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Your feedback is important to us. Please take our client survey today. Feature Feature ChartHouse Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) House Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) Real estate is the world’s most important asset class. It accounts for 60 percent of the $500 trillion of mainstream global assets. To put this into context, the $300 trillion worth of global real estate makes the $7 trillion worth of all the gold ever mined look like chicken feed. It even dwarfs the $90 trillion global economy by more than three to one. In recent years, the valuation of global real estate has decoupled from underlying rents, and has become critically dependent on ultra-low bond yields. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of the world’s income, would make the pandemic’s economic shock feel like a waltz in the park. Hence, to anybody calling for significantly higher bond yields, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate? House Prices Have Decoupled From Rents The $300 trillion valuation of global real estate in 2020 is an 80 percent increase compared with 2010. Coincidentally, the value of the global stock market has also increased by 80 percent over the past decade. But the stock market’s $75 trillion capitalisation is small fry compared to the $300 trillion real estate market.1  Within the real estate market, residential real estate constitutes the lion’s share, accounting for around 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. The valuation of global real estate has become critically dependent on ultra-low bond yields. It follows that the most important component of the real estate market is the homes that people live in. The overwhelming majority of these homes are owner-occupied. Making house prices the indicator that drives, as well as reflects, the fortunes of ordinary people. The 2010s was remarkable as the first decade in which there was a synchronised boom in housing markets around the world. In the previous decade’s global financial crisis, house prices had crashed in several major economies: most notably, the UK and the US. Yet the UK and US housing markets did not suffer long hangovers. In the 2010s, the party restarted, and got even wilder (Chart I-2). Chart I-2The UK And US Housing Markets Resumed Their Parties In The 2010s The UK And US Housing Markets Resumed Their Parties In The 2010s The UK And US Housing Markets Resumed Their Parties In The 2010s Meanwhile, in Sweden, Canada, Australia, and China the global financial crisis barely interrupted their housing market parties, which continued seamlessly into the 2010s (Chart I-3). But perhaps most important of all, in the 2010s, the previous decade’s housing market wallflowers such as Germany and Japan started partying too (Chart I-4). What was behind this synchronised and broad boom in real estate values during the 2010s? The common denominator is the universal decline in bond yields. Chart I-3In Sweden, Canada, Australia, And China, The Parties Never Stopped In Sweden, Canada, Australia, And China, The Parties Never Stopped In Sweden, Canada, Australia, And China, The Parties Never Stopped Chart I-4Germany And Japan Started Their Parties In The 2010s Germany And Japan Started Their Parties In The 2010s Germany And Japan Started Their Parties In The 2010s As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields. Now that yields have little room to shift further downward, the scope for capital growth becomes more limited and dependent on rental growth happening first” Empirically, there is a tight long-term connection between house prices and underlying rents (Feature Chart). For example, through the past forty years, US house prices have closely tracked rents, with only two significant deviations. The first deviation happened during the housing bubble of the early 2000s. When that bubble burst in 2007, house prices promptly crashed back to their established relationship with rents. The second deviation is happening now. Since 2012, US house prices have outperformed rents by 25 percent (Chart I-5). In Europe, German house prices have outperformed rents by 20 percent (Chart I-6). The concern is that this house price outperformance versus rents is justified only if bond yields remain ultra-low and rental growth remains robust. Chart I-5House Prices Have Outperformed Rents By 25 Percent In The US... House Prices Have Outperformed Rents By 25 Percent In The US... House Prices Have Outperformed Rents By 25 Percent In The US... Chart I-6...And By 20 Percent In ##br##Germany ...And By 20 Percent In Germany ...And By 20 Percent In Germany   The Pandemic Is Depressing Housing Rents Unfortunately, the pandemic is putting pressure on housing rents. Rent inflation is driven by the security and growth of wages, which itself is inversely tied to the structural unemployment rate. When the number of permanently unemployed workers rises, rent inflation collapses. Indeed, in the aftermath of the global financial crisis, US rent inflation turned negative. Therefore, for the housing rent outlook, the key question is: what is the outlook for structural unemployment? (Chart I-7) Chart I-7Higher Structural Unemployment Depresses Rents Higher Structural Unemployment Depresses Rents Higher Structural Unemployment Depresses Rents The biggest driver of the structural unemployment rate will be the pandemic. Unlike China, large liberal democracies like the UK cannot control the pandemic with a universal track and trace system, because not enough of the UK population will allow the government to track their every move. Hence, until an effective vaccine has protected most of the population, liberal democracies like the UK must go down the route of physical distancing and the use of face masks.  When the number of permanently unemployed workers rises, rent inflation collapses. But as we explained in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs, physical distancing and facemasks restrict any economy activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three labour-intensive sectors – hospitality, retail, and transport – which employ 25 percent of all workers. Hence, if physical distancing and facemasks force these labour-intensive sectors to operate at one third below full capacity, the economy will lose 8.3 percent of jobs. On less optimistic assumptions the economy could lose 10 percent of jobs. Will a vaccine be a gamechanger? Not immediately. While it will mark progress, it will certainly not ‘take us back to normal’. This is because the proportion of the population that is immunised is unlikely to be high enough, fast enough. First, note that: Immunisation rate = Vaccination efficacy rate * Vaccination rate Second, note that no vaccine is 100 percent effective; and that a significant minority of diehards will refuse to get vaccinated. Perhaps understandably so if the vaccine has been rushed out. Even if we optimistically assume that the first vaccine is 70 percent effective, and that 70 percent of the population gets vaccinated, then the resulting 49 percent immunisation rate will still leave most people as sitting ducks for the virus. Under less optimistic – and arguably more realistic – assumptions, the number of unprotected people will be even larger. This means that social and physical distancing will continue for much longer than many people realise. Moreover, some of the reduction in ‘social consumption’ and its associated jobs will become permanent. The result is that the structural unemployment rate will continue to head higher, until the economy fully adapts to the post-pandemic way of living, working, and interacting. For the foreseeable future, this will put further pressure on housing rents, and keep the housing market crucially dependent on ultra-low bond yields. Concluding Remarks The main purpose of this Special Report is to highlight that the $90 trillion global economy is dwarfed by the $300 trillion global real estate market, whose valuation is critically dependent on ultra-low bond yields. If we add in equities, corporate bonds, and emerging market debt, the valuation of so-called ‘risk-assets’ rises to over $450 trillion. Yet many people still put the cart before the horse. They say the economy will drive the asset markets. This year has proved them wrong. A deflationary impulse from the economy unleashed an inflationary impulse in the much larger asset markets, which then helped to stabilise the economy. Unfortunately, the reverse would also be true. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets, which would then destabilise the economy. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets. Of course, any government with its own fiat currency can generate inflation if it really desires. Just look at Argentina or Turkey. But why would an advanced economy like the US, the UK, or the euro area make such a reckless journey, when it is already in the best place, the place it took a lot of blood and sweat to reach – namely, the place known as price stability? Still, if the advanced economies do take the road to inflation, they should realise that the road isn’t straight. The deflationary impulse that would come from the collapse in $450 trillion of risk-assets means that the road to inflation goes via deflation. For investors, this means that the road to much higher bond yields, if ever taken, reverses on itself. The road to much higher bond yields goes via the lower bound. Fractal Trading System* This week’s recommended trade is a soft commodities pair-trade. Go long coffee versus corn. The specific contracts are Brazilian coffee New York traded and Corn number 2 yellow central Illinois. The profit target and symmetrical stop-loss is set at 12 percent. Chart I-8Coffee Vs. Corn Coffee Vs. Corn Coffee Vs. Corn The rolling 1-year win ratio stands at 54 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 $300 trillion is our conservative uplift to the $281 trillion assessment that Savills made in 2018. The 2020 valuation constitutes a 40 percent increase versus its 2015 valuation. Before 2015, Savills did not provide an aggregated valuation for global real estate. However, as a good proxy, the firm tells us that the capital values in the top 12 world cities rose by 30 percent in the first half of the 2010s. Please see Savills: 8 things to know about global real estate value, July 2018; What price the world? 28 January 2016; and 12 Cities, H1 2015. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

The equity volatility curve inverted on Monday for the first time since June when the SPX had suffered an 8% pullback. The election and fiscal policy related uncertainty has injected fear back into the equity market and the volatility curve inversion is contrarily positive. As a reminder, a VIX with a 33 handle implies that in the next 30 days the S&P 500 will either fall or rise by roughly 10% and vault to all-time highs or sink back to 3100. While there is a chance that the VIX will continue to roar as it did early in the year and push the vol curve deeper in backwardation, our sense is that the correction that commenced in early September is close to running its course. Historically, the chart shows that the VIX inversion is typically short-lived and more often than not serves as a launchpad for the SPX. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end courtesy of receding election and fiscal policy uncertainties. The VIX Curve Inverted. Now What? The VIX Curve Inverted. Now What?

Neutral – Downgrade Alert Sticking to the spirit of covering defensive sectors in this week’s US Equity Sector Insights, today we turn our attention to a major player by market cap weight in the healthcare sector – the S&P pharmaceuticals index. High odds of a Biden victory weigh heavily on this sector’s prospects as we outlined in the recent joined Special Report with our sister Geopolitical Strategy service (please see “Health Care Stands To Lose The Most From A Blue Sweep” section of the report). Simultaneously, the Fed’s almost overnight drop in the fed funds rate to zero in March, coupled with investors’ further rotation out of defensive and into cyclical stocks on the back of the reopening of the economy, further dampen the allure of Big Pharma (middle & bottom panels). The only reason keeping us from downgrading the sector is a potential spike in relative share prices due to a vaccine or other virus-related news. But our sense is that most of the good news is already priced in. Bottom Line: We are neutral the S&P pharmaceuticals index, but getting ready to pull the trigger on our downgrade alert and trim exposure to below benchmark. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. A Sour Pill A Sour Pill  

One-Way Ticket For Staples Stocks One-Way Ticket For Staples Stocks Your feedback is important to us. Please take our client survey today. Underweight In yesterday’s US Equity Sector Insight we highlighted why investors should stay on the sidelines when it comes to the defensive S&P household products index. But, with regard to the broader S&P consumer staples sector, our view remains that over the next 9-12 months this safe haven sector, which peaked in the depths of the COVID-19 recession, will continue to underperform. As the pandemic-induced recession disappears from the rear-view window, it no longer pays to favor stable cashflow growth staples companies. In fact, our relative macro earnings model paints a dark picture for this GICS1 sector (middle panel). Among other reasons, one of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis staples stocks cannot benefit from positive currency tailwinds to the same extent as the overall market can. Bottom Line: We remain underweight the S&P consumer staples sector.  

Caught In The Crosscurrents Caught In The Crosscurrents Neutral We remain neutral the S&P household products index. A V-shaped economic recovery following a recession has historically been synonymous with this defensive industry underperforming (top panel). However, the uniqueness of the current recession must be taken into account. The US consumer continues to binge on household products, which are currently outpacing overall retail sales growth by 13% year-over-year (middle panel, relative consumer spending shown truncated). This trend is slated to continue until a vaccine arrives as the second wave of infections emerges. The same story holds for foreign consumers who also have an incentive to keep up their spending on US household products: a softer US dollar. A weaker US dollar will boost competitiveness of US exporters, which will translate into robust top line growth (bottom panel). Bottom Line: Given the strangeness of the current recession, we remain neutral the S&P household products index. The ticker symbols for the stocks in this index are: BLBG: S5HOPR – PG, CL, KMB, CLX, CHD.    

Too Much Homebuilding Euphoria Too Much Homebuilding Euphoria Neutral – Downgrade Alert It no longer pays to chase the S&P homebuilding index higher; it is now on our downgrade alert watch-list. The recent pandemic-induced drubbing in interest rates boosted housing affordability and caused a knee jerk reaction in the mortgage application purchase index, which in turn served as a catalyst for the recent rally (top & middle panels). However, as the economy continues to open up, interest rates will reverse course and flip from a tailwind into a headwind. Sell-side analysts are also upgrading their earnings forecasts at the highest pace since the GFC, and we would lean against this extreme bullishness (bottom panel). Bottom Line: We are neutral the S&P homebuilders index, but it is now on our downgrade watch-list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. For more details, please refer to the recent Weekly Report.  

No Love For Banks No Love For Banks Neutral – Downgrade Alert Banks hit all-time lows again this week on the back of mixed profit results. While Q3 loan loss reserves will rise albeit at a slower pace than H1/2020, net interest income ails and difficulty in growing revenues are significant offsets. This backdrop makes banks hostage to the 10-year US Treasury yield (top panel). With regard to fiscal stimulus and economic uncertainty, Jamie Dimon recently warned that “If the double-dip (recession) happens, we would be under-reserved by $20 billion.” Worrisomely, the longer the new stimulus checks take to arrive, the longer it will take banks to rebound. Banks have been semi-sheltered from the recession courtesy of eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent a fresh stimulus package, the unemployment rate will remain elevated, warning that lagging non-performing loans will skyrocket. Bottom Line: Stay neutral the S&P banks index, but keep it on the downgrade watchlist. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT. For more details, please refer to this Monday’s Weekly Report.  

  Stretched Positioning Stretched Positioning Following up from yesterday’s US Equity Strategy’s sector insight, today we take a closer look at VIX and e-mini futures positioning, again from a contrarian perspective. Using CFTC weekly data, VIX non-commercial speculative positions are net short. In fact, as a percentage of total open interest, net shorts are more extended than the months both prior to “Volmageddon” and to the Q4/2018 20% SPX drawdown. With regard to this year’s equity market carnage, net shorts are almost as extended as in late-2019/early 2020 (VIX net positioning shown inverted, top panel). Similarly, non-commercial speculative positions in S&P 500 e-mini futures are net long on a par with readings recorded in early 2020 (bottom panel). The implication is that speculators are betting on a dying down in volatility and fresh SPX all-time highs. While this will likely materialize post the November election, in the near-term our fear is that speculators will get caught offside, as elevated election and fiscal policy uncertainties will sustain downward pressure on stocks. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.  

Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals ...And Offshore Cyclicals ...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps.  The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic  assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock.  In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel).    While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured.  Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B).  In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... When Interest Rates Rise... When Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8).  In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5  As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Monetary Tightening ≠ Lower Stock Prices Monetary Tightening ≠ Lower Stock Prices Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year.  A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Stay Invested In Chinese Stocks Stay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth,  2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper.  5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

What To Make Of Spiking VIX Put/Call Ratio? What To Make Of Spiking VIX Put/Call Ratio? Bulls regained control of the equity market, and frenzied buying on Monday pushed the SPX and NDX indexes within striking distance of fresh all-time highs. Our sense is that the market has finally come round to BCA’s view of better-than-even chances of a “Blue Wave” as we first articulated in a joined Special Report with our Geopolitical Strategy service in mid-July “Blue Trifecta: Broad Equity Market And Sector Specific Implications”. However, market leadership is slightly perplexing. While a “Blue Wave” would make a massive fiscal package highly likely in the New Year, bulls bidding tech titans to nose bleed levels anew argues that a new closing of the economy is upon us. The “sleeping giant” 10-year US Treasury yield still hovering below the June highs also signals that something is amiss with the economy, thus boosting the allure of the longest duration equity sector: tech stocks. Finally, the VIX (volume) put/call ratio recently had a 3 handle (shown inverted as a 21-day moving average, top panel). The chart also shows the VIX (open interest) put/call ratio (PCR) that has historically behaved as a contrarian indicator: a high reading leads to a higher VIX and lower SPX and vice versa (PCR shown inverted, middle panel). In other words, as investors are foregoing downside protection the odds are high that an equity pullback would materialize. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.