottom panel). In addition, service PMI weakened last month. A sharp resurgence in domestic COVID cases curbed service sector activity last month. Given uncertainties surrounding the Omicron variant and China’s zero-tolerance policy towards COVID, the service sector’s recovery will likely remain below-trend into 1H 2022 (Chart 15 and 16). Chart 15Lingering COVID Effects Will Continue To Impede Service Sector Activity In 1H22 Chart 16Service Sector Recovery In China Has Lagged Inflation Passthroughs Ongoing Producer price index (PPI) inflation may have peaked. Meanwhile, the consumer price index (CPI) shows another upturn in November. Despite the peak in PPI inflation, it will likely remain above trend through at least 1H22, supported by elevated commodity and energy prices (Chart 17). Chart 17PPI May Have Peaked, But Will Remain Elevated In The Near Term Chart 18Ongoing Inflation Passthroughs A synchronized rise between PPI consumer goods and non-food CPI, and a narrower gap between PPI and CPI inflation, suggest an ongoing inflation passthrough from producers to consumers (Chart 18). Price increases in some key sectors of manufactured consumer goods sped up in November (Chart 19). However, we do not think China’s consumer price inflation will prevent policymakers from further policy easing. Consumer goods prices are lightly weighted in China’s CPI. An acceleration in inflation passthroughs in this component is unlikely to significantly push up the CPI aggregates. Headline CPI may gather steam next year if food prices rise while energy prices remain at current levels. Nonetheless, in recent years China’s monetary policymaking has been more tightly correlated with the PPI and core CPI, and not headline CPI (Chart 20). Chart 19Manufactured Consumer Goods Prices On The Rise Chart 20Monetary Policy Is Tightly Correlated With Core CPI And Not Headline CPI Surging Prices Underpin China’s Exports, While The Rebound In Imports Is Unsustainable Chart 21Surging Export Prices Underpinned Strong Growth In The Value Of China's Exports Chinese exports in volume tumbled in November, however, surging export prices underpinned the strong growth in the value of exports (Chart 21). Demand from the US drove Chinese exports this year and the moderation in volume growth was more than offset by escalating prices (Chart 22). China’s export prices have caught up with the global average (Chart 23). Chart 22Strong Demand From US Has Driven Up China's Exports Chart 23Chinese Export Prices Have Caught Up With The Global Average We expect China’s export growth to slow in the new year on the back of softer global growth and a rotation in US household consumption from goods to services (Chart 24). However, while slowing, global economic growth is projected to remain above trend. The low level of industrial inventories will also provide support to the demand for goods, which will help to sustain strong growth in Chinese exports (Chart 25). China’s imports surprised to the upside in November, boosted by imports of commodities such as coal and crude oil. November’s acceleration in imports reflects a higher demand for primary commodities from Chinese producers, who recovered some production capacity from the power shortages in the previous few months. Chart 24US Household Spending Will Shift From Goods To Services Chart 25Inventory Restocking In The US Will Support Chinese Exports Next Year Furthermore, the increase in import prices in November outpaced the very modest uptick in the volume of imports, indicating that domestic demand remains sluggish (Chart 26). Credit growth, which normally leads import growth by about six months, only climbed moderately in November and will provide limited support to imports in the coming months (Chart 27). Chart 26Rising Import Prices Masked Weakness In China's Domestic Demand Chart 27Modest Rebound In Credit Impulse Will Provide Little Support To Chinese Imports Chart 28Chinese Demand For Industrial Metals Remains In Deep Contraction China’s imports of industrial metals, such as copper and steel, improved a little in November, but their year-on-year growth remains in deep contraction (Chart 28). Weakening construction activity amid a continued downtrend in China’s property market will likely reduce the demand for industrial metals. Therefore, the rebound in November’s import growth may be short-lived. The RMB Faces Headwinds In 2022 Regardless Of A Rise In FX Deposit RRR The RMB has climbed about 2% against the dollar since late July despite broad-based dollar strength. In trade-weighted terms, the RMB is at its strongest level since late 2015 (Chart 29). A rapidly appreciating RMB does not bode well for China’s industrial sector profits, and thus not at the PBoC’s best interests (Chart 30). Under this backdrop, last week the PBoC announced that it will raise the banks’ foreign exchange (FX) deposit reserve requirement ratio (RRR) to 9% from 7%, effective December 15. This is the second increase this year aimed at easing the RMB’s pace of appreciation. The RMB fell slightly against the US dollar following the announcement last week. Chart 29The RMB Has Strengthened Despite A Strong USD Chart 30Strengthening RMB Does Not Bode Well For Corporate Profit Growth The RMB appreciation against dollar this year was mainly enhanced by China’s record current account surplus and favorable interest rate differentials between China and the US (Chart 31 and 32). Although the increase in the deposit RRR rate will force banks to hold more foreign currencies and lift the cost of RMB speculation, the RRR hike itself has little impact on altering the existing path in RMB exchange rate. Moreover, the balance of FX deposits stands at US$1 trillion as of November this year. The 200bps increase in the FX deposit reserve ratio will only freeze about US$20 billion in FX liquidity, which is negligible compared with the US$580 billion in China’s trade surplus so far this year. Chart 31Current Account Surplus Will Likely Shrink Next Year Chart 32Interest Rate Differentials Will Narrow Further However, looking forward the conditions favored RMB this year are at risk of reversing in 2022. China’s weaker economic fundamentals and a slower pace in trade surplus next year, as well as narrowed interest rate differentials between the US and China due to falling long-duration bond yields in China, will provide headwinds to RMB. Therefore, investors should closely follow these key factors and to be cautious to bet on continued RMB appreciation. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Footnotes Market/Sector Recommendations Cyclical Investment Stance
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Stock buybacks have surged following last year’s pandemic-induced collapse. This trend reflects the solid US economic environment. Companies engage in buyback activity when they are in solid financial standing. Robust economic activity in the US has been…
Highlights 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it. Economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. Corporate profitability will return to trend. The likely deceleration in earnings growth and margin contraction will be driven by a combination of factors: A slowdown in top-line growth, a decline in corporate pricing power, and increases in labor and input costs. The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle, and volatility is heightened. We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation as in the middle single digits. Overweight Small vs. Large for the following reasons: First, Small is expected to outperform in an environment of rising rates - A BCA view for 2022. Second, Small is cheap. Third, the profitability of Small has improved dramatically which attests to the ability of smaller companies to efficiently manage their operations even under duress. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double of Large, 20% vs. 10%. We are neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. Overweight Cyclicals vs. Defensives as the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives. Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. Further, rising rates is an environment favorable for Cyclicals at the expense of Defensives. Within Cyclicals, we prefer the following sectors and themes: Consumers are flush with cash and there is strong pent-up demand for services and selected consumer goods like services: Overweight Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Also, overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. New Capex Cycle: Businesses bring their supply chains back to the US and excess consumer demand has driven the need for expanded capacity. Capex intentions are on the rise. Overweight Construction and Engineering, Building Materials, and Capital Goods. New Credit Cycle: Early signs that both consumer and business lending is picking up. Rising rates will also lend a helping hand to Banks – overweight Overweight Energy as demand for oil is robust on the back of global recovery and chronic underinvestment in Capex. Underweight resource stocks, which are exposed to a slowdown in China. The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. Overweight Real Estate and Homebuilders Multi-year structural themes are Millennials, Generation Z, EV revolution, and Cybersecurity. 2022 will be a big year for the new technology themes. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports. Feature House Views Last Week, BCA published its annual outlook, a transcript of our yearly discussion with the firm’s long-time clients, Mr. X and his daughter, Ms. X. In this document, we discussed the major themes for 2022. Below are some of the main conclusions: The COVID-19 pandemic is likely to recede in importance next year. The effect of the recently discovered Omicron variant remains unknown, but we expect any negative economic impact that occurs to be limited to the first half of the year. A receding pandemic will lay the groundwork for a more normal labor market, prices, and the supply of both goods and services. We expect actual inflation will come in lower next year than what short-maturity inflation expectations currently suggest. Economic growth in advanced economies will be above trend for the year on average, and we expect the US and euro area output gaps to close in 2022. Any economic activity disrupted by Omicron in the first half of 2022 will likely shift into the second half of the year. Above-trend growth will be supported by easy monetary policy, a shift in spending from goods to services, and a sizeable amount of excess savings that will support overall consumer spending. A reacceleration in Chinese economic activity is more likely in the latter half of next year rather