Government

No Panic From Powell

Highlights Duration: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. The Fed & Financial Conditions: The recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. The Fed & The Labor Market: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Feature Chart 1Bearish Trend Intact The bond bear market rages on. The Bloomberg Barclays Treasury Index returned -1.8% in February, its worst monthly performance since 2016. The sell-off then continued through the first week of March, culminating with the 10-year Treasury yield touching 1.56% as of Friday’s close (Chart 1). The 5-year/5-year forward Treasury yield ended the week at 2.41%, near the top-end of primary dealer estimates of the long-run neutral fed funds rate (Chart 1, bottom panel). We don’t want to catch a falling knife, but eventually, yields will look attractive enough for us to increase our recommended portfolio duration. To help us make that decision, we unveiled a Checklist For Increasing Portfolio Duration in our February Webcast (Table 1).1 Table 1Checklist For Increasing Portfolio Duration This week, we check-in with our Checklist, concluding that it is still too early to increase portfolio duration. Checking-In With Our Duration Checklist Chart 2Cyclical & Valuation Indicators The first item on our Checklist is the 5-year/5-year forward Treasury yield reaching levels consistent with survey estimates of the long-run neutral fed funds rate. As noted above, this condition has been met. Second, we would like to see survey-derived measures of the 10-year term premium reach extended levels. Specifically, we’d like to see them approach their 2018 peaks (Chart 2). Currently, our two measures are sending diverging signals. The term premium derived from the New York Fed’s Survey of Market Participants is 60 bps, only 15 bps off its 2018 peak. However, the term premium derived from the New York Fed’s Survey of Primary Dealers is only 22 bps, 53 bps off its 2018 peak. For now, our assessment is that this condition has not been met. It’s important to note that the surveys used to construct our two term premium measures and to obtain our fair value range for the 5-year/5-year forward Treasury yield have not been updated since January, and that they will be revised ahead of this month’s FOMC meeting. If primary dealers and market participants revise up their fed funds rate expectations, then our valuation measures will give the 10-year yield more room to rise. Third, we continue to track high-frequency cyclical economic indicators like the CRB/Gold ratio (Chart 2, panel 3) and the relative performance of cyclical versus defensive equity sectors (see section titled “The Fed’s Approach To Financial Conditions” below). These measures have yet to show any signs of deterioration, consistent with an environment where bond yields should be rising. Fourth, if current trends continue, we are concerned that US yields may rise too far compared to yields in the rest of the world. This could entice foreign inflows into the US bond market, sending yields back down. Historically, bullish sentiment toward the US dollar is a good indicator of when US yields have risen too far. At present, dollar sentiment remains extremely bearish (Chart 2, bottom panel). This suggests that we are not yet close to the point when foreign purchases will push US yields lower. Finally, we consider the market’s fed funds rate expectations relative to the Fed’s most recent forecast, as inferred from its quarterly “dot plot”. Currently, the market is priced for Fed liftoff to occur in January 2023, with a second rate hike delivered in May 2023 and a third in October 2023 (Chart 3). This is considerably more hawkish than the Fed’s median forecast from December, which called for no rate hikes until at least 2024! Chart 3Market Expects Liftoff In January 2023 We think it’s conceivable that economic conditions could warrant Fed liftoff in late-2022 (see section titled “Tracking Payrolls And The Countdown To Fed Liftoff” below), but the Fed will probably be more cautious about how quickly it brings its expected liftoff date forward. FOMC participants will have an opportunity to push back against the market when they update their funds rate forecasts at this month’s meeting. The Fed will likely bring forward its anticipated liftoff date, but probably not all the way to January 2023. This could halt the uptrend in bond yields, at least for a while. Bottom Line: Only 2 of the 5 items on our Checklist For Increasing Portfolio Duration have been checked. We will heed this message and stick with below-benchmark portfolio duration for the time being. We will have an opportunity to re-assess the items on our Checklist after the March FOMC meeting when the Fed’s interest rate forecasts will be updated. Other surveys used in the construction of our term premium estimates and 5-year/5-year yield targets will also be updated around this time. The Fed’s Approach To Financial Conditions Chart 4Financial Conditions Are Easy Remarks from Fed Chair Jay Powell were a catalyst for higher bond yields last week. Apparently, there had been some expectation in the market that Powell would use his platform to express concern about the recent increase in long-maturity bond yields. In fact, many expected him to foreshadow changes to the Fed’s balance sheet policy, either extending the maturity of its ongoing asset purchases or initiating an Operation Twist, where the Fed sells short-dated securities and buys long-dated ones.2 Powell didn’t announce any of these things. In fact, he didn’t even express concern about the recent rise in long-dated yields despite being given several opportunities to do so. To understand why, we need to understand how the Fed thinks about financial conditions. The Fed only cares about conditions in financial markets to the extent that they are expected to influence the real economy. This means that the Fed takes a broad view of financial conditions, including bond yields, credit spreads and equity prices. From this perspective, financial markets do not currently pose a risk to the economy (Chart 4). Yes, long-dated bond yields have risen, but short-dated yields remain low. Credit spreads also remain very tight and equity prices have only dipped modestly from high levels. The Chicago Fed’s broad index of financial conditions shows that they are extremely accommodative (Chart 4), and thus support continued economic recovery. This financial market back-drop is not one that will cause the Fed to take additional actions to ease policy. Even the recent drop in the stock market appears to be more a reflection of economic optimism than a cause for concern. Looking at the performance of different equity sectors, we find that the sectors that stand to benefit from the end of the pandemic and economic re-opening are surging. Meanwhile, the sectors that are performing poorly are simply giving back some of the huge gains that were realized when the pandemic was raging last year. For example, cyclical sectors (Industrials, Energy and Materials) are soaring while defensive sectors (Healthcare, Communications, Consumer Staples and Utilities) have hooked down (Chart 5A). The ratio between the two remains tightly correlated with the 10-year Treasury yield. Similarly, Bank stocks have exploded higher since bond yields troughed last fall while the Technology sector has had difficulty making further gains (Chart 5B). Last year, the Tech sector benefited from low bond yields and surging demand. This year, Banks stand to profit from higher yields and an improving labor market. Finally, our US Equity Strategy team put together a basket of “COVID-19 Winners” designed to profit from the pandemic and a basket of “Back To Work” stocks designed to benefit from economic re-opening. Not surprisingly, the former is dragging the S&P 500 lower while the latter is on a tear (Chart 5C). Chart 5ASector Rotation: Cyclicals Vs. Defensives Chart 5BSector Rotation: Banks Vs. Tech Chart 5CSector Rotation: COVID Winners Vs. Re-Open Winners The bottom line is that the recent dip in the stock market is not the result of investors pricing-in worse economic outcomes. Rather, it is a sector rotation driven by extreme economic optimism. It is certainly not a concern for the Fed. Other Reasons For The Fed To Change Its Balance Sheet Policy In addition to concerns about a drop in the stock market, several other reasons have been given for why the Fed might consider either increasing its asset purchases or shifting them toward the long end of the curve. 1) Treasury Market Liquidity Chart 6Treasury Market Liquidity First, there is an ongoing tension in the Treasury market between imposing stricter capital regulations on dealer banks and ensuring that they have enough balance sheet capacity to maintain Treasury market liquidity during periods of stress.3 This delicate equilibrium broke down last March when Treasury market liquidity evaporated at a time when both equities and bonds were crashing. The Fed was forced to step into the Treasury market to sustain market functioning. Last week’s Treasury sell-off had a whiff of illiquidity about it as well. One liquidity index that measures the average curve fitting error across all government bond yields increased slightly, but not nearly as much as it did last March (Chart 6). Treasury bid/ask spreads also widened a touch, but unlike last March, Treasury ETFs continued to trade close to their net asset values. A significant deterioration in Treasury liquidity would prompt a quick response from the Fed. That is, the Fed would quickly ramp up purchases to restore market functioning. However, last week’s blip was not nearly severe enough to raise alarm bells. Other periods of Treasury market stress that have prompted the Fed to step in have occurred during periods of extreme economic deterioration and market panic, such as in March 2020 and 2008. With economic growth accelerating rapidly, we place low odds on a major Treasury market liquidity event occurring this year. 2) Expiry Of The SLR Exemption Chart 7Reserve Supply Is Massive A second possible reason for the Fed to change its balance sheet policy is the upcoming expiry of the exemption to the Supplementary Leverage Ratio (SLR). The SLR is a regulation that requires large banks to hold common equity capital totaling at least 5% of assets. Assets are not risk-weighted for the purposes of the SLR. A problem arose with the SLR last March when the Fed bought massive amounts of bonds, flooding the banking system with reserves (Chart 7). The problem is that banks are forced to hold those reserves, and this makes it more difficult for them to meet their SLR requirement. To alleviate the problem, the Fed announced that reserves and Treasury securities would be exempted from the SLR calculation. Today, the issue is that this exemption is scheduled to expire at the end of March and the Fed has yet to announce whether it will be extended or allowed to lapse. Table 2US Bank Supplementary Leverage Ratios If the exemption lapses, then banks may try to unload Treasury securities to remain compliant with the SLR. In theory, this could lead to upward pressure on Treasury yields that the Fed could mitigate by ramping up its asset purchases. However, it’s unclear how much of an impact a lapsing of the SLR exemption would actually have on the Treasury market. Even adjusting for a lapsing of the exemption, all major US banks remain compliant with the 5% SLR (Table 2). Also, banks could always decide to increase their SLRs by reducing share buybacks rather than by shedding Treasuries. In any event, an increase in Fed asset purchases to lean against rising Treasury yields driven by bank selling would be counterproductive. It would only flood the banking system with more reserves, making the SLR even more difficult to meet. Our view is that a fair compromise would be for the Fed to continue the SLR exemption for bank reserves, but to allow the Treasury security exemption to lapse. But even if the SLR exemption is allowed to lapse completely, we doubt that it will lead to enough market turmoil to prompt a change in the Fed’s balance sheet strategy. 3) Supply/Demand Imbalance In Money Markets Finally, some have noted that the large and growing supply of bank reserves could lead to problems in money markets. Specifically, with the Treasury Department now in the process of paying down its cash account (Chart 7, bottom panel), there is a lot of cash flooding into money markets and coming up against limited T-bill supply. In theory, the Fed could try to mitigate this problem by engaging in an Operation Twist – selling some T-bills and buying some coupon bonds. But we doubt this will occur. The Fed already has tools in place to maintain control over short rates in such circumstances. For example, the same situation arose in 2013 when an over-supply of bank reserves pushed short rates down toward the bottom of the Fed’s target range (Chart 8A). The Fed’s response was to create the Overnight Reverse Repo Facility (ON RRP). This facility allows counterparties to park excess cash at the Fed in exchange for a security off the Fed’s balance sheet. This proved to be an effective floor on repo rates and the fed funds rate, and we expect it will be again (Chart 8B). Chart 8AFed Created ON RRP In 2013... Chart 8B... It Remains A Firm Floor On Rates T-bill yields remained below the ON RRP rate for some time in 2014 and 2015, and the same thing could happen again this year. But this will not be a major concern for the Fed as long as it maintains control over the fed funds rate and the overnight repo rate. Eventually, the Treasury Department can deal with the lack of bill supply by increasing the amount of T-bill issuance. Bottom Line: Treasury market liquidity remains an ongoing concern for the Fed, and the possible expiry of the SLR exemption and lack of T-bill supply present additional near-term technical challenges. We think it’s unlikely that any of these things will prompt the Fed to deviate from its current pace and composition of asset purchases in 2021. Tracking Payrolls And The Countdown To Fed Liftoff Chart 9The Fed's Maximum Employment Targets Employment growth surprised to the upside in February as 379 thousand jobs were added to nonfarm payrolls. This sent bond yields higher, but we caution that even stronger employment growth will be required to keep bond yields rising going forward. The Fed needs to see a return to “maximum employment” before it will lift rates off the zero bound. This means not only that the unemployment rate will have to fall to a range of 3.5% to 4.5%, but also that the labor force participation rate must make a full recovery to pre-pandemic levels (Chart 9). We calculate that average monthly employment growth of 419 thousand will be required to achieve this goal by the end of 2022 (Table 3). In other words, to justify the market’s January 2023 expected liftoff date, we will need to see average monthly payroll growth of at least 419 thousand going forward. Table 3Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date This number seems high, but it may be attainable. With vaccine distribution kicking into high gear, many service sectors of the economy will soon be able to re-open. This already started to happen last month when the Leisure & Hospitality sector added 355 thousand jobs. Even after last month’s gains, Leisure & Hospitality still accounts for 36% of the net job loss since last February (Table 4). This means that there is scope for extremely large employment gains this year if the coronavirus can be contained. Table 4Employment By Industry Bottom Line: We need to see monthly nonfarm payroll growth coming in consistently above 419 thousand before we can be confident that the Fed will hike rates by the end of 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 https://www.bloomberg.com/news/articles/2021-03-01/treasury-curve-dysfunction-ignites-talk-of-federal-reserve-twist?sref=Ij5V3tFi 3 For more details please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup, Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

5 years ago

Understanding China’s Growth Arithmetic For 2021

CoreMacro

Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth. Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20. From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally. We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2). Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4). Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line: It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed. In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy. Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12). Chart 11Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year. Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks. Jing Sima China Strategist jings@bcaresearch.com Footnote: 1 IMF World Economic Outlook and World Bank Global Outlook, January 2021 Footnotes Cyclical Investment Stance Equity Sector Recommendations

5 years ago

Ba-Rated Bonds Look Best

Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market Update Chart 9Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9). Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

5 years ago

Chinese Stocks: Which Way Will The Winds Blow?

CoreMacro

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market. The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets. Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks. Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply. The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns. Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak. An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

5 years ago

A Pause, Not A Peak, In Global Bond Yields

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

5 years ago

China Geopolitical Outlook 2021

GeoMacro

Special Report

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin Chart 13China Pares Local Government Spending Too Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Yushu Ma Research Associate yushu.ma@bcaresearch.com Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

5 years ago

Australia: Regime Change For Bond Yields & The Currency?

Special Report

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

5 years ago

Bonds Currencies

GeoMacro

Buy Reflation Plays On Georgia’s Blue Sweep

Special Report

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets. Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation Table 1What EPS Hit To Expect? Chart 2Democrats Won Georgia Seats, US Senate Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Chart 3B… In Georgia Runoffs By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Chart 13Energy And Financials Turned Around With Vaccine In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries. Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com Appendix Table A1Biden’s Cabinet Position Appointments Footnotes 1 Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2 Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3 Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.

5 years ago

2021 Key Views: Vaccination, Reflation, Rotation

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Chart 5B… But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment Chart 7Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25). Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

5 years ago