Policy
Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.
Highlights The cyclical bull market in stocks will last until the end of next year. That said, global equities have become increasingly vulnerable to a correction, so fast-money investors should consider putting on a tactical hedge spanning the next few weeks. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. We ultimately expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a larger budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Feature Rising Odds Of A Stock Market Correction We remain cyclically bullish on global equities based on the expectation that global growth will stay strong over the next 12 months, which should support corporate earnings. Nevertheless, the recent price action in credit markets is disconcerting. Yesterday's relief rally notwithstanding, junk bonds have been selling off in recent weeks, as have EM credit and currencies (Chart 1). We have found that credit trends generally lead the stock market. This raises the risk of an equity correction. The fact that the bull/bear ratio has reached a 30-year high in the weekly Investors Intelligence Sentiment survey (Chart 2), and that the most recent BofA Merrill Lynch Survey shows that a record share of fund managers are overweight risk assets, only add to our worries. Chart 1Junk Bond Selloff Raises ##br##Risks Of An Equity Correction Chart 2Equity Bullish Sentiment:##br## Getting Stretched Doubts about the ability of Republicans in Congress to push through tax cuts further muddle the picture. We continue to expect a tax bill to be signed into law early next year, but the intention of President Trump and Senator Majority Leader Mitch McConnell to include a provision in the bill to rescind the individual mandate to purchase health insurance could greatly complicate this task. Moreover, as we discuss in greater detail below, the economic benefits of the tax legislation are likely to be muted, even if equity prices do rise on the back of lower corporate tax rates. This will make selling the merits of the tax plan to the American people all the more difficult. With all this in mind, we are putting on a short S&P 500 trade recommendation. We are targeting a gain of 5% and putting in a stop-loss of 2%. We will close this trade before the end of the year, so this should be seen as a purely tactical decision appropriate for fast-money investors only. Fiscal Policy Was Tightened Too Early ... Global bond yields plummeted during the Great Recession, but then quickly recovered. The U.S. 10-year Treasury yield hit 3.95% in June 2009, while the German bund yield reached 3.72% that same month. Today, output gaps are much smaller globally than they were seven years ago, yet bond yields are substantially lower (Chart 3). Chart 3ASmaller Output Gaps... Chart 3B...But Lower Bond Yields Many theories have been offered to account for this seemingly paradoxical turn of events. Was it QE? Maybe the Phillips curve broke down? Perhaps investors have steadily revised down their estimate of the neutral rate of interest? One can make compelling arguments in support of all these explanations. However, there is one reason that has received relatively little attention: fiscal policy. Chart 4 shows that fiscal policy was tightened by an average of 4.1% of GDP in the G20 economies between 2010 and 2015. This happened despite the fact that unemployment was still quite high. One could make a half-plausible case that fiscal austerity was necessary in southern Europe, where one country after another was being attacked by the bond vigilantes (although even there, the failure of the ECB to act as a lender of last resort to European sovereigns greatly exacerbated the problem). It is harder to justify the shift towards austerity in countries such as the U.S. and the U.K. which were able to issue debt in their own currencies; or to explain why Germany felt the need to tighten fiscal policy when its structural primary balance was already in surplus. In Japan's case, the 2.9% of GDP in fiscal tightening that occurred between 2013 and the 2015 was a key reason why Abenomics failed to push the country out of deflation. Faced with the reality of what was happening on the fiscal front, central banks had no choice but to step in. They did so by slashing interest rates, in some cases pushing them into negative territory. They also engaged in massive asset purchases. The tsunami of easy money helped to keep economies afloat. But in many countries, slower government debt growth was replaced by faster private-sector debt growth (Chart 5). Debt continued to rise. It just did so in a different form. Chart 4Fiscal Belt-Tightening##br## In 2010-2015 Chart 5Private Debt Growth Picked Up##br## Amid Slowing Government Debt Growth ... And Is Now Being Eased Too Late The good news is that governments are abandoning their obsession with fiscal austerity. The bad news is that they are doing it at a time when fiscal easing is no longer warranted. Standard economic theory suggests that governments should run budget deficits when unemployment is high, and surpluses when it is low. In the U.S., the unemployment rate stands at 4.1%, 0.6 percentage points below the Fed's estimate of NAIRU. And yet, President Trump and the Republicans in Congress are pushing for massive tax cuts which, according to the CBO, would add $1.7 trillion to federal debt over the next ten years, while pushing up the debt-to-GDP ratio by an extra six percentage points to 97% (Chart 6). Limited Supply-Side Benefits Proponents of the legislation argue that lower tax rates will spur growth by so much that they will pay for themselves. This is highly unlikely. Chart 7 shows that major tax cuts in the past have always led to a rising debt-to-GDP ratio, whereas tax hikes have led to a deceleration, or even outright decline, in the debt ratio. Even the much lauded 1981 Reagan tax cuts had to be partially rolled back in 1982 after the budget deficit widened sharply. Chart 6More Red Ink Chart 7Do Tax Cuts Pay For Themselves? The growth-enhancing effects of lower tax rates are likely to be smaller at present than they were in the early 1980s. The Reagan tax cuts were introduced when the economy was in the doldrums and government debt levels were much lower than they are today. Cross-border ownership of foreign assets has also increased tremendously since the Reagan era. Foreigners now own more than $10 trillion of U.S. equities, or close to 35% of the total, up from 10% in the early 1980s (Chart 8). This implies that a corporate tax cut would not only represent a massive windfall for foreigners - a bizarre outcome for a self-professed nationalist president - but would mean that a smaller share of capital gains taxes will make their way into the coffers of the U.S. Treasury. Personal income tax cuts are also likely to generate much less bang for the buck. Most empirical studies suggest that lower personal tax rates increase labor supply largely by boosting female labor participation.1 The prime-age female labor participation rate in the U.S. today is 11 points higher than it was in 1980, which limits the scope for further gains. Moreover, when Ronald Reagan cut taxes in 1981, the top personal tax rate stood at 70% (Chart 9). At such a high rate, a one percentage-point cut in the top rate increases take-home pay by 3.3% (1/30). Today, the top rate stands at 39.6%, so a one-point cut would raise after-tax income by only 1.6% (1/60.4). Thus, the incentive effect from cutting the top marginal tax rate is only half of what it was back then. And, of course, the lower the tax rate, the less incremental revenue the government gets from every additional dollar of income. A reasonable estimate is that the revenue offset from tax cuts today would be only one-quarter of whatever modest amount it was in the early 1980s. Chart 8Growing Share Of U.S. Equities##br## Is Held By Foreigners Chart 9Lower Bang For The Buck From##br## Cutting Individual Tax Rates Tax Cuts Versus Tax Reform This is not to say that tax reform is undesirable. Statutory corporate tax rates in the U.S. are quite high, but effective rates are very low, given the myriad deductions and tax-sheltering strategies (Chart 10). The combination of base-broadening and lower statutory rates would make the economy more efficient. In this respect, the set of reforms unveiled by Paul Ryan earlier this year actually had a lot going for it. Unfortunately, the half-measures in both the House and Senate bills run the risk of making the current system even worse. For example, the proposed transition from the current system where U.S. companies are taxed on their worldwide profits to one where they are taxed only on the profits they earn in the U.S. is likely to increase the incentive to use accounting gimmicks to shift more taxable income to low-tax jurisdictions abroad.2 The new "pass through" tax rate of 25% would also provide passive business owners, who are currently subject to the top marginal tax rate, with a massive tax break. Chart 10Statutory Vs. Effective Corporate Tax Rates: Please Mind The Gap In theory, full business investment expensing is a good idea, but the economic impact is likely to be modest. Companies pay less tax upfront when they can write off the value of capital expenditures immediately, but incur higher taxes in the future due to the absence of any further depreciation expenses. When interest rates are low, as they are today, the present value gain from shifting tax liabilities around in this way is bound to be small. This, along with the fact that companies can already write off a large share of capital purchases under current law in the first few years after they are made, will limit the benefits of the proposal. The full expensing of capital purchases also expires after five years under the Republican plan. This could cause companies to pull forward capital spending simply to game the tax code. Such a policy could be justified if the economy were depressed, but that is not the case today. The Tax Foundation, a free-market think tank that a number of left-leaning economists have accused of overstating the benefits of tax cuts, estimates that temporary expensing would raise the level of real GDP by only 0.18% after a decade, compared to 1.6% in the case of permanent expensing.3 From Populism To Pluto-Populism Chart 11This Is Not Populism Martin Wolf has aptly referred to Donald Trump as a "pluto-populist" - someone who talks like a champion of the poor and middle class to his adoring supporters, but actually pushes for policies that mainly benefit the wealthiest Americans.4 Many of the proposals in the Republican tax bills - including the abolition of the Alternative Minimum Tax, the phase-out of the estate tax, and the aforementioned reduction in the business pass-through tax - would further skew the distribution of income towards the rich (Chart 11). Indeed, the benefits for the wealthy grow over time under the proposed plans, even as those for the middle class dissipate, eventually reaching the point where the average middle-class household ends up paying more taxes under the House plan than they do now (Chart 12).5 And no, one cannot say that this outcome is simply the inevitable consequence of the fact that the rich pay most of the taxes. Once regressive taxes such as the payroll tax and state and local taxes are included in the tally, the rich pay about the same share of their income in taxes as the middle class (Chart 13). To make matters worse, the Republican tax bill would trigger $25 billion in Medicare cuts and $111 billion in cuts to other government programs under current PAYGO rules. More pain for middle-class voters. Donald Trump was quick to throw Ed Gillespie under the bus after he failed to win the governor's race in Virginia, tweeting that Gillespie "did not embrace me or what I stand for." But the truth is Trump has not embraced Trumpism either. We were widely scorned in the early days of the primary season for saying that Trump would secure the Republican nomination, and mocked again in 2016 for predicting that he would win the presidential election. At this point, however, the odds are high that the Republicans will lose the House next November and Trump will fail to get re-elected in 2020. Chart 12Middle-Class Tax Cuts Will Morph Into Tax Hikes Chart 13U.S. Taxation Not Very Progressive Investment Conclusions U.S. equities are overbought and ripe for a correction. As is almost always the case, lower stock prices in the U.S. will negatively impact global bourses. Fortunately, the selloff is likely to be short-lived, with strong global growth and rising earnings powering stocks into 2018. The passage of tax legislation in the U.S. will face many hurdles, and this is likely to ruffle markets in the near term. Nevertheless, we expect Congress to pass a bill early next year. While lower corporate tax rates will be a boon for Wall Street, the gains to Main Street will be a lot more muted. A higher after-tax rate of return on equity will encourage capital inflows into the U.S. This will bid up the value of the dollar, depressing exports in the process. Over the long haul, a wider budget deficit will soak up private-sector savings that could otherwise have been used to finance investment spending. This will lead to less capital accumulation, and eventually a lower standard of living. Chart 14Inflation Higher In Countries Lacking Independent Central Banks Higher government debt levels will also increase the temptation to inflate away debt. As we discussed a few weeks ago, rising political polarization is affecting every facet of society, with the NFL just being the latest example.6 It is hard to believe that the Fed will remain above the fray. History suggests that the loss of central bank independence is often associated with higher inflation (Chart 14). Such may be America's fate as well. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Robert K. Triest, "The Effect Of Income Taxation On Labor Supply In The United States," The Journal of Human Resources, Special Issue on Taxation and Labor Supply in Industrial Countries, 25:3 (Summer 1990); and Costas Meghir and David Phillips, "Labour Supply And Taxes," IZA Discussion Paper No. 3405 (March 2008). 2 Both the House and Senate versions of the tax bill have a number of provisions to limit the ability of corporations to shift profits abroad, but at present, it is unclear how effective these measures will be. 3 Please see "Economic and Budgetary Impact of Temporary Expensing," Tax Foundation, dated October 4, 2017. 4 Martin Wolf, "Donald Trump Embodies How Great Republics Meet Their End," Financial Times, March 1, 2016. 5 This mainly occurs because the "Family Flexibility Credit" expires after 2022. The expanded Child Tax Credit is also not indexed to inflation under the House plan, implying that its value to tax filers will go down over time. In addition, the repeal of the individual mandate would cause fewer lower-income earners to buy health insurance, leading them to forego the tax subsidies that they would otherwise receive. 6 Please see , "Three Demographic Megatrends," dated October 27, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Broad Chinese equity market performance since last month's Party Congress is consistent with our view that the pace of reforms over the coming year will not cause a meaningful deceleration in China's industrial sector. Stay overweight Chinese stocks. After accounting for idiosyncrasy, divergent sector performance is largely consistent with the stated intentions of Chinese policymakers. Our new China Reform Monitor, which is based on sector performance, should help investors identify whether the pace of reforms is moving too rapidly to be consistent with a benign growth outlook. We are adding two new reform-themed trades this week, and closing one existing position (with a healthy profit). Feature BCA's China Investment Strategy service has presented a relatively benign view of the economic impact of stepped up reform efforts in China over the coming 6-12 months. As we noted in last week's report, while a "status quo" scenario of no significant reforms is highly unlikely over the coming year, the pace of reforms will be structured at a level of intensity that will be sufficient to avoid an outsized deceleration in China's industrial sector. We also highlighted that monitoring reform progress would be an important theme to revisit, and in this week's report we review the response of investors to the Party Congress, both at the broad market and sector level, to judge whether it is consistent with our outlook and positioning. We also introduce two new reform-themed trades, and recommend booking profits on an existing position. Broad Market Performance Post-Congress Before gauging the market's view of the likely impact of refocused reform efforts on the Chinese economy over the coming year, it is worth revisiting what kind of market performance would be consistent with our view. To recap the view of our Geopolitical Strategy service,1 President Xi's reform agenda is likely to intensify over the next 12 months, suggesting that Chinese policymakers will make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth2 Deleverage the financial sector Continue to crack down on corruption and graft From the perspective of BCA's China Investment Strategy service, a rapid and intense pace of these reforms would likely be a net negative for Chinese equities, as well as for emerging markets (EM) and other plays on China's industrial sector. For example, in terms of the impact on Chinese stock prices, we highlighted in last week's report that MSCI China ex-tech earnings have been closely correlated with the Li Keqiang index, which would likely decline non-trivially in the face of a very pressing reform push. In addition, the potential for a policy mistake would presumably raise the risk premium on Chinese equities, which would reverse at least some of their meaningful re-rating vs the global benchmark since late-2015. As such, to be consistent with our view, broad market performance (relative to emerging market or global stocks) should have been largely unaffected in the immediate aftermath of the Party Congress, but somewhat divergent at the sector level, given the likely creation of at least some industry "winners" and "losers" from renewed reforms. For the overall market, Chart 1 shows that this is exactly what has occurred over the past month. The chart presents the relative performance of Chinese equities versus the emerging market (EM) and global benchmarks, both in US$ terms and rebased to 100 on the day of President Xi's speech at the Party Congress. The initial reaction to the speech was modestly negative, with Chinese stocks falling a little over 2% in relative terms versus their global peers. But this loss disappeared less than three weeks following the speech, underscoring that market participants agree with our assessment that a rebooted reform effort will not threaten the economy as a whole. Investors should stay overweight Chinese stocks relative to their benchmark. Chart 1No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth The Sector Implications Of Renewed Reforms Chart 2 shows that the sector effects of President Xi's speech have indeed been more divergent, which is also in line with our perspective of view-consistent performance. The chart shows that the past month's performance of the 11 level 1 GICS sectors relative to the broad market can be grouped into three distinct categories: Chart 2China's Reforms Will Create Some Winners##br## And Losers Clear outperformers, which include health care, energy, information technology, and consumer staples, Neutral to modest underperformers, which include utilities, telecom services, and financials, and Clear underperformers, which include industrials, real estate, consumer discretionary, and materials Several of these results are not surprising, as they clearly resonate with the stated intensions of Chinese policymakers. In particular, the outperformance of health care, technology, and consumer staples stocks and the underperformance of capital-goods intensive industrials straightforwardly reflects the goal of re-orienting "old China" towards a new, consumer-focused economy. While energy stocks are viewed as a traditionally cyclically-sensitive carbon-intensive sector, oil prices have risen over the past month and China's share of global energy consumption is much smaller than that of base metals. However, the relative return profiles of a few sectors mentioned above are at least somewhat counterintuitive. On this front, several observations are noteworthy: At first blush, the significant underperformance of Chinese consumer discretionary stocks is counterintuitive if policymakers are aiming to reduce the country's reliance on investment and increase the share of private consumption. However, as Table 1 shows, Chinese consumer discretionary stocks have likely sold off due to the automobile & components industry group, which is potentially at risk of being negatively impacted by the environmental mandate of President Xi's proposed reforms. The table shows that the automobiles & components industry group accounts for a full 1/3rd of Chinese consumer discretionary market capitalization, which is non-trivially larger than in the case of the global benchmark. Table 1 also highlights that China's retailing industry group is as large as that of automobiles & components, which in theory should have provided an offset to the latter's weakness. However, in market capitalization terms, retailers in the MSCI China index are dominated by two large players, one of which is active in providing corporate travel management services. The continuation and expansion of China's anti-corruption campaign was a key message from the Party Congress, and it would appear that investors are concerned about the potential for anti-graft efforts to negatively impact the demand for goods & services that could be potentially linked to corruption or largesse. The underperformance of the materials sector is seemingly reform-consistent, although here too the details of China's investible indexes matter. Table 2 presents a sub-industry breakdown of the MSCI China materials index, as well as an indication whether rebooted reform efforts are a clear negative for the sub-industry. The table highlights that the likely impact of a renewed reform push is mixed: construction materials firms and copper producers (at least in terms of output) are like to suffer, but there are no obvious negative implications for aluminum,3 gold, and paper products producers. The impact on commodity chemicals producers is ambiguous, given that packaging for consumer goods is a significant end market for the petrochemical industry. Table 1Autos Make Up A Significant Share Of ##br##China's Consumer Discretionary Sector Table 2Impact Of Renewed Reforms ##br##On The Materials Sector Is Mixed Finally, there appears to be at least somewhat of a discrepancy between the benign performance of Chinese financials and the underperformance of the real estate sector. Attempts to curb "excessive" financial risks and debt could certainly hurt the real estate sector, but this would also negatively impact banks via a slowdown in credit growth. For now, the significant valuation gap between Chinese financials and real estate appears to be the only explanation for this divergent performance post Party Congress, but we will continue to watch these sectors for signs of a wider market implication. Sector idiosyncrasies aside, the broad conclusion from China's equity market performance over the past month is that investors acknowledge that there are likely to be winners and losers from a rebooted reform mandate, but that overall economic growth in China is not likely to significantly decelerate. This is consistent with our view that the pace of reform efforts over the coming year will not be so intense as to trigger a meaningful decline in the growth rate of China's industrial sector. But the potential for an aggressive pace of reforms is a clear risk to our view that the ongoing slowdown in China's economy is likely to be benign and controlled. Chart 3 introduces our China Reform Monitor as one way to monitor this risk, which is calculated as an equally-weighted average of the four "winner" sectors highlighted above relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching closely for signs that our monitor is rising largely due to outright declines in the denominator. Chart 3Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Two New Reform-Themed Trade Ideas, And One Trade Closure We have new two trade ideas for investors given the performance of Chinese equities in the wake of the Party Congress: Long investable consumer staples / short investable consumer discretionary Long investable environmental, social and governance (ESG) leaders / short investable benchmark The basis for the first trade stems from our earlier discussion of the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. In addition, while consumer staples stocks are reliably low-beta, they have recently been rising vs consumer discretionary in relative terms despite a rise in the broad investable market (Chart 4). The odds favor a continuation of this trend if a renewed reform push continues to appear likely (i.e., we are banking that this trade will be driven by alpha rather than beta). Chart 4Staples Are A Better Consumer Play Chart 5ESG Leaders Should Fare Quite Well In A Reform Environment The basis for the second trade is to overweight stocks that are best positioned to deliver "sustainable" growth. Our proxy for this trade is the MSCI ESG Leaders index, which favors firms with the highest MSCI ESG ratings in each sector (using a proprietary ranking scheme). The index maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that MSCI's ESG Leaders index has outperformed the broad market by almost 7% per year since 2010, with current valuation levels that are broadly similar to the benchmark. To us, this trade represents an attractive risk-reward profile even if the pace of China's reforms are not aggressive over the coming year. Chart 6Close Our China / DM Materials Trade Finally, we recommend closing our long MSCI China investable materials sector / short developed markets materials trade. A scenario where China continues to shrink the domestic production capacity of metals without significantly curtailing its overall import volume may be modestly positive for global base metals prices, but it would appear that DM materials producers would benefit more from this outcome than Chinese producers (owing to the impact of production constraints on the volume of product sold). While the Chinese material sector remains grossly undervalued versus its DM peer, the bottom line is that the outlook for this trade is cloudier than before at a time when it is correcting sharply from previously overbought conditions (Chart 6). We suggest that investors close the trade for now, booking a healthy profit of 11%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2016, available at bca.bcaresearch.com. 2 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle-income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 In our view, the use of aluminum in transportation is consistent with an environmental protection mandate, given that its light-weight properties allow for reduced energy consumption. For example, in the U.S. in 2014/2015, Ford Motor Company switched the production of the F150 from a steel to an aluminum frame, resulting in a significant improvement in fuel economy. Cyclical Investment Stance Equity Sector Recommendations
Highlights Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Dear Client, Next week on November 20th instead of our regular weekly publication you will receive our flagship publication "The Bank Credit Analyst" with our annual investment outlook. Our regular publication service will resume on November 27th with our high-conviction trades for 2018. Kind Regards, Anastasios Avgeriou Highlights Portfolio Strategy Melting medical care input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. Stay long health care insurers. Pharma and biotech stocks suffer from declining pricing power. Continue to avoid both. As a result, the S&P health care index remains in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities consolidated recent gains as earnings season drew to a close last week. Recent election results coupled with the revealing of the Senate tax bill raised fresh concerns, unwarranted according to our geopolitical strategists, about the likelihood of a bill passage. While such heightened fiscal policy uncertainty is disquieting, solid EPS growth on the back of synchronized global economic and capex growth should sustain the overshoot phase in stocks. Q3 EPS vaulted to a fresh all-time high (Chart 1) and, were it not for two financials sector sub-indexes - reinsurers and multi-line insurers that were severely hit by the one off hurricane catastrophes - financials EPS growth would have been nil from -7.3%, pushing the overall SPX EPS number to 9.2% from 8.1%. Chart 2 shows that the positive EPS surprise factor remained close to the recent average. Going into earnings season, Q3 EPS growth forecasts collapsed to 4.1%, but actual results ended up 400bps higher. Chart 1Earnings-Led Advance Continues Chart 2Surprise Factor In Line With Recent Average While EPS growth cannot stay in the high teens forever, settling down close to 10%/annum EPS growth rate is possible in the near run. The softness in the U.S. dollar along with the basic resource sector commodity-related comeback, synchronized global economic and capex growth and financials contributing more than sell side analysts expect to overall EPS, suggest that such profit growth is attainable in 2018. Tack on the possibility of fiscal easing and sustained lift in animal spirits (bottom panel, Chart 1), and the odds of low double-digit EPS growth increase further. Meanwhile on the monetary policy front, news of Powell's nomination to take the helm at the Fed barely budged the equity market, but some cracks are appearing in the bond market (Chart 3). Keep in mind that going back to Volcker's late-1970s nomination, Fed Chair transitions have been volatile. In fact, the market has tested the resolve of all four previous Fed leaders (Chart 4). As soon as Volcker come into power he had to deal with the early-1980s recession (and the LatAm crisis in 1982) that saw the market fall by 17% from peak to trough. When Greenspan was confirmed Chairman in August of 1987, two months into his tenure Black Monday happened and he had to step in and reiterate the Fed's function as a lender of last resort. In 2006 Bernanke took over from the Maestro, and a recession hit by the end of 2007 that morphed into the Great Recession. Finally in early-2014, Yellen become the Fed Chairwoman and in late-2015 a global manufacturing recession had taken hold resulting in a 14% drawdown in the SPX. Chart 3Watching The Bond Market Chart 4Testing Times Inevitably, the market will test the new Fed Chairman. This expansion has been long in the tooth and given BCA's 2019 recession view, this testing time is at least a year away. This week we reiterate our underweight stance in a defensive sector and highlight its key sub-components. Stick With Managed Health Care Exposure Following a two year hiatus, managed health care stocks broke out in 2017 and the juggernaut has now resumed (Chart 5). While the recent unsuccessful intra-industry M&A attempts (breakdown of both AET/HUM and ANTM/CI deals) were a mild setback, CVS's latest announcement, to take over AET and further vertically integrate, has brought euphoria back to this health care subgroup. We have added alpha to our portfolio as relative performance is up smartly, roughly 24% since our early-April 2016 overweight recommendation, begging the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy (comprising physician and hospital services and medical care commodity inflation) has plummeted by over 350bps from the recent peak (shown inverted, second panel, Chart 5). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside, i.e. the industry's medical loss ratio has room to fall. Not only is our medical care input cost proxy melting, but the latest employment cost index release revealed that managed health care wage inflation is also steadily decelerating (third & bottom panels, Chart 6). Taken together, these two cost categories are heralding a solid industry EPS growth backdrop in the coming months (total cost proxy shown inverted, second panel, Chart 6). Chart 5Melting Costs Are A Boon To Margins... Chart 6...And EPS Importantly, health care insurers are also set to benefit from the Trump administration's push toward lowering drug prices and the proliferation of generic drugs. While drug inflation is positive for the pharma/biotech space, it is an expense incurred by managed care providers and vice versa. The upshot is that the pharmaceutical sector's pain will be the managed health care industry's gain (bottom panel, Chart 5). On the legislative front, the failed attempts to repeal and replace the ACA is positive as the newly enrolled will likely remain insured and underpin recurring industry revenues. As long as costs stay in check, the implication is ongoing earnings improvement. Tack on any relief related to a tax bill passage (the managed care index has a 47% effective tax rate or 24% higher than the overall S&P health care sector, see Table 2) and the path of least resistance is higher for profits. Table 2Tax Relief Potential Despite all of these positives, relative valuation remains muted, hovering near the neutral zone. On a forward P/E basis the S&P managed care index is trading on a par with the S&P 500 (Chart 7). If our thesis of sustained earnings outperformance materializes in the coming quarters, then a valuation re-rating phase looms. In sum, melting input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. This is a recipe for a durable valuation expansion phase. Bottom Line: While we are underweight the broad health care index, our sole overweight remains the S&P managed health care index. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Ailing Pharma We downgraded pharma to an underweight stance on July 31 on the back of weak pricing power fundamentals, soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics. The S&P pharmaceuticals index relative performance is down 5% since then as our bearish profit thesis is validated. Our dual synchronized global economic and capex growth themes bode ill for defensive pharmaceutical stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, middle panel, Chart 8). A depreciating currency is also synonymous with pharma profit ails (bottom panel, Chart 8). Historically, a soft U.S. dollar has been closely correlated with global growth, whereas greenback strength tends to slowdown the global economy. In that context, pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases. However, pharma exports are contracting at an accelerating pace (top panel, Chart 8) despite the U.S. dollar's year-to-date softness, warning that global pharma demand is sick. Importantly, the news on the pricing power front is disconcerting. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam. In the context of a bloated industry workforce, the profit margin outlook darkens significantly (Chart 9). If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Worrisomely, were pharma prices to continue to trail overall corporate sector price inflation, as we expect, then the de-rating phase in the S&P pharmaceuticals index has a long ways to go (bottom panel, Chart 9). Finally, even on the operating metric front, the news is mostly grim. Pharma industrial production is nil and our pharma productivity proxy remains muted, warning that profits will likely underwhelm. Industry retail sales growth is also flirting with the zero line and pharma inventories have resumed growing on a short-term rate of change basis across the supply channel. Pharma shipments offer the only ray of hope. But the recent acceleration in the latter may be the result of the hurricane-related catastrophes (Chart 10). Chart 8Counter Cyclical With##br## No Export Relief Chart 9Weak Pricing Power And Bloated##br## Cost Structure Weighs On Margins Chart 10Operating Metrics ##br##Are Also Feeble Netting it out, pharma profit growth is on track to continue to disappoint as the confluence of synchronized global growth, softening U.S. dollar, pricing power losses and deteriorating operating metrics are all profit headwinds. Bottom Line: We reiterate our late-July downgrade in the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. A Few Words On Biotech Biotech stocks are another casualty of weakening pharmaceutical wholesale price inflation, and given that the industry's profits move neck-and-neck with their pharma siblings, revenue and EPS growth are bound to continue to surprise to the downside (Chart 11). We expect such profit woes will weigh on the S&P biotech index relative performance, and re-iterate our high-conviction underweight status. Chart 11Biotech Equities Hate Higher Rates Chart 12Technicals Say Sell Not only are biotech firms modestly concealed Big Pharma, i.e. they manufacture multi-billion dollar blockbuster drugs, and the Trump administration's scrutiny of drug price inflation is a profit negative, but also a rising interest rate backdrop is working against this health care sub-index. Historically, rising interest rates have been inversely correlated with biotech stocks. High flying valuations tend to gravitate back to earth when the Fed embarks on a tightening cycle. The opposite is also true. BCA's U.S. Bond Strategy view remains that in the coming 12 months interest rates will be higher, moving closer to the 3% mark on the 10-year Treasury yield front. If such a selloff materializes in the bond market, then investors will abandon biotech stocks in a heartbeat (Chart 11). Chart 13Heed The EPS Growth Model Signal Meanwhile, according to empirical evidence since the mid-1990s, relative momentum in biotech stocks is nearly perfectly inversely correlated with the global credit impulse (Chart 11). This negative correlation has become more pronounced in the past decade underscoring the non-discretionary/defensive nature of large biotech outfits. In other words biotech stocks behave like counter-cyclicals similar to their pharma brethren. Given BCA's view of a recession hitting some time in 2019, we recommend investors still avoid biotech stocks. Finally, technicals are also waving a red flag. Chart 12 shows that a head-and-shoulders formation has taken root and were the neckline to give way in the coming weeks, relative performance would suffer a substantial setback. Bottom Line: Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY. Health Care Sector Implications What does all this mean for the broad S&P health care sector? Our relative profit growth model best encapsulates these forces and is signaling that profits will remain downbeat into 2018 (Chart 13). Managed health care stocks (overweight) comprise 13% of the index, while pharma (underweight) and biotech (underweight) market capitalization weights both add up to 54% of the total. As a result of our intra-sector positioning and given our neutral weightings in the remaining health care sub-indexes, we continue to recommend a below benchmark allocation in the S&P health care index. Bottom Line: Stay underweight the S&P health care sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights China's mini-cycle has peaked, which has raised concerns among global investors that China may return to below-trend growth over the coming year, similar to what occurred in 2015. In our view, the severe slowdown in the Chinese economy in 2015 was due to overly tight monetary policy coupled with a severely weak external demand environment. A monetary conditions approach has done an excellent job of predicting industrial activity in China over the past several years. While monetary policy has tightened somewhat since the beginning of the year, none of the monetary conditions indexes that we track have come close to returning to 2015 levels. In short, an uncontrolled and sharp deceleration in the Chinese economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Feature Last week's report was replaced by a Special Report prepared by my colleague Matt Gertken, Associate Vice President of our Geopolitical Strategy team.1 The report presented a full "postmortem" on the Party Congress, and outlined how stepped up reform efforts in China are likely over the coming year, and beyond. By "reforms", our geopolitical team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. The implications of the "reform reboot" scenario presented in last week's report are negative for emerging markets (EM) and other plays on China's industrial sector (such as industrial metals). We agree that a "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector, even though the momentum of China's "mini" economic cycle of the past two years has very likely peaked. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity is a risk to our view that the slowdown in China's economy is likely to be benign and controlled. Monitoring reform progress is likely to be a key theme for this publication over the coming year. Over the nearer term, the potential impact of reform efforts is not the only risk to the economy, as many market participants appear to be worried that the peak in China's mini-cycle presages a destabilizing decline in economic activity. This week's report is the second of two parts examining the key differences facing China today from what prevailed in mid-2015,2 when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In Part II we focus on monetary policy, and outline how the monetary environment remains stimulative despite a significant rise in corporate bond yields over the past year. China's Monetary Policy Stance: A Brief Review Chart 1 presents the one-year policy lending rate over the past decade, and highlights the four distinct phases that have prevailed since the global financial crisis in 2008: Chart 1A Brief Review Of China's Monetary Policy Stance A long period of significant easing that began during the Great Recession and lasted until late-2010 A material rate tightening cycle that began in late-2010 and ended in mid-2012 A half-reversal of the 2011/2012 rate cycle, which happened quickly in the summer of 2012 and was followed by a long pause until late-2014, and A significant series of rate cuts over the course of 2015, followed by a 2-year pause at current levels. We contend that policymakers were too timid in responding to economic weakness in China at the end of the third monetary policy phase highlighted in Chart 1, and that this hesitation magnified the impact of the serious deterioration in China's external demand environment that we discussed in Part I of this report. Chart 2Monetary Conditions Predict ##br##Chinese Industrial Activity Of course, in a large, trade-sensitive, economy like that of China, interest rates are not the only determinant of the degree of monetary accommodation. In order to capture the effects of the exchange rate and other factors affecting the efficacy of monetary policy, we have tended to show a Monetary Conditions Index (MCI) as a stand-in for the policy stance. As shown in Chart 2, the Bloomberg MCI has done an excellent job of leading industrial activity in China over the past several years, particularly during the mini-cycle of the past two years. While the MCI appears to have peaked early this year, it remains well above (i.e. more accommodative) the levels reached in mid-2015 when policymakers finally became serious about easing monetary conditions. Looking Forward Chart 3 presents a few alternative MCIs for China alongside Bloomberg's measure. Analysts tend to employ a variety of approaches when calculating monetary conditions indexes, but the real interest rate and the real effective exchange rate almost always feature prominently. Of the three alternative measures, Citigroup's MCI is the most bearish, as it includes the year-over-year growth rate of M2 which has recently languished. The remaining two measures are BCA calculations, one that deflates interest rates using producer prices, and one that uses core consumer prices. Both of our measures employ an equal split between the real interest rate and the exchange rate. Chart 3 highlights that all four MCIs have either peaked or are now falling, suggesting that a tightening in financial conditions earlier this year has somewhat reduced the degree of monetary accommodation to the economy. However, there are three key points to consider when judging the likely impact of monetary tightening on China's economy over the coming 6-12 months: None of the MCIs shown in Chart 3 have returned to their 2015 low, implying that the policy tightening that has occurred over the past year is not likely to cause Chinese industrial activity to crash in over the coming 6-12 months. Most of the appreciation in the RMB this year has occurred versus the dollar, not against the euro or in trade-weighted terms (Chart 4). In fact, in trade-weighted the RMB remains 6.5% below where it was in August 2015 prior to the currency devaluation. This highlights that the recent appreciation largely reflects dollar weakness, rather than policy-induced strength in the RMB. Chart 3Monetary Conditions Have Not Returned##br## To 2015 Levels Chart 4Recent RMB Appreciation##br## Reflects Dollar Weakness Average lending rates have only increased approximately 40 bps over the past year, in comparison to the 200 bps of easing that occurred from 2014 to 2016 (Chart 5). In real terms (when deflated by core consumer prices), average interest rate have barely risen at all this year. The still modest rise in average lending rates is an important consideration, because it contrasts with the rise in Chinese bond yields, both in the government and corporate sectors. For example, Chart 6 shows that corporate bond yields have risen by 160 bps since late-2016 and are 25 bps higher than they were in early-2015. Chart 5Average Lending Rates ##br##Have Risen Only Modestly Chart 6Corporate Bond Yields##br## Have Tightened Materially But our view is that average lending rates are a more important driver of debt service payments for China's non-financial sector. In fact, Table 1 highlights that while corporate bond financing is a growing component of Chinese private social financing, it is still quite small. The table presents a breakdown of adjusted social financing, which highlights that the sum of local currency loans, foreign currency loans in RMB, trust and entrusted loans equals roughly 85% of total social financial excluding equity issuance. Corporate bonds, by contrast, account for only about 10%, suggesting that the economic impact of the rise in bond yields this year will be relatively small. Table 1Corporate Bonds Account For A Small Percent Of China's Social Financing Investment Implications We noted in our October 12 Weekly Report that the acceleration in the Chinese economy that began in mid-2015 has likely peaked (Chart 7), ending the upswing of this "mini" economic cycle. Chart 7A Stylized View Of China's Recent The framework illustrated in Chart 7 presented three distinct scenarios for China over the coming 6-12 months: A re-acceleration of the economy and a continuation of the V-shaped rebound profile, A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse). In our view, the Chinese economy in early-2015 began to operate below the "stable" growth range shown in Chart 7, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. While our research suggests that China's export growth will moderate over the coming year and that monetary conditions have tightened somewhat, the magnitude of these changes are not sufficiently large to return the Chinese economy back to 2015-like conditions. To us, this is consistent with the second scenario presented above. From an absolute equity perspective, this conclusion is positive for Chinese stock prices. Chart 8 highlights that the Li Keqiang index correlates fairly well with the growth in earnings for the MSCI China index ex technology; a moderate decline in the pace of growth in China's industrial sector would blunt the earnings growth of these firms, but not enough to cause an outright contraction. The combination of positive ex-tech earnings growth and very cheap valuation (Chart 9) suggests that the absolute uptrend in Chinese ex-technology stocks that began at the beginning of 2016 is likely to continue. Chart 8Ex-Tech EPS Growth Will Moderate, ##br##But Not Contract Chart 9Excluding Technology, ##br##China Is Extraordinarily Cheap In relative terms, the picture is somewhat cloudier, although for now we would continue to favor the China MSCI index versus global and emerging market stocks. Chart 10 highlights that Chinese equities have outperformed global stocks even when excluding tech companies, although it is clear that most of the recent outperformance is due to the IT sector. On the earnings front, while we expect Chinese ex-tech earnings growth to moderate over the coming year, this is also true of overall U.S. equities (Chart 11). Finally, Chart 12 highlights that while Chinese technology firms are richly priced vs their global counterparts, the multi-year relative outperformance trend has been fundamentally-driven, a situation that does not appear to be threatened by a slowdown in China's industrial sector (given the largely domestic & consumer orientation of Chinese technology firms). Chart 10China Is Beating Global,##br## Even Excluding Technology Chart 11U.S. Earnings Growth##br## Is Set To Moderate Chart 12China's Tech Rally Is ##br##Fundamentally-Driven Bottom Line: The economic momentum of China's 2-year mini-cycle has probably peaked, but an uncontrolled and sharp deceleration in the economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Report, "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart of the WeekChina Developments Significant##BR##To Base Metal Prices Reading the tea leaves following China's 19th National Communist Party Congress suggests a looming shift in President Xi Jinping's second term from pro-growth to pro-reform. Having consolidated power, Xi now has the capacity to implement his agenda over the next five years. Given China's outsized role in global base metals production and consumption, the direction of Xi's policy changes will have a profound impact on these markets (Chart of the Week).1 The Party Congress set the tone for economic policy and reforms going forward, from which we can extrapolate future policy direction. However, concrete plans and details will not be revealed until the National People's Congress, scheduled in March 2018. In this report we highlight the main takeaways of the Congress specifically those relevant to base metals. Broadly, these can be summarized as: Xi now has the political capital needed to implement real reform in his second term. Based on Xi's remarks at the Congress during his work-report commentary, we believe the environmental and supply-side reforms initiated during his first five-year term will be continued in his second term. Because these reforms will shrink the domestic production capacity for base metals and steel in China, they likely will be a tailwind for these commodities' prices. However, a focus on sustainable growth - i.e., organic growth that is not dependent on regular injections of credit to keep it going - and the elimination of GDP targets past 2021 risk weighing down base metals demand. Real-estate market fundamentals are more supportive than most perceive. This will prevent tighter policies from triggering a significant construction downturn, which will be supportive for steel and copper prices. China's efforts to expand its economic influence globally through the Belt and Road initiative (BRI) will be insufficient in offsetting a mainland slowdown, should one occur. Feature Balancing Stability And Reform Chart 2Stability Was A Priority...Not Anymore Despite reiterating a need for economic reforms, the focus of Xi's first term was maintaining stability and garnering the political capital necessary to implement his desired reforms. Emphasizing stability is a recurrent theme in Chinese politics, regardless of who is at the helm. The 2015-16 state interventions in the economy - including higher infrastructure spending, provincial government bailouts, currency depreciation and capital controls - illustrated the dominance of stability over reforms, during Xi's first term (Chart 2).2 The 19th Party Congress was the capstone event in Xi's effort to accumulate the support needed to implement long-sought reforms. BCA's Geopolitical Strategy points to three outcomes that support this assessment: With the inscription of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era in China's constitution, the president has cemented his position as one of the most powerful leaders of modern China. In fact, according to our geopolitical strategists, this induction signals that he is "second only to Chairman Mao as a philosophical guide in the party."3 Practically speaking, this means his economic initiatives will carry more weight than anything China has seen since at least the 1998-99 intense reform period. The leanings of members of the new Politburo Standing Committee (PSC) also are telling. Each of the three most recent presidents is represented by two protégés on the PSC. This is an almost-ideal configuration for reform.4 Finally, the appointment of Xi loyalist Zhao Leji as chief of the Central Commission for Discipline Inspection (CDIC), and the creation of the National Supervisory Commission to oversee the anti-corruption campaign give Xi the tools he needs to implement his policies. Thus, Xi has garnered sufficient ammunition to be much more effective in implementing reform policies during his second term. As such, we expect the pace of reform to accelerate. While the policy details are yet to be known, many of the takeaways from the party congress point toward supply- and demand-side changes. Supply-Side Reforms: Short-Term Sacrifice For Long-Term Benefit? While the aim for environmental regulation is not new - an "ecological" section was included in the work report for the first time by Xi's predecessor Hu Jintao in 2012 - we have reason to believe that, given Xi's focus on sustainable development, he will tackle environmental policies with more fervor than in the past. This signals that Xi may prioritize environmental preservation and pollution-reduction measures going forward, which would continue the efforts begun in his first term. In fact, environmental spending was the fastest growing category in central-government spending at the beginning of Xi's first term (Table 1). Table 1Xi Jinping Favors A Greener China Xi's environmental agenda will get an assist from his anti-corruption campaign. Our Geopolitical strategists highlight Xi's use of the CDIC - the anti-corruption watchdog - in enforcing the reforms as a signal of his resolve to implement change. The stakes are high for noncompliant managers who now risk not only financial penalties, but also arrest and jail time. Chart 3Shifting Gears: From Pro-Growth To Pro-Reform This reinforces the message that Xi is still keen on implementing the supply-side structural reforms first announced in 2015, and that he is willing to change the old-line economic model, forgoing potential growth drivers from traditional industries in favor of greener sectors (Chart 3). As the leading base metals producer in the world, a continuation - and potential intensification - of these reforms will weigh on global production and prop up base metal prices, as they have since last year. In fact, some of these reforms have already materialized in the form of earlier-than-anticipated winter production cuts. Steel production in Tangshan - China's largest steel-producing city - will be halved over the winter, with three other top steel producing cities - Shijiazhuang, Anyang, and Handan - expected to announce similar cuts.5 Similarly, the government of Shandong - a major producer of alumina and aluminum - recently instituted a crackdown program that includes production cuts during the winter months.6 Bottom Line: Xi used his platform at the Party Congress to reiterate his resolve to set China's economy on a more sustainable growth path through supply-side reform. Given that he has accumulated the political capital necessary to implement these changes, we expect to see a renewed push toward a "greener" China. Ceteris paribus, this will weigh on base metals production by reducing global supply and will support prices. "Houses Are Built To Be Inhabited, Not For Speculation" During the party congress, Xi reiterated his resolve to tighten control of the real estate market. In fact, the Chinese government has been trying for years to rein in demand for real estate, which typically involves raising mortgage rates. Tightening measures announced in late September include controls on home sales in eight major cities, which, among other things, prevent the resale of homes within five years of purchase. These controls have weighed on both prices and sales of real estate (Chart 4). More recently, the Ministry of Housing and Urban-Rural Development and the National Development and Reform Commission announced that they will jointly inspect real estate developers and commercial property sales agents, looking for "irregularities," including artificially inflating prices and hoarding unsold homes.7 Nonetheless, our China Investment Strategy desk does not foresee a major slowdown in construction activity.8 Simply put, they argue that strong demand amid declining inventories will prevent a construction slowdown, even in face of tighter policies (Chart 5). In fact, they do not see much excess in China's current property market to begin with, and thus doubt we will witness a major downturn. This will be important to bear in mind going forward, given that construction is the most important source of demand for base metals - copper in particular - and steel in China, accounting for about one-third of copper demand and half of steel demand. Chart 4Real Estate Policies Weigh##BR##On Prices And Sales Chart 5Housing Destocking Becomes Advanced Fundamentals##BR##Will Prevent A Major Real Estate Downturn Bottom Line: Despite efforts to tighten the property market, a sharp downturn in the construction sector, which is a major metals consumer, is unlikely. Structural tailwinds - most notably from China's continued urbanization - will eventually prevail, and the construction sector will remain a major contributor to China's economy, and base metals and steel consumption. Quality Over Quantity: Deleveraging The renewed focus on "sustainable and sound" growth, especially given the elimination of GDP growth targets beyond 2021, elevates the risk of a potential economic slowdown. The Xi administration has signaled that it is not afraid to prioritize financial regulation - targeting excessive risk and under-regulation - over economic growth. It is likely that it will continue doing so. In fact, Xi singled out systemic financial risk as a hazard to overall stability. While this is not China's first time to announce a deleveraging campaign, given that Xi has consolidated power and will use the CDIC to implement reforms, we expect these efforts to be more effective this time around. Furthermore, China has bounced back from the 2015 - 16 deflationary spiral so well that interest rate hikes and tighter financial controls are now on the table (Chart 6). Chart 6Interest Rate Hikes Are Now On The Table While the reforms are expected to improve Chinese productivity in the long-run, they may shake up the economy in the short run. We are somewhat reassured by the fact that traditionally, Chinese leaders have boosted fiscal spending when faced with slowing credit growth in periods when they aim to combat the negative effects of supply-side structural reforms and deleveraging. However, we remain cautious that, as Xi's priorities have shifted, fiscal stimulus may not be used with the same enthusiasm going forward. Given China's outsized role as a consumer of base metals, a slowdown would have serious repercussions on global markets. Researchers at the IMF find that surprises in the strength of China's economy - measured as the scaled deviation of year-on-year industrial production growth from the median Bloomberg consensus estimates immediately prior to the announcements - have significant impacts on base metals prices.9 This is true for all metals they studied - copper, nickel, lead, tin, and aluminum - with the exception of iron ore, which they put down to the relatively recent financialization of iron ore markets. In fact, they find that the more important China is to a specific base metal's fundamentals, the stronger the impact on prices. Using China's import share as a percent of world total as their measure of China's footprint in each individual market, they find that copper is most impacted by Chinese IP shocks, followed by nickel, lead, tin, and aluminum.10 Bottom Line: Beijing is continuously reassuring markets it will push for reforms - in the form of deleveraging the financial sector, restructuring industry, eliminating overcapacity, and environmental controls - without sacrificing growth. Nonetheless these reforms, which we believe are forthcoming following Xi's consolidation of power post-19th Congress, will be headwinds to growth. It is true that Xi may be willing to tolerate slower growth going forward in order to see his policies go through. Yet in all likelihood, fiscal stimulus will be used if social stability is threatened by reform measures. That said, reform is definitely in the cards. The Revival Of China's Silk Road - Enshrined In The Constitution Along with supply-side reforms, the Belt and Road initiative (BRI) - Xi's solution to a global slowdown through the physical integration of China's trading partners - was written into the constitution. This is a reiteration of Xi's intent to shift China away from being the factory of the world and toward playing a key role in global development. The ambition of the BRI plan is to connect many of China's trading partners in Asia, Europe, the Middle East, and Africa through a modern infrastructure of roads, ports, railway tracks, pipelines, airports, transnational electric grids, and fiber-optic lines. The objectives of the project, although speculative, are believed to be two-fold: It is an opportunity to create new markets for Chinese goods - giving the Chinese economy a push even in the event of a mainland slowdown. This is especially relevant, given the need to export excess capacity, most notably in the cases of steel and cement. In fact, Chinese industrial production will also benefit from the secondary effects of an improvement in demand for consumer goods from countries receiving economic aid from China. Furthermore, Xi hopes the project will help revive the economies of China's border regions. There is a possible ancillary benefit, in that heavy industry - e.g., steel mills and aluminum smelters - could be moved away from population centers to support the BRI. Chart 7BRI Investments On The Ascent Policymakers foresee the project - which was initiated in 2013 - injecting an estimated $150 billion annually into the construction of massive amounts of infrastructure (Chart 7). BCA's Frontier Markets Strategy (FMS) projects the value of Chinese BRI project investments will reach $168 billion in 2020.11 While this would boost China's economy in general, and base metals, steel and iron ore demand in particular, our FMS strategists argue that at ~ $102 billion, China-funded BRI investment expenditure in 2016 is dwarfed in comparison to China's gross fixed-capital formation (GFCF), which amounted to ~ $4.8 trillion last year. Simply put, the BRI is incapable of offsetting a general slowdown in China, were it to occur. In fact, our FMS desk estimates that a 0.4% contraction in GFCF is all that will be needed to offset BRI-related investments in 2018. Bottom Line: With the Belt and Road Initiative written into the constitution, we expect greater follow-through directed toward meeting the goals specified in it. On its own, this is positive for base metals, which will benefit from greater demand from infrastructure projects, as well as the secondary effects in the form of demand for consumer goods from trading partners. However, the BRI, in and of itself, will not super-charge base metals demand. The BRI will counteract some of the negative impacts of a slowdown in China growth on commodity markets generally. However, since the size of BRI investment expenditure accounts for only a small fraction of China's fixed capital formation, we are skeptical of the extent to which it can offset a slowdown, were it to occur in the mainland. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In our modelling of base metal prices, we find China's PMI has a large and significant impact on metal prices. Using year-on-year growth rates since 2010, a 1% increase in China's PMI is associated with a 0.54% increase in the LMEX base metals price index. 2 Please see BCA Research's Geopolitical Strategy's Special Report titled "China: Party Congress Ends...So What?," dated November 1, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report titled "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 4 Li Keqiang and Wang Yang are both from Hu Jintao's Communist Youth League, Han Zheng and Wang Huning are Jiang Zemin followers, and Li Zhanshu and Zhao Leji are Xi Jinping loyalists. 5 While this is positive for steel prices, it would dampen demand for iron ore, weighing down on its prices. 6 Alumina, aluminum, and carbon producers that meet emission discharge standards are ordered to cut production by over 30%, around 30%, and over 50%, respectively. Producers that do not meet emission discharge standards are ordered to halt production. 7 Please see "China to launch nationwide inspection on commercial housing sales," published October 25, 2017, available at www.chinadaily.com.cn. Noted "irregularities" include fabricating information on housing sales, publishing fake advertisements and artificially inflating housing prices, market manipulation, and hoarding unsold homes. 8 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 9 Please see IMF Spillover Notes, Issue 6 "China's Footprint in Global Commodity Markets," published September 2016, available at www.imf.org. 10 Interestingly, given the U.S.'s role as a harbinger of the global economy, U.S. IP surprises have a similar impact on commodity prices. 11 Please see BCA Research's Frontier Markets Strategy Special Report titled "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?," dated September 13, 2017, available at fms.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016