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BCA Research's China Investment Strategy service recommends a new trade: long Chinese industrial stocks/short A-shares. Chinese onshore stocks in the infrastructure, materials, and industrial sectors recently advanced strongly in the expectation that…
Last week’s PPI release came in strong, beating expectations and posting its eighth consecutive print of a higher-than-forecasted YoY increase. The release confirms that supply chains remain clogged and that businesses are forced to hike prices to offset pricing pressures. Anecdotally, the Suez Canal was briefly blocked once again last week as if foreshadowing more supply-side pain ahead. PPI internals also send the same message with goods inflation outpacing both the headline number and the services inflation (see chart). Given that service-producing industries are less reliant on raw materials, we expect the same divergence between goods and services PPI to hold over the coming several prints. Meanwhile our house view remains that the ongoing inflationary spike will be transitory in nature, and as businesses replenish inventories, inflation data will stabilize at lower levels. Please stay tuned for tomorrow’s Sector Insight report where we will update our Corporate Pricing Power table.
Highlights Investors are caught in the crosscurrents of inconsistent economic data and contradictory trends, which obscure the answer to the most important questions of the day: What will be the direction and rate of change of yields? The answer will dictate which US equity sectors and styles are to do well (Chart 1). In this report, we aim to cut through the noise and organize all the considerations and the economic data into two neat buckets: “lower for longer” vs “rates are about to rise”. “Rates Are About To Rise” vs “Lower For Longer” Arguments Fed Talk: Fed Chair Jay Powell’s Jackson Hole speech all but promised to start tapering in the coming months. However, this speech had many caveats, leaving the Fed with substantial latitude for the timing of the decision. Covid-19 Variants: The Covid-19 Delta variant is cresting, and it is unlikely that its transmission is a threat to global growth. However, Delta is the third prominent Covid-19 variant, and more vaccine-resistant variants may emerge, disrupting recovery, and derailing all plans for monetary tightening. Unemployment Rate: The unemployment rate has come down to 5.2% in August. There are also labor shortages. However, August payroll disappointed. African American unemployment remains at 8.8%. Inflation: Inflation has been running hot of late. Supply chain disruptions and upward pressure on wages perpetuate price increases. However, much of the inflation spike observed over the past several months was due to the base effect, which is rolling over. Economic Growth: The US economy is in good health: Pent-up demand for goods and services remains strong, manufacturing is booming. However, US economic data has been disappointing recently and most of the economic indicators have turned. GDP growth estimates have been downgraded. The Consumer Is Healthy But In A Bad Mood: Consumers have money to spend, and demand remains high. However, stimulus spending has peaked, which may dent consumer spending. The consumer confidence reading has slumped to a six-month low. It is apparent from this analysis that predicting the timing of tapering is close to impossible, as too much depends on the September employment report, the future rate of Covid-19 infections, potential emergence of variants, and the further patterns of inflation and supply disruption. Investment Implications: Barbell Approach To Portfolio Construction Considering the level of uncertainty in the markets, we recommend a barbell approach for portfolio construction, i.e., having an overweight in the portfolio to sectors that outperform when rates go up, such as Financials, and selected Cyclicals, and have overweights to parts of the market that benefit from “lower for longer” such as Growth, Technology, and Health Care. Feature The “easy” phase of the recovery, “the tide that lifts all boats”, supported by a torrent of ultra-easy monetary and fiscal stimulus is in the rearview mirror, leaving investors to guess the timing of Fed tapering and its implications for the different segments of the stock market. While the US equity market defies gravity, volatility is likely to make a comeback this fall thanks to near-term economic uncertainty, interest-rate uncertainty, and Covid risk (Chart 2). Chart 1Barbell Portfolio: Choose Outperformers From Each Regime Chart 2Policy Uncertainty Is On The Rise Investors are caught in the crosscurrents of inconsistent economic data and contradictory trends, which obscure the answer to the most important questions of the day: When will the Fed start tapering and where will the Treasury rates end the year? The direction and rate of change in yields will dictate which US equity sectors and styles are to do well: Growth or Value, Small or Large, Cyclicals or Defensives. The Fed has stated clearly that it has twin goals: To target average inflation and a low rate of unemployment. Yet, there is a lot of uncertainty around how long the Fed will tolerate “transitory inflation”, and what the target rate for unemployment might be. The “bad news is good news” theme is gaining prominence. Disappointing economic data points to a slowdown in recovery, which is certainly bad news. Yet, slower growth is likely to translate into a slowdown in employment gains, delaying the commencement of tapering, keeping rates rises at bay, and supporting equity prices. This sounds simple enough except for the worst-case scenario being stagflation, whereby growth slowdown is accompanied by rampant inflation, which would leave the Fed with no choice but to tighten monetary policy even if it constricts flagging growth. In this report, we aim to cut through the noise and organize all the considerations and the economic data into two neat buckets: “lower for longer” vs “rates are about to rise”. We also propose a barbell portfolio allocation for downside protection as it is not yet clear which of the possible scenarios will materialize. We are overweight Growth, Technology, Health Care, Financials, Industrials, and Consumer Services. Economic Crosscurrents Fed Speak Rates Are About To Rise The Fed has broadcasted its plans for tapering well in advance, and Fed Chair Jay Powell’s Jackson Hole speech all but promised to start tapering bond buying in the coming months. Lower For Longer Uncertain timetable: Chairman Powell’s speech had many caveats for tapering, leaving the Fed with substantial latitude for the timing of the decision. Further, Chairman Powell explicitly separated the decision to taper from the timing of the first rate hike, which is conditioned on full employment being “a long way off”. Further, tapering is tightening when it becomes a signal on the Fed’s monetary policy – the Fed went out of its way to reassure the markets that this is not the case. Covid-19 Variants Rates Are About To Rise Delta variant infections have peaked: There are early signs that the Covid-19 Delta variant is cresting (Chart 3). Around 75% of the US population has had at least one vaccine shot. Vaccinated persons are less likely to end up in a hospital even if infected. Covid-19 won’t disappear, but US consumers and businesses are learning how to live with it. Hence, worries about Covid are unlikely to keep the Fed on hold for much longer. We, too, are sanguine about the risk that Delta variant transmission is a threat to global growth. Chart 3The Covid-19 Delta Variant Is Cresting Lower For Longer New mutations are likely: Delta is the third prominent Covid-19 variant, and more vaccine-resistant variants may emerge, disrupting recovery, and derailing all plans for monetary tightening. Also, while the spread of the Delta variant is unlikely to trigger another lockdown, consumers may curtail their activities out of fear of infection, adversely affecting demand for goods and services, and stalling recovery. There are some signs that the new wave of Delta variant infections has dented consumer spending. Delta may also be behind the disappointing August jobs report, which could be a harbinger of a slowdown in employment gains. Unemployment Rate Rates Are About To Rise Unemployment rate is falling swiftly: The unemployment rate has come down to 5.2% in August. BCA estimates that at 750,000 average monthly job gains, the pre-pandemic level of unemployment can be reached in the summer of 2022, with the first rate hike in December 2022, which is somewhat earlier than consensus – the futures market is pricing in January 2023. Labor shortages: Companies are still struggling to fill job openings: There are 10.9 million job openings but only 8.5 million job seekers (Chart 4). Shortage of labor puts upward pressure on wages and increases companies’ costs, driving up inflation. Chart 4There Are More Job Openings Then Job Seekers Lower For Longer Disappointing jobs report: August payrolls grew only by 235,000. This low number may have resulted from the Delta hit to service industries. Next month’s report will be a decisive data point for the Fed’s tapering timing decision. Are there fundamental issues behind this number, such as Covid fears, flagging recovery, or skills mismatch between workers and jobs available? The African American unemployment rate remains elevated at 8.8%, which is still 2.8% above the pre-pandemic level (compared to the 5.2% total unemployment rate, which is only 1.7% above the 2020 pre-pandemic level), (Chart 5). The Fed is focused not only on the overall level of unemployment but also on an equitable unemployment rate across racial groups. Chart 5The African American Unemployment Rate Remains Elevated Inflation Rates Are About To Rise Inflation is here to stay: Inflation has been running hot of late. The US consumer price index rose by 5.3% yoy in both June and July—a spike the Fed calls transitory. BCA agrees but believes that over the longer term, inflation will be higher than the pre-pandemic average. The Fed is coming close to admitting that inflation is becoming a problem and has been around longer than was initially expected. Supply chain disruptions are still rampant: There are significant backlogs of goods (Chart 6), and shipping costs have soared in recent months: Container freight costs have increased nearly five-fold from pre-pandemic levels. It will take time for supply chains to normalize, with most industry participants expecting the situation to improve only in 2022. Supply chain disruptions drive up inflation and, unless progress is made, lead to stagflation. Companies continue raising prices: Pricing power remains at an all-time high, with 45% of companies planning to pass surging labor and supply costs on to consumers. This leads to broadening of inflation across categories, with even trimmed mean inflation indicators significantly overshooting 2% (Chart 7). Chart 6US Manufacturers Have Work Cut Out For Them Chart 7Trimmed Mean Inflation Is Overshooting 2% Lower For Longer: Inflation is transitory: Much of the inflation spike observed over the past several months was due to the base effect, which is rolling over. The consumer categories where prices have risen fastest are services most affected by the pandemic, such as airline tickets and hotels – these prices remain at pre-pandemic levels. Other elevated prices are due to supply disruptions, such as cars and durable goods – these readings are stickier and will go away only once supply chains normalize. Further, while 45% of companies intend to raise prices, the Corporate Pricing Power Indicator has turned, which may suggest that the vicious cycle of inflation may come to a halt (Chart 8). And lastly, divergence between CPI and PPI inflation, indicates that PPI will come down in the near future (Chart 9). Chart 8Corporate Pricing Power Has Reached Its Limit Chart 9Divergence Between PPI And CPI Has To Close Economic Growth Rates Are About To Rise US economy is in good health: GDP growth expectations are 6.3% for this year and about 4.3% in 2022. Pent-up demand for goods and services remains strong. ISM PMI Orders components are on the rise. Inventories are depleted and need to be replenished, offering further support for industrial activity in the US (Chart 10A). Philly Fed survey shows that about 40% of respondents plan to increase their capex expenditure (Chart 10B). Strong manufacturing activity is likely to translate into further robust employment gains. Chart 10AAre At All Time Low And Need To Be Replenished Chart 10BCapex Intentions Are On The Rise Lower For Longer: US economic data has been disappointing recently: Much of the good economic news has been priced in, and the Citigroup Economic Surprise Index is negative. Most of the economic indicators have turned, confirming that the surge in growth has run its course and the macroeconomic environment is normalizing. GDP growth estimates have been downgraded (Chart 11). The Conference Board Economic Indicator has turned, confirming that the US economy is in a slowdown stage of the business cycle (Chart 12). Prolonged friction of supply bottlenecks and transportation disruption may put the brakes on economic growth. Chart 11GDP Growth Estimates Downgraded Chart 12US Economy Is Slowing Consumer Is Healthy But In A Bad Mood Rates Are About To Rise Consumers have money to spend: There is still about $2 trillion in excess savings, and considering backlogs of orders across industries, pent-up demand remains high. Lower For Longer Fiscal Tightening: Stimulus spending has peaked. Supplemental federal unemployment benefits of $300 a week expired as of Sept. 6. This may dent consumer spending unless millions of unemployed rejoin the labor force. The rub is in the fact that, with an extra $300 per week, 48% of workers were making more money not working than while employed, according to a recent paper published by the JPMorgan Chase & Co. Institute. Consumer mood has soured: Consumer confidence has slumped to a six-month low of 114 from 125 a month earlier (Chart 13). Many consumers have also postponed durable goods and house purchases discouraged by soaring prices and low inventories (Chart 14). Consumers are also worried about rising prices and expect inflation to exceed 6.5% within 12 months. Chart 13Consumer Mood Has Soured Chart 14Soaring Prices And Low Inventories Discourage Purchases Investment Implications It is apparent from this analysis that predicting the timing of tapering is close to impossible, as too much depends on the September employment report, the future rate of Covid-19 infections, the potential emergence of variants, and the further patterns of inflation and supply disruption. How do different assets react to rate hikes? In case the “Lower for Longer” scenario dominates, Growth and Defensives will outperform. Specifically, sectors like Consumer Staples, Health Care, Communications, and Technology will thrive in this environment (Chart 15). If rates start rising, we expect Value, Small Caps, and Cyclicals to outperform, specifically, Financials, Consumer Discretionary, and Industrials. Chart 15Barbell Portfolio: Choose Outperformers From Each Regime US Equity Sector Strategy Positioning We recommend pursuing a barbell approach to portfolio construction: A mix of Growth sectors that benefit from low rates, and economically sensitive Cyclicals, which are geared to higher growth and rising rates. Rates Are About To Rise We are overweight cyclicals in our portfolio in case the economy keeps growing apace, US consumers prove to be undeterred by fears of Covid-19 variant(s), and market expectations shift towards imminent tapering. We are overweight Consumer Services and Industrials. Lower for longer We have been overweight Growth, Technology, and Media & Entertainment in our portfolio since June 2021. While the rates outlook remains uncertain and “lower for longer” is a realistic scenario, we will stick to this positioning while Covid variants are lurking, and growth slowing. For the same reason, we are also overweight Health Care (defensive growth). Underweights We are underweight Consumer Staples, Utilities, and Telecom as these sectors are bond proxies, and at this point it is unlikely that rates will move much lower from here. Our base case is stable or higher. We are also underweight Materials, and Metal & Mining specifically, as this sector is exposed to a Chinese growth slowdown, which suppresses demand for industrial metals. Changes in Positioning Upgrade Financials to an overweight from equal weight. Financials thrive in an environment of rising rates and a steepening yield curve when tapering arrives. From a broader investment perspective, Financials and Banks are cheap, trading at 14x and 12.2x forward earnings respectively. Further, commitment to returning cash to shareholders will benefit investors with a long-term investment horizon. We stay neutral on Insurance as the magnitude of the fallout from Hurricane Ida is still unknown, but it is already clear that payouts will be sizeable. Downgrade Energy to equal-weight from overweight. Although energy, in principle, should do well in the environment of rising rates, we don’t see much upside to this investment. Crude oil has come off its recent highs, with Brent trading at $73 a barrel compared to $76 at the beginning of August. Although demand will continue to recover and supply is somewhat constrained by the OPEC 2.0 agreement, our energy strategists see limited upside to oil prices over the next 12 months, with a forecast of Brent to average $73 a barrel in 2022 (Chart 16). Chart 16Limited Upside For Oil For The Next Year Bottom Line The Fed has been clear in communicating that we are drawing closer and closer to the doom day of tapering, yet there are so many countertrends in the market that it is not clear which will dominate and how soon tapering will commence. Our working assumption is that it starts in December 2021 / January 2022. Considering that markets are forward-looking, repositioning for tapering may start in advance, but there is also a danger of being too early if economic growth, inflation, and employment gains surprise on the downside and tapering is delayed. Considering the level of uncertainty in the markets, we recommend a barbell approach to portfolio construction, i.e., having an overweight in the portfolio to sectors that outperform when rates go up, such as Financials and Cyclicals, and have overweights to parts of the market that benefit from “lower for longer” such as Growth, Technology, and Health Care. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation
Highlights The equity risk premium has turned negative for the first time since 2002. It follows that any significant rise in bond yields will cause risk-asset prices to collapse, quickly flipping any incipient inflationary shock into a deflationary shock. Shorting bonds yielding 2 percent is a ‘widow maker’ trade, as anybody who has tried this with a long list of government bonds has learned to their cost, the most recent being UK gilts. Hence, the next on the list for the ‘widow maker’ is shorting the US 30-year T-bond which is now yielding 2 percent. In fact, the US 30-year T-bond is a must-own structural investment. Fractal analysis: Medical equipment versus healthcare services. Feature Chart of the WeekThe Equity Risk Premium Turns Negative For The First Time Since 2002 Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. Mainstream investments are now priced to deliver negative, zero, or at best, feeble long-term investment returns. For example, the US 10-year Treasury Inflation Protected Security (TIPS) and the UK 10-year index linked gilt are yielding -1.3 percent and -2.8 percent respectively. Meaning that anybody who buys and holds these bonds to redemption is guaranteed a deeply negative 10-year real return. Meanwhile, in nominal yield space, 10-year government bonds yield -0.35 percent in Germany and Switzerland, 0.7 percent in the UK, and 1.3 percent in the US. What about equities? Unlike a bond’s redemption yield, equities do not offer a guaranteed long-term return for buy-and-hold investors. So, some analysts assume that the equity market’s earnings yield is the proxy for this long-term return. According to these analysts, the US equity market’s earnings yield of 4.4 percent means that it will deliver a prospective long-term real return of 4.4 percent per annum. Compared to the 10-year TIPS real yield of -1.3 percent, they argue that this offers an excess return or ‘equity risk premium’ of a comfortable +5.7 percent. Therefore, claim these analysts, equities are reasonably valued, relative to bonds, and in absolute terms. But as we will now demonstrate, this analysis is deeply flawed. The Equity Risk Premium Has Turned Negative The equity market’s earnings yield is a valuation metric, so clearly there is some connection between it and the prospective return delivered by the equity market. Nevertheless, the crucial point to grasp is that: The equity market’s earnings yield does not equal its prospective return. Charts I-2 - I-3 should make this point crystal clear. As you can see, the earnings yield rarely equals the delivered prospective 10-year return, either real or nominal. When the earnings yield is elevated, the prospective return turns out higher. Conversely, when the earnings yield is depressed, as now, the prospective return turns out to be much lower. Chart I-2The Equity Market's Earnings Yield Does NOT Equal Its Prospective Return, Either In Real Terms... Chart I-3...Or In Nominal ##br##Terms Therefore, to take the current earnings yield of 4.4 percent and subtract the real bond yield of -1.3 percent to derive an equity risk premium of +5.7 percent is analytically flawed, just as it is analytically flawed to subtract apples from oranges. To derive the equity risk premium, the correct approach is first to translate the earnings yield into a prospective 10-year return based on the established mathematical relationship between these variables. Chart I-4 does this and shows that, based on a very tight mathematical relationship through the past thirty five years, an earnings yield of 4.4 percent translates into a prospective 10-year nominal return of just 1 percent. Chart I-4We Must Mathematically Map The Earnings Yield Into A Prospective Return... Having translated the earnings yield into a prospective 10-year nominal return of 1 percent, we can now make an apples-for-apples comparison with the 10-year T-bond yield of 1.3 percent (Chart I-5). Chart I-5...And Only Then Subtract The Bond Yield Derived correctly therefore, the equity risk premium has turned negative for the first time since 2002 (Chart of the Week). We deduce that the equity market is very richly valued both in absolute terms and relative to bonds. And crucially, that this rich valuation is contingent on bond yields remaining ultra-low, or going even lower. Shorting Bonds Yielding 2 Percent Is A ‘Widow Maker’ All of which brings us to one of the most pressing questions we get from clients. When a bond is offering a feeble yield, what is the point in owning it? Maybe the best people to answer are the casualties of the now infamous ‘widow maker’ trades. The original widow maker trade was the idea that the yield on the Japanese Government Bond (JGB), at 2 percent, was so feeble that there was no point in owning it. Furthermore, with massive Japanese fiscal stimulus coming down the pike, the ‘no-brainer’ investment strategy was not just to disown the JGBs, but to take an outright short position, as it seemed that the only direction that JGB yields could go was up. In fact, JGB yields did not go up, they continued to trend down. As feeble yields became even feebler, the owners of the short positions got carried out of their careers, feet first. Meanwhile, those investors who owned 30-year JGBs yielding a ‘feeble’ 2 percent in 2013 reaped returns of 75 percent, and even now, are sitting on handsome profits of 55 percent. Some people protest that Japan is an exceptional and isolated case, rather than a template for economies which will not repeat their putative policy-errors. Such protests have always struck us as factually wrong, blinkered, and even prejudiced. Nevertheless, let’s indulge these prejudices with a simple rejoinder – forget Japan, what about Switzerland, or the UK? (Chart I-6) Chart I-6Shorting Bonds Yielding 2 Percent Is A 'Widow Maker' Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Meanwhile, those investors who owned 30-year UK gilts yielding a ‘feeble’ 2 percent in 2018 reaped returns of 40 percent, and even now are sitting on tidy profits of 30 percent. Just like the JGB widow maker, anybody who shorted UK gilts yielding 2 percent is nursing heavy losses. Bear in mind that a 30-year bond yielding a feeble 2 percent will deliver a cumulative return of more than 80 percent to redemption. And that if the feeble yield becomes even feebler, this return will get front-end loaded, creating widow makers for the short positions and spectacular gains for the long positions, as witnessed in JGBs and UK gilts. The 30-Year T-Bond Is A Must-Own Structural Investment The next candidate for the widow maker is shorting the US 30-year T-bond, which is yielding, you guessed it, 2 percent. Remember that while Japan may not be a great template for the US, the UK certainly is – because the US and UK have very similar economic, financial, political, social, and cultural structures. Until recently therefore, bond yields in the US and UK were moving in near-perfect lockstep (Chart I-7). Chart I-7The Difference Between US And UK Bond Yields Is Just That The UK Has Had One More Deflationary Shock So, what happened? The one word answer is: Brexit. The recent difference between US and UK bond yields is simply that the UK has had one more deflationary shock than the US. Put the other way around, the US is just one deflationary shock away from a UK level of bond yields – meaning the 30-year yield not at 2 percent, but at 1 percent. But why can’t the next shock be an inflationary shock resulting in much higher yields? The simple answer is that the equity risk premium has turned negative for the first time since 2002. Moreover, as we pointed out in The Road To Inflation Ends At Deflation the extremely rich valuation of $300 trillion of global real estate is also highly contingent on ultra-low bond yields. It follows that any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. In a $90 trillion global economy, this will quickly flip any incipient inflationary shock into a deflationary shock. Any significant rise in bond yields will collapse the value of $500 trillion of risk-assets. We conclude that the US 30-year T-bond is a must-own structural investment. Fractal Analysis Update As hospitals have rushed to clear their backlog of non-pandemic treatments and procedures, medical equipment stock prices have surged. This is particularly true for US medical equipment (ticker IHI) which, since June, is up by 25 percent versus US healthcare services (Iqvia, Veeva, or loosely proxied by ticker XHS). Given that the backlog of treatments will eventually clear, and that the intense rally is now extremely fragile on its 65-day fractal structure (Chart I-8), a recommended countertrend trade is to short US medical equipment versus healthcare services. Set the profit target and symmetrical stop-loss at 8.5 percent. Chart I-8The Intense Rally In Medical Equipment Stocks Has Become Fragile Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Feature Chart 1Chinese Offshore Stocks Tumbled Amid Regulatory Crackdowns Relative to the global equity index, onshore and offshore Chinese stocks have fallen by 18% and 32%, respectively, since their peaks in mid-February (Chart 1). The panic sell-off in the offshore market, which saw greater losses due to its high concentration in internet stocks, appears to be overdone and may technically rebound in the near term. However, any short-term bounce in Chinese stocks from oversold levels will likely be short-lived (Chart 2). The crackdown on new economy companies reflects socio-political and economic shifts in China, which raises the odds that the restrictions will continue with further actions focused on social welfare and healthcare. August’s official PMIs and economic data indicate a broad-based softening in China’s domestic demand and production. However, compared with 2018/19 when the US-China trade war exacerbated the deterioration in an already slowing economy, the economy now remains well supported by strong exports. Moreover, the magnitude of the slowdown has not exceeded policymakers’ pain thresholds (Chart 3). Chart 2Tactical Bounce Was Short-Lived In Previous Downturns Chart 3China's Economic Recovery Losing Steam, But From An Elevated Level In 2018/19, stimulus was measured and the authorities did not meaningfully relax limits on bank lending standards and shadow banking. Furthermore, China recently reiterated its cross-cycle macro policy setting, which means that policymakers will not use significant stimulus to achieve high and short-term economic growth. Given financial stability measures that aim to contain risks associated with the housing market and hidden local government debt, any monetary and fiscal easing will likely help to stabilize credit growth instead of substantially boosting it this year. For the time being, China’s financial assets continue to face downside risks stemming from a confluence of a weakening business cycle and ongoing regulatory tightening. Thus, we recommend investors maintain an underweight allocation to Chinese equities within a global equity portfolio. Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com A Shining Moment For Chinese Small And Medium Caps Small and medium-cap (SMID-cap) stocks have outperformed large-caps since February and the recent regulatory restrictions have intensified the situation. The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the large-cap CSI300 by 34% since mid-February (Chart 4, top panel). Uncertainties surrounding the pandemic and corporate earnings growth have fueled extreme dislocations between large-cap and SMID-cap stocks last year. Large-cap stocks were the main contributors to China’s stock rallies in the second half of last year, while the valuation premia in small cap stocks was compressed to near decade lows (Chart 4, bottom panel). Chart 4A Low Valuation Premia And More Policy Support May Further Lift Prices Of SMID-Caps Chart 5SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Historically, SMID-caps tend to outperform large-caps in the late cycle of an economic recovery (Chart 5). The spate of regulatory changes aimed at monopolistic behaviors in various sectors has curbed investors’ appetite for the industry leaders. In addition, the government’s increasing efforts to support small and medium corporates (SMEs) will help to shore up confidence in those companies. Therefore, small and medium caps will likely continue to outperform large-cap stocks this year. Fiscal Support: How Much Room In 2H? The July Politburo meeting pledged more fiscal support for the economy later in 2021 and into 2022. We expect local government bond (LGB) issuance to accelerate: a 4.47 trillion RMB new local government bond issuance quota was approved for 2021, including 820 billion in general bonds and 3.65 trillion in special purpose bonds (SPBs). By end-August, 2.37 trillion new local government bonds had been issued, which was only 53% of the entire year’s goal. However, there are some constraints that will likely reduce the reflationary effects on the economy. First, the quota for LGB issuance approved by the National People’s Congress is 16% lower than last year, but the amount of LGBs maturing this year is 30% higher. Therefore, even though this year’s gross LGB issuance has kept pace with that of last year, more than half of the LGBs issued from January to August was used for debt repayment (Chart 6). The move by local governments to use a large portion of their bond issuance quota to pay off existing debt resembles the situation in 2018 when a financial de-risking campaign encouraged local governments to reduce the stockpile of their leverage. As noted in last week’s report, infrastructure investment and the economy did not rebound in 2H2018, even though LGB issuance picked up (Chart 7). Chart 6More Than Half Of LGBs Issued This Year Has Been Used For Debt Repayment Chart 7Improvement In Infrastructure Investment Was Short-Lived In 2019 Even if we assume that local governments will use all of their remaining bond quota by year end, the gross monthly average in local government bond issuance will be around 580 billion, only slightly higher than in 2H 2020. Secondly, infrastructure investment is discouraged by stringent regulations to approve projects (including project assessment and debt repayment ability) and the accountability of local officials for project failures. Approvals for infrastructure projects remain at the lowest level since March last year (Chart 8). Finally, SPBs made up only about 15% of overall infrastructure spending in the past three years, while the majority came from public-private partnerships (PPP) financing, revenues from government-managed funds, government budgets and bank loans. Falling proceeds from land transfers have dragged down government-managed funds (Chart 9). In addition, government expenditures show no signs of a material increase (Chart 9, bottom panel). Chart 8Infrastructure Investment Will Remain Subdued Chart 9Government Expenditures Remain Muted As discussed in previous reports, local government bonds issuance only accounts for 12% of total social financing. As such, without a sizeable acceleration in bank loans, enhanced LGB issuance would not be enough to prompt a substantial increase in infrastructure investment growth. Our argument is underscored by the structural downshift in infrastructure investment since 2017 (Chart 7, top panel). Therefore, additional local government bond issuance this year will help to stabilize but not boost credit growth. August PMIs Confirm Slowing Economic Activity China's official PMIs eased further in August. The non-manufacturing index fell to contractionary territory of 47.5, below the expectation of a more muted 1.3-point decline to 52.0. Similarly, the manufacturing PMI eased by 0.3 points to 50.1, which is a hair above the 50 boom-bust line. Together, weakness in both sectors pushed down the composite index to 48.9 (Chart 10). Stringent restrictions designed to halt rising rates in COVID-19 infections explain much of the deterioration in China’s service-sector activity. The sector will likely rebound in September with the easing in infection levels (Chart 11). Chart 10PMIs Show Slowing Economic Activity Chart 11Lingering COVID Effects Curb Service-Sector Recovery In 2H21 Meanwhile, the construction PMI surprisedly rebounded sharply in August (Chart 10, bottom panel). However, investors should be cautious not to read too much into the idiosyncratic month-on-month moves suggested by the construction PMI. Instead, construction activity has moderated significantly and is set to slow further, hinting at plunged excavator sales and real estate investment in construction (Chart 12). Chart 12Construction Activity Is Unlikely To Pick Up Meaningfully This Year It is clear that China’s economy is losing momentum, but greater economic weakness will be needed for policymakers to stimulate meaningfully. Export Sector Remains A Bright Spot China’s exports remain robust. Export growth picked up in August from July on a year-over-year basis. Although the improvement in August reflects a base effect, exports in level reached a new high (Chart 13). Both skyrocketed exports container freight index and strong Korean exports suggest that global demand for Chinese manufacturing goods remains resilient (Chart 14). Even though manufacturing PMIs from developed markets have rolled over, they remain elevated and should continue to support China’s exports (Chart 15). Chart 13Chinese August Exports In Level Reached A New High Chart 14Exports Will Remain Robust In The Rest Of The Year... In contrast to resilient exports, China’s official PMI export new orders subindex has declined for five consecutive months. Even though falling PMI new export orders subindex heralds a slowing in exports growth, a reading of below the 50 boom-bust threshold in the former does not suggest a contraction in the growth rate of the latter. Furthermore, the month-over-month nature of PMI new export orders subindex tends to overstate the volatility in exports. The divergence between the PMI new export orders subindex and real export growth also occurred in 2018/19 during the height of the US-China trade war when export orders were volatile (Chart 16). Chart 15...And Will Continue To Benefit From Strong Global Demand Chart 16A Divergence Between PMI New Export Orders And Export Growth Regulatory Tightening In Real Estate Sector Stringent regulations in housing since the beginning of the year have started to cool the sector (Chart 17). However, home prices inflation in tier-one cities is still elevated (Chart 18). Thus, we expect the controls on housing and among property developers will remain in place for the next 6 to 12 months. Chart 17Housing Sector Is Cooling... Chart 18...But Housing Prices In First-Tier Cities Keep Rising At A Faster Rate Industrial Profits: Rising Prices, Falling Production China’s industrial profit growth remained solid in July despite the waning low base effect. Manufacturing producer prices continued to rise, offsetting weaker production growth (Chart 19). In addition, a low interest-rate environment helped to lift profits in the manufacturing sector by reducing debt servicing costs. While we expect weakening domestic demand and peaking producer prices to weigh on corporate profits in the rest of this year, profit growth is rolling over from a lofty height and will not likely drop sharply in the coming months (Chart 20). In addition, producer prices will likely remain at a historically high level in the next six months given robust global demand for raw materials and persistent global supply shortages. Chart 19Rising Prices And Low Interest Rates Helped To Offset Falling Industrial Production Chart 20Peaking Producer Prices Will Weigh On Corporate Profits Meanwhile, there is a large gap between the prices for producer goods and consumer goods, suggesting that manufacturers in mid-to-downstream industries have not been able to fully pass on rising input costs to domestic consumers (Chart 21). Profit growth continues to be disproportionally stronger in the upstream industrial producers than in the downstream industries, while the profit margin in the manufacturing sector remains much more muted (Chart 22). Chart 21Inflation Passthrough From Manufacturers To Domestic Consumers Remains Limited Chart 22Profit Growth In Upstream Industries Still Outpaces Manufacturing Sector Table 1 Table 2 Footnotes Market/Sector Recommendations Cyclical Investment Stance
Highlights Economic policy uncertainty is rising in the US and will generate volatility this fall. But by the end of the year the result should be more fiscal reflation. Biden’s approval rating is now “underwater” – net negative – but this was expected. Unless he suffers another black eye, he can still shepherd his two big bills through Congress by year’s end. Public support for Biden’s tax hikes is weak. Some tax hikes are likely but aggressive hikes are now off the table. The midterm elections were already likely to produce a Republican win in the House. History supports this consensus. But the Senate is still an open game. The presidential election outlook is only marginally affected, at most, by the messy Afghanistan pullout. Value stocks are re-testing their low point against growth stocks. We do not expect them to break down when Congress is about to pass historic new spending increases. Feature Economic policy uncertainty is reviving in the US and set to increase this fall. This is true in absolute terms and relative to global uncertainty, even at a time when China’s sweeping regulatory crackdown is generating a lot of global uncertainty (Chart 1). Chart 1US Relative Policy Uncertainty Reviving Chart 2Policy Uncertainty Breakdown The latest increase in the policy uncertainty index is largely driven by rising uncertainty over future government spending (Chart 2, panel 2) and expiring tax provisions (Chart 2, panel 3), more so than by public sentiment reflected in the mainstream media or even the inflation debate. The looming budget battle this fall will have major implications for taxes and spending and will lift the uncertainty indicators regarding sentiment and consumer prices. Volatility will ensue in the coming months. But by the end of the year, Congress will have passed at least one, likely two, new laws that will increase government fiscal support for the economy and dispel deflationary tail risks. The lingering pandemic will if anything help concentrate lawmakers’ minds on passing more stimulus. Therefore we expect US equities and cyclical sectors to grind higher. The passage of these bills will mark the high point in policy reflation, after which clouds will loom on the horizon in 2022. Biden’s Net Negative Approval Rating President Biden’s job approval rating is now officially “underwater” – more people disapprove of his leadership than approve (Table 1). This is raising serious doubts about his ability to shepherd legislation through Congress this fall. However, these doubts are overrated. Table 1Biden’s Net Approval Is Officially Negative Biden’s approval has mostly fallen due to his mishandling of the US military’s withdrawal from Afghanistan – which most Americans agree was necessary, however much they deplored the commander-in-chief’s handling of it. Therefore Biden’s approval rating will not fall much farther – at least not until he suffers another black eye. Until that happens, Biden’s approval will stabilize in the range of Obama’s and above Trump’s. The reason is that he retains a solid political base of support – and his political base is larger than President Trump’s, so his general approval will stay higher. Indeed his approval is still stronger than Obama’s among Democrats (Charts 3A and 3B). This is counterintuitive since Obama was a charismatic, young, and progressive Democrat. The reason is that Democrats are still very cognizant and fearful of the alternative: President Trump. This anti-Trump tailwind will help Biden for some time. Support among Democrats is critical for maintaining party discipline in passing the reconciliation bill this fall. It is also important for the midterm elections. Chart 3ABiden’s Job Approval Collapses Chart 3BBiden’s Approval Holding Up Among Democrats On specific issues, Biden is weaker than Obama on foreign policy and than Trump on the economy (Charts 4A and 4B). The economy will remain the central concern, notwithstanding Afghanistan, and on this front Biden should stabilize or improve. However, other foreign policy issues could rise to the fore and hurt him at any time given today’s fraught geopolitical environment. Chart 4ABiden’s Falling Approval On Economy Chart 4BBiden’s Falling Approval On Foreign Policy We say Biden’s score on the economy will improve because consumer confidence will rebound once the Delta variant of COVID-19 subsides (Chart 5). Both manufacturing and service sectors are performing better than when Biden was elected and employment is holding up in both sectors. The new orders-to-inventories measures suggest the service sector will continue to improve (Chart 6). The headline unemployment rate has dropped to 5.2%. Chart 5Consumer Confidence Should Support Biden Chart 6PMIs Also Offer Some Support For Biden Given the above, Biden still has enough clout to steer his signature legislation through Congress this fall, albeit with major modifications to his unwieldy $3.5 trillion American Families Plan. Moderate Democratic Senator Joe Manchin of West Virginia has called for a pause in new big spending legislation, but a close look at his words shows that he does not oppose the bill, he merely wants to water it down, which is not a change from his earlier position.1 He speaks for other moderates. The left-wing faction led by Senator Bernie Sanders of Vermont will make counter-threats yet ultimately has no choice other than to support the most progressive social legislation in recent memory. The bill will be watered down. Could this watering down process result in a total jettison of the Democrats’ proposed tax hikes? The Wall Street Journal reports that congressional support for tax hikes is losing steam.2 While aggressive tax hikes are off the table, we highly doubt that all tax hikes will be removed. Financial markets have not responded much to the threat of higher taxes. Small business owners, who are most sensitive to the risk of new taxes and regulation imposed by Democrats, have not shown much concern for either issue this year – they are much more worried about inflation (Chart 7). We assume the equity market would rally if tax hikes were dropped but we do not think this is likely to happen. Americans support higher taxes – but only Democrats are enthusiastic about across-the-board hikes on individuals, corporations, and capital gains. Polls show that 59% of independent voters, not to mention Democrats, support higher taxes on high-income earners, although the proposed 28% corporate is increasingly likely to be cut down (Chart 8). This is the fundamental reason for investors to expect Democrats to band together in the eleventh hour and include tax hikes in their reconciliation bill. If nothing else, a partial reversal of President Trump’s Tax Cut and Jobs Act will be necessary to give a veneer of affordability to Biden’s giant spending bill to get it past Senate moderates. Chart 7Business Will Worry About Tax Hikes When (If) They Pass Chart 8Look Out: Americans Support Higher Taxes The impact of Biden’s corporate tax hike is expected to be a 5%-8% one-off hit to corporate earnings, according to our Global Investment Strategy. The impact could be less than that but the combination of popular opinion and the Democratic Party’s need to finance their social agenda suggests that investors should plan for the worst, which in this case is not that bad – key tax rates will still be lower than they were under President Obama. The chief risk to Biden’s legislation is that passing the bipartisan infrastructure bill (80% subjective odds) consumes so much political capital that there is not enough left for Biden’s reconciliation bill (50%-65% subjective odds, depending on circumstances). This is possible. Congressional Democrat leaders want to tie these two bills together but most likely the quick success of infrastructure, which is more popular than social welfare, will lead Democrats to conclude that a bird in the hand is worth two in the bush. They will pass infrastructure on less-than-perfect assurances from Senate moderates that they will support reconciliation. Then a separate battle over reconciliation will ensue, in which Biden must cajole the left-wing and moderate factions of his party into a “yea” vote while Republicans obstruct. The second major risk to Biden’s legislation – and the macro backdrop – comes if he mismanages foreign policy more generally, such as with the looming crisis over Iran. A foreign policy failure beyond Afghanistan could cause permanent damage to his political capital. And yet Democrats would be even more desperate for a legislative victory then, as they would face a wipeout in the midterm elections if they had no legislative victories and two foreign policy humiliations. In other words, Biden is nowhere near so unpopular that moderate Democrats will abandon his signature legislative agenda and condemn their party and his administration to a heavy defeat in 2022. Bottom Line: Biden’s legislation will pass, including some tax hikes. The revised magnitude of tax hikes will not be known until later this fall when the Senate and House start producing legislative text. Policy uncertainty and equity volatility will trend upward this fall but the end-game is more reflationary policy, which should keep equities grinding higher at least through Christmas. Midterm Elections: The Best Case For Democrats Is Not Good Enough Are Republicans more likely to take Congress now that Biden’s approval is underwater? How would this impact the policy and macroeconomic outlook? While Republicans are highly likely to retake the House of Representatives, the Senate is still slightly tipped for the Democrats. Biden would have to fail to pass legislation or commit another major policy mistake to give Republicans full control of Congress, although this outcome is slightly favored in online betting markets. The House currently consists of 220 Democrats and 212 Republicans. There is always some fluctuation in the exact numbers. Three vacancies should be filled in November’s special elections, which could bring the count to 222 Democrats and 213 Republicans.3 With 218 votes needed to pass legislation on an absolute majority vote, Democrats can only afford to lose three votes at present. This is an extremely tight margin and shows that this fall’s reconciliation bill is at risk in the House as well as the Senate. In the midterm elections, Republicans only need to take five-to-six seats to regain the majority (218). This is easy on paper: the average seat gain for the opposition in midterm House elections is 35. Biden’s latest approval rating puts Democrats in line to lose 37 seats based on history. The opposition typically makes gains in the midterm because it is fired up whereas the presidential party is complacent. In addition Republicans are expected to gain two seats (possibly as many as four) via gerrymandering in 2022. True, Democrats have some underrated supports in 2022. In all probability the pandemic will be waning while the economy will be waxing. Biden will likely have passed at least a bipartisan infrastructure deal. The divisions within Republican ranks over Trumpism will also persist, which may or may not increase Democratic turnout and vote-switching from suburban Republicans. Hence it is reasonable to ask whether Democrats could surprise to the upside and retain the House. Online betting markets put the probability at 29%, and these odds make sense to us. The historical record helps to define what kind of events might alter the outlook for the midterms. Table 2 shows the midterm elections in which the presidential party performed best (the opposition party disappointed the historical norm). The following points are salient: Table 2Best-Case Outcomes For Presidential Party In Midterm Elections There are only two cases in which the presidential party gained seats (Clinton 1998, Bush 2002) and three cases in which they only lost a few seats (Kennedy 1962, Reagan 1986, arguably Bush 1990). The Democratic victory of 1998 occurred at the top of an economic boom while the Republican victory of 2002 occurred one year after the 9/11 terrorist attacks. Neither is likely to be replicated for Democrats in 2022. Republicans’ mild losses in 1990 occurred just after Iraq invaded Kuwait. Republican’s mild losses in 1986 occurred despite a big legislative victory (tax reform). If either of the last two scenarios played out for Democrats in 2022, Democrats would likely lose the House by a whisker. Only if the Democrats’ 1962 scenario played out would Democrats retain the House in 2022, and only by a single seat. Yet the 1962 election occurred in the midst of the Cuban Missile Crisis! The takeaway is that a foreign policy crisis could help Democrats pare their losses in the midterms if Biden is deemed to have handled the crisis adroitly. But even then the ruling party would likely lose the House judging by history. Needless to say these are just historical examples. They also show that Democratic fortunes could turn around drastically between now and next fall (e.g. Kennedy went from a recession and the Bay of Pigs fiasco to gaining his party seats). The Senate outlook is less straightforward. Biden’s approval rating suggests a loss of four seats for Democrats based on the historical pattern. But the same pattern suggested Republicans would lose four seats in 2018 and instead they gained two. Our quantitative Senate election model, which we update every week in the Appendix, still tips the Democrats to gain one seat (a 51-49 majority) or at least retain their de facto one seat majority (50-50). Chart 9Presidential Vetoes In History What are the macroeconomic implications? A Republican House and Democratic White House would play “constitutional hardball,” just as occurred from 2011-14, given that the country is still at historically peak levels of political polarization.4 There are likely to be critical differences between 2011 and 2023 – populism has fundamentally weakened support for fiscal austerity – but the most likely result is gridlock and deadlock. Republicans will not be able to slash spending or cut taxes as Biden will have the presidential veto, but Democrats will not be able to increase spending or hike taxes (Chart 9). The problem for Biden would be the need to avoid a national default when and if the Republicans insist on spending cuts to raise the debt ceiling. The looming debt ceiling showdown this fall will increase uncertainty and volatility but ultimately Democrats have the votes to avoid a default. That would not necessarily be the case if Republicans controlled the House. And this time around Republicans could be driven to impeach the president, for whatever reason, in retaliation for President Trump’s impeachment in 2019. This situation obviously cannot be ruled out, even though it would be virtually impossible for the Senate to convict. At the same time, some bipartisanship could occur, as it did under Trump following the 2018 midterms. Anti-trust legislation and immigration reform are the two most important policy areas to watch on this front. Republican gains in Congress would marginally weaken the Democrats’ hold on the White House in 2024, though we continue to believe that Democrats are favored. American voters are likely to be better off in November 2024 than they were in November 2020, amid a pandemic, recession, and nationwide social unrest. Our quantitative model tips Democrats with 308 electoral votes (Appendix). Professor Allan Lichtman’s “13 Keys” to the presidency – a nearly flawless prediction system since 1984 – currently suggest that the Democrats only have three keys turned against them. They would need to see six or more in order to lose the White House (Table 3). Obviously the long-term status of the economy will be a critical factor (Chart 10). Table 3Lichtman’s Keys To The Presidency (Updated Sept 2021) Chart 10Will Biden's Economy Grow Faster Than That Of His Two Predecessors? Bringing it all together, US fiscal policy has taken a more proactive turn but it is still likely to freeze after this fall. It will be hard to pass major budget bills in 2022 ahead of the election and gridlock is the likeliest outcome, making 2025 the next realistic chance for major fiscal changes. The immediate implication is that Biden and Democratic leaders will have to disconnect the bipartisan infrastructure bill from the partisan social welfare reconciliation bill this autumn. This will require a major concession from House Speaker Nancy Pelosi. Otherwise both bills could collapse and with them the Democratic Party’s fortunes. Biden and moderate Democrats that face competitive races in 2022 will demand a quick victory before moving onto the less popular part. Investment Takeaways Value stocks are re-testing their cycle lows against growth stocks (Chart 11). The Delta variant and global growth jitters continue to weigh on this trade. Chart 11S&P Value Re-Tests Lows Versus Growth The S&P 500’s “Big Five” are rallying and outperforming the other 495 companies once again (Chart 12). Chart 12S&P 5 Recovery Versus 495 We expect politically induced volatility throughout the fall but we also expect it to be resolved in new and reflationary legislation. Signs that Biden’s legislation will pass should enable cyclical sectors and value stocks to recover, though the pandemic, global growth, and Chinese stability may prevent them from outperforming defensive sectors and growth stocks. A new set of hurdles will face markets if Republicans regain the House and halt fiscal easing from 2022-24. However, they will not be rewarded by voters if they create a fiscal or economic crisis, implying that the proactive fiscal turn in public opinion will prevail over the long run. If Biden’s legislation fails then it suggests that US fiscal policy is dysfunctional even under single-party control. This would heighten the deflationary tail risk and force us to reassess our macro and policy outlook. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes 1 See Senator Joe Manchin, “Why I Won’t Support Spending Another $3.5 Trillion,” Wall Street Journal, September 2, 2021, wsj.com. 2 Richard Rubin, “Progressives’ Tax-The-Rich Dreams Fade As Democrats Struggle For Votes,” Wall Street Journal, September 5, 2021, wsj.com. 3 The three special House elections are: Florida’s 20th District, previously Democratic held; Ohio’s 11th District, previously Democratic held; Ohio’s 15th District, previously Republican held. 4 See Mark V. Tushnet, “Constitutional Hardball,” John Marshall Legal Review 37 (2004), pp. 523-53, scholarship.law.georgetown.edu.
Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE). This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2 Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside. Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday. Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation. Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at 56%. Chart 6 Chart 7 Footnotes 1 Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2 Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3 Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021. 4 Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Our willingness to spend money depends on which ‘mental account’ it occupies. Once windfall income enters our ‘savings mental account’, we will not spend it. Hence, the pandemic’s windfall income receipts will have no sustained impact on spending, or on inflation. This means that US monetary tightening will be later and shallower than the market is pricing. As we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples). Fractal analysis: The US dollar, and base metals versus precious metals. Feature Chart of the WeekNo Tsunami Of Spending Despite Excess Income Many people claimed that the war chest of savings that global households accumulated during the pandemic would unleash a tsunami of spending. Well, it didn’t. For example, US consumer spending remains precisely on its pre-pandemic trend (Chart I-1 and Chart I-2). This, despite stimulus checks and other so-called ‘transfer payments’ which boosted aggregate household incomes by trillions of dollars. Indeed, paste over 2020, and you would be forgiven for thinking that there was no pandemic! Chart I-2No Tsunami Of Spending Despite Excess Income Of course, households that lost their livelihoods during the pandemic, and thus became ‘liquidity constrained’, did spend the lifeline stimulus payments that they received. Yet in aggregate, households did not spend the excess income received during the pandemic. Moreover, the phenomenon is global – the savings rate in the UK has surged near identically to that in the US (Chart I-3). Chart I-3The Savings Rate Has Surged Everywhere The excess income built up during the pandemic did not unleash a tsunami of spending. Neither will it unleash a tsunami of future spending. We can say this with high conviction because we have seen the same movie many times before. Previous tranches of stimulus and transfer payments that boosted incomes in 2004, 2008, and 2012 (though admittedly by less than in 2020) had no lasting impact on spending. Whether We Spend Or Save Money Depends On Which ‘Mental Account’ It Occupies Why do windfall income receipts not trigger a tsunami in spending? (Chart I-4) Chart I-4Stimulus Checks Had No Meaningful Impact On Spending One putative answer comes from Milton Friedman’s Permanent Income Hypothesis. Contrary to the Keynesian belief that absolute income drives spending, Friedman postulated that income comprises a permanent (expected) component and a transitory (unexpected) component. And only the permanent income component drives spending. In the permanent income hypothesis, spending is the result of estimated permanent income rather than a transitory current component. Therefore, for households that are not liquidity constrained, a windfall receipt – like a stimulus payment – will not boost spending if it does not boost estimated permanent income. Nevertheless, this theory does require households to estimate their future permanent incomes, and it is debatable if households can do this. Stimulus and transfer payments that boosted incomes in 2004, 2008, 2012, and 2020 had no lasting impact on spending. We believe that a more real-world answer to how we deal with windfalls comes not from Economics but from the field of Psychology, and the theory known as Mental Accounting Bias. Mental accounting bias states that we segment our money into different accounts, which are sometimes physical, sometimes only mental, and that our willingness to spend money depends on which mental account it occupies. This contrasts with standard economic theory which assumes that money is perfectly fungible, so that a dollar in a current (checking) account is no different to a dollar in a savings account. In practice, money is not fungible, because we attach different emotions to our different mental accounts. A dollar in our current account we will gladly spend, but a dollar in our savings or investment accounts we will not spend. Hence, the moment we move the dollar from our current account into our savings or investment account, our willingness to spend it collapses. This explains why consumption trends have no connection with windfall income receipts once those income receipts end up in our savings mental account. Pulling all of this together, the war chest of savings accumulated during the pandemic is unlikely to change the overall trend in spending. More likely, it will be used to reduce household debt, and thereby constrain the broad money supply. In effect, part of the recent increase in public debt will just end up decreasing private debt, as happened in Japan during the 1990s (Chart I-5). Chart I-5In Japan, Public Debt Ended Up Paying Down Private Debt With no permanent boost to spending, the pandemic’s windfall income receipts will have no sustained impact on inflation. As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable While consumer spending remains precisely on its pre-pandemic trend, the sub-components of this spending do not. Specifically, spending on durable goods stands way above its pre-pandemic trend, while spending on services languishes below trend (Chart I-6). Chart I-6The Pandemic Distorted Spending Patterns This makes perfect sense. Pandemic restrictions on socialising, interacting, and movement meant that leisure, hospitality, in-person shopping, and travel services were unavailable. Therefore, consumers just shifted their firepower to items that could be enjoyed within the pandemic’s confines; namely, durable goods. But now that shift is reversing. In turn, these massive and unprecedented shifts in spending patterns explain the recent evolution of inflation. As booming demand for durable goods created supply bottlenecks, durables prices skyrocketed (Chart I-7). Chart I-7The Pandemic Distorted Prices Remarkably though, the 10 percent spike in US durable good price through 2020-21 was the first increase in an otherwise persistently deflationary trend through this millennium (Chart I-8). As such, it was a huge aberration and as Jay Powell pointed out last week in Jackson Hole: Chart I-8The Increase In Durables Prices Was A Huge Aberration “It seems unlikely that durables inflation will continue to contribute importantly over time to overall inflation.” Meanwhile, with services simply unavailable, their prices did not fall, given that the price of something that cannot be bought is a meaningless concept. Moreover, unlike for an unbought durable good, which adds to tomorrow’s supply, an unbought service such as a theatre ticket – whose consumption is time-sensitive – does not add to tomorrow’s supply. Hence, when unavailable services suddenly became available, the initial euphoric demand for limited supply caused these service prices also to surge. But excluding such short-lived euphoria in airfares, car hire, and lodging way from home, services prices remain well-contained. This reinforces our conclusion from the first section. The pandemic’s windfall income receipts will have no sustained impact on inflation. As Jay Powell went on to say: “We have much ground to cover to reach maximum employment, and time will tell whether we have reached 2 percent inflation on a sustainable basis.” All of which means that US monetary tightening will be later and shallower than the market is pricing. Another important investment conclusion is that as we learn to live with the pandemic, the massive displacement in spending patterns is normalising. This means that the abnormally high spending on durable goods has a long way to fall. The abnormally high spending on durables has a long way to fall. Given the very tight connection between spending on durables and the relative performance of the goods dominated consumer discretionary plays in the stock market, this will weigh on consumer discretionary sectors (Chart I-9). Chart I-9As Spending Patterns Normalise, Consumer Discretionary Plays Are Vulnerable Hence, today we are recommending a new 6-month position: underweight consumer discretionary plays. One easy way of expressing this is to underweight XLY (US consumer discretionary) versus XLP (US consumer staples) (Chart I-10). Chart I-10Underweight XLY Versus XLP Fractal Analysis Update Fractal analysis suggests that the dollar’s rally since late-Spring could meet near-term resistance, given the incipient fragility on its 65-day fractal structure (Chart I-11). Chart I-11The Dollar's Rally Could Meet Near-Term Resistance A bigger vulnerability is for the strong and sustained rally in base metals versus precious metals, which is now extremely fragile on its 260-day fractal structure (Chart I-12). We are already successfully playing this through short tin versus platinum, but are adding a new expression: short aluminium versus gold. The profit target and symmetrical stop-loss are set at 13.5 percent. Chart I-12The Massive Rally In Base Metals Versus Precious Metals Is Vulnerable Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights China’s credit tightening may have surpassed maximum strength. Monetary policy will remain accommodative and fiscal policy will become more supportive in the rest of the year. However, overall regulatory oversight is still restrictive, limiting the scope of reflationary effects on the economy. There were signs that the “cross-cyclical” approach – a new catchphrase from the July Politburo meeting - emerged even before the start of the pandemic. The current policy backdrop resembles the situation in 2H2018. China’s new “common prosperity” plan, which sets up guidance for long-term policy direction, will likely have cyclical implications. Chinese investable stocks are in oversold territory and will probably rebound in the near term. In the next 6 to 12 months, however, we remain cautious given the lack of a catalyst to revive investor sentiment. Feature Chart 1Chinese Stocks Are Oversold In Absolute Terms China’s economic momentum has slowed, while regulatory crackdowns show no signs of dissipating. Meanwhile, Chinese investable stocks in absolute terms have slumped into technically oversold territory (Chart 1). Global investors are looking at fiscal and monetary policy easing for clues to what may be next. A shift in policy direction from restrictive to reflationary will help to shore up market sentiment and the outlook for the economy. Fiscal policy implementation in 1H21 was tighter than budgeted, leaving room for more support in 2H21. The PBoC’s unexpected reserve requirement ratio (RRR) cut in early July may have been a signal that policy tightening has ended. In short, China’s financial tightening has most likely passed its peak strength. Chart 2Valuations Are Almost Back To 2018 Lows We have no doubt that China will announce some compensatory measures in the coming months in response to rising downward pressures on the domestic economy. However, we continue to hold the view that the bar for a fresh round of material stimulus is higher today than it was in the past. The policy focus pivoting from a countercyclical to cross-cyclical adjustment, the rising emphasis on common prosperity, and the ongoing regulatory clampdowns in an array of industries, all limit the extent to which authorities can deploy the expected magnitude in infrastructure spending and bank lending. Therefore, we continue to recommend investors remain underweight Chinese stocks versus their global peers – a stance we have maintained since earlier this year – despite cheapened relative valuations in Chinese equities (Chart 2). Shifting To A Cross-Cycle Approach China’s policy shift to a cross-cyclical stance has gained more market attention since the late-July Politburo meeting. However, there were signs that the cross-cyclical approach emerged even before the start of the pandemic. Chart 3Size Of Stimulus Was Already Getting Smaller During the height of the 2018/19 US-China trade war, policymakers responded to the economic shocks from imposed import tariffs with much more measured stimulus than in previous cycles (Chart 3). President Xi repetitively used the “Long March” analogy during the trade war, warning Chinese citizens to prepare for protracted hardship stemming from conflict with the US.1 The metaphor had important market implications because the attitude was fundamental to how the government handled the cyclical slowdown in 2018/19. Despite aggressive RRR and policy rate cuts in the second half of 2018, authorities maintained tight restrictions on bank lending and local government spending. Consequentially, aggregate credit growth continued to slide through end-2018 (Chart 4). Furthermore, authorities became uneasy about the sharp rise in the rate of credit expansion in Q1 2019. Following a public spat between the Premier Li Keqiang and the central bank, bank lending slowed sharply in the rest of the year. As a result, the improvement in infrastructure investment growth was small and short-lived. Despite an acceleration in local government bond issuance in 2H18 and Q1 2019, infrastructure investment growth remained on a structural downward trend throughout most of 2018 and 2019 (Chart 5). Chart 4China: A Deja Vu Of 2018-2019? Chart 5Improvement In Infrastructure Investment Was Short-Lived In 2019 Chart 6Financial De-Risking Mode Is Still On The current policy backdrop resembles the situation in 2H2018: while the central bank has kept interest rates at historically low levels and preemptively cut the RRR rate in July, lending standards remain tight and shadow bank credit continues to shrink (Chart 6). In the past Chinese authorities stimulated substantially following exogenous shocks, but did not stimulate much when business cycle was slowing in an orderly manner. A resurgence of domestic COVID cases and the severe flood in central China in July and August represent exogenous shocks and occured when the economy was losing steam. Hence, there are higher odds authorities will provide some support in response to these exogenous shocks. However, the recurring battle against COVID and lingering tensions with the US have likely prompted Chinese top leadership to extend their cross-cycle strategy. Officials may feel that a modest easing in both monetary and fiscal policies will be sufficient to offset the current economic weakness without overstimulating the economy. Bottom Line: A cross-cycle policy approach means not only responding early to small shocks with piecemeal stimulus to stabilize growth but also limiting the scope of stimulus and preparing for “protracted battles”. The response from Chinese leaders during the trade war with the US in 2018/19 may be a roadmap for policy direction in the next 12 months. Cyclical Implications From “Common Prosperity” President Xi Jinping laid out a plan for “common prosperity”, a guideline for the country’s national policy in the coming decades, at the August 18th Central Committee for Financial and Economic Affairs. Most of the plan’s objectives have 2035 deadlines and will be achieved gradually in multiple phases.2 However, in the next 12 months and leading to the 20th National Party Congress in the fall of 2022, we expect the authorities to accelerate some reform agendas that are consistent with the 14th Five-Year Plan (2021-2025). A key area that may gain momentum is increasing labor income and household consumption share in national output. Both labor compensation and household consumption as a share of GDP improved from 2011 to 2016, but the progress stalled in recent years and further deteriorated last year in the wake of the pandemic (Chart 7). Policy decision makers can reverse the falling share by either boosting income/consumption or lowering the share of capital formation in the national output, or a combination of both. Regulatory tightening in the property market has reduced investment growth in the sector, which accounts for 66% of the country’s total fixed-asset formation (Chart 8). We expect policy restrictions to continue curbing real estate investment in the rest of the year and into 2022, further shrinking the share of capital formation in the aggregate output.3 Chart 7China's Economic Rebalancing Progress Has Stalled In The Past Five Years Chart 8Policymakers Are Moving Away From The 'Old Economy' Pillars Chart 9Recovery In Household Income And Consumption Has Significantly Lagged Other Sectors Recovery in household income and consumption has significantly lagged other sectors in China’s recent economic rebound (Chart 9). In addition to short-term, pandemic-related factors, household consumption has been sluggish due to China’s long-standing imbalanced income distribution. Given that China will be under more pressure to deliver economic progress in 2022, boosting wage growth and consumption will help to facilitate both the nation’s cross-cyclical economic strategy and President Xi’s longer-term reform plan for income and wealth redistribution. If successfully implemented, a rebalancing of labor income and consumption as a share of the national aggregate will have long-term economic benefits. However, for investors with a cyclical time frame, the transition will likely have the following implications on the market: Policymakers will keep a large fiscal budget deficit and increase spending in public services and social welfare, but there will be more pressure on the central government to keep local government debt in check. The increased fiscal burden also means that while the government will provide subsidies for households and key new-economy industries, policy at margin may move away from boosting investment in traditional infrastructure and construction (Chart 10). Chart 10Traditional Infrastructure Investment Will Remain Subdued Empirical research shows that lower-income households have a higher marginal propensity to consume.4 Last year China refrained from meaningful stimulus to incentivize consumption. In contrast, the statement from the August 18th meeting indicated the focus is on securing living standards and wages among lower-income households. Common prosperity related policies may boost consumption of staples and some durable goods but will likely discourage splurging in high-end luxury goods and services. Large corporations and high-net-worth individuals will be expected to share social responsibility and the cost of reducing income inequality, either through higher and stricter tax burdens, raising minimum wages for employees, and/or donations. Bottom Line: The “common prosperity” theme will mostly entail long-term policy initiatives, but it may also have some cyclical market repercussions. Investment Recommendations Chart 11Tactical Bounce Gave Way To Cyclical Downturn In Previous Cycles We do not rule out the possibility of a tactical (within the next three months) / technical rebound in Chinese stocks. Our August 4th report discussed how prices managed to rebound strongly within 90 days of the policy-triggered market riots in both 2015 and 2018. However, the rallies quickly faded and stocks fell to new lows (Chart 11). Prices bottomed when policy decisively turned reflationary. For now, the risks to Chinese equities are largely to the downside. Although there are some remedial measures to ease monetary and fiscal policies, officials have not sent a clear signal to ease on the regulatory front. Conversely, there are two scenarios that could prompt us to upgrade Chinese stocks to either neutral or overweight in both absolute and relative terms. Chart 12No Clear Signal Chinese Policymakers Will Ease On The Regulatory Front The first scenario is that the economy does not slow further and a modest policy easing is sufficient to stabilize the economic outlook. This may happen if strong global economic growth and demand continue to support China’s export and manufacturing sectors, while domestic household consumption improves. In this case, the downside risks on the overall economy would abate, but the gradual underlying downtrend in China's old economy would be intact. We would need an additional reflationary tailwind, such as a boost from fiscal spending or a reversal of industry policy tightening, to upgrade Chinese stocks to overweight. We have argued in the past that housing appears to be the best candidate; the catalyst is missing at the moment (Chart 12). In the second scenario, Chinese policymakers may determine that the downside risks to growth are unacceptably large given existing slowdowns in the industrial and service sectors, and decide to temporarily reverse course on structural reforms. We will watch for indications of a shift in attitude. For now, we think that China’s leadership has a higher pain threshold than in the past, suggesting that this outcome is not yet probable. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1"Xi Jinping calls for ‘new Long March’ in dramatic sign that China is preparing for protracted trade war", South China Morning Post. 2"Xi stresses promoting common prosperity amid high-quality development, forestalling major financial risks", Xinhua, English.news.cn 3We use fixed-asset investment (FAI) as a proxy for gross fixed capital formation (GFCF) because the National Bureau of Statistics of China does not publish the GFCF breakdown by sectors. GFCF comprises FAI, less the purchase of existing fixed assets, land and some minor items. Historically, the two series have closely tracked each other. 4"The Stimulative Effect of Redistribution", Federal Reserve Bank of San Francisco Market/Sector Recommendations Cyclical Investment Stance