than in the coming six months. Stocks will outperform bonds in 2022, but equity market returns will be in the single-digit territory – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Equity market volatility may increase in the lead-up to US monetary policy tightening at the end of the year, but we expect only a moderate rise in long-maturity bond yields—which will not threaten economic activity or cause a major decline in equity multiples. Equity investors should favor small-cap over large-cap stocks in 2022. Small-cap stocks tend to outperform when bond yields are rising, and relative valuation levels are attractive. We generally favor cyclical sectors next year but stretched relative performance versus defensives means that we expect to rotate away from cyclicals at some point over the coming year. A window exists for value outperformance versus growth in 2022, in response to higher long-maturity government bond yields. We do recommend the former over the latter. Brent oil prices will average around $80-81/bbl next year, essentially flat from pre-Omicron levels. The US dollar may remain strong over the coming few months, depending on the extent of the economic impact from the Omicron variant. Beyond that, the dollar’s countercyclical nature, above-trend global growth, and overbought conditions suggest that investors should bet on a lower dollar. In this report, we will explore the implications of the above views for US Equities. 2022 Is A Year Of Normalization If 2021 passed under the banner of recovery, 2022 will be a year of economic normalization. We hope that even if we can’t leave COVID behind, we will learn to live with it, variants and all, and it will become less disruptive to the economy and our personal lives. As such, economic growth will remain strong, but it will be trending down towards its long-term average, while inflation will cool off somewhat on the back of the resolution of supply chain bottlenecks and waning pent-up demand. Monetary conditions will tighten, and 10-year rates will move up towards the 2-2.25% mark. US Economic Growth And Corporate Profitability Will Return To Trend The economy is expected to grow at a robust pace next year (7.3% nominal GDP growth), albeit slower than this year (Chart 1). After a growth surge on the back of the post-COVID recovery, the economy has entered the slowdown phase of the business cycle. Economic growth is poised to shift closer to its long-term trend in 2022. Corporate profitability is also expected to trend lower next year (Chart 2). While corporate earnings in 2021 have been impressive, this performance is unlikely to be repeated, as the unique circumstances of the pandemic and the recovery are giving way to more ordinary business conditions. Amid the pandemic and during the early innings of recovery, companies have cut costs aggressively, improved productivity, while lower interest rates have reduced debt servicing burdens, and a weaker dollar has boosted overseas earnings. As the economy restarted, sales growth surged, and corporate pricing power was on the rise thanks to significant pent-up demand for goods and services and consumers being flush with cash. Chart 1Economic Growth Will Return To Trend Chart 2Sales Growth Is Poised To Slow In 2022, earnings growth will return to trend (Chart 3). The likely deceleration in earnings growth and margin contraction (Chart 4) next year will be driven by a combination of factors: First and foremost, a slowdown in top-line growth, a decline in corporate pricing power, i.e., the ability of companies to raise prices, which has been diminished by consumers’ income increasing slower than inflation. Chart 4Profit Margins Are Set To Compress In the meantime, the tight labor market is putting upward pressure on wage growth (Chart 5). Labor costs are singlehandedly the largest expense, hovering around 50% of sales, dwarfing all the other expense items. Input costs are also on the rise with PPI soaring, cutting into corporate profitability (although we do expect PPI to decelerate) (Chart 6). Chart 5Wage Growth Is Accelerating Chart 6Corporate Pricing Power Has Been Waning In addition, there are a few minor expenses that are set to rise in 2022: Capex recovery will push up depreciation expense, interest expense is set to go up because of rising rates and corporate re-leveraging, and taxes are projected to increase, especially for the US multinationals exposed to the international minimum tax. And of course, there is also an appreciating dollar, diminishing the translated value of overseas profits. While each of these line items is minor, in concert they will have a noticeable adverse effect on corporate profitability. We provide analysis of the S&P 500 margins in Marginally Worse and Sector Margin Scorecard reports. 2022: Pedestrian Returns And Higher Volatility The US economy is firmly in the slowdown stage of the business cycle. However, growth is coming off high levels, and this phase is likely to be prolonged, and this is by no means a death knell for the bull market. Yet, during the slowdown, returns tend to be lower than during the recovery and expansion phases of the business cycle (Chart 7). Slowdowns are also usually accompanied by heightened volatility. The TINA trade is still on – there are few inexpensive asset classes, and yield is hard to come by. With rates expected to rise, equities are still a more attractive alternative to bonds (Chart 8). Equities are real assets that do a good job protecting investments from rising prices (that is until inflation triggers tighter monetary policy). With rate hikes still a few quarters away, the party is continuing. There is still a lot of liquidity sloshing around looking for attractive corners of the market. This is manifested in positive equity inflows and a “buy-on-dips” mentality, which, so far, has precluded any major market corrections. Buybacks are on the rise – many corporations have had bumper profits and are returning cash to shareholders (Chart 9). This trend is exacerbated by the current administration’s hostility to M&A activity. Chart 9Buybacks Are Reverting To The Pre-pandemic Level Returns: Multiple Expansion Passes Baton To Earnings Growth Multiple expansion was a key driver of returns in 2020. In 2021, the baton was passed to earnings growth, which contributed 40% to realized returns this year (Chart 10). 2022 will be more like 2021 than 2020. Multiple expansion is highly unlikely as it tends to be a driver of returns during the recovery stage of the business cycle when the market anticipates economic rejuvenation. Furthermore, valuations are already elevated. When the S&P 500 is trading at over 21x forward earnings, the probability of negative returns over the next 12 months has historically been around 65% (Chart 11). While we believe that there are many factors supporting equities delivering positive returns next year, it is hard to be overly optimistic. Hence, it will be earnings growth again that will rule the day in 2022, with a little help from dividends and buybacks. However, while earnings growth is a key driver of returns, it is expected to slow from the current levels, returning to its historical trend (Chart 12). The blockbuster returns of 2021 will be in the rear-view mirror. Chart 12Earnings Growth Is Slowing Total Return Estimate: Mid-To-High Single Digits Above-trend economic growth and consumer price inflation point to revenue growth in the high single digits, and this would normally serve as a conservative estimate for earnings growth given that profit margins have been trending higher since the beginning of the 2009 economic recovery. However, margins are expected to compress in 2022, and earnings growth to decelerate. We proxy sales growth to nominal GDP growth of 7.6%. With margins expected to contract, the best scenario for the degree of operating leverage for the S&P 500 is a historical average of 0.96, translating sales growth into earnings growth of 7.3% (Table 1). For reference, sell-side analysts expect S&P 500 earnings to grow by 8% in 2022 (Chart 13). S&P 500 PE NTM stands at 20.5 which, historically, on average, is about three points below realized PE LTM in 12 months. We assume that PE LTM at the end of 2022 will be 25.6, or a 1.6% contraction from the 25.2 multiple today. Table 12022 S&P 500 Price Target And Total Return Estimate With an average historical dividend yield of 2.2%, we get: (1+7.3%)*(1-1.6%)*(1+2.2%) = 7.9% - Total Return Estimate 4,591*(1+7.3%)*(1-1.6%) =~ 4,850 - Price Target We expect an S&P 500 total return of just under 8% – the net result of robust revenue growth and some return compression from profit margins and equity multiples. Point estimates are difficult in finance, so we will characterize this return expectation in the middle single digits. The rate of multiple contraction, earnings growth, and dividend yield in 2022 are just educated guesses. Sector And Styles Key Views Small Vs. Large Cap: It Is Finally A Small World 2021 was a tumultuous year for small caps. After a strong outperformance at the beginning of the year on the back of a recovery trade, this asset class has been languishing since March, with each new attempt for a prolonged rally failing (Chart 14). Over the year, small caps have become extremely cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. So why was Small so unloved considering two blockbuster reporting seasons with earnings growth of more than 200%? Even on an annualized basis, since 2019 Small has delivered 47% annualized growth compared to 14% from Large (Chart 15). Moreover, smaller companies have been successful in repairing their balance sheets, which now look much healthier. Chart 14Small Had A Tumultuous Year Small was out of favor as investors fretted about an economic slowdown (Chart 16), the Delta variant (along with the other Greeks), razor-thin margins, and the ability of smaller companies to navigate the economy, plagued with supply bottlenecks and labor shortages. Yet, we went overweight Small vs. Large back in October and are still sticking to our guns. First, Small, which has higher allocations to Cyclicals, such as Financials and Industrials, is expected to outperform in the environment of rising rates (Chart 17) - A BCA view for 2022. Second, in a market where most asset classes are exuberantly expensive, Small is cheap. Third, the profitability of Small has improved dramatically, which attests to the ability of smaller companies to efficiently manage their operations even under duress, as well as to pass costs on to their customers. Last, while Small is trading with a 25% discount to Large on a forward PE basis, its earnings growth over the next 12 months is expected to be double that of Large, 20% vs. 10%. The froth in expectations for the earnings growth of Small has also come down from its peak at 88% and now appears to be a low bar to clear. Chart 16Small Earnings Growth Expectations Are Reasonable And Profitability Has Rebounded Chart 17Small Is Expected To Outperform In The Environment Of Rising Rates What are the risks to this call? If economic growth disappoints, and the yield curve continues its relentless flattening, signifying a Fed policy mistake or the onset of another COVID Greek, Small is bound to underperform. Margins are narrow and continued cost pressures, especially surging labor costs, have the potential to dent small caps’ profitability. Yet, on a balance of probabilities of such an outcome vs. attractive valuations and fundamentals, this is a risk we are willing to take. Growth Vs. Value: Be Nimble The story of Growth vs. Value is similar to that of Large vs. Small. Value had a fantastic run as the pandemic started to recede, but then as worries about the Delta variant emerged, Growth took over yet again. Over the past year, Growth outperformed Value by 11%, and by 18% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is a 80% premium to Value (which is trading at 16x). The Growth/Value BCA Valuation indicator is nearly 3 standard deviations above average, and from a statistical perspective, is 99% likely to mean revert. What makes this valuation discrepancy absurd is that both asset classes are bound to deliver roughly the same earnings growth over the next year, i.e., 10%. What is the deal? Just like Small vs. Large, this year, Value vs. Growth has been strongly linked to the 30-year Treasury yield (Chart 18). This has not always been the case in the past, but since the onset of the pandemic, very long-maturity bond yields have done a good job at explaining the relative performance of these asset classes. Growth is overweight Technology, which has been a star of the “work from home” theme. Further, falling long rates inflate the present value of cash flows and earnings of the growth stocks. In the meantime, Value is highly exposed to Financials, which have a hard time maintaining their profitability during times of falling rates and flattening yield curves. Apart from sector composition, Growth as an asset class has also become synonymous with quality, which comes to the rescue at times of heightened risk aversion and uncertainty. This is usually accompanied by falling rates. Indeed, profit margins for Growth are 7% higher than for Value. Since 2019, the annualized earnings growth of Growth is 14.4% compared to 9.8% for Value. The difference is even more dramatic for Sales growth: 6.5% for Growth vs. -1.1% for Value (Chart 19). Chart 18US Value Versus Growth Is Strongly Correlated With Interest Rates However, while we observe that Growth is more reliable for churning out strong numbers, falling sales of Value indicate substantial pent-up demand for products and services. Value also thrives in the environment of robust economic growth and the steepening yield curve. We are currently neutral in our Growth/Value allocation, but we find the argument of rates rising and Value outperforming highly compelling. Our neutral position will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates. In the meantime, we choose a selective exposure to value sectors by the means of our hand-picked cyclical themes. We have also retained some exposure to Growth by staying with our overweights to Technology and Pharma, as a means of protecting our portfolio from the kind of volatility we have experienced because of the Omicron scare and the Fed’s policy adjustments. Growth Is Robust And COVID Is Receding: Overweight Cyclicals Cyclical sectors have significantly outperformed Defensives this year (by 12%), benefiting from economic reopening and ubiquitous pent-up demand both from businesses and consumers. Despite a strong run and exceeding the pre-pandemic peak (Chart 20), Cyclicals have room to move higher when compared with the prevailing levels in 2010-2011, but that period reflected resource price levels that we are unlikely to see in the coming year. Yet, we expect further outperformance of Cyclicals in 2022. Chart 20Cyclicals/Defensives Performance Has Exceeded Pre-Pandemic Peak Chart 21Cyclicals Rally When COVID Fears Reced We do hope that the pandemic will recede in importance in 2022: Every time COVID fears subside, Cyclicals outperform Defensives (Chart 21). Pent-up demand has not yet waned, hindered by supply shortages and shipping delays. For many cyclical sectors, such as Consumer Discretionary, Financials, Real Estate, and Industrials, annualized sales growth from 2019 to 2021 is below historical levels, suggesting that there is room for catchup growth (Chart 22). One of the cornerstones of the BCA outlook is that rates will rise. This is an environment favorable for Cyclicals. Defensive sectors tend to underperform when bond yields are rising, as many of them are heavily indebted and have somewhat fixed cash flows because of regulations (Utilities, Telecoms) or strong competition from cheaper substitutes (Pharma amid challenges from generics and biosimilars). Cyclicals are not that much more expensive than Defensives (22x vs. 19x forward earnings) and are trading with a 13% premium. The Cyclical/Defensive Valuations Indicator has come down from three to two standard deviations (Chart 23). Despite a modest valuations premium, earnings of Cyclical sectors are expected to grow at 25% while Defensives will only grow at 6% over the next 12 months. In short, Cyclicals are more attractive than Defensives as a group, but we prefer a granular approach and handpick cyclical sectors that we expect to thrive in the current macroeconomic environment and have favorable sales and earnings growth prospects. Later in the report, we will discuss some of our cyclical sector picks. Chart 23Relative Valuations Of Cyclicals Have Come Down But Are Still Rich Despite Worries About Inflation, Consumers Still Have Money To Spend: Overweight Consumer Services The US government has supported consumers during the lockdowns with a series of helicopter cash drops to all Americans, enumerated in trillions of dollars. As a result, even nine months after the last cash disbursement, consumers are sitting on $2.3 trillion in excess savings (Chart 24). Extremely loose fiscal and monetary policy have lifted household net worth by 128% of GDP (Chart 25). And while consumers do indeed worry about inflation, expecting it to rise to 7.5% in 12 months, there is still plenty of dry powder sitting in their bank accounts. Chart 24Consumers And Businesses Have A Lot Of Dry Powder Chart 25Household Wealth Has Soared Consumer spending on goods has been above the pre-pandemic trend for months and has recently turned. In the meantime, spending on services is still below pre-pandemic levels, suggesting that there is plenty of pent-up demand (Chart 26). Specifically, spending on sports clubs, public transportation, personal care, medical services, and professional services are still below pre-pandemic levels. Pent-up demand will boost Consumer Services, and we recommend overweights to Hotels, Restaurants, Cruises, Amusement Parks, and Casinos, along with Commercial and Professional Services. Further, while pent-up demand for goods has generally been met, there are still pockets of demand out there due to shortages, such as for automobiles and selected consumer durables. We are also overweight Healthcare Equipment and Services which benefits from the backlog in elective procedures. Chart 26Spending On Services Is Still Below The Pre-pandemic Trend New Capex Cycle: Overweight Industrials Industrials is another cyclical sector that we favor. Supply chain disruptions have demonstrated for many businesses that they need to bring their supply chains back to the US, launching the US Manufacturing Renaissance. Also, excess consumer demand has driven the need for expanded capacity. For months now, manufacturers have been inundated with orders (Chart 27). The industrial sector is also exposed to the restocking of inventories and is poised to benefit from the Infrastructure Bill. Therefore, Industrials will continue to benefit from the surge in capital expenditures, as evidenced by the sharp increase in US core capital goods orders. Capex intentions have been on the rise as well (Chart 28). Chart 27Producers Inundated With Orders And Need More Capacity To profit from this emerging trend, we are overweight Construction and Engineering, Building Materials, and Capital Goods. Chart 28Surge In Capital Expenditure Will Benefit Industrials New Credit Cycle: Overweight Banks 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. Both businesses and consumers have repaired their balance sheets, and the re-leveraging cycle is set to commence to finance Capex and higher price tag purchases like autos. There are early signs that lending is likely to pick up next year (Chart 29). According to JPM: “The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again.” Credit card spending is recovering (Chart 30). Chart 29Early Innings Of A New Credit Cycle Chart 30Consumers Are Borrowing Again While sell-side analysts anticipate that margins will decline, we believe that they may surprise on the upside: High operating leverage, improving pricing power, and growing demand for loans will contribute to strong profitability. Further, the BCA house view is 10-year rates rising to 2.0 – 2.25% in 2022, which will support net interest margins. Energy Sector Vs. Materials Energy profit margins are linked to underlying commodity prices. The BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate Capex. Although the price of oil has risen above the break-even level, energy companies are reluctant to invest in Capex due to pressure from shareholder activists and newly found financial discipline (Chart 31). As a result, prices are likely to remain high until “high prices cure high prices.” In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yields. Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Chart 31Chronic Underinvestment Is Driving Up Price Of Oil Chart 32A Slowdown In China Is Hurting Demand For Raw Materials Resource stocks, on the other hand, may not meaningfully outperform in 2022, at least not consistently – our views on China imply that metals and mining stocks may at least passively underperform in the first half of the year (Chart 32). US Housing Rally Still Has Legs To Run On The US housing market should post a solid performance next year on the back of the structural demand tailwinds: Since the GFC, around five million houses were underbuilt. This supply shortage also coincides with millennials, a cohort that has 11 million more people compared to the previous generation, starting families. The data is also reflective of the supply/demand mismatch with inventories of new and existing homes for sale, and the homeowner vacancy rate at all-time lows, and housing prices exploding higher. At the same time, US building permits are still below the two million SAAR print that historically marked previous housing cycle peaks (Chart 33). The implication is that the current housing boom still has room to go further, benefiting US homebuilders as they monetize the supply/demand mismatch. Homebuilder sentiment rose to a six-month high in November. Tack on the 80bps sell-off in the 30-year US Treasury yield that translates into more affordable mortgage rates for consumers, and there is little that can undercut the US housing market throughout 2022. We are bullish on both the Real Estate and Homebuilders sectors. However, we would be remiss not to mention risks to this call: The performance of the real estate market is highly dependent on the direction of the rates. If long rates rise substantially, this sector will be in the crosscurrents of housing shortages and less affordable mortgages. However, the 2-2.25% 10-year yield that BCA anticipates by end -2022 should not put a significant dent into house ownership affordability. Chart 33Housing Shortages Will Drive Multi-Year Outperformance of Real Estate And Homebuilders Risks To The Outlook Rising rates are a key condition for our sector and style calls to pan out. However, if supply chain bottlenecks do not clear soon, inflation will not slow down meaningfully, and the US economy will enter a rising price-wage spiral. The Fed will realize that it is behind the curve and will start hiking rates aggressively, i.e., faster than the pace currently anticipated by the market. As a result, economic growth will disappoint, and the unemployment rate will rise. The yield curve will continue flattening with long rates staying range-bound or moving lower. In this scenario, Growth and Defensives will outperform, while Small, Value and Cyclicals will underperform. Multi-Year Structural Themes To finish, we want to remind clients of our long-term themes, which we expect to continue to pan out next year. Millennials Are Not Coming Of Age; They Are Already Here According to the US Census Bureau, millennials (born 1982 to 2000), are the US's largest living generation and represent more than one-quarter of the US population. This is a generation that is highly educated, and relatively unburdened by debt. While in the past, this generation was perceived as “forever young,” it is rapidly showing signs of maturing: Joining the labor force, starting families, and shopping for houses and cars, thereby pushing consumption up. However, millennials’ consumption basket is different, with an emphasis on new technology, homeownership, electric vehicles, and green energy. ETFs that capture the theme are MILN and GENY. Gen Z Is Coming Of Age And Has Money To Spend Generation Z in the US includes 62 million people born between 1997 and 2012. With $143B in buying power in the US alone, making up nearly 40% of all consumer sales, Gen Z wields increasing influence over consumer trends. This is the first generation of digital natives—they simply can’t remember the world without the internet. They are the early adopters of the new digital ways to bank, get medical treatments, and learn. Gen Z is joining the workforce and replacing retiring baby boomers. We have created a Gen Z basket with stocks representing fintech, investing and crypto, online gaming, quality-over-price, and some others. There are no ETFs just yet that capture this emerging theme. Cybersecurity Is A Must-Have Global digital transformation as well as rising geopolitical tensions create fertile ground for attacks by both cybercriminals and malicious state actors. The cyber defenses of most private and public companies are still ill-prepared, and the space is poised for robust growth since cybersecurity is a “must-have” for survival. This growing market has attracted a plethora of new cybersecurity players who provide cloud-based SaaS solutions and are well-versed in deploying AI and ML to counter cyber threats. While many of these companies are still young with relatively small capitalization, their potential is enormous. We recommend tactical and structural overweights to the theme. The following ETFs provide exposure to the theme: BUG, CIBR, and HACK. EV Revolution The auto industry is undergoing a major technological disruption. This process is expensive and perilous yet presents an enormous future earnings growth opportunity. And all the ingredients for success are in place: The proliferation of new technologies, government support, changing consumer preferences, and a surging US economy. This tide will lift all boats: Legacy and EV-only auto manufacturers and suppliers as well as EV ecosystem players. We are bullish on the sector on a 12-month investment horizon. ETFs are DRIV, IDRIV, KARS, BATT, and LIT. What We Are Researching For 2022 2022 will be a big year for the new technology themes. Some are brand new, while others have been around for a while. We are reading about gene editing, the metaverse, 3D printing, and cleantech. We will be sure to share what we learn in a series of Special Reports. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation