Corporate Profits
Dear Client, China Investment Strategy will take a summer break next week. We will resume our publication on July 14th. Best regards and we wish you a happy and healthy summer. Jing Sima, China Strategist Highlights A USD rebound and higher domestic bond yields pose near-term challenges to Chinese risk assets. A sharp deceleration in credit growth in the past seven months will lead to weaker-than-expected data from China’s old-economy sectors in the second half of the year. Robust global trade has propelled Chinese exports, allowing the country to pursue financial deleverage and structural reforms. However, next year policymakers will face increased pressure to support the domestic economy as the global economic recovery peaks and demand slows. Investors should maintain an underweight stance towards Chinese stocks in 2H21, but remain alert to any improvements in China’s policy tone. An easing monetary policy may signal a potential upgrade catalyst in 1H22. Feature Most recent macro figures confirm that China’s impressive economic upcycle has peaked. We expect that the official manufacturing and non-manufacturing PMIs, which will be released as this report is published, will come in modestly down. We maintain the view that a major relapse in economic activity is unlikely, but the strong tailwinds that have propelled China's recovery since Q2 last year have since abated and will lead to softer growth. Meanwhile, the rate of economic and export expansions has given Chinese policymakers confidence to scale back leverage and continue with market reforms. In the second half of the year, investors' sentiment towards Chinese stocks will be tested based on three risks: A rebound in the US dollar index. A tighter liquidity environment and higher interest rates. A weakening in macro indicators beyond market expectations. As the global economic recovery peaks into 2022, pressures to support the domestic economy will become more urgent if policymakers want to maintain an average rate of 5% real GDP growth in 2020 - 2022. The current policy settings are not yet favorable to overweight Chinese risk assets. Major equity indexes remain richly valued and the market could easily correct if domestic rates move higher. However, signs of policy easing may emerge by yearend, which would prompt us to shift our view to overweight Chinese stocks in both absolute and relative terms. The Case For A Dollar Rebound On a tactical basis (next three months), a rebound in the US dollar index may curb investors’ enthusiasm for Chinese stocks. A stronger dollar will give the RMB’s appreciation some breathing room and will be reflationary for China’s economy. However, in the short term a stronger USD will also lead to weaker foreign inflows to China’s equity markets. Chinese stock prices have become more closely and negatively correlated with the dollar index since early 2020 (Chart 1). A weaker dollar is usually accompanied by a global economic upturn and a higher risk appetite from investors, propelling more foreign portfolio flows to emerging markets (which includes Chinese risk assets). Although foreign inflows account for a small portion of the Chinese A-share market cap, global institutional investors’ sentiment has become more influential and has led fluctuations in Chinese onshore stock prices (Chart 2). Chart 1Closer Correlations Between Chinese Stocks And The Dollar Index Chart 2Foreign Investors Matter To Chinese Onshore Stock Prices Chart 3Rising Market Expectations For The Fed's Rate Liftoff The US Federal Reserve delivered a slightly more hawkish surprise at its June FOMC meeting with the message that it will move the projected timing of its first fed fund rate liftoff from 2024 to 2023. Since then, market expectations have shifted from growth and inflation to focusing on the next monetary policy tightening phase, with the short end of the US yield curve rising sharply (Chart 3). Given that currency markets trade off the short end of the yield curve, higher US interest rate expectations will at least temporarily lift the US dollar. The timing and pace of the Fed’s tapering of asset purchases and rate hikes will be determined by how rapidly the US economy approaches the US central bank’s definition of “maximum employment.” BCA’s US Bond Investment strategist anticipates that sizeable and positive non-farm payroll surprises will start in late summer/early fall, which will catalyze a move higher in bond yields. As such, we expect additional upside risks in the dollar index in the coming months, which will discourage foreign investors’ appetite for Chinese equities. Bottom Line: A rebound in the dollar index will be a near-term downside risk to Chinese stocks. Risk Of Higher Chinese Interest Rates Another near-term risk to Chinese stock prices is a tightening in domestic liquidity conditions and a rebound in interest rates, particularly in Q3. Chart 4The PBoC Has Managed To Keep Domestic Rates Low While Pulling Back Overall Stimulus So far this year the PBoC has kept liquidity conditions accommodative to avoid massive debt defaults, while allowing a faster deceleration in the pace of credit expansion and a sharp contraction in shadow banking (Chart 4). In the coming months, however, the trend may reverse. Even though we do not think China’s current inflation and growth dynamics warrant meaningful and sustainable monetary policy tightening, there is still room for rates to normalize to their pre-pandemic levels in the next few months. Our view is based on the following: First, there was a major delay in local government bond issuance in the first five months of the year. The supply of government bonds will pick up meaningfully in Q3 to meet the annual quota for 2021. An increase in government bond issuance will remove some liquidity from the banking system because the majority of these local government bonds are purchased by commercial banks. Adding to the liquidity gap is a large number of one-year, medium-term lending facility (MLF) loans that will be due in 2H21. Secondly, the PBoC may shift its policy tightening from reducing the volume of total credit creation (measured by total social financing) to raising the price of money. Credit growth (on year-over-year basis) in the first five months of 2021 dropped by three percentage points from its peak in Q4 last year, much faster than the 13-month peak-to-trough deceleration during the 2017/18 policy tightening cycle. As the rate of credit creation approaches the government’s target for the year, which we expect around 11%, the pressure to further compress credit expansion has eased into 2H21. China’s policy agenda is still focused on de-risking in the financial and real estate sectors, therefore, we expect policymakers to keep overall monetary conditions restrictive by raising the price of money. Furthermore, we do not rule out the possibility of a hike in mortgage rates. Chart 5Rising Risk For A Bear Flattening In Domestic Yield Curve In Q3 Lastly, as the Fed prepares market expectations for its rate liftoff and China’s domestic economy is still relatively solid, the PBoC may seize the opportunity to guide market-based interest rates towards their pre-pandemic levels. Thus, the market will likely price in tighter liquidity conditions while lowering expectations for the economy and inflation. The short end of the yield curve will rise faster than the longer end, resulting in a flattening of the curve (Chart 5). There is a nontrivial risk that the market will react negatively to tighter liquidity conditions and rising bonds yields, particularly when the economy is slowing. We mentioned in previous reports that rising policy rates and bond yields do not necessarily lead to lower stock prices, if rates are rising while credit keeps expanding and corporate profit growth accelerates. However, currently credit impulse has decelerated sharply, and corporate profit growth has most likely peaked in Q2. Therefore, even a small increase in bond yields or market expectations of higher rates will likely trigger risk asset selloffs. Bottom Line: Bond yields will move higher in Q3, risking market selloffs. Chinese Economy Standing On One Leg China’s economic fundamentals also pose downside risks to Chinese stock prices. Macro indicators on a year-over-year comparison will soften further in 2H21 when low base effects wane, although they will weaken from very high levels. This year’s sharp credit growth deceleration will start to drag down domestic demand, with the risk of corporate profits disappointing the market. A positive tailwind from global trade prevented China's old economy from decelerating more in the first half of the year. It is reflected in the nominal imports and manufacturing orders components in the BCA Activity Index (Chart 6). However, while rising commodity prices boosted the value of Chinese imports, the volume of imports has been moving sideways of late (Chart 7). Chart 6Our BCA Activity Index Is Still Rising... Chart 7...But The Volume Of The Import Component Has Rolled Over Chart 8Export Growth Is Moderating From Current Level Moreover, China’s export volume is peaking as the reopening in other countries shifts consumer demand from goods to services. Strong export growth would likely decelerate and converge to global industrial production growth in the coming 12 months, even though a regression-based approach suggests that export growth will stay above trend-growth if global economic activity remains robust (Chart 8). All three components of the official Li Keqiang Index, which measures China’s industrial sector activity and incorporates electricity consumption, railway transportation and bank lending, have rolled over (Chart 9). Among the three components in BCA’s Li Keqiang Leading Indicator, only the monetary conditions index improved on the back of lower real rates. Contributions from the money supply and credit expansion components to the overall indicator have been negative (Chart 10). Chart 9The Official Li Keqiang Index Is Weakening... Chart 10...So Is Our BCA Li Keqiang Leading Indicator Chart 11Household Consumption Recovery Remains A Laggard The recovery in household consumption remains well behind the industrial sector in the current cycle (Chart 11). We expect consumption and services to continue recovering very gradually. Apart from China’s long-standing structural issues, such as sliding household income growth and a high propensity to save, the cyclical recovery in consumption is dependent on China’s domestic COVID-19 situation. The country is on track to fully vaccinate 40% of its population by the end of June and 80% by year-end (Chart 12). However, hiccups in the service sector recovery are expected through 2H21, given China’s “zero tolerance” policy on confirmed COVID cases, which could trigger sporadic local lockdowns (Chart 13). Chart 12China Is Racing To Reach “Full Inoculation Rate” By Yearend Chart 13Expect Some Hiccups In Service Sector Recovery In 2H21 Bottom Line: Any moderation in exports in the rest of 2021 may add to the slowdown in China’s economic activity. Don’t Count On Fiscal Support Chart 14Fiscal Spending Has Been Disappointing In 1H21 During the first five months of the year, fiscal spending has downshifted (Chart 14). The amount of local government special-purpose bonds (SPBs) issued was far less than in the same period of the past two years, and below this year’s approved annual quota. Although we expect fiscal support to increase into 2H21, backloading SPBs would qualify, at best, as a remedial measure rather than a meaningful boost to economic activity. The RMB3 trillion SPBs to be issued in 2H21 represent only about 10% of this year’s total credit expansion. To substantially boost credit impulse and economic activity, the pickup in SPB issuance will need to be accompanied by looser monetary policy and an acceleration in bank loans (Chart 15). We do not expect that liquidity conditions will remain as lax as in 1H21. Additionally, given that the central government’s focus is to rein in the leverage of local governments and their affiliated financial vehicles (LGFV), provincial officers have little incentive to take on more bank loans against a restrictive policy backdrop. Historically, a stronger fiscal impulse linked to hefty increases in local government bond issuance has not necessarily led to meaningful improvements in infrastructure investment, which has been on a structural downshift since 2017 (Chart 16). Following a V-shaped recovery in 2H20, the growth in infrastructure investment will likely continue to slide in 2H21 due to sluggish government spending. Chart 15Bank Loans Still Hold The Key To Stimulus Impulse Chart 16Don't Count On SPBs To Meaningfully Boost Infrastructure Investment Bottom Line: There are no signs that the overall policy stance is easing to facilitate a higher fiscal multiplier from an upturn in local government bond issuance. As such, fiscal support for infrastructure spending and economic activity will disappoint in 2H21 despite more SPB issuance. Investment Conclusions Monetary conditions may tighten in Q3 although credit growth will decelerate at a slower pace. Pressures to support domestic demand will be more pronounced next year as tailwinds abate from the global recovery and domestic massive stimulus. Our view is that Chinese authorities will likely ease on the policy tightening brake towards the end of this year and perhaps even signal some reflationary measures in early 2022. Therefore, while we maintain an underweight stance on Chinese stocks for the time being, investors should remain alert to any improvements in China's policy direction. In particular, any monetary policy easing by end this year/early 2022 may signal a potential catalyst to upgrade Chinese stocks to overweight in absolute terms. Although both Chinese onshore and investable equities are currently traded at a discount relative to global stocks, they are richly valuated compared with their 2017/18 highs (Chart 17). China's economy is slowing and the corporate sector has substantially increased its leverage in the past decade. We believe that the current discount in Chinese equities relative to global stocks is warranted. Chart 18 presents a forecast for A-share earnings growth in US dollars, based on earnings’ relationship with the official Li Keqiang index. The chart shows that while an earnings contraction is not probable, without more stimulus the growth rate may fall sharply in the next 12 months from its current elevated level. This aspect, combined with only a minor valuation discount relative to global stocks, paints an uninspiring outlook for Chinese onshore stocks. Chart 17Chinese Onshore Stocks Are Traded At A Slight Discount To Global Equities Chart 18An Uninspiring Domestic Equity Earnings Outlook Our baseline view is that Chinese authorities will be more willing to step up policy supports into 2022. Fiscal impulse will likely turn negative for most major economies next year and global economic recovery will have peaked. In this scenario, both China’s economy and stocks will have the potential to outperform their global peers next year. Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Spread Product: The macro environment is highly supportive for spread product and it will likely remain supportive for the next 12-18 months, at least until the yield curve flattens to below 50 bps. Remain overweight spread product versus Treasuries in US bond portfolios. High-Yield: High-yield spreads still look fairly valued, or even slightly cheap, compared to our base case outlook for corporate defaults. Investors should continue to favor high-yield over investment grade corporates and maintain an overweight allocation to high-yield in US bond portfolios. EM Corporates: Within the A and Baa credit tiers, US bond investors should favor USD-denominated EM corporates over USD-denominated EM sovereigns and should favor both over US corporate bonds. Within the Aa credit tier, investors should favor USD-denominated EM sovereigns over USD-denominated EM corporates and should favor both over US corporate bonds. Feature Chart 1Fed Meeting Didn't Shock Credit Markets Last week’s report looked at how the June FOMC meeting prompted a massive re-shaping of the Treasury curve.1 It didn’t discuss, however, the impact that June’s meeting had on credit spreads. There’s a simple reason for this. Corporate bond spreads didn’t move very much post-FOMC. In fact, neither investment grade nor high-yield spreads have widened significantly during the past two weeks, despite the Fed’s apparent “hawkish turn” (Chart 1). The VIX jumped briefly above 20 in the days following the Fed meeting but it has since re-discovered its lows (Chart 1, bottom panel). This week’s report considers whether the corporate bond market is too complacent. The first section updates our assessment of where we are in the credit cycle based on two indicators that did see large swings post-Fed. The second section updates our outlook for high-yield defaults and considers whether junk spreads continue to offer adequate compensation. Finally, the third section of this report presents an introductory look at valuation in the USD-denominated Emerging Market (EM) corporate sector. We find that, for the most part, investment grade EM corporates are attractively valued relative to EM sovereigns and US corporates of the same credit rating and duration. Credit Cycle Update Chart 2Credit Cycle Indicators As we have repeatedly stated in past research, the slope of the yield curve is a very important credit cycle indicator.2 We have documented that spread product tends to outperform duration-matched Treasuries by a wide margin when the yield curve is steep. This outperformance tapers off once the 3-year/10-year Treasury slope falls below 50 bps and it falls off even more when the slope dips below zero.3 With that in mind, it is notable that the Treasury curve flattened dramatically following the June FOMC meeting (Chart 2). At 106 bps, the 3-year/10-year Treasury slope remains well above the 50 bps threshold that would start to get concerning for spread product. However, it’s likely that the yield curve will continue to flatten as we approach a Fed rate hike in 2022. In other words, we expect that monetary conditions will turn sufficiently restrictive for us to reduce our recommended spread product allocation within the next 12-18 months. On the other hand, one positive development for spread product returns is that the 5-year/5-year forward TIPS breakeven inflation rate declined following the June FOMC meeting. In fact, it is now below the 2.3% to 2.5% range that is consistent with the Fed’s inflation target (Chart 2, bottom panel). This is a positive development for spread product because the Fed will strive to ensure that monetary conditions stay accommodative at least until these long-dated inflation expectations are consistent with the 2.3% to 2.5% target. Or put differently, a rebound in long-maturity TIPS breakeven inflation rates back to the target range will slow the near-term pace of curve flattening, giving the credit cycle a small amount of extra running room. In short, the macro environment is highly supportive for spread product and it will likely remain supportive for the next 12-18 months, at least until the yield curve flattens to below 50 bps. Investment Grade Corporates The highly supportive macro environment applies to investment grade corporate bonds, just as it does to all spread sectors. However, investment grade corporates have the problem that valuation is extremely tight. Much like a flat yield curve environment, a tight spread environment tends to coincide with low excess corporate bond returns. However, our research reveals that tight spreads alone are not sufficient for investment grade corporates to underperform duration-matched Treasuries. Table 1 classifies each month since May 1973 based on the investment grade corporate bond spread and the 3/10 Treasury slope. It then shows a 90% confidence interval for corporate bond excess returns during the following 12 months. It shows that, even when the corporate bond spread is below 100 bps (it is 81 bps today), investment grade corporates still tend to outperform duration-matched Treasuries as long as the 3/10 Treasury slope is above 50 bps. Table 1Expected 12-Month Corporate Bond Excess Return* (BPs) Based On OAS And Yield Curve Slope Bottom Line: The yield curve has started to flatten but it remains very steep, consistent with spread product outperforming duration-matched Treasuries. We remain overweight spread product versus Treasuries but will re-consider this position once the yield curve flattens to below 50 bps. We expect this could happen within the next 12-18 months. We maintain only a neutral allocation to investment grade corporate bonds because of stretched valuations. We see more attractive opportunities in high-yield corporates (see next section), municipal bonds, USD-denominated EM sovereigns and USD-denominated EM corporates (see final section below). High-Yield Default Update We last updated our default rate outlook in March.4 At that time, we concluded that junk spreads offered adequate compensation for expected default losses. Since then, we have received nonfinancial corporate sector profit and debt growth data for the first quarter of 2021, crucial inputs to our macro-based default rate model. Our macro-based model of the 12-month trailing speculative grade default rate is based on nonfinancial corporate sector gross leverage (i.e. pre-tax profits over total debt) and C&I lending standards (Chart 3). Lending standards enter our model with a lag, but we need a forward-looking estimate of gross leverage for our model to generate predictions. Chart 3Macro-Driven Default Rate Model To estimate gross leverage we first model corporate profit growth based on real GDP (Chart 4) and assume that real GDP grows by 7% over the next four quarters, consistent with the Fed’s median forecast. This gives us a profit growth expectation of roughly 30%. Chart 4Profit & Debt Growth We also need an estimate for corporate debt growth. Corporate debt exploded last year, growing 10% in 2020, but it then slowed to an annualized rate of 4% in Q1 2021. We think corporate debt growth will remain slow going forward. The nonfinancial corporate sector financing gap has been negative in each of the past four quarters (Chart 4, bottom panel), meaning that retained earnings have exceeded capital expenditures. In other words, firms have built up a lot of excess capital that can be deployed in place of debt to finance new investment opportunities. Table 2 shows our model’s predicted 12-month default rate based on different assumptions for profit and debt growth. If we assume corporate profit growth of 30% and corporate debt growth between 0% and 8%, then our model predicts that the 12-month default rate will fall from its current 5.5% to a range of 2.3% - 2.8%. Table 2Default Rate Scenarios Next, we need to consider what sort of expected default rate is priced into the High-Yield index. Our analysis of historical junk spreads and returns suggests that we should require a minimum excess spread of 100 bps in the High-Yield index after subtracting default losses to be confident that junk bonds will outperform Treasuries.5 If we also assume a recovery rate of 40% on defaulted debt, then we calculate that the High-Yield index is fairly priced for a 12-month default rate of 2.9% (Chart 5). That is, junk spreads appear slightly cheap compared to the 2.3% - 2.8% range predicted by our macro model. Finally, it’s worth noting that actual corporate default events have been quite rare in recent months. In the first five months of 2021 we’ve seen between 1 and 3 default events per month. If we extrapolate that trend and assume we see 3 defaults per month going forward, then we calculate that the 12-month trailing default rate will fall to 2.0% by December, before leveling off at 2.2% (Chart 6). In other words, the recent trend has been one of significantly fewer defaults than predicted by our macro model Chart 5Spread-Implied Default Rate Chart 6Recent Default Trends Bottom Line: High-yield spreads still look fairly valued, or even slightly cheap, compared to our base case outlook for corporate defaults. Investors should continue to favor high-yield over investment grade corporates and maintain an overweight allocation to high-yield in US bond portfolios. An Attractive Opportunity In EM Corporates This week we present an introductory look at the risk/reward opportunity in USD-denominated EM corporate bonds. Specifically, we look at the investment grade Bloomberg Barclays USD-denominated EM Corporate & Quasi-Sovereign index. We compare this index to both the investment grade USD-denominated EM Sovereign index and the US Credit index.6 First, we look at recent performance trends and average index statistics (Table 3). Both the EM Corporate and EM Sovereign indexes have average credit ratings between A and Baa, so we compare their performance to the A-rated and Baa-rated US Credit indexes. We observe a significant option-adjusted spread (OAS) advantage in both the EM indexes, though part of the extra spread offered by the Sovereign index is compensation for its longer duration. The EM Corporate index sticks out as offering an extremely attractive OAS per unit of duration. Table 3Performance Trends & Index Statistics As for performance, we see that the EM Corporate index experienced less of a drawdown (in excess return terms) during the COVID recession, though it has also returned less than both the EM Sovereign index and the Baa Credit index during the recent upswing. Chart 7Spreads Versus Credit Rating & Duration-Matched US Credit Next, we look at each individual credit tier of both the EM Corporate & Quasi-Sovereign index and the EM Sovereign index, and we calculate the spread relative to a credit rating and duration-matched position in the US Credit index (Chart 7). In general, we see that both EM indexes offer a spread advantage versus duration-matched US Credit across all credit rating tiers. EM sovereigns look better than EM corporates in the Aa credit tier. This is the result of attractive spreads on the sovereign bonds of UAE and Qatar. However, EM corporates clearly dominate sovereigns in both the A and Baa credit tiers. Finally, we consider the risk/reward trade-off in our EM indexes by using our Excess Return Bond Map. Our Excess Return Bond Map shows the relationship between expected return (on the vertical axis) and risk (on the horizontal axis). In Chart 8A our risk measure is the 12-month spread widening required for each index to lose 100 bps versus a position in duration-matched Treasuries divided by that index’s historical spread volatility. It can be thought of as the number of standard deviations of spread widening required for the index to provide an excess return of -100 bps. A higher value corresponds to less risk, and vice-versa. Chart 8B uses the same risk measurement, only we use the spread widening required to lose 500 bps versus Treasuries to assess the risk of a large drawdown. Both Charts 8A and 8B use OAS as the measure of expected return. Chart 8AExcess Return Bond Map (100 BPs Loss Threshold) Chart 8BExcess Return Bond Map (500 BPs Loss Threshold) The first thing that sticks out in Charts 8A & 8B is that Baa-rated EM corporates offer greater expected return and less risk than the EM Sovereign index and the Baa US Credit Index. This is true whether our loss threshold is set at 100 bps or 500 bps. Unfortunately, we do not have sufficient data to split the EM Sovereign index by credit tier in these charts. A-rated EM corporates offer slightly less expected return than the EM Sovereign index but with significantly less risk, they also clearly dominate the A-rated US Credit Index. Aa-rated EM corporates appear to offer a similar risk/reward trade-off as the EM Sovereign index, though we know from Chart 7 that sovereigns have a spread advantage in the Aa credit tier. The bottom line is that USD-denominated EM corporates are attractively valued relative to investment grade US corporate bonds with the same duration and credit rating. EM corporates also look preferable to EM sovereigns in the A and Baa credit tiers. EM sovereigns are more attractive than EM corporates in the Aa credit tier. Within the A and Baa credit tiers, US bond investors should favor USD-denominated EM corporates over USD-denominated EM sovereigns and should favor both over US corporate bonds. Within the Aa credit tier, investors should favor USD-denominated EM sovereigns over USD-denominated EM corporates and should favor both over US corporate bonds. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021. 2 Please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 3 We use the 3-year/10-year Treasury slope in place of the more widely tracked 2-year/10-year slope in our credit cycle research only because using the 3-year/10-year slope allows us to include more historical cycles in our analysis. 4 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 5 Please see page 33 of the US Bond Strategy Quarterly Chartpack, “Testing The Limits Of Transitory Inflation”, dated May 18, 2021. 6 The US Credit Index consists predominantly of US corporate bonds, but also some non-corporate credit such as: Sovereigns, Foreign Agencies, Domestic Agencies, Local Authority bonds and Supranationals. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights In the near term, the RMB against the US dollar has ceased to be a one-way bet. Market sentiment will re-focus on economic fundamentals, which are less supportive of further RMB appreciation. In the longer term, the RMB still has some upside potential, but the pace of its growth should be much slower than in the past 12 months. The sharp rise in the trade-weighted RMB index is starting to threaten China’s export sector and has exacerbated the tightening of domestic monetary conditions. Barring a monetary policy reset by Chinese authorities, even a small increase in the broad-RMB index would heighten the risk of a contraction in corporate profit growth in the coming 12 months. We remain risk adverse to Chinese stocks for the next 6 months. Feature Chart 1The RMB Back On A Fast Ascending Path After a brief pause in March, China’s currency versus the US dollar extended its steep upward trend began in mid-2020 (Chart 1). Chinese policymakers recently ramped up their strong-worded statements warning against speculating on the RMB. Regulators have also taken steps to stem the rise. Questions we have recently been getting from our clients about the RMB can be summarized as follows: After a 10% appreciation since its trough a year ago, does the RMB have more upside in 2021 and beyond? If the RMB continues to appreciate, what would be the impact on China’s economy and corporate sector? What can the PBoC do to slow the pace of the currency’s appreciation? One could argue that the US dollar will continue to weaken, but we see substantial headwinds to the RMB within the year. A weaker US dollar would support global stock prices outside of the US and foreign inflows have driven the recent rally in China’s onshore stocks. However, we think China’s domestic macro policy and economic conditions pose more downside risks on a cyclical basis. How Far Can The RMB Go? A continued upswing in the CNY relative to the USD can no longer be taken for granted. In the coming months, there is a strengthening case for the RMB to fall against the greenback as factors supporting a strong RMB in the past year start to abate. Economic fundamentals will no longer prop up the RMB’s rise going into 2H21. China’s growth momentum is softening due to significant tightening in the monetary environment in the second half of last year and a rapid deceleration in credit growth this year (Chart 2). Meanwhile, the massive rollouts of COVID-19 vaccines in North America and Europe have successfully reduced new infections and hospitalization rates, allowing these countries to reopen their economies. The economic growth gaps between China and the developed markets (DMs) will narrow more significantly in the coming months (Chart 3). Chart 2Chinese Economic Fundamentals Will Start To Weaken Chart 3China's Growth Gap Relative To DMs Will Narrow Chart 4Global Consumption Recovery In Services Will Likely Outpace Goods China’s large current account surplus will likely start narrowing. It has been driven by strong global demand for goods, which is unlikely to be sustained as the pent-up demand for services in DMs will outpace the consumption for goods (Chart 4). Emerging countries (EMs), many of which are China’s export competitors, lag far behind DMs and China on inoculation rates and some have resurging COVID cases (Chart 5). However, EMs will likely benefit from meaningful expansions in global vaccine production in the second half of the year.1 A catchup in vaccinations in these countries will reduce China’s export-sector advantage, reversing the RMB’s gains over other Asian currencies in the past month. Chart 5China's Asian Neighbors Have Been Hit By Resurging COVID Cases The future trend of the USD also matters to the USD/CNY exchange rate. The recent strength of the CNY vis-à-vis the dollar was the mirror image of USD weakness, which has been due to low real rates in the US and recovering economic momentum outside the US (Chart 6). However, the broad dollar index is sitting at a critical technical level that could either breakout or breakdown (Chart 7). When the Fed announces the slowing of asset purchases, which our BCA US Bond Strategy expects before the end of 2021, it could lead to higher US real yields and reverse the trend of hot money flows into China. Chart 6The Sharp Rise In The RMB In The Past Two Months Has Been Dollar-Driven Chart 7The Dollar Index: Breakout or Breakdown? Furthermore, the financial market does not seem to have priced in unstable US-China relations, which could undermine global risk appetite (Chart 8). Recent actions by US President Joe Biden – from expanding the investment ban on 59 blacklisted Chinese tech companies to calling for the US intelligence community to investigate the origins of COVID-19 – point to risks for escalating tensions between the two nations. Longer term, the RMB is at about one standard deviation below its fair value, which suggests that it still has more upside potential (Chart 9). Based on our BCA’s Foreign Exchange Strategist’s real effective exchange rate (REER) model, the RMB’s fair value mostly climbed in the past three decades, driven by higher productivity in China relative to its trading partners. However, part of the RMB’s appreciation since mid-2020 has been a catch up to its pre-trade war value and its valuation gap has rapidly narrowed. From the current valuation levels, the pace of RMB appreciation should be much slower going forward. Chart 8Geopolitical Surprises Could Spook The Market Chart 9Valuation Gap Has Rapidly Narrowed We also expect China’s real interest rates relative to the US to dwindle in the next three to five years. Demographic headwinds in China herald lower real rates while the Fed is primed to start rate liftoffs within the next two years. Bottom Line: The RMB still has some upside potential in the long run, but the pace of its appreciation should be much slower than in the past 12 months. In the near term, odds are high that economic fundamentals will not boost the RMB any further. How Does A Stronger RMB Affect China’s Economy? Historically, a stronger RMB relative to the dollar has not had a significant impact on China’s economy. However, if the CNY appreciates considerably versus the greenback so that it pushes up the trade-weighted RMB index, then China’s corporate profits will be negatively affected (Chart 10). Chart 10Strengthening Broad-RMB Index Has Historically Led To Weaker Corporate Profit Growth... Chart 11...And Could Significantly Raise Prob Of A Earnings Contraction In 12 Months Our earnings growth recession probability model confirms our view. If all else is equal, a 3% rise in the trade-weighted RMB index from its current level would more than double the probability of a contraction in earnings growth in the coming 12 months (Chart 11, Scenario 1). On the other hand, all else will not be equal if the broad RMB index goes up by 3%. A quick increase in the RMB’s value against the currencies of its trading partners will impede China’s export growth and tighten domestic monetary conditions. Chart 12Moving Into Restrictive Territory For Chinese Exports Chart 12 shows the impact on export growth from the speed of the RMB’s appreciation; we calculate the rise in an export-weighted RMB index relative to its highs and lows in the past few years. The metric implies that the acceleration in the RMB’s value has reached levels that should be restrictive for exports. The nominal export-weighted RMB index has been significantly above the median value since 2015 and it is approaching the peak reached in that year. Clearly, the strong RMB is linked to a recent weakness in the PMI surveys on export orders. A 3% increase in the trade-weighted RMB from the current level, coupled with a drop in export growth and further deceleration in credit impulse would prop up the earnings contraction probability to more than 50% (Scenario 2 in Chart 11 above). Bottom Line: Our metrics suggest that the RMB’s recent sharp rise is starting to threaten the export sector. An additional 3% appreciation in the broad RMB index would cause a meaningful increase in the probability of a corporate earnings growth contraction in the coming 12 months. What Can The PBoC Do To Halt The RMB Rally? We break this question into two parts: the willingness and the capability of the PBoC to intervene in the currency market. On the first aspect, the PBoC in recent years has largely refrained from draconian intervention measures in the currency market. Allowing a more market-based currency exchange rate regime is a crucial part of China’s RMB internationalization process. The PBoC seems to be mostly sticking to this long-term goal. Chart 13New FX Regime Began In 2015 Has Significantly Lowered USD Weight In The Broad-RMB Index... Importantly, the new exchange rate regime that the PBoC switched to at end-2015 has greatly weakened the link between the USD and the broad RMB trend (Chart 13). Since then China has continuously cut the weighting of the USD in the CFETS currency index basket, which has reduced the impact of dollar moves on the index. Therefore, the PBoC has mostly ignored short-term volatilities in the CNY/USD exchange rate. The central bank tends to intervene only when swings in the CNY/USD exchange rate are large enough and/or the market forms a unilateral view on the Chinese currency to drive sustained movements in the broader RMB index. For example, the RMB value rose at a much faster rate against the USD compared with its other trading partners in the second half of 2020. However, this year, the pace of growth in the broad RMB index has caught up with that of the CNY/USD appreciation. Moreover, even when the RMB depreciated against the USD in March, the CFETS index basket kept rising and is now breaching its previous peak in April 2018 (Chart 14). As discussed in the previous section, a sharp jump in the trade-weighted RMB would be more detrimental to China’s corporate profits than an increase in the CNY/USD. Chart 14...But The Massive Appreciation In The CNY/USD Of Late Has Pushed The RMB Index To A Three-Year High Chart 15The PBoC Has Been Trying To Guide Market Expectations Lower On The RMB On the second aspect, the PBoC is unlikely to alter its monetary policy trajectory to tame the RMB’s appreciation. A looser monetary environment would encourage more asset price bubbles domestically and jeopardize policymakers’ ongoing progress in financial and property-market de-risking. If the CFETS strengthens further, Chinese authorities will probably use tools such as managing market expectations and various capital controls to mop up excess FX liquidity generated from capital inflows. In the near term, the PBoC may set a weaker fixing rate against the dollar to dampen market expectations for more RMB growth (Chart 15). An increase in the FX deposit reserve requirement ratio (RRR) rate, announced by the PBoC last week, is another example of the central bank trying to prevent a one-sided expectation by market participants. However, the previous three FX deposit RRR hikes –all taken place more than a decade ago—did little to alter the path of the CNY exchange rate; the pace of USD/CNY depreciation actually accelerated following the May 2007 RRR hike. The two-percentage point bump in the FX deposit RRR rate will drain China’s domestic FX liquidity by about US$20 billion. Its effect on domestic FX liquidity and FX loan rates is rather limited – FX inflows to Chinese financial institutions since 2H20 were more than US$20 billion a month –more than offsetting the tightening from a RRR rate hike. The PBoC can further loosen outward capital controls to release some pressure on the RMB’s increase. In a report from November last year we wrote that Chinese policymakers attempted to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by commercial banks and other financial institutions . Since August last year, China has relaxed outbound investment regulations and increased quotas to help channel domestic money into offshore financial markets. China’s commercial banks significantly ramped up their FX assets last year (Chart 16). In Q1 this year, commercial banks enriched their FX asset holdings by US$518.5 billion, a record high in the past five years. Bottom Line: The PBoC is willing to allow more volatility in the USD/CNY exchange rate, but a sharp jump in the RMB’s value against a basket of other currencies would warrant further policy actions. Chart 16Chinese Banks Ramped Up FX Asset Holdings Chart 17Chinese Onshore Stocks Propped Up By Foreign Investors Investment Conclusions A tightened monetary and credit environment has created headwinds for Chinese equities since early this year. However, the domestic market appears to have found support at a key technical level of late (Chart 17). The recent rebound in China’s onshore stocks on the back of a sharp CNY appreciation and accelerated foreign capital inflows, in our view, are unsustainable on a cyclical basis. Despite buoyant global economic growth, investors should consider deteriorating cyclical conditions in China when judging the appropriate allocation for Chinese equities. While policy tightening has brought multiples closer to earth than last year, the upside in Chinese stock prices will be capped by subsiding stimulus and slower profit growth ahead. As such, a decisive breakout to the upside in Chinese stock prices will require major reflationary catalysts, and it is the reason we are still risk adverse on Chinese equities (Chart 18). Meanwhile, we continue to favor onshore consumer discretionary stocks relative to the broad A-share market. A strong RMB can be a booster to domestic discretionary spending. We initiated this trade in May last year and it has largely outperformed China’s onshore broad market (Chart 19). We will close the trade when the CNY loses its strength and Chinese domestic demand starts to falter. Chart 18Cyclical Performance In Chinese Stocks Is Still Driven By Economic Fundamentals Chart 19Keep A Long CD Position, But On A Short Leash Jing Sima China Strategist jings@bcaresearch.com Footnotes 1The UN estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. Cyclical Investment Stance Equity Sector Recommendations
Highlights A slower money and credit growth in China will eventually generate disinflationary pressures by weighing on demand for commodities. The PBoC has shifted its inflation anchor and policy framework to target core CPI and the PPI rather than headline CPI. Beijing is scaling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. In the next six to nine months we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. We are long CSI500 relative to China’s A shares. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market. Feature As a follow up to last week’s report, we look at another topic raised in recent client meetings: whether rapidly rising producer prices in China will morph into a broad-based inflationary risk and how macroeconomic policies will evolve to counter such a risk. Clients who believe that the ongoing producer price inflation is transitory cited China’s low consumer price inflation, and slowing money and credit growth, as leading indicators of budding disinflationary pressures. Advocates of sustained inflation pointed to robust recoveries and demand among advanced economies, extremely accommodative monetary conditions worldwide, massive fiscal stimulus in the US, a weak US dollar, and supply constraints. It remains to be seen what the worldwide pandemic’s impact will be on the balance between global production capacity and aggregate demand. In this report we analyze the PBoC’s inflation target and policy framework, and conclude that while China’s monetary policy has not become more hawkish, policy tightening seems to be taking place on the fiscal front. Is Inflation In China A Risk? It is debatable whether the strong rebound in GDP growth in Q4 last year and in Q1 this year has closed China’s output gap and will lead to widespread inflation. Given data distortions due to low-base effects from the previous year and uncertainty about China’s productivity and labor force growth, any calculation of the output gap will be unreliable. In addition, China’s employment statistics lack cyclicality and cannot be used to gauge inflationary pressure stemming from wage growth and unit labor costs. Chart 1A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities Our cyclical view of inflation is therefore based on the framework that the ongoing moderation in China's money and credit growth will eventually generate disinflationary pressures by weighing on the country’s demand for and price of commodities (Chart 1). Furthermore, behind a resilient PPI, there are suggestions that the strength in China’s economy is still bifurcated. A narrow-based uptrend in the PPI lacks the ground for sustained inflation, and is unlikely to trigger a general tightening in monetary policy. While mounting global prices for raw materials propelled strong upstream PPI, producer prices for consumer goods and core consumer price inflation remain very subdued (Chart 2). The inconsistency in producer prices among various industries highlight the unevenness of the economic recovery and, importantly, persistently muted household consumption (Chart 3). Chart 2A Bifurcated Economic Recovery Chart 3A Muted Recovery In Household Consumption Chart 4Weak Price Transmission From Upstream To Downstream Industries The transmission from upstream industrial PPI to the middle and downstream sectors has also been weak (Chart 4). It is evidenced in the faster growth of manufacturing output volume compared with price increases (Chart 5). This contrasts with the previous inflationary cycles, as well as mining and ferrous metals where surging prices for raw materials have way surpassed recovery in output volume (Chart 6). Given that price changes are more important to corporate profits than volume changes, Chinese middle-to-downstream industries face downward pressure on their profit margins and will likely deliver disappointing profits, despite a strong rebound in production. Chart 5China's Manufacturing Recovery: Stronger Volume Than Prices Chart 6China's Upstream Industries: Prices Surged Faster Than Production Furthermore, PMI input prices, which lead core CPI by about nine months, rolled over in April (Chart 7). While it is too soon to conclude that input prices have peaked, it is implied that upward pressure on core CPI from input prices may start to ease in 2H21. Bottom Line: So far there is no sign that elevated upstream producer prices will create sustainable inflationary pressure on consumer prices. Hence our view is that the PBoC will not respond to a rising PPI by further tightening monetary policy. Chart 7PMI Input Prices Have Rolled Over Chart 8Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 The PBoC’s Inflation Target Since 2015, China’s monetary tightening cycles have closely correlated with a combination of the core CPI and PPI instead of headline CPI (Chart 8). The shift to targeting core CPI and PPI occurred despite the central bank’s frequent mention of headline CPI as its inflation target. The reasons for the shift are twofold. First, swings in food and fuel prices have become much larger since 2014, often dominating fluctuations in headline CPI (Chart 9). Secondly, the price swings were often driven by supply-side factors and did not reflect changes in demand. Therefore, monetary policies could do little to mitigate inflationary or deflationary pressures. Furthermore, the PPI seems to play a greater role in the PBoC’s monetary policymaking than the headline and core CPI (Chart 10). The tighter relationship between the de facto policy rate and the PPI is not surprising, given that China’s ex-factory price inflation reflects changes in corporate pricing, profit, and inventory cycles – all are driven by the country’s money supply and credit cycles. Chart 9Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Chart 10PPI Plays A Greater Role In The PBoC's Monetary Policymaking The relationship between the 7-day repo rate - the de jure policy rate - and the PPI has broken down since 2015 (Chart 11). Meanwhile, the 3-month repo rate has maintained a close relationship with the PPI (Chart 10, bottom panel). The change in the relationship is because the PBoC shifted its policy to target interest rates instead of the quantity of money supply since 2015 (Chart 12). Moreover, since 2016 the PBoC has generated monetary policy tightening measures through changes in its Macro Prudential Assessment Framework (MPA) rather than directly through interest rate hikes. Chart 11Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Chart 12...Due To Monetary Policy Regime Shifted Bottom Line: The PBoC has shifted its inflation anchor and policy framework since 2015. Core CPI and the PPI are now the main inflation targets. A Quiet Fiscal Tightening? Despite a jump in the PPI, the 3-month repo rate fell sharply in the past two months (Chart 10 on page 6, bottom panel). It is possible that the PBoC considers escalating producer prices as transitory and, therefore, intends to keep its overall policy stance unchanged. However, the PBoC’s relaxed policy response towards inflation risk may be explained by Beijing’s quiet tightening on the fiscal front. Chart 13The Central Bank Has Made Little Interbank Liquidity Injections Lately The PBoC can hold its policy rates steady by supplying adequate liquidity to the interbank system through open market operations or by reducing the demand for liquidity. On a net basis, the PBoC has recently injected very little liquidity into the interbank system, implying that banks’ liquidity demand has likely softened (Chart 13). This might be a sign of weakening credit origination. In a previous report we discussed how fiscal stimulus has become a more relevant driver of China’s credit origination since the onset of the 2014/15 economic downcycle. A rising 3-month SHIBOR can be the result of rapid fiscal and quasi-fiscal expansions, which occurred in Q3 last year. A flood of local government bond issuance drained liquidity from commercial banks, which boosted the banks’ needs to borrow money from the interbank system and pushed up interbank rates. Despite higher interest rates, credit growth soared in Q3 as fiscal multiplier provided an imminent and powerful reflationary force to the economy. In contrast, local government bond issuance was down sharply in the first four months of this year, compared with 2019 and 2020. Local governments sold 222.7 billion yuan of special-purpose bonds (SPBs) from January to April, a plunge from 730 billion yuan of debt sold in the same period in 2019 and 1.15 trillion yuan in 2020. The total local government bond issuance in Q1 this year has also been 36% and 44% lower than in Q1 2019 and 2020, respectively. A lack of local governments’ appetite to borrow coupled with a shortage in profitable infrastructure projects might have contributed to the sharp drop in bond issuance this year. Local government financing and spending have been under increased scrutiny this year. Following the State Council Executive Meeting in late March, in which Premier Li Keqiang pledged to reduce government leverage ratio and raise regulatory standards on infrastructure investment, Beijing suspended two high-speed rail projects that were initiated by provincial governments. Messages from Politburo’s meeting last week reinforced our view that policymakers may be scaling back fiscal support while further tightening regulations in the property sector. Both aspects have the potential to cool China’s demand for industrial metals and global industrial material prices (Chart 14 and Chart 15). Chart 14A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices Chart 15Lower Housing Demand In China Will Help To Cool Industrial Metal Prices We expect the intensity of policy tightening to reach its peak between mid-year to third-quarter 2021. It is unclear at this point whether policymakers are willing to allow local governments to significantly undershoot their SPB quota for this year. Local governments reportedly experienced a shortage in profitable investment projects towards the end of last year, and thus, parked more than 10% of proceeds from 2020 SPB issuance at the central bank. The central government may be taking a wait-and-see attitude this year, and saving more fiscal dry powder for later this year when the economic slowdown becomes more meaningful. Bottom Line: Beijing is pulling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. The deleveraging efforts will curb China’s demand for commodities, and may work to ease inflationary pressure on prices for raw materials. Investment Conclusions The outlook for China’s risk asset prices remains bearish, at least in the next six months. If the credit and fiscal impulse slow enough to depress corporate pricing power, inflation will not be a problem because disinflationary pressures will resurface. However, the growth of corporate profits will disappoint (Chart 16). Beijing may be saving more fiscal dry powder for later this year. Still, SPBs are only a small part of local governments’ financing source for infrastructure projects. Given the central government’s renewed focus on reducing public debt, policymakers are unlikely to unleash fiscal power to significantly boost infrastructure spending or economic growth. In the next six to nine months, we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. With this week's report, we initiate a long position on the CSI500 index, which has a larger exposure to the global market and lower valuation relative to China’s broad onshore market (Chart 17). Chart 16Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Chart 17Long CSI500/Broad Market Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights If fully implemented, President Biden’s Made in America Tax Plan would reduce S&P 500 earnings by about 8%. We expect some of the proposed tax measures to be watered down, resulting in a 5% decline in earnings. Investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy. Looking further out, however, we see four reasons why US tax rates are likely to keep rising, eventually reaching levels that hurt stock prices: First, the effective US corporate tax rate is still very low; second, the failure of President Trump’s tax cuts to boost investment spending will make it easier eventually to fully reverse them; third, rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing; and fourth, and most importantly, the political winds are shifting in favor of higher taxes on corporations and the wealthy. The Democrats have been moving leftward on economic matters for some time. For their part, conservative Republicans are starting to ask themselves why they should support tax cuts for a growing list of “woke” companies that seemingly hate them. The US corporate sector is at risk of being left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. The Biden Tax Plan On March 31st, President Biden unveiled the American Jobs Plan. The plan proposes $2.25 trillion in new federal spending, spread out over eight years, on public infrastructure and other areas. As outlined in the Made In America Tax Plan, the Biden Administration will seek to raise $2 trillion in tax revenue over the next 15 years in order to fund the new spending package. The three most important provisions in the tax plan are: Raising the domestic corporate income tax rate from 21% to 28%. This would bring the tax rate halfway back to where it was prior to the Trump tax cuts (35%). Taking into account the global distribution of corporate profits and other factors, such a tax hike would reduce S&P 500 earnings by about 4%. Increasing the minimum tax on the foreign profits of US companies. The Biden administration proposes doubling the minimum tax rate on Global Intangible Low-Taxed Income (GILTI) from 10.5% to 21%. It also plans to eliminate the Foreign-Derived Intangible Income deduction (FDII). These two measures would reduce S&P 500 earnings by about another 3.5%. A 15% minimum tax on “book income” (i.e., the earnings that companies report to shareholders). The tax applies to corporations with annual profits in excess of $2 billion. The Treasury department estimates that 45 companies will be liable for this tax. It would cut S&P 500 earnings by a further 0.5%. Taken together, these provisions would reduce S&P 500 earnings by about 8%. In practice, we think the impact will be closer to 5%. The Biden plan includes a variety of tax credits, focusing on areas such as clean energy and R&D, which should offset some of the tax increases. The ultimate corporate tax rate is also likely to fall short of 28%. West Virginia Senator Joe Manchin, the critical swing voter, has already said he would prefer to cap it at 25%. What Has Been Priced In? Chart 1Companies That Stand To Lose The Most From Higher Taxes Have Fared Well Our reading of the data suggests that very little of the impact from higher taxes has been baked into either analyst earnings estimates or market expectations. Chart 1 displays the performance of Goldman‘s “Formerly High Tax” and “Formerly Low Tax” equity baskets. The formerly high-taxed companies gained the most from Trump’s tax cuts and presumably would lose the most if the tax cuts were rolled back. Yet, they have outperformed their low-taxed peers since the Georgia runoff election, which handed the Senate to the Democrats. Likewise, earnings estimates have not reacted to the prospect of higher taxes. This is not surprising. Chart 2 shows that analysts did not adjust their earnings estimates until shortly after President Trump signed the Tax Cuts and Jobs Act into law on December 22, 2017. Similar to what happened back then, analysts appear to be waiting for the details of the ultimate tax package before changing their estimates. Chart 2Analysts Have Not Adjusted Their Earnings Estimates To Reflect The Likelihood Of Higher Taxes For Now, Business Cycle Dynamics Are More Important Than Taxes While the failure of the investment community to price in higher taxes represents a headwind to stocks, we would characterize it as a modest headwind. IBES estimates still point to earnings growth of 15% for S&P 500 companies in 2022. It would take an unrealistically large tax hit to keep corporate profits from rising next year. The IMF’s latest economic projections, released a few weeks ago, foresee US real GDP growing by 3.5% in 2022, one full percentage point faster than the Fund expected in January (Table 1). Given the strong correlation between equity returns and economic growth, the equity bull market will likely survive a tax increase (Chart 3). Table 1Growth Remains Robust Chart 3Stocks Usually Outperform Bonds When Economic Growth Is Strong Of course, some stocks could still feel the pinch from higher taxes. The tech sector is especially vulnerable, given that it currently enjoys one of the lowest effective tax rates in the S&P 500 (Chart 4). Tech companies have also been very adept at shifting income from intangible assets such as patents to offshore tax havens, which is likely to put them in the crosshairs of the soon-to-be bulked up IRS.1 We currently favor value over growth stocks. The likelihood that higher taxes will have a disproportionately negative effect on growth sectors such as tech only reinforces this view. Chart 4Tech Is Vulnerable To Higher Taxes Higher Taxes: Start Of A Long-Term Trend? While we are not too worried about the near-term impact of higher taxes on equity prices, we are more concerned about the longer-term consequences. As we discuss below, not only is Biden likely to raise personal income and capital gains taxes to fund future spending initiatives such as the forthcoming American Families Plan, but the pressure to keep raising business taxes will persist well beyond his administration. There are four reasons for this: Reason #1: The effective US corporate tax rate is still very low Chart 5Corporate Tax Revenues Are Low In April 2018, four months after the Tax Cuts and Jobs Act came into effect, the Congressional Budget Office projected that US corporations would pay $276 billion in corporate taxes in 2019. In the end, they paid only $230 billion.2 US corporate income tax receipts stood at only 1% of GDP in 2018-19, half of what they were in 2013-17 (Chart 5). During Ronald Reagan’s second term in office, US corporations faced an effective tax rate of around 30%. Today, it is less than 15% (Chart 6). As a share of GDP, the US government collects less corporate tax revenue than almost all other OECD economies (Chart 7). Chart 6The Economy-Wide Effective Corporate Tax Rate Has Been Shrinking For More Than Three Decades Chart 7US Corporate Taxation Is Not High Chart 8Trump Was Unlucky To Be Singled Out By The IRS Moreover, the US government often does not even bother to even collect the money that is owed to it. Audits of corporations with more than $20 billion in assets are down 50% since 2011. Audits of individuals with annual income above $1 million are down 80% (Chart 8). In his testimony to the US Senate this week Chuck Rettig, IRS Commissioner, estimated that tax evasion costs the government $1 trillion per year. Reason #2: The failure of Trump’s tax cuts to boost investment spending will make it easier to eventually fully reverse them If the Trump tax cuts had raised investment spending, it would be easier to overlook the negative effect that they had on the budget deficit. The evidence, however, suggests that lower corporate taxes did very little to spur capex. Chart 9 shows that capital spending barely increased as a share of GDP in the two years following the passage of the Tax Cuts and Jobs Act. According to the International Monetary Fund, only one-fifth of the tax cuts were used to finance capital investment and R&D spending.3 Along the same lines, Hanlon, Hoopes, and Slemrod found that fewer than a quarter of S&P 500 companies discussed plans to increase capex in response to lower taxes during their conference calls.4 Chart 9Trump's Tax Cuts Did Little To Spur Investment Chart 10Business Equipment And IP Do Not Last Long Why did corporate investment fail to rise much? One answer is that a tax on profits is not the same thing as a tax on capital investment. As Appendix 1 explains, lower corporate taxes are unlikely to have much of an effect on debt-financed capital spending when interest costs are tax deductible. Unlike long-lived assets such as homes, most of the corporate capital stock is fairly short-lived (Chart 10). The demand for business equipment and software depends more on the outlook for aggregate demand than on the cost of capital. Finally, as we explained in a report entitled Inequality Led To QE, Not The Other Way Around, the majority of corporate profits these days can be attributed to monopolistic power of one form or another. Standard economic theory suggests that taxing monopoly rents will not reduce output or investment. Reason #3: Rising bond yields will make it more expedient to fund spending with higher taxes rather than increased borrowing With interest rates still at exceptionally low levels, there is no immediate need to raise taxes to finance increased government spending. This is especially true for infrastructure spending, which can reasonably be expected to boost economic growth (and hence tax receipts) over the long haul. Chart 11US Interest Payments Will Skyrocket Under The Status Quo If interest rates were to rise, however, governments would likely find it advantageous to increase taxes rather than face spiralling debt-servicing costs. Public debt levels are very high in the US and in most other economies, so any increase in interest rates would siphon funds from social programs towards bondholders. This would not be popular with voters. The Congressional Budget Office estimates that federal government interest payments will swell rapidly over the coming decades if measures are not taken to rein in budget deficits (Chart 11). As we discuss next, these measures are likely to take the form of higher taxes rather than spending cuts. Reason #4: The political winds are shifting in favor of higher taxes on corporations and the wealthy Democrats have been moving leftward for some time. In 2001, 50% of Democrats said that “government should do more to solve our country’s problems.” Today, that number is 83% (Chart 12). Chart 12Democrats Want More Government Chart 13Big Ticket Social And Health Care Spending To Keep Rising While Republicans continue to show a preference for small government, this may not last. Medicare and Social Security consume over 40% of all federal non-interest spending. Outlays on both programs (Medicare in particular) are set to grow rapidly over the coming years (Chart 13). To the extent that the political preferences of older Americans lean Republican, this could make the GOP more inclined to support higher taxes in order to sustain benefits to the elderly. The fact that corporations and the rich increasingly favor socially liberal policies is leading conservative Republicans to ask why they should continue to support tax cuts for people and companies that seemingly hate them. Whereas Joe Biden won the richest US counties by 20 percentage points last November, Trump saw his support rise in the poorest counties (Chart 14). Reflecting this trend, the share of Republicans who expressed “hardly any confidence in Corporate America” rose from 19% in February 2018 to 30% in March 2021 (Chart 15). Chart 14Democrats Have Made Serious Inroads Among The Better-Off Chart 15Republicans Growing More Skeptical Of Corporate CEOs More than twice as many Republicans now favor raising corporate taxes as lowering them (Chart 16). Nationally, 73% of Americans are dissatisfied with the influence that corporations have over the nation, a 25-point jump from 2001 (Chart 17). Chart 16More Americans Want To Soak The Rich Chart 17Souring Attitudes Toward Big Corporations Given the shift in public opinion, it is not too surprising that the Republican response to Biden‘s tax plan was decidedly “low energy”. After a perfunctory condemnation of the plan, Republican leaders quickly pivoted to attacking “woke” corporations. Addressing the corporate reaction to Georgia’s new election law, Senate Republican Leader Mitch McConnell declared “We are witnessing a coordinated campaign by powerful and wealthy people to mislead and bully the American people.” He went on to say, “From election law to environmentalism to radical social agendas to the Second Amendment, parts of the private sector keep dabbling in behaving like a woke parallel government. Corporations will invite serious consequences if they become a vehicle for far-left mobs to hijack our country from outside the constitutional order.” If current trends continue, as we suspect they will, the US corporate sector will be left without a party to defend its interests. Thus, while the near-term outlook for stocks is still bright, the long-term outlook is growing increasingly dim. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Appendix 1: When Do Higher Taxes On Corporate Profits Reduce Investment? Suppose a company is considering whether to purchase a piece of machinery for $1000. Let us assume that the company faces an external rate of return, r, of 8%. That is to say, it can borrow and lend at 8%. The accompanying table illustrates how the firm’s profits will vary depending on its internal rate of return (the return on investment that the machine will generate). Let us start with the case where the company finances the purchase of the machine by issuing new debt. For now, assume that the internal rate of return is 10% and that the machine can be used indefinitely (i.e., it never depreciates). In this case, the machine will generate $100 in operating income per year. After subtracting the $80 in interest expense, the company will be left with $20 in pre-tax income (Example A). Suppose the company faces an income tax of 20% and interest is fully tax deductible. Then, the company will pay a tax of $20*0.2=$4, leaving it with $16 in after-tax profits (Example B). Notice that while the tax reduced the company’s after-tax profit, it did not extinguish the incentive to purchase the machine in the first place. After all, while $20 is better than $16, $16 is still better than zero. Thus, in this simple example, we see that when the purchase of capital equipment is financed through debt and interest payments are fully tax deductible, the imposition of a profit tax will not affect the ultimate decision of whether to invest or not. Things change when interest is not tax deductible. In this case, the internal rate of return must rise to r/(1-t) to make the company indifferent between buying the machine or not. In the example above, this means the internal rate of return must increase to 8%/(1-0.2)=10%. Then, the company will make an operating profit of $100, pay $20 in tax on that profit, and after paying $80 in interest, end up breaking even (Example C). The calculus in deciding whether to invest in new capital equipment is similar for equity financing as it is for debt financing when interest payments are not tax deductible. The best way to think about equity financing is to ask how much the market price of the machine will be after the company purchases it. If there is no tax and the internal rate of return is 10%, the market price will be $100/0.08=$1250 (Example D). Since the company can buy the machine for $1000, it makes sense to buy it. If the owner of the machine has to pay a profit tax of 20% on the stream of income that it generates, its market value will only be $80/0.08=$1000 (Example E). At this point, the company is indifferent about whether to purchase the machine or not. How do things change when we abandon the assumption that the machine lasts forever? The main difference is that the decision of whether to buy the machine becomes less sensitive to changes in the cost of capital. For example, suppose the machine only lasts one year. To make it worthwhile for the company to purchase that machine, the revenue that it generates in that one year must rise dramatically (Example F). This makes the decision to purchase the machine much less dependent on the interest rate and more dependent on business cycle considerations, especially the outlook for aggregate demand. Appendix Table 1 Footnotes 1 Jed Graham, “Biden's Tax Plan: What It Means For Amazon, Google, Facebook, Apple, Microsoft,” Investor’s Business Daily (April 8, 2021). 2 “The Accuracy of CBO’s Baseline Estimates for Fiscal Year 2019,” Congressional Budget Office (December 2019). 3 Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “U.S. Investment Since the Tax Cuts and Jobs Act of 2017,” IMF Working Paper (May 31, 2019). 4 Michelle Hanlon, Jeffrey L. Hoopes, and Joel Slemrod, “Tax Reform Made Me Do It!” NBER Working Paper 25283 (November 2018). Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores
Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance
Highlights Duration: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Corporate Bonds: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Disposable personal income fell in February compared to January, but it has risen massively since last year’s passage of the CARES act. The large pool of accumulated household savings will help drive economic growth as the pandemic recedes. Feature There is widespread anticipation that the economic recovery is about to kick into high gear. To us, this anticipation seems rather well founded. The United States’ vaccination roll-out is proceeding quickly and the federal government is pitching in with a tsunami of fiscal support. But it’s important to acknowledge that this positive outlook is still a forecast, one that has not yet been validated by hard economic data. The risk for investors is obvious. Market prices have already moved to price-in a significant amount of economic optimism and they are vulnerable in a situation where that optimism doesn’t pan out. In this week’s report we look at how much economic optimism is already discounted in both the Treasury and corporate bond markets. We conclude that the most likely scenario is one where the economic data are strong enough to validate current pricing in both markets. Investors should keep portfolio duration below-benchmark and continue to favor spread product over Treasuries, with a down-in-quality bias. Optimism In The Treasury Market The most obvious way to illustrate the economic optimism currently embedded in Treasury securities is to look at the rate hike expectations priced into the yield curve relative to the Fed’s own projections (Chart 1). The market is currently looking for four 25 basis point rate hikes by the end of 2023 while only seven out of 18 FOMC participants expect any hikes at all by then. Chart 1Market More Hawkish Than Fed We addressed the wide divergence between market and FOMC expectations in last week’s report.1 We noted that the main reason for the divergence is that while the market is focused on expectations for rapid economic growth the Fed is making a concerted effort to rely only on hard economic data. This sentiment was echoed by Fed Governor Lael Brainard in a speech last week:2 The focus on achieved outcomes rather than the anticipated outlook is central to the Committee’s guidance regarding both asset purchases and the policy rate. The emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than preemptive at this stage in the recovery. The upshot of the Fed’s excessively cautious approach is that its interest rate projections will move toward the market’s as the hard economic data strengthen during the next 6-12 months, keeping the bond bear market intact. As evidence for this view, consider that the US Economic Surprise Index remains at an extremely high level, consistent with a rising 10-year Treasury yield (Chart 2). Further, 12-month core inflation rates are poised to jump significantly during the next two months as the weak monthly prints from March and April 2020 fall out of the 12-month sample (Chart 3). Then, pipeline pressures in both the goods and service sectors will ensure that inflation remains relatively high for the balance of the year (Chart 3, bottom panel).3 Chart 2Data Surprises Remain Positive Chart 3Inflation About To Jump Finally, the hard economic data still do not reflect the truly massive amount of fiscal stimulus that is about to hit the US economy. Chart 4 illustrates how large last year’s fiscal stimulus was compared to what was seen during recent recessions, and this chart does not yet incorporate the recently passed $1.9 trillion American Rescue Plan (~8.7% of GDP) or the second infrastructure focused reconciliation bill that is likely to pass this fall. Our political strategists expect 2021’s second budget bill to be similar in size to the American Rescue Plan though tax hikes will also be included and, due to the infrastructure-focused nature of the bill, the spending will be more spread out over a number of years.4 Chart 4The Era Of Big Government Is Back Bottom Line: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Optimism In The Corporate Bond Market Chart 5What's Priced In Junk Spreads? The way we assess the amount of economic optimism baked into the corporate bond market is to calculate the 12-month default rate that is implied by the current High-Yield Index spread (Chart 5). We need to make a few assumptions to do this. First, we assume that investors require an excess spread of at least 100 bps from the index after subtracting 12-month default losses. In past research, we’ve noted that High-Yield has a strong track record of outperforming duration-matched Treasuries when the realized excess spread is above 100 bps. High-Yield underperforms Treasuries more often than it outperforms when the realized excess spread is below 100 bps.5 Second, we must assume a recovery rate for defaulted bonds. The 12-month recovery rate tends to fluctuate between 20% and 60%, with higher levels seen when the default rate is low and lower levels when the default rate is high (Chart 5, bottom panel). For this week’s analysis, we assume a range of recovery rates, from 20% to 50%, though we expect the recovery rate to be closer to the top-end of that range during the next 12 months, given our expectations for a rapid economic recovery. With these assumptions in mind, we calculate that the High-Yield Index is fairly priced for a default rate between 2.8% and 4.5% for the next 12 months (Chart 5, panel 2). If the default rate falls into that range, or below, then we would expect High-Yield bonds (and corporate credit more generally) to outperform a duration-matched position in Treasuries. If the default rate comes in above 4.5%, then we would expect Treasuries to beat High-Yield. To figure out whether the default rate will meet the market’s expectations, we turn to a simple model of the 12-month speculative grade default rate that is based on nonfinancial corporate sector gross leverage (aka total debt over pre-tax profits) and C&I lending standards (Chart 6). If we make forecasts for nonfinancial corporate 12-month debt growth and pre-tax profit growth, we can let the model tell us what default rate to anticipate. Chart 6Default Rate Model Debt Growth Expectations We expect corporate debt growth to be quite weak during the next 12 months (Chart 7). This is mainly because firms raised a huge amount of debt last spring when the Fed and federal government made it very attractive to do so. Now, we are emerging from a recession and the nonfinancial corporate sector already holds an elevated cash balance (Chart 7, bottom panel). Debt growth was also essentially zero during the past six months, and very low (or even negative) debt growth is a common occurrence right after a peak in the default rate (Chart 7, top 2 panels). It is true that the nonfinancial corporate sector’s Financing Gap – the difference between capital expenditures and retained earnings – is no longer negative (Chart 7, panel 3). But it is also not high enough to suggest that firms need to significantly add debt. Chart 7Debt Growth Will Be Slow For our default rate calculations, we assume that corporate debt growth will be between 0% and 8% during the next 12 months. However, our sense is that it will be closer to 0% than to 8%. Profit Growth Expectations Chart 8Profit Growth Will Surge Our expectation is that profit growth will surge during the next 12 months, as is the typical pattern when the economy emerges from recession. Year-over-year profit growth peaked at 62% in 2002 following the 2001 recession, and it peaked at 51% in 2010 coming out of the Global Financial Crisis (Chart 8). More specifically, if we model nonfinancial corporate sector pre-tax profit growth on real GDP and then assume 6.5% real GDP growth in 2021, in line with the Fed’s median forecast, then we get a forecast for 31% profit growth in 2021. If we use a higher real GDP growth forecast of 10%, in line with our US Political Strategy service's "maximum impact" scenario, then our model forecasts pre-tax profit growth of 40% for 2021.6 Default Rate Expectations Table 1 puts together different estimates for profit growth and debt growth and maps them to a range of 12-month default rate outcomes, as implied by our Default Rate Model. For example, profit growth of 30% and debt growth between 0% and 8% in 2021 maps to a 12-month default rate of between 3.2% and 3.8%. This falls comfortably within the range of 2.8% to 4.5% that is consistent with current market pricing. Table 1Default Rate Scenarios In fact, for our model to output a default rate range that is higher than what is priced into junk spreads, we need to assume 2021 profit growth of 20% or less. This is quite far below the estimates we made above based on reasonable forecasts for real GDP. Bottom Line: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Household Income Update Last week’s personal income and spending report showed that disposable household income was lower in February than in January, a decline that is entirely attributable to the fact that the $600 checks to individuals that were part of the December stimulus bill were mostly delivered in January. These “Economic Impact Payments” totaled $138 billion in January and only $8 billion in February. This drop-off of $130 billion almost exactly matches the $128 billion monthly decline seen in disposable personal income. Consumer spending also fell in February compared to January, a result that likely owes a lot to February’s bad weather conditions, particularly the winter storm that caused much of Texas to lose power. Though spending has recovered a lot from last year’s lows, it remains significantly below its pre-COVID trend (Chart 9). In contrast to spending, disposable income has skyrocketed since the pandemic started last March. Chart 10 shows that disposable personal income has increased 8% in the 12 months since COVID struck compared to the 12 months prior. Moreover, it shows that the increase is entirely attributable to fiscal relief. Chart 9Households Have Excess ##br##Savings Chart 10Disposable Personal Income Growth And Its Drivers The result of below-trend spending and a surge in income is a big jump in the savings rate. The personal savings rate was 13.6% in February, well above its average pre-COVID level (Chart 9, panel 3), as it has been since the pandemic began. This consistently elevated savings rate has led to US households building up a $1.9 trillion buffer of excess savings compared to a pre-pandemic baseline (Chart 9, bottom panel). Perhaps the biggest question for economic growth is whether households will deploy this large pool of savings as the economy re-opens or whether they will continue to hoard it. In this regard, the individual checks that were part of last year’s CARES act are the most likely to be hoarded, as these checks were distributed to all Americans making less than $99,000. The income support provisions in this month’s American Rescue Plan are much more targeted. Only individuals making below $75,000 will receive a $1,400 check and the bill also includes expanded unemployment benefits and a large amount of aid for state & local governments. All in all, we anticipate that a substantial amount of household excess savings will be spent once the vaccination effort has made enough progress that people feel safe venturing out. This will lead to strong economic growth and higher inflation in the second half of 2021. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20210323b.htm 3 For more details on our outlook for core inflation in 2021 please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 4 Please see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com 5 For more details on this excess spread analysis please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 The "maximum impact" scenario assumes that the full amount of authorized outlays from the American Rescue Plan will be spent, with 60% of the outlays spent in FY2021. For more details see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Even though bonds have cheapened relative to stocks, the equity risk premium remains elevated. The end of the pandemic and supportive fiscal and monetary policies should buoy economic activity in the second half of the year, lifting corporate earnings in the process. Some critics charge that low interest rates and QE have exacerbated wealth and income inequality. The evidence suggests the opposite: Rising inequality since the early 1980s has depressed aggregate demand, forcing central banks to loosen monetary policy. The tide of inequality may be turning, however. Ongoing fiscal and monetary stimulus, increasingly aggressive income distribution policies, heightened anti-trust enforcement, and waning globalization could all shift the balance of power from capital back to labor. Investors should overweight global equities for now but prepare for a more stagflationary environment later this decade. Market Overview We continue to favor global equities over bonds on a 12-month horizon. While bonds have cheapened relative to stocks, the global equity risk premium is still quite wide by historic standards (Chart 1). The distribution of vaccines over the coming months should pave the way for a strong rebound in economic activity in the second half of 2021. This will lift corporate earnings. The macro policy mix will also remain supportive. Thanks to the combination of increased fiscal transfers and subdued spending last year, US households have accumulated $1.5 trillion in savings – equivalent to 10% of annual consumption – over and above the pre-pandemic trend (Chart 2). Chart 1Equity Risk Premia Remain Elevated Chart 2Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending US household balance sheets are set to improve further. Congress passed a $900 billion stimulus bill in December, which provides direct support to households, unemployed workers, and small businesses. On Thursday, President-elect Joe Biden unveiled an additional $1.9 trillion relief package. Biden’s plan calls for making direct payments of $1400 to most Americans, bringing the total to $2000 after the $600 in direct payments in December’s deal is included. President Trump had earlier called for stimulus payments of $2000 per person, a number the Democrats quickly seized on. Biden’s plan would also extend emergency unemployment benefits to the end of September, boost funding for schools, raise the child tax credit, and increase spending on Covid testing and the vaccine rollout. Unlike the December deal, it would also provide $350 billion in assistance to state and local governments. We expect at least $1 trillion of Biden’s proposal to be enacted into law. A trillion here, a trillion there, and pretty soon you are talking big money. Admittedly, taxes are also likely to rise. During the election campaign, Joe Biden pledged to lift the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He also promised to introduce a minimum 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and boost payroll taxes on households with annual earnings in excess of $400,000. If carried out, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. Given the slim majority that Democrats maintain in the Senate, it is unlikely that taxes will rise as much as Joe Biden’s tax plan calls for. Nevertheless, a tax hit to EPS of around 5% starting in 2022 looks probable. On the positive side, the additional spending will goose the economy, so that the net effect of the tax increase on corporate profits should be fairly small. Meanwhile, monetary policy will remain exceptionally accommodative. The Fed is unlikely to hike rates until late 2023 or early 2024. It will take even longer for policy rates to rise in the other major economies. Our bond strategists think that the Fed will start tapering QE only about six months before the first rate hike. Hence, for the time being, ongoing bond buying will limit the upside to yields. We see the US 10-year Treasury yield rising to 1.5% by the end of this year, only modestly higher than market expectations of 1.36%. Rising Inequality: The Dark Side Of QE? Chart 3Inequality Has Risen Across Major Developed Economies One often-heard objection to QE is that it has exacerbated inequality by pushing up equity prices without doing much to help the real economy. Some even contend that QE has hurt the middle class by depriving savers of a critical source of interest income. It is certainly true that inequality has risen sharply over the past 40 years, especially in the US (Chart 3). It is also true that the bulk of equity wealth is held by the very rich. According to Fed data, the wealthiest top 1% own half of all stocks (Chart 4). However, QE has pushed up not only equity prices. Falling bond yields have also pushed up home prices. Unlike stocks, housing wealth is broadly held across the population. Moreover, monetary policy operates through other channels. Lower interest rates tend to weaken a country’s currency, boosting competitiveness in the process. Lower rates also encourage investment. Again, real estate figures heavily here. Chart 5 shows that there is a very strong correlation between mortgage yields and housing starts. And while lower interest rates do penalize savers, the middle class is not the main victim. Interest receipts represent a much larger share of total income for ultra-wealthy individuals than for everyone else (Chart 6). Chart 4The Rich Hold The Bulk Of Equities Chart 5Strong Correlation Between Mortgage Rates And Housing Activity Chart 6Interest Represents A Bigger Share Of Overall Income At The Top Of The Income Distribution Far from exacerbating income inequality, a recent IMF research paper argued that easier monetary policy may dampen inequality by boosting employment and wage growth. Chart 7 shows that labor’s share of GDP has tended to rise whenever the labor market tightened. Chart 7Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Inequality Paved The Way To QE Chart 8The Rich Save More Than The Poor Rather than QE exacerbating inequality, a more plausible story is that rising inequality led to QE. The rich tend to save more than the poor (Chart 8). Consistent with estimates by the IMF, we find that the shift in income towards the rich has depressed US aggregate demand by about 3% of GDP since the late 1970s (Chart 9). A standard Taylor Rule equation suggests that real interest rates would need to be 1.5-to-3 percentage points lower to offset a 3% loss in demand.1 That’s a lot! Thus, not only have the rich benefited directly from receiving a bigger share of the economic pie, they have also benefited indirectly from the fact that falling interest rates have pushed up the value of their assets. Chart 9Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s For a while, lower rates allowed poorer households to take on more debt, thus masking the impact of rising income inequality on consumption. However, after the housing bubble burst, households were forced to retrench and start living within their means. The resulting collapse in spending pushed interest rates towards zero and forced the Fed to undertake one QE program after another. It Is Not About Education Many of the popular explanations for rising inequality have focused on the widening gap between well-educated and less well-educated workers. While there is evidence that the demand for skilled workers increased in the 1980s and 1990s, Beaudry, Green, and Sand have shown that it has declined since then. Together with a rising supply of college-educated workers, softer demand for skilled workers compressed the so-called “skill premium.” So why has inequality increased? One can get a sense of the answer by looking at Chart 10. It shows that almost all the increase in US real incomes has occurred not just near the top of the income distribution, but at the very very top – people in the highest 0.1% of income earners. These are not university professors. These are hedge fund managers and corporate chieftains, with a sprinkling of celebrities (Chart 11). Chart 10The (Really) Rich Got Richer Chart 11Who Are The Top Income Earners? Superstars In his seminal paper entitled “The Economics of Superstars,” Sherwin Rosen argued that technological trends have facilitated the rise of winner-take-all markets. The classic example is that of stage actors. A century ago, tens of thousands of actors could eke out a living performing at the local theater. Today, a small number of superstars dominate the entertainment industry, while countless others work odd jobs, waiting in vain for their chance for stardom. A similar argument applies to professional athletes. The applicability of the superstar model to other classes of workers is more debatable. How much of the income of star hedge fund managers reflects their unique skills and how much of it reflects a “heads I win, tails you lose” approach to investing client money? Similarly, do CEOs get paid what they do because there is no one else who can do the same job with less pay? Or is it because CEOs can effectively set their own compensation, subject to an “outrage constraint” from shareholders and the broader public — a constraint that has loosened in recent decades due to rising stock prices and a shift in public attention away from class issues towards the debilitating distraction of identity politics? The Rise Of Monopoly Capitalism Where the superstar model may be more relevant is at the firm level. Standard economics textbooks treat profit as a return on capital. This implies that when the after-tax rate of return on capital goes up, firms should respond by increasing investment spending in order to further boost profits. In practice, this has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. Yet, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 12). Why did the textbook economic relationship between investment and the rate of return on capital break down? The answer is that the textbook approach ignores what has become an increasingly important source of corporate profits: monopoly power. Chart 12No Evidence That Trump Corporate Tax Cuts Boosted Investment Chart 13A Winner-Take-All Economy A recent study by Grullon, Larkin, and Michaely finds that market concentration has increased in 75% of all US industries since 1997. Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times higher than the median firm, a massive increase from the historic average of two times (Chart 13). The rise of monopoly power has been most evident in the tech sector. Over the past 25 years, rising tech profit margins have contributed more to tech share outperformance than rising sales (Chart 14). Chart 14Decomposing Tech Outperformance Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Tech companies also benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Monopolies And The Neutral Rate Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output tends to depress selling prices, thus leading to lower profit margins. As such, rising market power may simultaneously increase profits while reducing investment spending. This may be deflationary in two ways: First, lower investment will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. An increase in savings relative to investment, in turn, will depress the neutral rate of interest. An Inflection Point For Inequality? After rising for the past four decades, inequality may be set to decline. Central banks are keen to allow economies to overheat. A feedback loop could emerge where overheated economies push up labor’s share of income, leading to more spending and even higher wages. Fiscal policy is likely to amplify this feedback loop. As we discussed last week, loose monetary policy is allowing governments to pursue expansionary fiscal policies. Fiscal stimulus raises the neutral rate of interest, making it easier for central banks to keep policy rates below their equilibrium level. Government policy is also moving in a more redistributive direction. Tax rates on high-income earnings will rise over the next few years, which will support new spending initiatives. Minimum wages are also heading higher. It is worth noting that Florida voters, despite handing the state to President Trump in November, voted 61%-to-39% to raise the state minimum wage from $8.56 an hour to $15 by 2026. Joe Biden also reaffirmed today his pledge to hike the federal minimum wage to $15 from its current level of $7.25. In addition, there is bipartisan support for strengthening anti-trust policies. On the left, Senator Elizabeth Warren has stated that “Today’s big tech companies have too much power – too much power over our economy, our society, and our democracy.” Increasingly, Republicans agree with this sentiment. According to a Pew Research study conducted last June, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). This number has probably gone up following last week’s coordinated effort by the largest tech companies to banish Parler, a Twitter-style app popular with conservatives, from the internet. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Meanwhile, globalization is on the back foot. After rising significantly, the ratio of global trade-to-output has been flat for over a decade (Chart 16). As competition from foreign workers abates, working-class wages in advanced economies could rise. Chart 16Globalization Plateaued More Than A Decade Ago Long-Term Investment Implications What is good for Main Street is usually good for Wall Street. For the past 70 years, the S&P 500 has generally moved in sync with the ISM manufacturing index (Chart 17). The same pattern holds globally. Chart 18 shows that the stock-to-bond ratio has correlated closely with the global manufacturing PMI. Chart 17Strong Correlation Between Economic Growth And Stocks Cyclical fluctuations can disguise important structural trends, however. US productivity has doubled since 1980, but real median wages have increased by only 20% (Chart 19). The bulk of productivity gains have flowed to upper-income earners and owners of capital. Hence, corporate profits rose, while inflation and interest rates declined. Chart 18Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 19Real Median Wages Failed To Keep Up With Productivity If we are approaching an inflection point for inequality, we may also be approaching an inflection point for profit margins and bond yields. To be sure, with unemployment still elevated, wage growth and inflation are not about to take off anytime soon. However, investors should prepare for a more inflationary – and ultimately, stagflationary – environment in the second half of the decade. This calls for reducing duration risk in fixed-income portfolios, favoring TIPS over nominal bonds, and owning inflation hedges such as gold and farmland. It also calls for maintaining a bias towards value over growth stocks, as the former usually outperform when inflation and commodity prices are on the upswing (Chart 20). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 20Value Stocks Usually Outperform When Commodity Prices Are On The Upswing Footnotes 1 One can specify different parameters to weight the inflation and capacity utilization segments of a Taylor rule equation so that they are equally-weighted, meaning there is a coefficient of 0.5 on the gap between the year-over-year percent change in headline PCE and the Fed's 2% target and a coefficient of 0.5 on the output gap term. Previous Fed Chair and incoming Treasury Secretary Janet Yellen preferred an alternative specification where there was a coefficient of 1 on the output gap term so that the equation is as follows: RT= 2 + PT + 0.5(PT- 2) + 1.0YT, where R is the federal funds rate; P is headline PCE as expressed as a year-over-year percent change; and Y is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook and Monetary Policy," April 11, 2012. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores