Fiscal
Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Q: And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3 For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Equities hit an air pocket last week after making another recovery high: Investors seemed to reassess the economy’s direction following official forecasts that ranged from sober to grim. “Whatever we can, and for as long as it takes”: The FOMC’s outlook may have dampened investors’ mood now, but it contained the promise of an extended period of easy policy. Further fiscal help is on the way: The White House supports additional spending and some new Republican proposals offered a hint of what the next phase of fiscal relief might look like. Bank stocks quailed at the prospect of lower rates: The SIFI banks sold off sharply as investors feared that falling rates and a flatter yield curve would crimp net interest margins. We are undeterred from our bullish stance on the group. Feature Coming into last week, the gap between the effervescence of the stock market and the gloom of the pandemic-stricken economy was Topic A for investors and the financial media. We have interpreted the gap as a vote of confidence for policymakers. The Fed and Congress have thrown nearly everything they have at shielding the economy from the virus’ depredations and investors have concluded that they’ll succeed, bidding equities higher and corporate bond spreads tighter (Chart 1). Chart 1Spreads Are Back To The Middle Of Their Post-GFC Range ... Through last Monday, the benchmark Bloomberg Barclays Investment Grade and High Yield Corporate Bond Indexes had generated total returns of 17% and 24%, respectively, since their March 20-23 lows, while the S&P 500 was up 45% peak-to-trough on a total return basis. Equities’ torrid run had the S&P in the black year-to-date and within just 5% of its mid-February peak (Chart 2). Given that the economic projections have only worsened since late March, and the virus toll has been worse than the consensus expected, policy has had to shoulder the entire load. Chart 2... And Equities Made It All The Way Back To Their 2019 Close In the monetary sphere, the Fed swiftly cut the fed funds rate to zero, purchased Treasuries and agency MBS at a faster rate than it did during the global financial crisis, revived several GFC initiatives and announced it would lend money directly to investment-grade-rated corporations1 for the first time. The medley of measures quickly gained traction. Though the new issuance market initially seized up upon the arrival of the pandemic, record amounts of corporate bonds were issued in both March and April. All-out stimulus efforts from Congress and the Fed have produced a remarkable market turnaround. From the fiscal side, Congress passed several measures to speed aid to vulnerable parts of the economy, crowned by the CARES Act. As we detailed last week,2 its expansion of state unemployment insurance benefits has made two-thirds of the unemployed eligible to earn more than they did at their jobs. Bolstering unemployment insurance and sending direct $1,200 payments to nearly two-thirds of taxpayers has allowed households to service their debt and pay their rent, preventing wider contagion. Although several fiscal hawks cited May’s way-better-than-expected employment situation report as evidence that Congress can relax its fiscal efforts, we expect that another phase of assistance will follow by the end of July. The potential vulnerability in financial markets stems from the prevailing certainty that policymakers have already won. But things could still go wrong, as highlighted by last week’s bracing economic projections from the OECD and the Fed. US financial markets are generally unaware of the OECD’s semi-annual outlooks, but this one’s probability assessments were striking: it sees a 50-50 chance that an infection second wave will require new lockdowns before the end of the year. The Fed Has The Economy’s Back … Chart 3Take All This ZIRP And Call Me In 2023 “At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, and for as long as it takes, to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” As Chair Powell stated at the beginning of his prepared remarks, whatever it takes was the theme of last week’s FOMC meeting press conference. He made it very clear that the Fed intends to err to the side of providing too much accommodation as it confronts the highly uncertain environment. Asked how long the Fed would stick with zero interest rates if the economy surprises to the upside, he said, “we’re not even thinking about thinking about raising rates.” The first Summary of Economic Projections (SEP) since December validated his statement. Every voter projected that the fed funds rate will remain at its current near-zero level for all of 2020 and 2021, and only two voters foresaw rate hikes in 2022 (Chart 3). After Powell described the new round of QE purchases as a necessary measure to support the smooth functioning of financial markets and ensure credit access, a reporter asked if they were still needed, given how market disruptions have dissipated amidst the recovery rally. He replied that the FOMC did not want to take anything for granted and risk prematurely withdrawing its support. As he said in his prepared remarks, “We will continue to use [our emergency lending] powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery.” The Fed is not even thinking about thinking about raising rates. Powell’s pledges to keep applying the Fed’s full range of tools to support the economy went to the heart of our rationale for overweighting equities over the cyclical timeframe: the Fed will maintain hyper-accommodative policy settings even after they’re no longer necessary. Every rose has its thorn, however, and the Fed would not be on an emergency footing if conditions weren’t dire. Though Powell and the committee expect a recovery to take hold over the next two quarters, the median SEP participant expects the unemployment rate to exceed 9% at the end of this year and does not see GDP returning to its 2019 level until the second half of 2022. The glum projections dampened investors’ enthusiasm and halted equities’ upward march. … And Congress Eventually Will, Too In testimony before a Senate committee on Wednesday, Treasury Secretary Mnuchin touted the budding recovery but made it clear that the administration wants additional stimulus measures. “I definitely think we are going to need … to put more money into the economy,” he said. He expressed a preference for programs that get people back to work and voiced concern that the first round of enhanced unemployment benefits may encourage people to stay out of work, but left the door open to some form of extension. He also indicated that the administration would consider another round of direct payments to taxpayers. Unemployment benefits well in excess of median wages may not be extended beyond July 31st but Republican senators and representatives have begun to put forth appealing alternative proposals like a temporary $450 weekly bonus or an additional two weeks of the existing $600 supplement for those returning to work. The bottom line is that events are validating our geopolitical strategists’ view that another fiscal stimulus package is inevitable. Senate holdouts caught between the House’s and the White House’s desire for more aid will be unable to thwart another round. Banks And The Yield Curve Just a week ago, when the animal spirits sap was rising and a range of indicators suggested that growth may be bottoming, the 10-year Treasury yield surged 26 basis points (bps) in six sessions, from 0.65% to 0.91%, and the 2s/10s segment of the curve steepened by 20 bps. Bank stocks surged, and the SIFIs gained an average of 22% (Table 1). Then the 10-year yield reversed field, tumbling 25 bps in just three sessions from Tuesday to Thursday, and the curve flattened by 23 bps. The SIFI rally evaporated across the three midweek sessions, and the group fell 18% to end the nine-day round trip 30 bps from where it began. Table 1Back So Soon? The violent back and forth reinforced the conventional wisdom that banks are joined at the hip with long yields and the slope of the curve. If the 10-year doesn’t go anywhere, the thinking goes, and the curve doesn’t steepen, bank stocks can’t make any significant headway. We beg to differ. The link from the curve to bank earnings runs through net interest margin (NIM), the difference between the banks’ weighted-average lending yield and cost of funds. It makes perfect sense that NIM would expand and contract as the yield curve steepens and flattens, and it did into the early nineties. But by then banks had learned the lesson of the savings and loan debacle – borrowing short and lending long can be fatal if inflation and/or the Fed drive short rates much higher – and they became fastidious about matching the duration of their assets and liabilities. In the new duration-matched regime, NIM has become insensitive to the slope of the curve (Chart 4). With the NIM link broken, the yield curve has no influence on bank earnings (Chart 5). There is no doubt that banks regularly trade with long yields, but any link with the yield curve is easily severed (Chart 6) by earnings surprises. If the policy outlook doesn’t change between now and mid-July, we expect the SIFI banks will get a boost from smaller than expected loan-loss reserve builds. Taking our cue from the way monetary and fiscal largess will hold down defaults, we reiterate our overweight on the SIFI banks. Chart 4There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... Chart 5... Or Bank Net Income And The Yield Curve Chart 6Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Investment Implications A client asked us last week how investors who have built up cash holdings over the last few months should approach re-entering the equity market. Patiently, we replied, in line with the qualms we’ve had about the magnitude and speed of the rally from the March lows. We are only neutral equities over the tactical 0-to-3-month horizon because the S&P 500’s forward P/E multiple is elevated (Chart 7) and investors don’t seem to be assigning a high enough probability to the possibility that the virus, Congress, or geopolitics could create a bump in the road. We are still looking for a double-digit correction. Our SIFI banks thesis doesn't require a steeper curve or higher long yields; it'll work as long as loan-loss reserve builds fall short of investors' fears. Chart 7Stocks Are Expensive Table 2Downside Insurance Is Awfully Expensive We suggested that the client get 15-20% of the desired allocation deployed that day (Thursday, fortuitously) and parcel the rest out at lower limits all the way down to 2,875 (10% below the recent peak around 3,200) or some lower target like 2,700 or 2,800. With the revival in the VIX, we also suggested considering writing out-of-the-money put options on the SPY ETF. As of Thursday’s close, an investor could be compensated handsomely for agreeing to get hit down another 6.7% (280) or 10% (270) any time between now and the third Friday of July (Table 2). Writing puts is a way to get paid to wait to deploy capital, and with the VIX in the 40s, an investor can earn 20-30% annualized on the notional amount of capital s/he is committing by writing the option. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Corporations downgraded to junk ("fallen angels") after the lending facility was announced subsequently became eligible to participate. 2 Please see the June 8, 2020 US Investment Strategy Weekly Report, "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)", available at usis.bcaresearch.com.
Highlights The relaxation of lockdown measures, along with mass protests over the past two weeks, have made a second wave of the pandemic more likely than not in many countries. Unlike during the first wave, most governments will not shutter their economies in response to a renewed spike in infection rates. For better or for worse, the “Sweden strategy” will become commonplace. As today’s stock market selloff illustrates, a second wave could significantly unnerve investors, especially since it is coming on the heels of a substantial rally in stocks. However, global equity prices will still rise over a 12-month horizon. Easy monetary policy, improving labor market conditions, and significant amounts of cash on the sidelines should allow the equity risk premium to decline, especially outside the US where valuations remain quite cheap. The US dollar has entered a cyclical bear market. This is especially positive for commodities, economically-sensitive equity sectors, and non-US stocks. Opening The Hatch Chart 1Governments Are Lifting Lockdown Restrictions Three months after the virus burst out of China, countries around the world are starting to relax lockdown measures. Our COVID-19 Government Response Stringency Index, created by my colleague Jonathan LaBerge and showcased in last week’s Global Investment Strategy report, has been on an easing course since May. A similar measure developed by Goldman Sachs broadly shows the same loosening pattern. Reflecting these developments, the Dallas Fed’s index of “mobility and engagement” has been slowly returning to normal (Chart 1). The reopening of economies is taking place despite limited success in containing the virus. While some countries have seen a considerable drop off in the number of new cases and deaths, others continue to experience an increase in both metrics (Chart 2). Globally, the number of new cases has begun to trend higher after remaining flat for most of April. The number of deaths — which lags new cases by about three weeks but is less vulnerable to statistical distortions caused by changes in testing prevalence — has also ticked higher after falling for nearly two months. Mass protests starting in Minneapolis and spreading to much of the western world have the potential to further increase the infection rate. As Jonathan noted last week, large gatherings have been an important vector of transmission for the virus. While the protests have occurred outdoors, many protestors did not wear masks while singing and shouting nor practise social distancing. Chart 2Globally, The Number Of New Cases and Deaths Has Started To Trend Higher Again A Risky Gambit How markets react to a second wave of the pandemic will depend a lot on how policymakers and the broader public respond. For better or for worse, the patience for continued lockdowns has waned. The US and a number of other countries appear to be moving towards the “Swedish model” of trying to keep a lid on the virus without imposing draconian lockdown restrictions. It is a risky gambit, especially in light of the jump in infections that Sweden has reported in the past two weeks. While some countries such as China and New Zealand, which have effectively eradicated the virus, can allow most activities – with the exception of international travel – to resume, others should arguably wait longer until they too have defeated the disease. As Professor Peter Doherty, renowned immunologist and co-recipient of the 1996 Nobel Prize for Medicine, discussed in a webcast with my colleague Garry Evans on Monday, significant progress has been made towards developing a vaccine for COVID-19. Opening up economies now could cause a lot of needless death before a vaccine becomes available. Near-Term Risks To Stocks… Chart 3Earnings Estimates Have Taken It On The Chin Even if governments continue opening up their economies despite rising infection rates, some people will increase the amount of social distancing they practise regardless of official recommendations. Airline, cruise ship, and restaurant stocks had rallied mightily off their March lows before giving up some of their gains over the past few days. If a second wave occurs, they will fall further. The rally in stocks linked to the reopening of the economy occurred alongside a retail investor speculative frenzy. In one of the more bizarre episodes in financial history, stocks of bankrupt or soon-to-be-bankrupt companies surged on Monday as novice day traders snapped up shares of companies that most institutional equity investors had left for dead. Meanwhile, earnings estimates have taken it on the chin (Chart 3). Many companies chose not to provide guidance for the second quarter, citing unprecedented uncertainty over the near-term business outlook. Since Q2 will be the worst quarter for economic growth, it will probably also be a very bad quarter for earnings. The prospect of a slew of poor earnings reports in July could further dent investor sentiment, exacerbating the stock market correction we have seen over the past few days. All this suggests that global equities could experience some further weakness over the next few months. …But Still Sticking With Our 12-Month Overweight To Equities Chart 4Economic Activity Has Started Rebounding Despite these short-term risks, we are not ready to abandon our cyclical overweight view on stocks. While many people have remarked that the equity market has diverged from the economy, in fact, the rebound in the stock market has tracked the peak in initial unemployment claims and the trough in current activity indicators quite closely (Chart 4). A second wave would certainly slow the economic rebound. However, it would probably not reverse it completely given that the mortality rate from the virus now appears to be somewhat lower than initially feared and an increasing number of medical treatments are becoming available. If output and employment keep rising, stocks are likely to trend higher. A Deep Hole This does not mean that everything will return to normal soon. Even though global growth appears to have bottomed in April, the level of employment remains at depression-like levels (Chart 5). About 12% of US workers are employed in the hospitality, restaurant, and travel sectors. A return to normalcy in those sectors will take several years at best. Nevertheless, the recovery will not be nearly as drawn out as the one following the Global Financial Crisis. The Congressional Budget Office expects that it will take another eight years for the US unemployment rate to fall back to 5% (Chart 6). That seems unduly pessimistic. Chart 5Employment Remains At Depression-Like Levels Chart 6CBO Projects The Unemployment Rate Will Fall Very Slowly Cyclical Versus Structural Unemployment Chart 7Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Commentators like to talk about structural unemployment, but the truth is that large increases in joblessness usually reflect deficient labor demand rather than insufficient supply. For example, the decline in residential construction employment and related sectors accounted for less than one-fifth of the job losses during the Great Recession (Chart 7). You don’t have to fill a half-empty pool through the same pipe from which the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs will likely find new jobs elsewhere, whether it be at an Amazon distribution center or any number of manufacturing companies that will benefit from the repatriation of production back onshore. The shift in jobs from one sector to the next is not instantaneous, but it need not drag on for years either. Policy Will Stay Stimulative This is where the role of monetary and fiscal policy takes center stage. Despite the improving economic outlook, government bond yields have barely moved off their lows as investors have become increasingly convinced that central banks will keep rates at rock-bottom levels (Chart 8). This week’s FOMC meeting made it clear that the Fed has no intention of raising rates through 2022. “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates,” Fed Chairman Jerome Powell declared during his press conference. Granted, the zero lower bound has prevented yields from falling as much as they normally would. Fortunately, fiscal policy has stepped in to fill the void. Chart 9 shows that governments have eased fiscal policy much more this year than they did in 2008-09. If governments tighten fiscal policy prematurely like they did after the Great Recession, the recovery will indeed be sluggish. Such a risk cannot be ignored. BCA’s geopolitical team, led by Matt Gertken, has argued that Republican Senators will initially resist the proposed $3 trillion in new stimulus, until they are forced to act by a major new round of financial or social turmoil. Nevertheless, Matt thinks that the Republican Senate will ultimately buckle under the political pressure, knowing full well that a large dose of fiscal largess could prevent a Democratic sweep in November. Chart 8Yields Remain Close To Recent Lows Chart 9Will It Be Enough? Chart 10China Has Ramped Up Stimulus Outside the US, fiscal support shows little sign of being scaled back. Germany has pushed forward with additional stimulus, going so far as to propose a risk-sharing arrangement via the creation of an EU Recovery Fund. On Wednesday, the Japanese House of Representatives approved a draft supplementary budget of 32 trillion yen ($296 billion) providing additional funding for small businesses and medical workers. Jing Sima, BCA Research's chief China strategist, expects Chinese credit formation as a share of GDP to reach the highest level since 2009 and the budget deficit to widen to the largest on record (Chart 10). The upshot is that we may find ourselves in an environment over the next few years where global GDP and corporate profits are moving back to trend, while interest rates (and the implied discount rate used for valuing stocks) stay at very low levels. If profits return back to normal but interest rates do not, the surreal implication is that the pandemic could end up increasing the fair value of the stock market. Ample Cash On The Sidelines Stocks also have another factor working in their favor: huge amounts of cash on the sidelines (Chart 11). The combination of massive fiscal income transfers and low spending has led to a surge in private-sector savings. The US personal savings rate reached 33% in April, the highest on record. Reflecting this increase in savings, private sector bank deposits have ballooned (Chart 12). Chart 11Sizable Amount Of Dry Powder Chart 12Savings Have Spiked Amid Stimulus Investors often talk about cash “flowing” in and out of the stock market. This is a somewhat misleading characterization. Setting aside the impact of corporate buybacks and public share offerings, the decision by one person to buy shares requires a corresponding decision by someone else to sell shares. The buyer of the shares loses some cash, while the seller gains some cash. On net, there is no inflow of cash into the stock market. Rather, what happens is that the price of shares adjusts to ensure that there is a seller for every buyer. If people feel that they have too much cash relative to the value of their equity holdings, they will bid up the price of stocks until enough sellers come forward. This will cause the amount of cash that people hold as a percentage of their total wealth to shrink, even if the dollar value of that cash remains the same. The process will only stop when the amount of cash that people hold is in line with their preferences. The amount of cash held in US money market funds and personal cash deposits has surged by $2.6 trillion since February. Despite the rally in equities, cash holdings as a percent of stock market capitalization remain near multi-year highs. This suggests that the firepower to fuel further increases in the stock market has not been exhausted. Start Of The Dollar Bear Market After peaking in March, the broad trade-weighted US dollar has weakened by 5.3%. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 13). While the dollar could strengthen temporarily in response to a second wave of the pandemic, global growth should continue to recover in the second half of the year provided that severe lockdown measures are not reintroduced. Stronger global growth will push the greenback lower. Chart 13The US Dollar Is A Countercyclical Currency Unlike last year, the dollar no longer has support from higher US interest rates. Indeed, US real rates are below those of many partner countries due to the fact that US inflation expectations are generally higher than elsewhere (Chart 14). Chart 14The Dollar Has Been Losing Interest Rate Support A Weaker Dollar Will Support Non-US Stocks The combination of a weaker dollar and stronger global growth should disproportionately help the more cyclical sectors of the stock market, particularly commodity producers. Since cyclical stocks tends to be overrepresented outside the US, non-US equities should outperform their US peers over the next 12 months. A weaker dollar will also reduce the local- currency value of dollar-denominated debt. This will be especially helpful for emerging markets. Despite the recent rally, the cyclically-adjusted PE ratio for EM stocks remains near historic lows (Chart 15). EM equities should fare well over the next 12 months. Chart 15EM Stocks Are Very Cheap Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Historically, when global growth picks up, the yen weakens. But this is less likely in an environment where global yields remain anchored at low levels. Meanwhile, there is rising risk that consumption in Japan will remain muted. This will limit any pickup in domestic inflation. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. That said, cheap yen valuations will buffet Japanese exports. Go short USD/JPY with an initial target of 100. Feature Chart I-1Higher Volatility, Higher Yen The powerful bounce in global markets since the March lows is at risk of a bigger technical correction. As we enter the volatile summer months, it may only require a small shift in market sentiment to trigger this reversal. The yen has tended to strengthen when market volatility rises (Chart I-1). Should this happen, it will provide the necessary catalyst for established long yen positions. On the other hand, if risk sentiment stays ebullient, the yen will surely weaken on its crosses but can still strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Growth And Monetary Policy Like most other economies, Japan entered a recession in the first quarter of this year, with GDP contracting at a 2.2% annualized pace. For the private sector, this is the worst growth rate since the Fukushima crisis in 2011. This is particularly significant, since the structural growth rate of the economy has fallen below interest rates. Going back to Japan’s lost decades, where private sector GDP growth averaged well below nominal rates (due to the zero bound), it is particularly imperative that Japan exits this liquidity trap in fast order (Chart I-2). A strong yen back then, on the back of deficient domestic demand, led to a self-fulfilling deflationary spiral. Chart I-2The Story Of Japan In One Chart The Bank of Japan began to acknowledge this problem with the end of the Heisei era1 last year. For example, with the BoJ owning almost 50% of outstanding JGBs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. The yen has become extremely sensitive to shifts in the relative balance sheets between the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at the current pace, then the rate of expansion in its balance sheet will severely lag behind the Fed, and could trigger a knee-jerk rally in the yen (Chart I-3). Chart I-3The Yen And QE Inflation And The 2% Target The US is a much more closed economy than Japan, and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream for any timeline in the near future. There are three key variables the authorities pay attention to for inflation: Core CPI, the GDP deflator and the output gap. All three indicators point towards deflationary pressures, with the recent slowdown in the global economy exacerbating the trend. In fact, since the financial crisis, prices in Japan have only been able to really rise during a tax hike (Chart I-4). Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. The overarching theme for prices in Japan is a rapidly falling (and ageing) population, leading to deficient demand. More importantly, almost 50% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for domestically-driven prices, an ageing demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years, a strong voting lobby has been able to advocate for lower telecom prices, which makes it difficult for the BoJ to re-anchor inflation expectations upward (Chart I-5). Chart I-4Japan CPI At A Glance Chart I-5Strong Deflationary Pressures In Japan Meanwhile, the BoJ understands that it needs domestic banks to expand the credit intermediation process if any inflation is to take hold. Unfortunately, the yield curve control strategy and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-6). This puts the BoJ in a precarious balance between trying to stimulate the economy further and biting the hand that will feed a pickup in inflation. Chart I-6Point Of No Return For Japanese Banks? Japanese Consumption And Fiscal Policy The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. COVID-19 has dealt a fatal blow. In prior episodes of the tax hikes, it took around three to four quarters for growth to eventually bottom. This suggests that a protracted slowdown in Japanese consumption is a fait accompli (Chart I-7). Foreign and domestic machinery orders are slowing, employment growth has gone from over 2% to free fall and the availability of jobs relative to applicants has reversed a decade-long rising trend. The Abe government has passed an additional 117 trillion yen of fiscal stimulus. With overall fiscal announcements near 40% of GDP, could this fully plug the spending gap? Not quite. The consumption tax hike last year delivered a severe punch to aggregate demand in Japan. First, as is usually the case with Japanese stimulus announcements, the timeframe is uncertain for when the funds will be deployed. It could be one year or ten years. Chart I-7A V-Shaped Recovery Might Stall Chart I-8More Jobs, More Savings Second, Japanese consumption has been quite weak for some time. Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has trended downward. The reason is that government spending triggered a rise in private savings, because of expectations of higher taxes. In other words, the savings ratio for workers has surged. If consumers were not willing to spend prior to COVID-19 due to Ricardian equivalence,2 they are unlikely to do so with much higher fiscal deficits (Chart I-8). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. In particular, the postponement of the Olympics will continue to be a drag on Japanese construction activity, and the labor (and income) dividend from immigration has practically vanished. The important tourism industry that faced sudden death will only recover slowly. This suggests a much more protracted recovery in many nuggets of Japanese activity. The Yen As A Safe Haven Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-9). Real interest rates are already higher in Japan, well before any of the above factors began to meaningfully generate a deflationary impulse. With global growth bottoming, a continued rise in global equity markets is a key risk to our scenario. However, if inflows into Japan accelerate on cheap equity valuations, the propensity of investors to hedge these purchases will be much less today, given how cheap the yen has become. This is especially important since in an era of rising budget deficits, balance of payments dynamics can resurface as the key driver of currencies. This suggests the negative yen/Nikkei correlation will continue to weaken, as has been the case in recent quarters. Chart I-9Real Rates And The Yen Chart I-10USD/JPY And DXY Are Positively Correlated As a low-beta currency, our contention is that the yen will surely weaken on its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-10). This places short USD/JPY trades in an envious “heads I win, tails I do not lose too much” position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito from 8 January 8th, 1989 until his abdication on April 30th, 2019. 2 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: Nonfarm payrolls increased by 2.5 million in May after declining by a record 20.7 million in April. This was better than expectations of an 8 million job loss. The unemployment rate fell from 14.7% to 13.3%. The NFIB business optimism index increased from 90.9 to 94.4 in May. Headline consumer price inflation fell from 0.3% to 0.1% year-on-year in May. Core inflation fell from 1.4% to 1.2%. Initial jobless claims increased by 1542K for the week ended June 5th. The DXY index fell by 1.3% this week. On Wednesday, the Fed left interest rates unchanged, with a signal that rates might not be increased before the end of 2022. The Fed also stated that it will maintain the current pace of Treasuries and mortgage-backed securities purchases, at minimum. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The Sentix investor confidence index improved from -41.8 to -24.8 in June. Employment increased by 0.4% year-on-year in Q1. GDP contracted by 3.1% year-on-year in Q1. The euro appreciated by 1.2% against the US dollar this week. At an online seminar held this week, Isabel Schnabel, member of the executive board of the ECB, noted that "evidence is increasingly pointing towards a protracted impact of the crisis on both demand and supply conditions in the euro area and beyond" and that the current PEPP remains appropriate in de aling with the global recession. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The coincident index fell from 88.8 to 81.5 in April. The leading economic index also decreased from 85.1 to 76.2. The current account surplus shrank from ¥1971 billion to ¥262.7 billion in April. Annualized GDP fell by 2.2% year-on-year in Q1. Machine tool orders plunged by 52.8% year-on-year in May, following a 48.3% decrease the previous month. The Japanese yen appreciated by 2.6% against the US dollar this week. According to a Bloomberg survey, the majority of economists believe that the BoJ has done enough to cushion the economy, and expect the BoJ to leave current monetary policy unchanged next week. We continue to recommend the yen as a safe-haven hedge, especially given a possible second wave of COVID-19. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Halifax house prices increased by 2.6% year-on-year in May. Retail sales surged by 7.9% year-on-year in May, up from 5.7% the previous month. GfK consumer confidence was little changed at -36 in May. The British pound rose by 1% against the US dollar this week. On Wednesday, BoE governor Andrew Bailey noted that easing lockdown restrictions has been fueling a recovery in the UK, which could be faster than previously anticipated. Our long GBP/USD and short EUR/GBP positions are 4% and 0.2% in the money, respectively. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The NAB business confidence index increased from -45 to -20 in May. The business conditions index also ticked up from -34 to -24. The Westpac consumer confidence index increased from 88.1 to 93.7 in June. Home loans declined by 4.8% month-on-month in April, down from a 0.3% increase the previous month. That said, expectations were for a fall of 10%. AUD/USD was flat this week. While the RBA has other options in its policy toolkit to combat the global recession, negative interest rates is still on the table and hasn't been totally ruled out. We remain positive on the Australian dollar both against the US dollar and the New Zealand dollar due to cheap valuations and increasing Chinese stimulus. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Manufacturing sales declined by 1.7% quarter-on-quarter in Q1, down from a 2.8% increase the previous quarter. ANZ business confidence increased from -41.8 to -33 in June. The activity outlook index also ticked up from -38.7 to -29.1. The New Zealand dollar appreciated by 0.8% against the US dollar this week. RBNZ's Deputy Governor Geoff Bascand said that house prices in New Zealand could fall by 9-10% or even worse. Besides disrupting exports and imports for a trade-reliant country like New Zealand, the global health crisis is also likely to further reduce immigration to New Zealand, curbing housing demand. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: The unemployment rate ticked up from 13% to 13.7% in May, versus expectations of a rise to 15%, but this was due to a rise in the participation rate from 59.8% to 61.4%. Average hourly wages increased by 10% year-on-year in May. Net employment increased by 289.6K, up from a 1994K job loss the previous month. Housing starts increased by 193.5K in May, up from 166.5K the previous month. The Canadian dollar fell by 0.2% against the US dollar this week. The labor market has seen some recovery in May with the gradual easing of COVID-19 restrictions and re-opening of the economy. Employment rebounded and absences from work dropped. Notably, Quebec accounts for nearly 80% of overall employment gains in May. Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: FX reserves increased from CHF 801 billion to CHF 816 billion in May. The unemployment rate increased from 3.1% to 3.4% in May, lower than the expected 3.7%. The Swiss franc appreciated by 2.3% against the US dollar this week, reflecting a flight back to safety amid concerns over political risks and a second wave of COVID-19. While the euro has been strong recently and EUR/CHF touched 1.09, the franc has lost most of those gains. We are lifting our limit buy on EUR/CHF to 1.055 on expectations we are in a run-of-the-mill correction. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing output shrank by 1.6% month-on-month in April. PPI fell by 17.5% year-on-year in May. Headline consumer prices increased by 1.3% year-on-year in May, up from 0.8% the previous month. Core inflation also increased from 2.8% to 3% in May. The Norwegian krone fell by 1.5% against the US dollar this week. The recent OPEC meeting over the weekend concluded that all members agreed to the extension to curb oil production. We believe that oil prices will continue to recover, and recommend to stay long the Norwegian krone. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption plunged by 10% year-on-year in April. The current account surplus increased from SEK 43.2 billion to SEK 80.6 billion in Q1. Headline consumer prices recovered from a 0.4% year-on-year decline to flat in May. The Swedish krona increased by 0.6% against the US dollar this week. Sweden is benefitting economically from a less stringent Covid-19 agenda. With very cheap valuations, we remain short EUR/SEK and USD/SEK. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights If policymakers can neutralize default pressures arising from the lockdowns, the lasting impacts of this recession may not be so bad: As Jay Powell put it on 60 Minutes several weeks ago, policymakers just have to keep people and businesses out of insolvency until health professionals can gain the upper hand over the virus. Fiscal spending caused income and savings to spike, … : Generous transfer payments have left the majority of the unemployed better off than they were when they were working, and April household income and savings soared accordingly. … allowing consumers to meet nearly all of their obligations … : April’s income and savings gains showed up in reduced delinquencies across all categories of consumer loans and in solid April and May rent collections. May’s employment gains suggest that the private sector may not be too far away from taking the baton from Congress: The May employment report blew away expectations and sent risk assets surging, but the positive surprise may derail plans for further fiscal support. Feature Since March, investors have been presented with a simple choice: believe their eyes or believe in the government. They could either focus on horrendous economic data illustrating the crippling effects of widespread lockdowns, or they could trust in policymakers’ ability to shield most citizens and businesses from lasting damage. Our base case has been that policymakers would succeed, for the most part, provided they didn’t have to contend with acute COVID-19 pressures for more than six months. There are as many guesses about the virus’ future path as there are commentators, but it seems reasonably conservative to estimate that the most onerous restrictions will be eased by October. Chart 1DC To The Rescue In our view, preventing defaults is the key to mitigating the effects of the virus. If newly vulnerable debtors can be kept from defaulting until the economy can return to something resembling normal, a negatively self-reinforcing dynamic will not take hold, the infection will not spread to the financial system and creditworthy individuals’ and viable businesses’ temporary liquidity issues will not morph into solvency issues. Banking system data to confirm or disprove our thesis will not be available until August, however, as Fed and FDIC data are quarterly, and the shutdowns only began in late March. The unemployment safety net has turned into a trampoline; ... In this report, we have turned to a range of other sources for higher-frequency insights into what is happening in real time. We start with an academic paper showing that most laid-off workers are eligible for benefits comfortably exceeding their previous income, a conclusion reinforced by the April personal income data (Chart 1). We then look at April delinquency data from TransUnion, one of the major credit reporting agencies, and April and May rent-collection data from an apartment trade organization and large-cap publicly traded apartment REITs. We also review the Fed’s Survey of Consumer Finances to get a sense of household indebtedness across the income and wealth spectrums. For now, the data support the conclusion that policymakers have successfully defused credit distress pressures. What Comes In … Unemployment benefits typically fall far short of workers’ regular compensation, averaging about 40% of the median worker’s wage. To cushion the blow of unemployment from COVID-19, the CARES Act included a federal supplement to unemployment benefit payments distributed by the individual states. Added onto the average $400 weekly state benefit, the $600 federal supplement would make the average worker whole (mean earnings are a little less than $1,000 a week). As income inequality has intensified, the compensation distribution for all American workers has come to exhibit a pronounced rightward skew. That skew has pulled mean compensation (the average of all Americans’ earnings) well above median compensation (the earnings of the worker at the exact middle of the earnings distribution).1 By targeting mean compensation, the CARES Act opened the door for a lot of lower-income workers to make more money in unemployment than they did when they were working. According to a recent paper from three Chicago professors, 68% of unemployed workers are eligible to receive benefits that exceed their previous income, while 20% of unemployed workers are eligible for benefits that will at least double it. Overall, they calculate that the median worker is eligible to receive benefits amounting to 134% of his/her previous income.2 ... instead of keeping laid-off employees' incomes from falling below 40 cents on the dollar, it's launched them to $1.30. We offer no judgments about the policy merits of a 134% median replacement rate, but unusually generous benefits should help reduce the drag from unemployment that would otherwise ensue with a 40% replacement rate. Thanks to lower-income households’ higher marginal propensity to consume, consumption should rise at the margin (once activity resumes). Thanks to increased income, lower-income households should be better positioned to meet their financial obligations. We suspect the marginal consumption boost may be hard to see with the naked eye, but auto, credit card and mortgage delinquencies should be appreciably lower than any regression model not adjusted to reflect record replacement rates would predict. … And What Goes Out The Personal Income and Outlays data for April reflected the significant impact on household income of the up-to-$1,200 stimulus checks (economic impact payments) and the supplemental unemployment benefits. Despite an annualized $900 billion decline in employee compensation, personal income rose by nearly $2 trillion in April, thanks to a $3 trillion increase in transfer payments. De-annualizing the components, $250 billion in transfer payments offset a $75 billion decrease in compensation. At about $220 billion, the economic impact payments accounted for the bulk of the transfer payments, and they will fall sharply in May. The IRS did not disclose the amount of economic impact payments it had disbursed by April 30, but it appears that around 80% of the distributions have been made, leaving approximately $55 billion yet to be disbursed. Unemployment insurance receipts will rise in May on an extra week of benefits and an increase in the weekly sums of initial and continuing unemployment claims. We project that employee compensation rose about 3% in May, based on a 2% gain in employment and a 1% increase in average weekly earnings. Aggregating the February-to-May changes, it appears that May personal income ought to exceed February (Table 1). Absent another round of stimulus checks, however, personal income will slide below its pre-shutdown level beginning in June. Table 1May Personal Income Should Exceed Its Pre-Pandemic Level Income is not the sole driver of households’ capacity to service their debt, however. Assets matter, too, and even if the surge in cash flow was a one-off event, it left behind an elevated stock of cash as households slashed consumption in both March and April. Real personal consumption expenditures have fallen 19% from February’s all-time high and are now back to a level they breached in January 2012 (Chart 2). Households saved 33% of their April disposable income, and on a level basis, April savings were up nearly fivefold from their 2019 average. They were a whopping 20 times April interest payments, ex-mortgages (Chart 3). Chart 2Eight Years Of Spending Undone In Two Months Chart 3Consumers' Interest Coverage Ratios Have Soared Household Borrowers Are Staying Current … Table 2Consumer Borrowers Are Hanging In There It is possible to make too much of the April income and outlays data. We had been expecting another round of stimulus checks, but lawmakers’ comments even before the blockbuster employment report suggested one may not be forthcoming. Some of the savings activity was forced on homebound consumers, and some pent-up demand will surely be unleashed as the economy re-opens. Households amassed a mighty savings war chest across March and April, however, and it has left them better-positioned to service their debt obligations going forward. Despite an unemployment rate not seen since FDR, households made their scheduled payments in April. According to TransUnion, delinquency rates fell month-over-month across every major consumer loan category and delinquency rates for mortgages and unsecured personal loans declined on a year-over-year basis (Table 2). The TransUnion data comes from its inaugural Monthly Industry Snapshot, intended to provide a higher-frequency read on headline consumer credit metrics than its typical quarterly releases. In addition to crunching the delinquency numbers, the report noted that forbearance programs have helped ease consumer liquidity pressures, consumers have reduced their outstanding credit card balances and credit scores have slightly improved. None of the factors is decisive on its own, but they contribute to a marginally improved consumer credit outlook. … And Apartment Tenants Are Paying Their Rent It is more common for households in the lower half of the income and net worth distributions to rent their residence than own it. Just one in every five households in the bottom two quintiles of the income distribution (Chart 4, top panel), and one in four in the bottom half of the net worth distribution (Chart 4, bottom panel), have a mortgage. Rent is the single largest recurring expense for these households and the shutdowns made paying it a concern. Several newspaper stories have highlighted the plight of distressed renters while discussing grassroots rent-strike movements, but the National Multifamily Housing Council’s (NMHC) Rent Payment Tracker tells a different story.3 Chart 4Households In The Lower Half Of The Income And Wealth Distributions Rent Their Homes The Rent Payment Tracker distills the results of a national survey covering over 11 million professionally managed apartment units. Through May 27th, it reported that 93.3% of renters had made full or partial payments for the month of May. The share of paying tenants was down just 150 basis points year-over-year, and up 160 basis points month-over-month. The six apartment REITs in the S&P 500 reported April and May rent collections that were better than the NMHC data. By the end of May, the REITs had collected 94-99% of the April rent they were due, and 93-96% of their May rents (Table 3). (Equity Residential (EQR) reported its April collections through April 7th and did not provide an end-of-month update; on June 1st, it reported that its May collections through May 7th were in line with April’s.) Essex Property Trust (ESS), which owns a portfolio of apartments in southern California, the Bay Area and greater Seattle, provided a table showing how the economic impact payments and the supplemental unemployment benefit would affect the income of unemployed California and Washington state couples without children. Table 4 expands it to cover four income scenarios, illustrating just how far up the income distribution CARES Act relief stretches. Table 3Residential Tenants Are Paying Their Rent Table 4The CARES Act For Essex Property Trust Renters Who Borrows: Evidence From The Survey Of Consumer Finances Helping the households in the bottom half of the income distribution won’t materially limit credit distress across the economy if those households don’t have access to credit. The latest edition of the Fed’s triennial Survey of Consumer Finances, published in 2017, makes it clear that they do. Those households may be much less likely to carry mortgage debt (Chart 5), but they make up for it by borrowing via other channels. 64% of households in the bottom two quintiles have some debt, and the share grows to 70% when the middle quintile, which qualified for the full $1,200 economic impact payment, is included (Chart 6). Chart 5The Homeownership Income Divide Chart 6Households In The Lower Two Quintiles Have Debt To Service, Too Investment Implications The discussion above focused solely on the consumer, as we discussed the Fed’s efforts to assist lenders and business borrowers in a joint Special Report with our US Bond Strategy colleagues in April.4 Record corporate bond issuance in March and April – before the Fed bought a single corporate bond – testifies to the effectiveness of the Fed’s measures. Its corporate credit facilities bazooka was so large that it was able to soothe the roiled corporate issuance market without firing a single shot. Spreads have narrowed across the spread product spectrum and the primary and secondary markets are once again able to function normally. Too much economic improvement could be self-limiting, and the S&P 500 is trading at an ambitious multiple. We remain equal weight equities over the tactical three-month timeframe. The foregoing review of consumer performance reinforces our view that the SIFI banks should be overweighted relative to the S&P 500. The ongoing data indicate that the SIFI banks will not have to build up their reserves for loan losses as much as investors feared. Our conviction that the SIFI banks are unlikely to face material book value declines has only increased. It has become possible that second- and third-quarter reserve builds may be even less than our optimistic two-times-the-first-quarter view, but the virus will have the final say. The SIFI banks remain our favorite long idea. At the asset allocation level, we remain equal weight equities over the tactical three-month timeframe. We are encouraged by the green shoots visible in the employment report, but stocks are generously valued and the virus outlook is still unclear. The improvement on the ground could prove to be self-limiting if it kills the momentum for further fiscal assistance, or if it encourages officials and individuals to let their guard down regarding the social distancing measures that have been effective in lowering COVID-19 infection rates. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to the Census Department’s annual Current Population Survey, mean household income ($90,000) exceeded median household income ($63,000) by 42% in 2018. 2 Ganong, Peter, Noel, Pascal J., Vavra, Joseph S. "US Unemployment Insurance Replacement Rates During the Pandemic," NBER Working Paper No. 27216. 3https://www.nmhc.org/research-insight/nmhc-rent-payment-tracker/ Accessed June 1. 4 Please see the April 14, 2020 US Investment Strategy/US Bond Strategy Special Report, "Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures," available at usis.bcaresearch.com.
Highlights Risks assets have entered a FOMO-driven mania phase that could last for a few more weeks. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this mania phase runs out of steam. We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. Within EM, local rates will perform well in both risk-on and risk-off phases. Feature The recovery in global risk assets has entered a fear-of-missing-out, or FOMO, mania phase. Like any mania, this one could last longer and go further than any fundamental analysis could presume. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy. Within EM, local rates offer the best risk-reward profile. A recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. The global equity rally has taken place amid a shrinking forward EPS. The top panel of Chart I-1 demonstrates that even the ever-bullish bottom-up analysts have been cutting their expectations of the level of corporate 12-month forward earnings per-share. As a result, the global forward P/E ratio has spiked to a 18-year high (Chart I-1, bottom panel). Chart I-1An Unprecedented Divergence: Surging Stocks Prices Amid Plunging Forward EPS Levels Chart I-2EM Forward EPS Level Has Been Falling Chart I-2 illustrates that the same phenomenon is true for EM equities. Their forward EPS has been contracting and their forward P/E has jumped to a decade high. Any overdrive in asset prices without supporting fundamentals can last for a while but typically ends with a crash. This FOMO-driven mania is unlikely to be any different. It is fair to say that during the March carnage, many investors operated on a “sell now, think later” principle. Since the rally began, they have switched to a “buy now, ask questions later” attitude. As this rally persists, global stocks and credit will become overbought and expensive. At that point, any negative shock could produce a sharp pullback that would likely devolve into another nasty selloff as investors shift back to a “sell now, think later” mentality. The Narratives Driving The Rally The narratives supporting this mania are simple and seem to be both accepted and embraced by a growing number of investors. We agree with some and disagree with others: Economies around the world are opening, which will ensure that an economic recovery will follow. Our interpretation: Surely as confinement policies are eased, activity will improve. However, in our opinion, this should not come as a surprise to investors. This is especially pertinent for the trend-setting US stock market. With US equity valuations not particularly cheap, the market was never pricing in extended lockdowns. Hence, it appears strange to us that markets have so exuberantly cheered the reopening of the economy. Looking forward, the key to the medium-term (six-month) equity outlook is the shape of the recovery following the initial partial normalization. The latter presently looks V-shaped because as stores and businesses reopen economic activity is bound to improve. Yet the odds are that following this initial normalization, the shape of the recovery is most likely to be U-shaped. For what it’s worth, manufacturing PMIs in export-oriented economies like Korea, Japan and Taiwan made new lows in May (Chart I-3). We are not suggesting these indicators will not improve in the months ahead; they surely will. Nevertheless, a marginal rise in diffusion indexes like PMIs from extraordinary depressed levels do not signify a profit recovery. This recession differs from previous ones as the level of business activity has dropped below breakeven points for more businesses than it did in other recessions. When a company operates below its breakeven level, a marginal rise in sales may not be sufficient to improve its debt-servicing capacity, hiring and capital spending intentions. However, it seems markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. This is why we feel risk assets are in a FOMO-driven mania phase, where fundamentals do not matter. Authorities around the world are stimulating, with the US pumping enormous amounts of fiscal and credit stimulus into the economy (Chart I-4, top panel). Chart I-3Asian Manufacturing PMIs Made New Lows In May Chart I-4An Unparalleled Global Money Boom Chart I-5China Is Ramping Up Stimulus China has finally embarked on aggressive stimulus. The National People’s Congress has set the monetary policy objective for 2020 as follows: Substantially accelerate the growth of broad money supply and total social financing (Chart I-4, bottom panel). Our interpretation: Indeed, government stimulus worldwide is massive. Yet, it is hard to know if it will be sufficient to produce a V-shaped recovery. The rise in money supply at the moment is being offset by the drop in the velocity of money. As a result, nominal GDP levels are extremely low. That said, last week we upgraded our growth outlook for China because of the above-mentioned aggressive policy stimulus. It is possible that China’s credit and fiscal impulse will reach about 15% of GDP before year-end (Chart I-5). What presently deters us from recommending outright long positions in China-related plays is the escalating US-China confrontation and the risk of a relapse in global stocks. Central banks around the world both in DM and EM are monetizing debt and injecting immense liquidity into the system. Our interpretation: Correct, but equally relevant is investors’ animal spirits. The latter will determine whether and when these liquidity injections leak into risk assets. For now, it seems that once again central banks’ actions have been successful in lifting asset prices, despite poor fundamentals. Equity valuations are cheap, especially outside the US. This is especially true given the low risk-free rate. Our interpretation: We agree that EM equities are cheap, something we have been highlighting since mid-March (Chart I-6). Yet valuations are not a good timing tool, as they can stay depressed so long as profits are not worsening. Meanwhile, US equities are expensive (Chart I-7). Critically, we argued in a recent report that equity multiples depend not only on the risk-free rate but also on the equity risk premium (ERP). Chart I-6EM Equities Are Cheap Chart I-7US Stocks Are Expensive Given the immense ambiguities investors are facing with respect to both the business cycle and economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. In this context, US equity valuations are rather expensive, despite the very low risk-free rate. In short, the expensive US stock market has until very recently been the locomotive of this rally. If US share prices had not rallied hard in the past two months, EM and other international bourses would not have caught a bid. The Fed’s public debt monetization is a structural, not near-term negative for the greenback. The US dollar is expensive and will depreciate a lot due to unrestrained fiscal and monetary stimulus in the US. Our interpretation: The US dollar is one standard deviation expensive (Chart I-8) and EM currencies have become cheap (Chart I-9). Chart I-8US Dollar Valuations Are Elevated Chart I-9EM Currencies Are Cheap Chart I-10EM Currencies And Stocks Correlate With Industrial Metals We do not disagree with the view that the US dollar is vulnerable in the long term due to the Federal Reserve’s aggressive debt monetization and that the Fed will eventually fall behind the inflation curve. Yet inflation is not imminent, and the Fed’s public debt monetization is a structural, not near-term negative for the greenback. As such, these potholes for the US dollar may not be pertinent in the next several months. Critically, Chart I-10 illustrates that EM currencies move with industrial metals prices, and EM stocks correlate with global materials stocks. The common driver of all of these markets is global growth in general and China’s industrial sectors in particular. In short, a recovery in global trade and mainland industrial sectors is necessary for EM equities and currencies to rally on a sustainable basis. Investors are underinvested in global equities in general and cyclical plays in particular. Our interpretation: Indeed, we showed last week that institutional equity investors had been skeptical of this rally. What has driven or supercharged this equity rally since late March has been unsophisticated retail investors. They have been opening up broker accounts worldwide and aggressively trading since March lockdowns. We cited a few pieces of anecdotal evidence confirming this phenomenon in last week’s report. However, it seems that institutional investors in recent weeks have capitulated by raising their risk exposure in general and their exposure to cyclical plays in particular. This explains the recent surge in cyclical equities and currencies. Bottom Line: The narratives driving this rally are only partially correct. Markets are ignoring the particularities of this recession and are treating the post-lockdown activity snapback as a V-shaped recovery. A weaker than expected global recovery and rising geopolitical tensions between the US and China are the two primary risks that will weigh on EM risk assets after this FOMO-driven mania phase runs out of steam. Nuances To Beware Of There are several nuances about the market’s internals and characteristics that we would like to draw investors’ attention to: There is mixed evidence as to whether China’s economy in general and its industrial sectors in particular have entered a sustainable recovery. First, examining the Taiwanese manufacturing PMI data could help in assessing the growth outlook for both the mainland economy and for global trade. The basis is that Taiwan has done extremely well by avoiding COVID-19 outbreaks and lockdowns. Therefore, there are no domestic reasons for weak output growth. In addition, its manufacturing sector is very export-oriented, with about 40% of exports destined for mainland China. PMI export orders for Taiwan's aggregate manufacturing and its three key sectors plunged to new lows in May (Chart I-11). This includes both the electronic optical (semiconductor) and basic materials sectors. The latter correlates well with global materials stocks. There has so far not been a bullish signal from this indicator (Chart I-11, second panel). Second, China’s domestic A-share market in general and its cyclical sectors in particular have not yet broken out (Chart I-12). Given China was the first nation to exit from lockdowns, its share prices should be the first to signal a sustainable economic recovery. Yet onshore share prices have been rather subdued. China’s economy will eventually stage a recovery later this year. Our point is that global cyclicals might have run ahead of themselves by pricing in a recovery too early. Chart I-11Taiwanese Manufacturing PMIs In May: New Lows Across All Industries Chart I-12Chinese Onshore Share Prices Are Not Flagging An Imminent Recovery Equity market and sector leadership changes occur during selloffs or at the inception of rallies. Chart I-13 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM. And all of them occurred during selloffs in global share prices. Chart I-13EM Versus DM Equity Leadership Rotations Took Place During Selloffs Similarly, the relative performance of global growth versus value stocks experiences trend reversals during global bear markets (Chart I-14). Chart I-14Global Growth Versus Value Leadership Rotations Occurred During Bear Markets Chart I-15EM Could Outperform DM For A Few Weeks Leadership of US equities and global growth stocks did not change during the March crash nor during the following two-month rally from the bottom. Only in the past week or so have US equities and global growth stocks begun to lag EM bourses and global value, respectively (Chart I-15). In brief, the latest leadership rotation from US to EM did not occur during the selloff or at inception of the rally – i.e., it does not fit the typical profile of sustainable leadership reversal. As such, it may not be enduring. The internals of this rally are consistent with the fact that it might already be at a late stage. During rallies, laggards are the last to catch a bid. Contrarily, during selloffs, outperformers are the last to be liquidated. For example, US growth stocks were the last ones to be liquidated in both the 2015-early-2016 and 2018 selloffs. When the decade-long leaders – US growth stocks – were finally stamped out, it marked the bottom of those selloffs. We are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Using an analogous framework for this rally, the latest extraordinary spike in the laggards such as EM, Europe and both value and cyclical stocks could be a sign of bear capitulation, and could signify the final phase of this equity rally. Bottom Line: There are several nuances to the current equity market rally, but investors seem reluctant to consider them amid a FOMO-driven mania. Investment Considerations The FOMO-driven rally could last for several more weeks. Afterwards it will be followed by a major setback. Investors who are long or cannot afford to stay on the sidelines should play this rally with tight stop points. Investors with longer time horizon should wait for a pullback in EM equities and currencies to buy. Chart I-16EM Local Rates Offer Value We are making the following adjustments and changes to our strategy and trade recommendations: In regard to our EM versus DM asset allocation strategy, we are making one change: we are upgrading EM sovereign and corporate credit from underweight to neutral within a global credit portfolio. The Fed’s purchases of US bonds will likely continue pushing investors into EM credit markets. Consistently, we are closing two positions: (1) our short EM corporate and sovereign credit / long US investment-grade corporate bond trade; and (2) our long Asian investment-grade /short high-yield corporate bond trade. Within the EM credit space, we continue to favor sovereigns versus corporates – a strategy recommended on April 23. We are still reluctant to strategically upgrade EM stocks versus DM ones even though odds of EM outperforming DM stocks are high in the coming weeks. In light of the potential FOMO-driven rally, to protect profits we are closing the following two currency positions: Take profits on short BRL/long USD trade. It was initiated on November 29, 2019 and has produced a 19% gain. Book profits on short SGD/long JPY position. This recommendation has generated a 2.3% gain since its initiation on June 8, 2018. We are still maintaining shorts in the following EM currencies: CLP, ZAR, TRY, IDR, PHP and KRW. They could continue rallying in the near term but will relapse afterwards. We are also structurally short low beta currencies: the RMB and the Saudi riyal. Within EM, local rates offer the best risk-reward profile: they will perform well in both risk-on and risk-off phases. Real bond yields remain somewhat elevated in many EMs, as shown in Chart I-16. We continue to receive long-term rates in Mexico, Colombia, Russia, Ukraine, India, Pakistan, Malaysia, China and Korea, as well as 2-year rates in South Africa. Their central banks will reduce policy rates much further. In addition, several of these local bond markets will benefit from ongoing quantitative easing by their central banks. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
Highlights There are no atheists in foxholes, and no Austrians ahead of this election: Republican senators and White House staffers may grumble about giveaways, but they cannot risk being painted as the Grinch who Stole Essential Services in the homestretch of the campaign. A Biden victory will mean a leftward swing: Our geopolitical strategists believe markets are underestimating the extent to which a Biden victory would lead to a less friendly backdrop for investment capital. Tensions with China are likely to escalate: China-bashing is popular with the electorate, and a desperate White House may turn up the heat to recover its standing in the polls. The battle for great-power supremacy remains unresolved. The pandemic is causing the retreat from globalization to accelerate before our eyes: Curtailing offshoring and building new redundancies into supply chains will weigh on corporate profit margins and undermine earnings growth. Feature We had the pleasure of sitting down with Matt Gertken, the leader of BCA’s Geopolitical Strategy service, for a webcast last week. The timing could not have been better, as the pandemic has thrust Washington into the spotlight and the campaign will keep it there until Election Day. This report blends the US Investment Strategy and Geopolitical Strategy teams’ takes on the broad themes we discussed and is a starting point for thinking about the 2020 election and its financial market implications. We will return to the topic throughout the summer and early fall as developments unfold. Republicans in the Senate can talk tough now, but they will have to knuckle under if they want to keep their majority (and the White House). Future Fiscal Largesse Though the scale of the CARES Act was huge, powering the United States to the head of the global class in terms of fiscal stimulus (Chart 1), both parties were discussing the next phase of COVID-19 relief before the ink on the bill was dry. Two months later, that momentum has stalled as Republicans have begun to push back against a fifth wave of spending (the CARES Act was the third). Senator Lindsey Graham (R-SC) has taken direct aim at the $600 weekly federal unemployment benefit supplement, scheduled to expire at the end of July, calling unemployment benefits in excess of pay an “aberration,” and pledging that the program will be extended “over [his] dead body.” Chart 1A Massive Amount Of Fiscal Stimulus That benefit may be generous on a Scandinavian scale,1 but along with the direct $1,200 payments sent to nearly two-thirds of households, it is helping the economy withstand deleterious social distancing measures. Shoring up the finances of vulnerable households will help them stay current on their auto loans and rent or mortgage payments, staving off a wave of repossessions, evictions and foreclosures, and preventing a cascading chain of defaults that would intensify the economic pressure. Table 1The Battleground States Need Help Graham’s rhetorical flourishes aside, Republicans cannot hand the Democrats an opening to cast them as Scrooge when the campaign intensifies in late summer. Trump’s 2016 victory turned on flipping Florida and Rust Belt stalwarts Pennsylvania, Ohio, Michigan and Wisconsin from the Democrats, and all those states are in play again except Ohio (Chart 2). Unemployment is elevated in the battleground Rust Belt states, and we think it must be higher than the official measure in a state as dependent on tourism as Florida (Table 1).2 Channeling the Grinch by taking unemployment benefits and essential workers away from put-upon voters in pivotal states3 is not a winning electoral strategy. Caught between an aid proposal that both Democrats and the White House want, Republican senators will ultimately have to concede. Chart 2The Midwest And Florida Are Crucial Rounding Out The Democratic Ticket Chart 3A New Obama-Biden Ticket? Presumptive Democratic nominee Biden is considering the pool of candidates to fill the number two spot on the ticket. Vice-presidential picks generate a lot of discussion when they’re made, but they typically have little influence on election outcomes. Among this year’s crop of contenders for the presidential nomination, only Senator Amy Klobuchar (D-MN) could fulfill the typical VP function of helping to land a swing state. Klobuchar would likely appeal to soccer moms and suburban independents capable of being swayed back to the Democrats, but her moderate sensibilities wouldn’t expand Biden’s appeal to the party’s progressive wing or inspire younger voters. Senator Elizabeth Warren (D-MA) could help attract progressives and younger voters who see Biden as the status quo, but her antipathy toward big business could turn off swing voters and she would come at the cost of a senate seat.4 Voters have an unfavorable view of Kamala Harris (D-CA) and her contentious exchanges with Biden in the early debates could make for an awkward pairing. Stacey Abrams has recently entered the picture and would be an asset if she were able to increase African-American voter turnout, but she has a thin government resume. Michelle Obama is the only choice who would make a splash and significantly boost Biden’s prospects. She is viewed way more favorably than the rest of the field (Chart 3), would solidify Biden’s connection with Barack Obama, and increase turnout among the progressive, female, and minority voters the ticket needs to tip the scales in its favor. Unfortunately for the Democrats, she has unequivocally indicated that she does not wish to run. Biden has said he’d welcome her onto the ticket in a second, and he will likely put off his choice until efforts to draft her definitively fail. Michelle Obama could shake up the race if the Democrats can convince her to join the ticket. Investors should keep an eye on the Democratic ticket. Joe Biden will turn 78 in November. He will be a one-term president if he wins, and his public appearances suggest that he’s slower on the draw than he used to be. He may rely on his second-in-command much more than the average president and she will immediately become the odds-on favorite for the 2024 nomination. If the Democrats gain control of the Senate alongside a Biden victory, as our Geopolitical Strategy service projects, financial markets may have to begin discounting a future with materially less friendly regulatory and tax policy. China Tensions Will Not Go Away Chart 4The Middle Kingdom Is Out Of Favor Our geopolitical strategists have long flagged US-China tensions as the paramount geopolitical flashpoint. The only standalone nations with superpower potential are engaged in a long-term struggle for hegemony. The trade tensions that waxed and waned across all of 2019 were only one act of a longer-running play. Investors should not have been lulled into thinking the Phase 1 trade agreement would end the friction between the two countries. Politicians can be counted upon to give their constituents what they want, especially during election campaigns. China’s unpopularity with US voters has reached a new high in the wake of the pandemic (Chart 4), and candidates are likely to compete with one another to appear tougher on China. Between now and the election, there is a possibility that tensions could ramp up considerably. If the president finds his re-election prospects suffering from the COVID-19 outbreak and soaring unemployment, he may look to transform himself into a wartime president, boldly asserting American interests globally, and serially baiting an unpopular foe like China. Profit Margin Pressures Are Coming Except when interrupted by recessions, S&P 500 profit margins have climbed steadily higher since the early ‘90s (Chart 5). Several factors contributed to the increase in corporate profitability: the PC revolution, outsourcing, China’s entry into the WTO, the declining power of labor unions and, punctuating the rise in 2018, the 40% cut in the top marginal corporate tax rate (from 35% to 21%). If the Democrats take the White House and the Senate, we expect that corporate tax rates will swiftly rise. The top marginal rate may not go all the way back to 35%, but it has room to rise from its lowest level since before the US entered World War II (Chart 6), and any increase will represent a profit headwind. Re-configuring supply chains will reduce margins. Higher taxes will, too, if Democrats can take the White House and the Senate. Chart 5Corporate Profit Margins Are Vulnerable Chart 6A Democratic Sweep Will Lead To Higher Taxes Our Geopolitical Strategy service identified peak globalization as an important theme not long after it began publishing in 2012. The outbreak of the pandemic seems as if it will accelerate the retreat from globalization (Chart 7), and any reduction in outsourcing is likely to weigh on profit margins until automated inputs can supplant more expensive domestic labor. Onshoring is not the only factor likely to increase corporate costs after the pandemic, however. Companies are likely to seek to diversify their supply chains so that they are not so reliant on a single country or supplier. Building up redundancies within supply chains will make those chains more stable, but it will also increase costs. Chart 7The Pandemic Is Accelerating The Trend Away From Globalization A Biden victory is not the only source of election downside. If the president wins re-election, the odds of tariff conflicts with Europe will rise significantly. Unconstrained by having to contest another election, the administration could ratchet up the pressure on Europe, prompting certain retaliation from Brussels. Our strategists see a greater chance for trade peace, ex-China, if Biden captures the White House. Investment Implications The overriding questions on investors’ minds are why the stock market and the economy have parted company so decisively and how long they can continue to diverge. Our explanation turns on policy: the Fed has intervened mightily to hold down Treasury yields and keep financial markets functioning, while Congress has thrown open the federal coffers to keep laid-off workers and suddenly teetering businesses afloat. The social distancing measures imposed to slow the spread of COVID-19 caused economic activity to crater. Monetary and fiscal policy have been deployed to build a bridge over that crater, lest capital, people and businesses disappear into it like the Union troops at Petersburg. Ever since they began to rally in late March, financial markets have focused exclusively on the bridge. The Fed has the capacity and the will to install more monetary planks should the crater prove to be wider than initially estimated. Congress’ commitment is shakier, but the election will compel Republicans to provide more funding should it become necessary to prevent a dire outcome. The virus alone will dictate how long the bridge will have to be in place and investors can only guess at the virus' future course. Given the stock market’s pattern of surging on positive preliminary data for potential treatments or vaccines and barely easing when those data are shown to hold far less promise, it appears that its expectations are skewed to the right-hand side of the distribution. There appears to be considerable room for disappointment on the public health front. The possibility that markets are giving short shrift to a robust second wave of infections, or overestimating the speed with which a vaccine can be developed and distributed, is not a reason to short equities or be underweight them in balanced portfolios, though. The rally has been too strong, and there is a subset of right-tail outcomes that could well come to pass. We continue to expect a correction, and are carrying excess cash to prepare for it, but we are maintaining a neutral tactical outlook in the event of a positive surprise. We are optimistic about equities’ prospects over a twelve-month timeframe. Our rationale is that easy monetary policy and generous fiscal spending will outlive the social distancing measures they were prescribed to treat. Low interest rates, ample liquidity and pumped-up aggregate demand form a highly supportive backdrop for equities and should help them handily outperform bonds. The difference between our outlook and the equity market’s may simply be a matter of timing; the resurgent S&P 500 seems to be skipping ahead to the twelve-month conclusion and looking through the uncertainties that will arise along the way. The bears face daunting odds if Congress approves a meaningful fifth phase of fiscal stimulus: every trillion dollars extends the dark US bar in Chart 1 by another five percentage points. TIPS will eventually be the asset of choice when the debt has to be repaid but, in the meantime, equities have undeniable appeal. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to a new working paper, the median unemployed worker is eligible for benefit payments equivalent to 134% of his/her pre-layoff compensation. https://www.nber.org/papers/w27216 Accessed May 26, 2020. 2 Nevada, home to the Magic Kingdom for adults, has the nation’s highest unemployment rate (28.2%). 3 Most state constitutions mandate balanced budgets. In the absence of federal aid, local school, fire, police and public hospital payrolls will have to be pared in response to declining sales and income tax revenues. 4 Massachusetts’ Republican governor would get to appoint her replacement until a special election could be held.
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will be examining the global effectiveness of recent pandemic containment measures to judge both the odds of a second infection wave and what policy responses are likely to be effective in countering one were it to occur. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Fiscal deficits have soared in the wake of the pandemic, putting government debt-to-GDP ratios on a trajectory to reach post-WWII highs in many countries. Contrary to popular belief, there is little reason to think that fiscal relief will make it more difficult for governments to repay their obligations down the road. Larger budget deficits tend to increase overall national savings when the economy is depressed because private savings rise more than enough to compensate for the decline in government savings. The end result is a higher level of national wealth that governments can tax in the future. That said, there is more than one way to tax national wealth. For political reasons, higher inflation coupled with financial repression may prove to be more feasible than other forms of taxation. While inflation is not an imminent risk, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. Gold prices will rise over the long haul. The yellow metal should perform well even in the near term if the dollar weakens during the remainder of this year, as we anticipate. Real estate investors should reallocate capital away from densely populated urban areas towards suburbs and farmland. Stay Cyclically Overweight Equities Global equities continued to climb higher this week, as more countries reopened their economies. As we discussed three weeks ago in our report entitled “Risks To The U,” the main downside risk facing stocks is a second wave of the disease.1 While the number of new COVID-19 cases has declined in many countries, it continues to rise in others. As a result, the global tally of new cases remains broadly flat. The daily number of deaths seems to be trending lower, but that could easily reverse if social distancing measures are abandoned too quickly (Chart 1). Chart 1COVID-19: Global New Cases Remain Broadly Flat, While Deaths Seem To Be Trending Slightly Lower Chart 2Joined At The Hip Given this risk, we do not have a strong near-term (3-month) view on the direction of equities. Google searches for the “coronavirus” have closely correlated with equity prices and credit spreads (Chart 2). If fears of a new outbreak were to escalate, risk assets would suffer. Looking at a cyclical (12-month) horizon, we still recommend a modest overweight to stocks. Even if a vaccine does not become available later this year, increased testing should allow for a more economically palatable approach to containment strategies. Ample fiscal support will also help. As we provocatively asked in a report entitled “Could The Pandemic Lead To Higher Stock Prices?”,2 one can easily imagine a scenario where central banks keep rates near zero for the foreseeable future, while ongoing fiscal stimulus enables the labor market to reach full employment. Such an outcome could allow corporate profits to return to pre-pandemic levels, but leave the discount rate lower than before. The end result would be a higher fair value for the stock market. Although we would not counsel investors to bank on such a fortuitous outcome, the probability of it occurring is reasonably high – probably in the range of 30%-to-40%. This makes us inclined to favor stocks over a cyclical horizon. Will Indebted Governments Spoil The Party? One potential flaw in this bullish thesis is that massive government deficits could push up interest rates, crowding out private-sector investment in the process. As we argue below, such worries are misplaced for now. For the time being, bigger budget deficits will likely lead to an increase in overall savings, thus raising investment relative to what would have happened in the absence of any stimulus. That said, as we conclude towards the end of this report, there will come a time – probably in two-to-three years – when most economies are back to full employment. If budget deficits are still high at that point, inflation and long-term bond yields could end up rising substantially. Keynes To The Rescue The IMF expects budget deficits in advanced economies to exceed 10% of GDP in 2020, significantly higher than during the financial crisis. The sea of red ink is projected to push government debt-to-GDP ratios to fresh highs in many economies (Chart 3). Chart 3AGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 3BGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 4The Paradox Of Thrift: Not Just A Theory Should bond investors be worried? Not for now. One of John Maynard Keynes’ great insights was that an individual’s attempt to increase savings could lead to a collective decline in savings, a phenomenon he called the paradox of thrift. Keynes argued that if everyone tried to save more, the resulting contraction in spending would cause total employment to fall by so much that overall income would decline by more than spending. As a result, aggregate savings would fall. This is precisely what happened during the Great Depression and in the aftermath of the Global Financial Crisis (Chart 4). The paradox of thrift implies that bigger budget deficits in a depressed economy will lead to an increase in overall savings, as private savings rise more than one dollar for every dollar decline in government savings. S-I=CA One can see this point using the familiar macroeconomic accounting identity which says that the difference between what a country saves and invests should equal its current account balance.3 In the absence of a change in the current account balance, any increase in investment will translate into an increase in savings. If the government stimulates aggregate demand by increasing spending, cutting taxes, or boosting transfer payments, companies are likely to respond by investing more (or at least not cutting capital expenditures as much as they would otherwise). Thus, if fiscal stimulus raises investment, it will also raise aggregate savings. Chart 5Huge Spike In The US Personal Savings Rate This conclusion has important implications for bond yields. If bigger budget deficits lead to an increase in overall savings, there is no reason to expect real bond yields to rise very much, at least in the short term. The failure of bond yields to rise since March, when governments began to trot out one fiscal stimulus package after another, is a testament to this fact. So too is the stimulus-induced surge in the US personal saving rate, which reached a record high of 33% in April (Chart 5). All That Money Printing If bigger government budget deficits are, in some sense, self-financing, why are so many people convinced that the Fed and other central banks are effectively “monetizing” deficits by buying up bonds? Part of the answer has to do with how one defines monetization. Governments create money whenever they purchase goods or services or make transfers to the public by running down their deposits at the central bank. In theory, the public could use that money to buy government bonds, which would allow the government to replenish its account at the central bank. In practice, it is usually a bit more circuitous than that. Chart 6Commercial Banks Deposits, Bank Reserve Held At The Fed, And Fed Holdings Of Treasuries Have All Expanded This Year What normally happens is that the public places the money in a commercial bank deposit and the commercial bank then transfers the money to its account at the central bank. Next, the central bank buys the bonds from the government, crediting the government’s deposit account at the central bank in the process. Chart 6 shows that this is precisely what has happened this year: Commercial bank deposits, bank reserves held at the Fed, and the Fed’s holdings of Treasuries have all risen by roughly the same amount. Granted, there is a bit more to the story. If the central bank buys bonds, it will push down bond yields at the margin, allowing the government to finance itself more cheaply than it could otherwise. However, this is a far cry from the sort of “money printing” that many people have in mind. True debt monetization occurs when governments lose all access to outside financing, forcing the central bank to pick up the tab. Such situations invariably involve accelerating inflation and a collapsing currency, which often culminates in hyperinflation. This is clearly not the case today. Back To Full Employment The idea that bigger budget deficits can generate enough private savings to more than fully compensate for any loss in government savings is applicable only for economies with spare capacity. Once the economy reaches full employment, fiscal stimulus will not lead to more income or production since everyone who wants a job already has one. At that point, bigger budget deficits will cause the economy to overheat and inflation to rise, potentially forcing the central bank to raise rates. Higher interest rates will reduce investment. Higher rates will also put upward pressure on the currency, leading to a reduction in net exports and a corresponding deterioration in the current account balance. If investment and the current account balance both decline, then savings, which is just the sum of the two, must also fall. Strategies For Alleviating A Debt Burden Once the free lunch from fiscal stimulus disappears, the question of how to address the government debt accumulated during the downturn becomes paramount. There are four ways to reduce the ratio of government debt-to-GDP: 1) outgrow the debt burden; 2) tighten fiscal policy; 3) default; and 4) inflate away the debt. Outgrowing It At the end of the Second World War, many governments found themselves saddled with high levels of debt. In the US, the government debt-to-GDP ratio stood at 121% in 1945. In the UK, it hit 270%. In Canada, it reached 155%. For the most part, these governments did not repay the debt they incurred during the war. As Chart 7 shows, the nominal value of debt outstanding either rose or remained broadly constant following the war. What happened was that rapid GDP growth led to a shrinkage in debt-to-GDP ratios. Compared with the post-war period, the two drivers of an economy’s growth potential, labor force and productivity growth, are both weaker now. Thus, outgrowing the debt by raising the denominator of the debt-to-GDP ratio will be more difficult than in the past. It’s About g-r That said, the trajectory of the debt-to-GDP ratio does not depend solely on GDP growth; it also depends on the interest rate that the government pays to service its debt. Conceptually, it is the difference between the two that determines whether the level of any given budget deficit is sustainable or not. While trend GDP growth in advanced economies has declined since the 1950s, equilibrium interest rates have also fallen. As a consequence, the spread between growth rates and interest rates is only somewhat smaller in advanced economies today than it was in the 1950s and 60s and notably higher than it was in the 1980s and 90s (Chart 8). Indeed, as Chart 9 shows, g-r has been trending higher for hundreds of years! Chart 7The Case Of Outgrowing The Debt Burden Post-WWII Chart 8The Rate Of Economic Growth Has Been Higher Than Interest Rates Chart 9A Multi-Century Trend In The Spread Between Growth And Interest Rates Today, government borrowing rates in most economies are well below trend growth rates. No matter the size of the budget deficit, the ratio of debt-to-GDP will converge to a stable level as long as the interest rate the government pays on the debt is below the growth rate of the economy.4 A Gordian Fiscal Knot Of course, there is no guarantee that real rates will remain below the rate of trend growth. As we have discussed before, the exodus of baby boomers from the labor force, a peak in globalization, and rising political populism could all curtail aggregate supply, leading to a depletion of national savings.5 What would happen if governments allowed debt levels to reach very high levels only to find that the neutral rate of interest — the interest rate consistent with full employment and stable inflation — has risen above the growth rate of the economy? Raising the policy rate would be very painful in a high-debt environment because even a small increase in interest rates would lead to a large rise in interest payments. Faced with this reality, some governments might elect to tighten fiscal policy. An increase in taxes or a decline in government spending would not only create some resources to pay back debt, but it would also reduce aggregate demand, pushing down the neutral rate of interest in the process. Don’t Blame The Stimulus Ironically, all the fiscal relief efforts that governments have carried out over the past few months have probably left them better placed to pay back debt than if no stimulus had been undertaken in the first place. Box 1 illustrates this point with a numerical example, but the intuition for this claim can be seen easily enough. As noted earlier, fiscal stimulus in a depressed economy will raise overall savings. This means that after the pandemic is over, governments will have a larger tax base available to them than they would have had in the absence of any stimulus (although, obviously, the tax base would be even larger if the pandemic had never occurred). The Inflation Solution Chart 10Long-Term Inflation Expectations Remain Very Depressed Still, any decision to tighten fiscal policy down the road is going to be an inherently political one. What if governments do not have the political will to tighten fiscal policy even if the economy begins to overheat? Defaulting on the debt is always an option in that case, but not one that any sensible government would choose given the devastating impact this would have on the financial system and broader economy. Rather, it is conceivable that governments will lean on central banks to keep rates low and let inflation accelerate. While higher inflation will not boost real GDP, it will raise nominal GDP, allowing the ratio of government debt-to-GDP to decline. Investors currently assign very low odds to such an outcome. Long-term market-based inflation expectations remain very depressed (Chart 10). Yet, we think such an eventuality is more plausible than widely believed. As long as inflation does not spiral out of control, central banks are likely to welcome rising prices. A higher inflation rate would make monetary policy more effective by allowing central banks to bring real rates deeper into negative territory whenever the economy falls into recession. Higher inflation would also result in steeper yield curves, reoxygenating commercial banks’ profitability. Profiting From Higher Inflation The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment. Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate. As a countercyclical currency, the dollar tends to fall whenever global growth picks up (Chart 11). Chart 11Gold Will Do Well When The Dollar Weakens As Global Growth Picks Up Chart 12Farmland Would Benefit From High Inflation Lastly, land will gain from low interest rates in the near term and higher inflation in the long term. Farmland and suburban land are particularly appealing. The pandemic has made remote working more commonplace. It has also highlighted the potential dangers of living in densely populated cities. Since most suburbs are built on top of land that was previously zoned for agriculture, farmland should benefit from the retreat from urban living, much like it did during the inflationary period of the 1970s (Chart 12). Box 1Saving More By Spending More Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2 Please see Global Investment Strategy Weekly Report, “Could The Pandemic Lead To Higher Stock Prices?” dated April 23, 2020. 3 Gross Domestic Product (GDP) can be computed as the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). Gross National Product (GNP) is equal to GDP except that the former includes net income from abroad (which is included in the current account balance). Thus, GNP=C+I+G+CA, or GNP-C-G=I+CA. Savings (S) is equal to GNP-C-G. Taken together, the two expressions imply S-I=CA, or S=I+CA. 4 Please see Global Investment Strategy Weekly Report, ”Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 5 Please see Global Investment Strategy Weekly Report, “A Structural Bear Market In Bonds,” dated February 16, 2018. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights This year’s NPC refrained from announcing a numeric economic growth target. However, the targeted employment growth will be a reliable indicator of the government’s pain threshold. The announced stimulus package did not exceed market expectations. At the same time, the government is keeping the liquidity tap open and the fiscal budget flexible. We expect the government to utilize both policy tools before July. The stimulus focuses on supporting infrastructure investment and consumption, with marginal loosening of property market restrictions. While we maintain a positive view on Chinese equities in the next 6 to 12 months, we favor large cap stocks in domestic demand-driven sectors, to hedge rising geopolitical risks. We also recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. Feature This year’s National People’s Congress (NPC) delivered two surprises on opening day: a new national security bill on Hong Kong SAR, which will be voted on at the May 28th plenary session;1 and a lack of an annual economic growth target in the Government Work Report (GWR), for the first time since the early 1990s. Chinese stock prices in both the onshore and offshore markets plunged following Friday’s NPC session (Chart 1). Chart 1Messages From This Year's NPC Did Not Bode Well For Market Sentiment Numeric targets in the stimulus package announced at the NPC did not exceed the consensus. However, citing global geopolitical and economic uncertainties, Chinese policymakers have kept the liquidity tap open and the fiscal budget flexible. This means that policymakers can add to the existing stimulus without the approval of the NPC at the Politburo’s mid-year review in July. Investors will likely turn their focus back to economic fundamentals in the coming months. In Q2, the market will trade on the back of disappointing corporate earnings and news from the geopolitical front. In H2, however, a confluence of further domestic policy easing and a global economic recovery should lift Chinese corporate earnings. As such, our cyclical (6-12 months) outlook on both China’s economic recovery and equity performance remains upbeat. The Economy: No Growth Target ≠ No Growth The GWR set targets for this year’s urban job creation and unemployment rate, even though it refrained from setting an explicit objective for economic growth in 2020 (Table 1). A numeric target on job growth implicitly provides a floor to the economy, i.e., stimulus will have to step up if the economy does not provide adequate jobs to meet the employment target. Table 1No Growth Target, But Big Spending Anecdotes indicate that, to keep the unemployment rate in abeyance, the government has mandated corporations to retain their employees on payrolls even if there is no pay. This may help to explain the meager 6.0% unemployment rate in China compared with a near 20% rate in the US. It is undoubtedly much harder to create new jobs than to maintain a stable unemployment rate. Economic and demand growth is still the foundation for job growth, and administrative measures can only go so far in creating new jobs, particularly in the private sector. The government pledges to create 9 million new jobs in 2020, about 20% lower than the target of 11 million new jobs set for last year. In 2019, 13.52 million urban jobs were created and the nominal GDP expanded at 7.8%. A back-of-the-envelope calculation suggests that China economy needs to grow by 4-5% from 2019 (in nominal terms) to achieve the employment target for this year. Given that Q1 registered a 5.3% contraction, China’s economy must expand by at least 8% (year on year) in H2 (Chart 2). Chart 2Employment Growth Will Be This Year's Government Policy Anchor Stimulus: Keeping Options Open “We will use a variety of tools such as required reserve ratio reductions, interest rate cuts, and re-lending to enable M2 money supply and aggregate financing to grow at notably higher rates than last year.” – Li Keqiang at the NPC, May 22, 2020. Chart 3Further Monetary Easing Likely In June This statement makes it clear that policymakers intend to keep the liquidity tap running. The easing of local government financing vehicle (LGFV) borrowing and shadow banking regulations also indicates that Chinese policymakers have given an all-clear signal to accelerate money and credit growth. We expect another round of cuts in interest rates and required reserve rates ahead of the July Politburo meeting. The credit impulse should reach around 35% of China's GDP this year, well above the 25% in 2019 (Chart 3). A notable exception in this year’s GWR is that it did not put a lid on the size of fiscal stimulus. The fiscal deficit for 2020 is set at an ambiguous “above 3.6% of GDP”. Furthermore, the GWR states that the current policies “can be improved according to changes in the economic situation,” which will allow for greater leeway in easing. We believe that while the government pledges to maintain a measured stimulus, more easing actions are inevitable. China’s post-pandemic economic recovery is on track and not yet close to the policymakers’ pain threshold. However, the global economy faces tremendous uncertainties. The pandemic is not yet controlled worldwide and the US-China rivalry is expected to grow more acrimonious in the months to come. A temporary setback in China’s economic recovery and financial market in Q2 is a strong possibility. Employment is also set to come under more pressure in Q2 when an estimate of 8.7 million new college graduates enter the job market. As mentioned in our previous report, China’s job losses so far are concentrated in lower-skilled, lower-income manufacturing and service sectors.2 However, the new graduates will seek middle-income, white-collar jobs, which can only be provided by real demand in the economy. Young middle-class professionals in China are not only a major source of consumption growth, but also are a source of domestic instability if they are discontent – a political risk we do not think the Chinese leadership is willing to take. Fiscal Stimulus: Largest On Record Raw material prices have closely tracked Chinese credit cycles since the Global Financial Crisis (GFC). China’s fiscal impulse and government-led investment have helped to speed up commodity price recoveries and bridged the gap between economic slowdowns and a rebound in the private sector (Chart 4). Fiscal deficit will likely be enlarged by more than 3% of GDP in 2020 from last year's near 5% of GDP, and will be the largest annual deficit increase on record. The announced budgetary fiscal deficit in 2020 is set at above 3.6% of GDP, but the broad-measure fiscal deficit will most likely reach to more than 8% of GDP this year when taking into account both government budgetary and fund expenditures (Chart 5). Chart 4Commodity Prices Will Get A Lift From Fiscal Stimulus Chart 5Fiscal Deficit Largest In Decades Chart 6"New Infrastructure" Investment Moved Into The Fast Lane The local government special purpose bond (SPB) budget is set at 3.75 trillion, 1.6 trillion above last year. We expect 80% of the 2020 SPB to be invested in infrastructure projects. With the additional 700 billion yuan of central government budgetary investment fund, infrastructure investment will be increased by 2.5 trillion compared with 2019, a 10% growth (Chart 6). A reason why the market reacted negatively to the announced stimulus is that the headline figure for central government special treasury bonds (STB) is below market expectations. However, STBs are special transfers from the central government to localities to replenish fiscal reserve funds, which have little stimulative impact on business activity. The fact that the figure is below market expectations does not have the same kind of market relevance as government expenditure or local government SPB. Real Estate: More Dovish Chinese policymakers have always maintained an enigmatic attitude towards the housing sector. Although no housing stimulus was announced this year, the tone on keeping housing demand in check has softened. Phrases have been added to this year’s GWR, allowing provincial and city officials to adjust their housing policies. Housing policy has become progressively less restrictive since mid-2019 and we anticipate some modest property stimulus going forward. Chart 7Construction Set To Pick Up As mentioned in our previous reports, the massive contraction in fiscal revenue growth this year will inevitably push up land auctions and housing construction activity (Chart 7). We continue to expect a strong recovery in housing demand, particularly in China’s top-tier cities. Lower mortgage rates, easier access to bank loans and the preference to hold hard assets to hedge inflation, all will drive up housing demand among higher-income Chinese households. High-frequency data show that since the beginning of May, the contraction in property sales in tier-1 and tier-2 cities have narrowed by 17 percentage points from April. Investment Conclusions The NPC delivered a stimulus package that did not exceed market expectations, which means that investors will be re-focusing on China’s economic fundamentals in the near term. We think that geopolitical tensions and weak corporate earnings will dominate the performance of equities in Q2. On the geopolitical front, Beijing’s move to pass a new national security law on Hong Kong will likely be met with retaliatory actions from the US, adding fuel to the US-China tensions. The near-term response in the equity market will be negative if President Trump follows through with his retaliatory threats. Consequently, we recommend investors to hedge their RMB exposure in Chinese stocks by opening a long USD-CNH trade, with the expectation that further weakness in the RMB is likely in Q2. On China’s domestic economy, industrial profit growth will likely remain in contraction during most of Q2, before returning to modest positive growth in H2. As such, near-term investors’ risk appetite will experience periods of setbacks, and there will be better price entry points to go long on Chinese stocks in both relative and absolute terms. We remain positive on Chinese equities in the next 6 to 12 months. The speed of the economic recovery will likely accelerate in H2, and there is a distinct possibility that the stimulus will step up following a lackluster economic recovery in Q2. Some cyclical industries will significantly benefit from the ongoing stimulus and recover ahead of the broad market. We favor consumer discretionary stocks in both onshore and offshore equity markets.3 We also recommend that investors focus on large cap firms that draw their revenues from domestic demand-oriented industries. This will help to hedge volatilities created from escalating US-China trade frictions. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 We will discuss the implications from the Hong Kong national security bill proposal in future research. 2 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com 3 Please see China Investment Strategy, "A Consumption Recovery On Two Tracks," dated May 20 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations