Asia
Highlights The complexity of global supply chains and the competitive advantages that China holds will likely reinforce China’s status as the world’s largest manufacturing hub. Moving up of the manufacturing value chain will put a floor on China’s productivity growth. Increasing regionalized global supply chains will benefit several emerging Asian economies – Vietnam and India in particular. Meanwhile, Mexico will gain in terms of global manufacturing share due to its geographic proximity to and favorable trade-agreement with the US. Feature Global supply chains have gone through a severe stress this year as the Covid-19 pandemic battered manufacturing hubs across the world. The shortages of critical medical equipment, including personal protective equipment and ventilators, generated heated debates over strategies of reshoring/nearshoring manufacturing due to concerns over national security. Meanwhile, the escalating US-China conflict and the increasing US pressure on multinational businesses to relocate production primarily from China to the US are also affecting global manufacturers’ decisions about supply chains. There is an old saying, “never let a good crisis go to waste”, which also applies to the global supply chain. The pandemic, together with intensified US-China tensions, have accelerated the transformation of the global supply chain towards digitalization, automation, and regionalization (Appendix 1 below). Chart I-1China's Share Of Global Exports Has Not Dropped Despite US Tariffs Our analysis suggests that the competitive advantages that China holds will likely strengthen its status as the world’s leading factory. Notably, China’s share of global exports has not declined despite the US import tariffs on many goods produced in China (Chart I-1). We also conclude that China will likely gain global market share in the production of high-value technology in general and semiconductors in particular. In turn, Vietnam, India and Mexico will gain global market share in the production of garments and smartphones. China’s Resilience As The World’s Factory Despite the secular nature of the US-China confrontation, the increase in protective trade policies around the world and rising nominal wages in China, an en masse supply chain diversification away from China over the next several years is still unlikely. Chart I-2China: Strong Productivity Growth Offsets Rising Wages First, rising wages in China have not so far threatened the country’s status as a manufacturing powerhouse as they have been matched by comparable gains in productivity. Indeed, China’s unit labor costs in US dollar terms have been flat in the past six years (Chart I-2, top panel). Second, the importance of low wages in determining where to build a manufacturing factory is on the decline. In addition to productivity growth, the competitive advantages that China holds –technology availability, talent accessibility, proximity to the end consumers and the extent of support from government – play a much more important role in determining the location of a manufacturing plant. For example, Tesla invested $5 billion in its Shanghai factory in 2018 despite high nominal wages in the city. The most important determining factor for a country’s future competitiveness is the extent of its technological advances. Over the past decade, China has already transformed into a global technology leader in advanced fields such as 5G, robotics, artificial intelligence, supercomputing, bullet trains, mobile payments among others. A technology leader and innovator: China is currently the world’s number one source of Patent Cooperation Treaty (PCT) patent applications (Chart I-3). It also became the world’s innovation leader in areas such as digital communications, computer technology, audio-visual technology and telecommunications (Chart I-4). For a detailed discussion on the state of innovation in China, please refer to our special report published on June 24, 2020. Chart I-3China Leads In PCT Patent Applications Chart I-4China Leads In The Areas Of Advanced Technology A 5G leader: About 65% of global 5G phones are currently sold in China. In addition, China’s 5G infrastructure is the fastest developing and has the largest geographic coverage in the world. As of early September, China had installed 480,000 5G base stations, close to hitting its annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations. For a detailed discussion on China’s 5G development, please refer to our special report released on August 20, 2020. The 5G ecosystem development in China is more advanced than that of most countries in the world. Chart I-5China: A Leading Robots Producer A leading robot producer: China’s robotic output is the largest in the world, with strong growth amid the pandemic (Chart I-5). In 2018, China accounted for 36% of total worldwide installations of industrial robots, followed by Japan (13%), the US (10%), South Korea (9%) and Germany (6%), according to the International Federation of Robotics (IFR). A survey of selected companies by the China Development Research Foundation in September 2018 showed that companies had cut 30% to 40% of their labor force between 2015 and 2017 due to the increased adoption of automation. One example is China’s steel industry, where increased automation had contributed to a significant increase in output and a drastic drop in the number of employees (Chart I-6). As a result, steel output per employee has surged. These efficiency/productivity gains have allowed China to increase its share of global steel production from 50% in 2015 to 54% in 2019. Talent accessibility: There is a large talent pool in China focusing on science and engineering advances. This will help China continue its rapid progress in technological innovation. China has already exceeded the US in terms of the number of doctorate recipients in 2018 – 60.7 thousand vs. 55.2 thousand (Chart I-7, top panel). At the doctoral level, the proportion of engineering students is much higher in China (34.8%) than in the US (15.2%), and the proportion of students opting for the natural sciences is only slightly higher in the US than it is in China. The share of doctorates in social sciences – which matter less to the growth of technological innovation - is much higher in the US than in China. In addition, the number of bachelor-equivalent degree graduates in science and engi-neering (S&E) in China is about twice that of the US. Chart I-6Increased Automation In China: Rising Output And Falling Employment Chart I-7China Has A Large And Expanding Talent Pool Besides the availability of advanced technology, China is also competitive in the following areas. The proximity to the end consumers: Many American, European and Japanese firms still cite China’s large and growing market as a reason to retain manufacturing in China. A June 2020 European Chamber of Commerce Business Confidence Survey showed that 65% of members still rank China among their top three destinations for new investment. Chart I-8China Exceeded The US And Euro Area In Terms Of PPP-Adjusted GDP The size of the Chinese economy adjusted for prices in PPP terms has become 10% and 40% larger than the US and the euro area economies, respectively. In PPP-adjusted terms, the share of China in global GDP has jumped from 3.2% in 1990 to 17.3% in 2019 (Chart I-8). The extent of government support: China is firmly committed to providing support for foreign investment in China. In August, the government urged efforts to stabilize foreign trade, foreign investment and the industrial supply chain. For example, Beijing demanded that domestic financial institutions provide export credit insurance and easier financing to help export-oriented enterprises. Echoing the government’s request, the Export–Import Bank of China established a special fund of RMB 50 billion to support manufacturing factories that are facing difficulty this year. The complexity of the global supply chain: A large multinational company can have hundreds of tier-one suppliers from which it directly purchases components. Each of those tier-one suppliers in turn can rely on hundreds of tier-two suppliers. The entire supplier ecosystem associated with a large company can encompass tens of thousands of companies around the world when all tiers are included.1 For example, General Motors has 856 tier-1 suppliers but has over 18,000 Tier-2 and below suppliers (Chart I-9). Chart I-9The Complexity Of Global Supply Chains Hence, exiting an existing key geographic location is not a simple decision, nor is it one taken lightly. Given the complexity of the global supply chain, China has the distinct advantage of easy access to most of the intermediate goods required for the supply chain. After all, China produces the broadest category of manufactured products in the world. This can save considerable transportation and logistics costs for manufacturers in China. Chart I-10China: Rising Exports And Stagnant Imports In The Auto Parts Sector For example, China has become the world’s largest auto market, accounting for 28% of global auto demand and production. As auto producers prefer to use domestically supplied parts in order to save operational costs, China now houses almost all the world-leading auto parts manufacturers and has become a key link in the global supply system of auto parts and automobiles. This is evidenced by the significant increase in Chinese exports and stagnant imports of auto parts and accessories (Chart I-10). The fast-expanded auto parts industry in China has been supported by the large domestic market and the sheer scale of production. Economies of scale have allowed auto parts producers in China to cut production costs and reduce prices. Smaller developing economies do not offer similar economies of scale even though their wages are lower and they are less developed than China. Chart I-11High-Tech Sectors Make A High Proportion Of Global Exports Technology has always been the main driver for both connectivity and value added for the global supply chain. In 2018, high-tech sectors – automotive, machinery, computer & electronics, communication equipment, and semiconductors & components – accounted for about 35% of global exports. In contrast, the labor-intensive sectors – textiles, apparel and furniture – only contributed to 6% of global exports (Chart I-11). Meanwhile, in terms of the degree of internationalization, which can be measured by export intensity (exports as a share of total industry output), Chart I-12 shows high-tech sectors including electronics, machinery and automotive rank at the top while sectors that typically produce for the domestic market, such as agriculture as well as wholesale and retail, rank at the bottom. Chart I-12High-Tech Products: Higher Internationalization = More Trade This suggests that while every country can have its own financial services, wholesale and retail trade, agro-based products, as well as food and beverage production, only a limited number of countries can produce high-tech products due to technological barriers. Bottom Line: With China’s competitive advantages in technological innovation, talent accessibility, the proximity to the end consumers, as well as the extent of support from the government, odds are that high-value manufacturing will not be relocating from China to other countries on a large scale. Sector Supply Chains: Where China Gains And Loses China will gain market share in global manufacturing of high-tech products including semiconductors, home appliances and construction machinery over the next five years. In the meantime, China will likely continue to lose some manufacturing capacity in labor-intensive sectors such as apparel and textiles. Chart I-13China's High-Tech Exports Are Gaining Market Share In Global Exports First, China will gain a market share in global high-tech manufacturing sectors over the next several years (Chart I-13). Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance, i.e., access to technology and the capability to develop new technologies. China currently accounts for about 35% of global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers create tremendous barriers for Chinese tech development in the short term (i.e. this year and next year). However, it also forces China to ramp up the country’s investment (both financial capital and human capital) in semiconductor development, which will benefit China over the longer run. China has long regarded the semiconductor sector as an area requiring strategic development, and as such the country is determined to increase its self-sufficiency rate (calculated as domestic production over domestic consumption) in this sector from a current 15% to 70% by 2025. Although this goal is too ambitious to achieve, we still expect the country to cut its semiconductor imports as a share of its semiconductor demand considerably over the next five years and beyond. For the first eight months of this year, the Chinese semiconductor trade deficit reached US$144 billion, having already exceeded the country’s crude oil trade deficit of US$ 121 billion. Semiconductors became the sector where China had the largest trade deficit. Chart I-14China’s Share Of Global Semiconductor Manufacturing: A Significant Rise Is Expected Both global and local semiconductor companies will build on/add to their capacity in China. Based on Boston Consulting Group’s (BCG) recent estimate, China’s share of global semiconductor manufacturing capacity will rise from its current rate of 15% to 24% in 2030, overtaking the number one position from Taiwan (Chart I-14). Second, China will gain market share in global manufacturing of home appliances and construction machinery over the next five years. Both sectors will benefit from the country’s Belt & Road Initiative (BRI). BRI so far covers over 70 countries, accounting for about 65% of the world’s population and around one-third of the world’s GDP. For a detailed discussion on the topic of BRI, please refer to our special report published on January 7, 2020. Many of these countries are emerging or frontier economies with strong economic growth potential. Chinese BRI investment has declined moderately this year but is still at a high level. This will facilitate economic growth in those BRI-recipient countries, which will boost their demand of household goods. China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies (Chart I-15). Chart I-15China: Rising Exports Of Home Appliances And Autos Chart I-16China’s Construction Machinery Net Exports Will Likely Increase Further As a considerable proportion of China’s BRI investment will remain focused on infrastructure projects, it will help boost recipient countries’ imports of construction machineries. We expect China’s construction machinery net exports to continue to rise, with a rising market share for mainland producers due to their increased competitiveness (Chart I-16). For a detailed discussion on this subject, please refer to our special report released on February 26, 2020. Lastly, in the low-tech and labor-intensive sectors such as textile and apparel, the global supply chain had already moved away from China to Vietnam, Bangladesh, and Cambodia due to cheaper labor cost in those countries. Chinese textile, garment and footwear exports fell about 5% (US$ 18 billion) from US$ 335 billion in 2015 to US$ 317 billion in 2019. Interestingly, Vietnamese textile, garment and footwear exports increased about 48% (US$ 18.7 billion) from US$ 39 billion in 2015 to US$ 58 billion in 2019. This trend will likely continue, as lower-tech industries, such as textiles and apparel, are less likely to undergo a robot-led transformation in the short to medium term. The number of robots in this industry is still the lowest in manufacturing, for reasons relating to both economic and technical feasibility. That said, as China holds its position as a key producer of raw materials/intermediate goods for the textile, apparel and footwear industries, an expansion in manufacturing capacities of those industries outside of China will likely increase the import demand of raw materials, intermediate goods and capital goods from China. This may somewhat offset the country’s loss in apparel/footwear manufacturing capacity. In fact, from 2015 to 2019, Chinese textile exports indeed increased about 10% (US$ 11 billion), offsetting the 13% decline (US$ 23 billion) in Chinese garments exports and the 12% drop (US$ 6 billion) in Chinese footwear exports. Most textile products are used as intermediate goods for final products like garments and footwear. A declining share of labor-intensive exports and a rising share of high-tech exports shows that China has been moving up the value chain (Chart I-17). As this trend continues, closing down textile factories might shed more employees than new hires in semiconductor plants because semiconductor production is more automated. As a result, the country’s manufacturing employment will continue to shrink (Chart I-18). Chart I-17China Has Been Moving Up On The Value Chain Chart I-18Manufacturing Employment In China Will Shrink Further However, this is not a bad thing. While the net employment in manufacturing in China will drop, the quality of employment and wages will rise because one engineer in a new automated plant will be paid several times more than a worker in a textile factory. This shift coincides with a generational change in China: older employees in labor-intensive factories are retiring and the new generation is more educated and can perform higher value operations. Bottom Line: China will gain market share in technology and high-value added sectors while losing some share in labor-intensive sectors. Overall, Chinese manufacturing production and exports will continue to rise. Sector Supply Chains: Where Other Countries Gain And Lose We expect Vietnam, India and Mexico to be the big winners of newly added global manufacturing capacity in sectors such as textiles/apparel and smartphones. Vietnam, India and Mexico are set to account for an increased share of global exports (Chart I-19). Increasing regionalized global supply chains will benefit several emerging Asian economies – Vietnam and India in particular. Vietnam is attractive to global companies given its low labor cost, its geographic proximity to China, an educated work force and its rich material and component supply ecosystem. Apart from its expanding network of free trade agreements, many of which, like the EU-Vietnam FTA, will present significant cost-saving opportunities, it has been gaining manufacturing and export share from China in sectors such as apparel, footwear, electronic products and smartphones (Chart I-20). Chart I-19Vietnam, India and Mexico: Share Of Global Exports Will Likely Increase Chart I-20Vietnam Has Gained Manufacturing And Export Share From China India is an appealing location to global manufacturers due to its large domestic market, low wages and its relatively high innovation capability. Apple manufacturer Foxconn started building iPhone 11 units in India this year. This is the first time Apple has made one of its top-tier phones in that country. Up until this year, Apple had only manufactured lower-priced iPhone models in India since 2017. Mexico will capture global export market share due to its geographic proximity to the US, its relatively large domestic market, low labor cost and the ongoing US-China conflict. Meanwhile, Mexico will gain in terms of global manufacturing share due to its geographic proximity to and favorable trade-agreement with the US. Bottom Line: Vietnam, India and Mexico will gain market share in sectors such as textiles/apparel and smartphones over the next five years. Conclusions The complexity of global supply chains and the competitive advantages that China holds will likely reinforce China’s status as the world’s largest manufacturing hub. Chart I-21China: Productivity and Labor Force Growth Moving up the manufacturing value chain will put a floor under China’s productivity and thereby potential GDP growth. China’s potential GDP growth has fallen from double digits in the 2000s to about 6-6.5% due to both decelerating productivity growth and falling labor force growth (Chart I-21). Even as the labor force is beginning to shrink, productivity growth will benefit from technological advancements, automation/robotization and a rising share of the highly educated labor force and ensuing focus on higher-value industries (Chart I-7, bottom panel). As a result, the Middle Kingdom’s potential GDP growth could stabilize in the 5-5.5% range in the years to come. Expanding manufacturing and rising share in global trade will boost income growth in Vietnam and India and potentially in Mexico too. We have been and remain structurally bullish on Vietnam. There are chances that India will benefit from the relocation of labor-intensive manufacturing out of China. If this occurs, India’s manufacturing will finally thrive with benefits spilling to the rest of the economy. Finally, Mexico should also be watched closely. It will likely gain in terms of global manufacturing share due to increasing US import tariffs on China and its geographical proximity to and favorable trade-agreement with the US. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Appendix 1 Global Supply Chain: Key Trends Global supply chains are networks that can span across multiple continents and countries for the purpose of sourcing and supplying goods and services. One unintended consequence of this pandemic is an accelerated transformation of the global supply chain towards digitalization, automation, and regionalization. Digitalization covers the Internet of Things (IoT), the cloud, augmented and virtual reality (AR and VR), and platform-based technologies, including e-commerce, fintech and blockchain. The application of digital technologies results in more integrated production processes, a reduction in governance and transaction costs, and effective coordination of complex value chains. Automation increases quality, output and efficiency along the supply chain by reducing human input, thereby slashing the risk of error. COVID-19 has accelerated the adoption of 3D design technologies, as companies are forced to collaborate remotely and share digital assets with manufacturers. Global operational stock of industrial robots has doubled between 2013-2019. The International Federation of Robotics expected a 13% compound annual growth rate (CAGR) during 2020-2022. Technological advancement in AI, IoT, cloud computing and edge computing will help upgrade automation along supply chains as well as assist in designing smaller and more powerful robots. Regionalization applies the standard model of fragmented and vertically specialized value chains at the regional or local level. For example, nearly 80% of the world’s semiconductor production is located in Asia, with 36.4% in mainland China and Taiwan, 18% in South Korea and 17.6% in Japan. Regionalized supply chains can help reduce distances, decreasing the environmental impact of long-distance transportation of intermediate and final goods. The momentum for value chain regionalization is high and likely to grow further over the coming years, including progress on several regional integration initiatives. Also, in the aftermath of the pandemic, many countries could come to see regionalism as a realistic and valid alternative to globalism for building a degree of local self-reliance and resilience. Footnotes 1“Risk, resilience, and rebalancing in global value chains”, McKinsey Global Institute, August 2020
Chinese industrial profits hit the press last weekend. In August, they grew 19.1% annually, which represented the fourth straight month of profit growth. The continued industrial production rebound, the stabilization of PPI inflation, and the strengthening of…
Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs. Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities. Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow. Figure 1The Fiscal Policy Loop It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3). Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4). Chart 4Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7). Chart 6Enticing Chinese Backdrop Chart 7Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… Chart 9…To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Chart 11Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs. Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13). Chart 12Liquidation Phase… Chart 13…Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Chart 15… EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key Chart 17Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities. Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2 Our example assumes benchmark allocation in all sectors for illustrative purposes. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth
BCA Research's China Investment Strategy service analysis concludes that the extremely accommodative phase of monetary conditions has ended. Authorities will begin tightening policy by the middle of next year. The rising policy rate in the past couple months…
Highlights The rising policy rate in the past couple months has been driven by a liquidity crunch, which is expected to ease in Q4. Government bond yields, which have been trending upwards since May, will also take a breather. The extremely accommodative phase of monetary conditions has ended. Monetary policy will be tightened, possibly by the middle of next year. We expect the yield curve to move broadly sideways in Q4 and into early 2021. As early as Q2 next year, a rebound in rate hike expectations will cause the curve to flatten. We remain overweight on Chinese stocks over the next six to nine months. Beyond that, a more restrictive monetary policy and less buoyant economic outlook may warrant a trimming of positions in Chinese stocks. Feature Chinese government bond yields have rebounded sharply since bottoming in late April; 10-year yields have climbed by 62 basis points to 3.1% as we go to press. Given that the 3-month SHIBOR (the PBoC’s de facto policy rate) has gone up by 128 basis points from its nadir in April, the higher bond yields reflect policy-driven liquidity tightening. The economy’s quick turnaround following the reopening of business activities has prompted the authorities to normalize the monetary stance (Chart 1). China recently made more interbank liquidity injections to slow the speed of policy rate normalization. We think it is the right move. China’s economic recovery is still at an early stage and may not withstand a rapid tightening in monetary policy. Furthermore, the chances are low that the 3-month SHIBOR will rise above its pre-COVID-19 level of 3% in this calendar year. Yields on short-duration government bonds will have little room to move higher in 2020. China’s 10-year government bond yield may even drop slightly when geopolitical tensions between the US and China heat up as the US election nears. Chart 1Policy Rate Normalization Started In May Chart 2Rate Normalization Will Resume In 2021 As China’s economic recovery is expected to continue accelerating into the first half of 2021, interest rates will also resume their climb (Chart 2). Our base case view is that the first rate hike, which will lift the policy rate above its pre-COVID-19 level, will happen as early as Q2 next year but no later than mid-2021. This means that the cyclical bear market in the bond market will continue. A Temporary Easing In Q4… In our report published on February 19, we argued that the rally in Chinese government bonds in early 2020 would be short lived rather than a cyclical (6-12 month) play.1 Furthermore, a journey back to the pre-outbreak monetary stance would start as early as Q2 this year. Notably, Chinese policymakers have pivoted to normalize monetary policy from an ultra-loose stance linked to COVID-19. In our view, the speed of the rebound in the policy rate has run ahead of the economic recovery. In other words, the policy stance tightened before inflation expectations turned more optimistic (Chart 3). Retail sales growth barely turned positive in August from a year ago, core inflation has dropped to its lowest level since the Global Financial Crisis and producer prices are still contracting on an annual basis (Chart 4). Chart 3Policy Stance Tightened Before Inflation Moved Higher In the past two weeks, the PBoC has injected liquidity more frequently through open market operations, an indication that policymakers may be trying to slow the pace of tightening (Chart 5). Maintaining nominal GDP growth above 4% this year is politically imperative for the Communist Party to achieve its employment growth objective.2 This overarching goal will likely hold back the PBoC from easing off the gas too abruptly. Chart 4The Economy Is Still Growing Below The Trend Growth Liquidity conditions will continue to improve into Q4, moderating the rise in the 3-month SHIBOR. The liquidity crunch in the banking system since May was created by a massive government bond issuance and curbing of high-yield structured deposits. Government bond issuance has reached its peak this year and bond quotas will plummet in Q4, which will help ease liquidity shortages in the banking sector (Chart 6). In turn, demand for interbank liquidity should moderate as banks have fewer bond purchasing obligations, giving the 3-month SHIBOR some breathing room with or without the PBoC’s intervention. Chart 5The PBoC May Be Trying To Slow The Pace Of Its Rate Normalization A pause in the policy rate hike will limit any upside risks for yields on short-duration government bonds. Yields on 10-year bonds may even drop if tensions between the US and China escalate leading up to the November US election, and/or additional significant pandemic waves affect the global economy. Chart 6Liquidity Conditions Should Ease In Q4 Bottom Line: It is unlikely that China’s policy rate and the long-duration government bond yield will end the year above their pre-COVID-19 levels. …Followed By Decisive Rate Hikes In 2H21 There are good and rising odds that Chinese authorities will fully switch to a tightening mode in 2021. Barring any domestic resurgence in COVID-19 that could trigger lockdowns, the PBoC may resume policy rate hikes as early as Q2, and no later than mid-2021. Our reasoning is as follows: Chart 7The PBoC Has Been Consistent With Policy Reaction In Previous Recoveries Consistent policy reaction in previous recoveries. Our April 23 report showed how the PBoC has been consistent in normalizing its monetary policy following each of the past three economic and credit cycles.3 The central bank raised interest rates on average nine months following a bottom in the business cycle. The tightening of interest rates occurred even after the prolonged economic downturn and deep deflationary cycle in 2015/16. The structurally slowing rate of China’s economic growth since 2011 has not prevented the PBoC from cyclically raising its policy rate (Chart 7). When the output gap is closed in 1H21, the PBoC will gain enough confidence to push for higher interest rates. Property market is strong. The property market has been heating up on the back of falling bank lending rates, despite policymakers’ efforts to curb both property lending and purchases. New home sales surged by 40% in August, the highest year-over-year growth since the last housing boom in 2016. In particular, demand for the first- and second-tier cities have rebounded sharply (Chart 8). This trend will likely prompt policymakers to enact stronger and earlier policy responses by tightening the medium lending facility (MLF) rate, an anchor for the mortgage lending rate. The labor market is recovering. The employment sub-indexes in the official PMIs of late point to an improvement in both the manufacturing and non-manufacturing sectors (Chart 9). Additionally, by the end of June, the number of returned migrant workers reached 96% of last year’s level. At this rate, the labor market should return to its pre-COVID-19 level by early next year. Chart 8Property Market Is Heating Up Chart 9The Labor Market Is Recovering Inflation will probably accelerate next year. We expect the recovery in the labor market to drive up both wage income and core CPI next year. Higher oil and industrial metals prices should also lift producer prices (Chart 10). Higher interest rates may not be counterproductive to policymakers’ support for SMEs. This is due to the authorities’ “window guidance”, mandating banks to reduce the spread between the loan prime rate (LPR) and bank lending rates. As seen in the past five months, although the policy rate has been rising, average bank lending rates have fallen (Chart 11). Policymakers will likely continue hiking policy rate to curb financial and property market speculations, but at the same time still able to guide bank lending rates lower and target their support for SMEs. Chart 10Inflation Will Likely Accelerate Along With Economic Growth In 1H21 Chart 11Bank Lending Rates Have Been Trending Down Despite Rising Policy Rate Bottom Line: Odds are rising that the PBoC will continue to hike interest rates (short and medium-term) by the middle of next year. In turn, the rebound in Chinese government bond yields will resume early next year in the expectation of better economic conditions and policy tightening. Investment Conclusions The upward momentum in both the short and long-end of the yield curve will likely abate from now till year-end (Chart 12, top panel). As early as Q2 next year, however, a rebound in rate hike expectations will cause the curve to flatten. Historically, the yield curve has always moved in lockstep with the 3-month SHIBOR with a perfect reverse correlation (Chart 12, bottom panel). Given the extremely dovish stance among central banks (the Fed in particular), the upside in rate hikes by PBoC will be capped. We expect a less than 30bps rise in long-term bond yields. Tighter monetary policy is bullish for the RMB. Nonetheless, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction. The CNY has appreciated against the USD by 5% since bottoming in May, and we doubt that there will be a meaningful upside in the RMB against the dollar leading up to the US election. Meanwhile, widening interest-rate differentials have further reduced the odds of any significant CNY/USD depreciation (Chart 13). Chart 12A Rebound In Rate Hike Expectations In 1H21 Will Flatten The Yield Curve Chart 13Limited Upside For The RMB Against USD And On Trade-Weighted Basis In this vein, the CNY/USD exchange rate will be dominated by broader dollar performance. Furthermore, it is highly unlikely that the PBoC will tolerate sharp, trade-weighted currency appreciations. A declining USD will also limit the upside in the trade-weighted RMB. The RMB may be less reflationary to businesses in China, but it will not become outright deflationary for the time being (Chart 13, middle and bottom panels). In terms of equities, we maintain our positive cyclical view on China's growth outlook. The PBoC will maintain its tightening bias, but this should not lead to major growth disappointments. We continue to expect Chinese domestic and investable equities to outperform in both absolute and relative terms, at least for the next six to nine months. Beyond the next six months, however, a more restrictive monetary policy should bring China’s economy closer to its trend growth in 2H21. Sectors such as technology and real estate, which benefit the most from easy liquidity conditions and strong economic growth, will be negatively and disproportionally impacted. Given their heavy weight in China’s investable equity market, we will probably trim our positions in investable stocks by the middle of next year. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 Please see BCA Research China Investment Strategy Weekly Report, "Don’t Chase China’s Bond Yields Lower", dated February 19, 2020, available at cis.bcareseach.com. 2 Please see BCA Research China Investment Strategy Weekly Report, "Taking The Pulse Of The People’s Congress", dated May 28, 2020, available at cis.bcareseach.com. 3 Please see BCA Research China Investment Strategy Weekly Report, "Three Questions Following The Coronacrisis", dated April 23, 2020, available at cis.bcareseach.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics. Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long. Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Taiwanese export orders rose 13.6% annually in August, or the fastest pace in two and a half years. Orders for electronics products and information & communication products were both particularly strongly, rising 28.2% and 26.4%, respectively. The strength of…
BCA Research's China Investment Strategy service analyzes the impact of the evolution of Chinese households savings The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably,…
Highlights Lower-income Chinese households are overly indebted, while higher-income groups hold too much cash. Apart from real estate and cash, ordinary Chinese people have few choices in allocating their assets. Household consumption has not been stimulated to the same degree as during previous cycles. The recently announced “dual circulation” strategy may not be an imminent solution to China’s chronic high debt, high savings issue. However, an acceleration in policy actions of late may be steps in the right direction in encouraging Chinese households to spend more domestically and to invest in domestic companies. Feature The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably, the pace of consumer spending growth started decelerating almost two years before the pandemic struck the country (Chart 1). Chart 1Chinese Consumers Scaled Back Spending Before COVID-19 Chart 2Chinese Households Save Cash, Lots Of It Furthermore, Chinese households have added a total of 8.3 trillion yuan to their bank deposits so far this year, or about 8% of China’s 2019 national output (Chart 2). Outsized cash savings helped to cushion consumers from the pandemic’s economic impact and will support a consumption rebound as China’s economic and service sector activities continue to normalize. However, an acceleration in cash savings and decline in households' propensity to spend would not bode well for a structurally balanced economic growth model. Chinese policymakers recently announced a new “dual circulation” strategy, and fast-tracked several policy actions to facilitate easier access for households to consume luxury goods and participate in the domestic capital markets. The policies will likely have a small, near-term economic impact. But in the long run they can set up a trend which will benefit domestic consumption growth and better utilize the substantial cash holdings among Chinese domiciles. Too Much Saving Or Too Much Debt? While Chinese households have excessive cash savings, they also carry too much debt. Families hold a total of 55 trillion yuan of debt, or 94% of their aggregate disposable income. The debt-to-income ratio is fast approaching that in the US (Chart 3). At the same time, their debt-to-cash ratio, on an aggregate basis, is extremely low relative to other countries (Chart 4). Chart 3Chinese Households Are Almost As Leveraged As The US Ones Chart 4But They Also Hold Way More Cash Than The US Ones Chinese people are net savers, and only about 30% of Chinese families are in debt, which is less than half of the number in the US (Chart 5 and Table 1). This means approximately two-thirds of households have a positive net worth. On the other hand, Chinese consumers who borrow are deeply indebted. China’s median debt-to-income ratio is around 180%, according to recent surveys, with the lowest income group carrying debt loads that are a whopping 12 times their income (Table 2). Chart 5Two Thirds Of Chinese Households May Be Debt Free Table 1Chinese Household Credit Participation Rate Table 2Chinese Household Debt-To-Income Ratio, By Income Groups Bottom Line: Lower-income groups are heavily indebted, while higher-income families have too much cash on hand. Too Few Investment Choices Chinese households hold a majority of their assets in real estate investments and cash. The former has seen prices skyrocket, crowding out the discretionary spending capability of lower-income families.1 On the other hand, cash and cash equivalents such as CDs, currently earn a meager 2%. The obsession with holding properties has been reinforced by the astonishing pace of money creation in the past 10 years (Chart 6). Despite sky-high prices, real estate has been the main counter-inflation measure in China. According to the 2019 China Household Finance Survey, nearly 60% of Chinese household debt is in home loans, which is about twice the number compared with the US. Furthermore, the share of second-home loans (as a share of all residential housing loans) escalated from less than 30% in 2011 to 65.9% in 2018, greatly exceeding the share of first home loans. Post-pandemic demand for housing has remained strong and household debt is still expanding faster than nominal disposable income growth (Chart 7). Even though lower-income groups have significantly scaled back on mortgages, given that such a large portion of household assets is tied up in real estate means that any deflation in property prices will have a devastating impact on consumer net worth (Table 2 on Page 4). Consequently, discretionary spending by even middle- and high-income households will be curtailed. Chart 6Helicopter Money In China Chart 7Household Credit Still Expands Faster Than Income Growth In addition to the long-standing issue of a lack of social safety net, Chinese families’ high cash holdings are due to a lack of investment alternatives. Even though the country has the world’s second largest equity market by value, only 11% of Chinese residents participate in the stock market, a dismal number compared with a 50% equity market participation rate in the US.2 The low participation rate is not surprising: over a 10-year time span, returns on cash have more or less matched returns on A-share stocks (Chart 8). The extreme volatility in Chinese equities has curbed citizens’ enthusiasm to participate in the market. Chart 8Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Bottom Line: Chinese household profile is characterized by the heavy concentration of cash among higher-income households and the elevated indebtedness of low-income ones stemming from sky-high real estate prices. Is The New “Dual Circulation” Strategy A Solution? Consumer spending in China has been growing rapidly in the past 20 years, at a rate roughly in line with the increase in disposable incomes. Income and consumption growth peaked in 2007 but since then has been dwindling along with falling productivity (Chart 9). Cyclically, the consumption recovery will bring its growth rate back to the pre-COVID 19 level. Demand for real assets and consumer durable goods has been strong after the pandemic (Chart 10). Even the demand for luxury goods has made a comeback.3 Chart 9Chinese Consumption, Income, And Productivity Growth Chart 10Chinese Consumption Is Recovering However, for consumption to sustain an expansion rate similar to the past decade, China’s productivity growth must accelerate and, in turn, boost per capita income growth. Conversely, the country would need to maintain a high rate of credit expansion to generate enough economic growth and inflation to spur strong nominal income growth (Chart 11). Credit expansion can boost nominal growth but it is productivity growth that generates per capita income growth. Chart 11Household Credit Impulse Has Been Muted Since 2018 The recently announced “dual circulation” strategy and an acceleration in policy actions by the Chinese leadership may suggest a different path than in previous cycles. Policymakers seem to focus on changing and upgrading the composition of China’s existing consumption base rather than boosting consumption growth through monetary stimulus in the household sector. Moreover, they are looking to change the configuration of family savings and investments. Our colleagues at BCA Research's Emerging Markets Strategy have stated that improvements in the turnover of consumers’ bank deposits and cash, if successful, may allow China to slow its overall credit and money growth but still sustain a steady nominal GDP growth rate.4 Details of the new “dual circulation” strategy are sparse, but we think the following developments in the past couple of months are relevant to investors: Bringing home overseas consumption and reducing the service trade deficit: China fast-tracked policies that target duty-free shopping venues, a strategy designed to lure Chinese consumers back to the domestic market. Beijing made unprecedented moves to invigorate Hainan province’s duty-free shopping and issue new licenses to allow companies to operate duty-free shops both online and offline. In the past five years, Chinese residents have spent an average of 250 billion USD annually shopping overseas. Purchases of duty-free products overseas account for a small share of China’s 12.5 trillion yuan retail industry. Nonetheless, repatriating some overseas consumption would allow China to not only narrow its service trade deficit, but also to create more service businesses and jobs internally (Chart 12). The move signifies that Chinese policymakers are committed to change domestic consumer spending behavior while upgrading the retail industry. However, we remain cautious on retail stocks in the next 6 to 12 months. Retail growth has not yet rebounded to its pre-pandemic level, and the valuations in retail-sector stocks are overly stretched (Chart 13). Chart 12China Has Been Running A Huge Service Trade Deficit Chart 13Retail Sector Valuations Are Elevated Increasing households’ equity holdings in domestic companies: Direct financing in the form of equities and corporate bonds only accounts for about 15% of total social financing, compared with 65% in bank lending. Chinese corporations rely mostly on bank loans and retained earnings, whereas US companies are heavily dependent on equity financing. The “dual circulation” strategy encourages more direct financing for SMEs, science and technology companies. It also explicitly calls for a greater household participation in the financial markets, which would guide more savings into domestic capital markets. In the past few months, the government has accelerated financial market reforms aimed at providing easier access for corporations and individuals to domestic equity markets. In the first half of this year, 119 companies went public in Shanghai and Shenzhen; these companies raised about 140 billion yuan, which was more than double the amount from a year ago. New individual investor accounts on the Shanghai exchange rose by 30% (year to date) from a year ago. Notably, both the IPO and household participation rates resemble the onset of the boom-bust cycle in 2015. However, this time Chinese regulators have been much more vigilant and restrictive about over-leveraging, acting early and removing some steam from retail investor rush (Chart 14). Chart 14Chinese Authorities Have Less Tolerance For Equity Market Leverage Chart 15Chinese Stocks Still Have Upside Potentials It remains to be seen whether the authorities will be able to boost and sustain consumer confidence in the domestic equity market. The efforts by the Chinese government will either succeed by securing a gradual and healthy secular bull market, or they will fail by triggering another boom-bust cycle in the domestic market. Either way, investors should stay overweight Chinese stocks on at least a 6-month horizon (Chart 15). Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Households in the bottom 40 percentile in China have no discretionary spending capacity. “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 2投保基金公司《2019年度全国股票市场投资者状况调查报告》and Pew Research Center. 3China ‘Revenge Spending’ Offsets Plunge in Luxury Goods Revenue 4Please see Emerging Markets Strategy Special Report "China’s Rebalancing: Will Consumers Rise To The Challenge?" dated August 29, 2019, available at ems.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations