The Great Debate: Does China Have Too Much Debt Or Too Much Savings?

In this month’s BCA webcast I moderated a round table with my colleagues Peter Berezin (Global Investment Strategist), Arthur Budaghyan (Emerging Markets Strategist), and Yan Wang (China Investment Strategist) discussing the global macro and market implications of China’s rising debt burden:

1. What implications does a country’s savings/investment balance have for credit growth? Do credit bubbles originate from high national savings?

2. The world is climbing a wall of worry about China’s debt load and the pace of its domestic credit growth. Are these concerns justified? How worried should we be about the misallocation of capital in China?

3. What are the investment implications of China’s debt profile for global financial markets? Is rampant capital flight still a risk for the RMB?

4. What signposts should investors watch to determine whether China’s macro outlook is evolving in either a constructive, benign, or ominous direction for the global economy and financial markets?

The focal point of the view cleavages on China within BCA centers on how analysts interpret the relationship between savings, debt, and the ensuing implications for the allocation of capital. Links to the special report and webcast (enclosed) elaborate on how these issues inform the macro and market outlook for China and beyond.

See our Special Report:
Listen to our Webcast replay:


The Reflationary Window: Open How Wide For How Long?

The global manufacturing purchasing manager index is comfortably above the 50 threshold signaling expansion. Importantly, the upturn is fairly synchronized, with improvement visible in the US, Europe, and Asia. This corroborates the upward adjustment in global bond yields we’ve seen in recent months.


A big source of recovery in global industrial momentum in the past year has emanated from China. But growth tailwinds from real interest rate relief and fiscal expansion are set to wane in the second half of 2017, while protectionist elements of proposed US tax reform pose risks to EM growth prospects more generally. Those countries with the highest percentage of exports to and trade surplus with the US as a share of GDP are most at risk of any combination of tariffs or border adjusted elements of US corporate tax reform.


One of the primary axes of debate around the sustainability of US growth momentum revolves around how to interpret the surge in soft, survey measures of economic activity – namely consumer and business confidence – relative to expectations, running well ahead of the hard data – barometers of the health in the housing, industrial, labor, household, and retail sectors. We have some sympathy for the view that the survey data usually leads hard data, and that the pickup in confidence reflects a revival in long dormant animal spirits which is feeding higher capacity expansion and hiring plans, particularly among small firms in the NFIB survey. But the large gap between the sentiment-oriented readings of the growth outlook and the mediocre pulse of coincident real time data underscores how great expectations for a sizeable upgrade in the plane of US economic growth are. Fears of secular stagnation have done a 180 degree turn to supreme confidence about the growth outlook in the last few months. The New York Fed’s primary dealers’ survey has extended expectations for the longevity of this business cycle, such that the median respondent now thinks the expansion will last twice as long as expected just a year ago.


We agree that US growth is likely to remain firm over the next 12 months, because the economy has a lot of momentum behind it right now. But the reflationary window is likely to start to close as the economy reaches the upper limits of its potential from a supply perspective. Exuberant growth expectations and equity market momentum reflect expectations that tax and regulatory reform will reinvigorate the economy’s longer term growth potential, via increased spending leading to higher productivity growth. We think the dysfunction in Washington portends a long, protracted debate on tax policy and infrastructure spending, such that the impact on growth is a story for 2018, not 2017. But once again, markets are forward looking. A positive shock to aggregate demand from looser fiscal policy applied to an economy already operating near capacity would translate into higher inflation rather than increased output. This dynamic would drive up real interest rates and reduce spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, crowding out the pro-growth pulse of fiscal stimulus. Fiscal multipliers are much smaller when an economy is close to full employment.


But the global profit recovery is real, for the coming few quarters at least, supporting our cyclically bullish stance on global equities through the coming 12 months.


The dollar remains in a cyclical bull market. The recent pause in its advance has not keyed off a reversal in the 2 year real rate differential between the US and its trading partners, which continues to expand. More likely the ‘weak dollar’ rhetoric from the Trump administration, consolidation of crowded long dollar positioning, and the benign pulse of the average hourly earnings read in the latest US employment report have cooled sentiment, temporarily at least. We assign low odds to another Plaza-Accord type coordinated agreement. History suggests that currency intervention only works when it is consistent with underlying macroeconomic fundamentals. With the Fed signaling a tightening bias which America’s trading partners’ economies don’t currently justify, a globally coordinated pact to weaken the US dollar would lack market credibility. With respect to the value of the US dollar, President Trump cannot suck and whistle at the same time.


The risk-adjusted value proposition in US equities has deteriorated, but over a 12 month horizon, moderately above trend growth, benign inflation, and a still relatively accommodative Fed will prolong the cyclical equity bull market. One way to indemnify an equity portfolio against a near term pullback would be to reduce exposure to the sectors that have overpaid for dividends from business-friendly policy changes, namely deep cyclicals and industrials. Conversely, the outperformance of developed economy growth relative to emerging economies suggests that defensive sectors will enjoy a revival if EM growth remains relatively lackluster and the dollar remains well bid.


As for credit markets, we continue to expect the economy to track towards the Fed’s dual employment and price stability mandate over the course of 2017. There is still 30-40 bps of upside in breakeven inflation yields before that threshold is reached, leaving scope for TIPS to outperform nominal Treasuries, and the yield curve to steepen via a rise in longer dated yields. There is no immediate urgency for the Fed to tighten in March, but we still see scope for three rate hikes in this calendar year, more than markets discount. We place high odds on the 10-year US Treasury yielding more than the current 12 month forward rate of 2.77% in a year’s time.

To find out more, click here to listen to BCA Global Strategist Caroline Miller’s February 16th Webcast.

The 2017 Outlook: Shifting Regimes

Mr. X, BCA’ loyal client paid us his annual visit to discuss the economic and market outlook. He is suspicious of the optimism in the macro and market air, and grilled us on the disconnect between the post US election euphoria in global markets and his more sober view that many of the secular drags on global growth will remain with us, even if policy shifts into a more pro-growth gear on a cyclical basis.

The US election did not trigger the flip of a switch in global growth momentum. It was already improving. The window between the end of deflation and the rise of inflation is a fertile macro environment for risk assets. Global inflation is likely to remain subdued for another couple of years because the global economy still suffers from a fair amount of spare capacity. Even though the global output gap has indeed declined from its post crisis 2009 peak, it’s still as large as in the early 1990’s.


Mr. X was quick to remind us that in addition to high debt levels and the apex of globalization, many other structural macro forces have driven down the advanced economies’ growth potential. We agree with Mr. X that it is premature to declare the death of secular stagnation, but over the coming 12 months, stronger cyclical economic momentum will be the dominant driver of bond yields, which we see grinding higher as inflation expectations continue to recover. American consumers are brimming with confidence, and the business sector is celebrating the prospect of a reduced regulatory and corporate tax burden under Trump as the 2-year US profit recession has ended. A surge in capex spending intentions registered in the regional Federal Reserve bank surveys foretells a pickup in overall economic growth. The contrast between rising optimism and flat current revenue growth, particularly in the small business sector, underscores how high expectations are…


With all the focus on the US of late, Europe is getting less attention for its above trend growth momentum. The euro area’s composite PMI survey has a good track record of leading European growth, and is consistent with a 2% level. Moreover, in its November report, the European Commission actually suggested that a rise in member states’ budget deficits in 2017 might make sense, no doubt partly a response to the populist backlash sweeping the region. The ECB estimates that the euro area’s output gap is still a wide 4% of potential GDP; wage growth is still weak, and declining, relative to the US. Europe is on the mend, but has a long way to go, and is still lagging the US in terms of business cycle expansion.


In contrast to the euro area, Japan has almost absorbed all the slack in its economy. The Bank of Japan actually estimates that it has a positive labor input gap, meaning the economy has run out of surplus workers. A tight labor market and pause in fiscal consolidation will be reflationary, but unlike the Fed, the BOJ has committed to letting inflation significantly overshoot before removing any accommodation. This commitment will sustain the US’s real rate advantage over Japan, a welcome development for Japanese equities.


So even as the euro area and Japan are recovering, neither central bank will pursue policies that interrupt the virtuous cycle sustaining upward pressure on the US’s real interest rate advantage which has been a powerful driver of dollar strength since 2014. The recent recovery in inflation expectations in both the euro area and Japan has outpaced the rise in their nominal yields, depressing real yields. We concede that bullish sentiment towards the dollar is stretched, but still think it can rally another 5% in broad trade weighted terms over the coming 12-18 months.


The virtuous feedback loop between dollar strength and lower real rates applies less to China and the rest of the developing world, even though they too are experiencing currency weakness. The end of wholesale deflation belies anxiety about the durability of the recovery in China’s ‘old’ highly levered and asset-heavy economy. The government engaged in hefty fiscal stimulus, increasing government spending significantly throughout 2015 and early 2016, but the growth tailwind from that fiscal thrust is now fading. The decline in real rates and return on invested capital in China has stoked capital flight, the politically destabilizing optics of which have prompted policymakers to impose a variety of restrictions to stem outflows. Meanwhile, because the RMB has weakened faster than factory prices have recovered, Chinese export prices are still deflating in dollar terms, which doesn’t bode well for pricing power throughout the rest of the global manufacturing and industrial materials complex.


While the reflationary window for global growth makes us bullish on global equities over a 12 month horizon, the US market appears to have discounted this goldilocks scenario. Bullish sentiment is stretched, earnings growth expectations at 12% y/y seem high in an environment where a tight labor market is driving up wage costs and a strong dollar will challenge industrial pricing power. Optimism about the economic benefits of the new administration’s policies could last while plans for tax cuts, increased infrastructure spending, and regulatory relief are being debated, but policy uncertainty is still sky high. U.S. profit growth may well come in just positive enough to sustain momentum, but we continue to have more faith in the constellation of monetary policy support, margin expansion potential, and lower valuation hurdles available in the Euro area and Japan.


Emerging markets are a tougher call. The combination of a strengthening US dollar, growing protectionist sentiment in the developed world, high debt levels, and weak productivity, are all bad news for emerging markets, which have lagged the post-election surge in global and cyclical relative to domestic and defensive sectors. This underscores that EM valuations are not cheap on an equal sector weighted p/e basis; non-financial return on equity is at a 10 year low; and net forward earnings revisions are still negative. Developed markets should outperform this year, even given the reflationary window that typically flatters EM equities. The burst of speed in deep cyclicals in the post-election period is likely to fade as the reality of a surging US dollar saps margin prospects. The more consumer-oriented, domestic plays will then shine. We are even more comfortable with that theme since the post-election relative valuation reset.


Amid this reflationary window over a cyclical horizon, in the very near term, investors should heed the rising risk of a correction, spurred either by the recent rise in bond yields or the unprecedented divergence between global policy uncertainty and market momentum.


To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s January 11th Webcast.

Trump Cards: What Hand Have Investors Been Dealt?

Markets have rushed to conclude that the Trump administration will unshackle developed world economies from the secular growth stagnation that has depressed equilibrium interest rates and bond yields since the financial crisis. But expansionary fiscal and protectionist trade policies won’t impact growth in a vacuum; their knock on effect on inflation, and thus monetary policy and bond yields, will dictate the ultimate pass through to final aggregate demand in the economy. How will the FOMC shape monetary policy in an environment where visibility on current economic momentum is constructive, but uncertainty around the sequencing and ultimate economic impact of Trump’s policy mix clouds the forecast horizon? The balance of risks in the Treasury market has shifted. Prior to the election, Treasury investors under-estimated the potential for any pro-growth impulse from fiscal policy over the coming year, but the recent reset in yields acknowledges the possibility that instead of continually revising its rate forecast lower for longer, Trump’s policies may force the Fed to transition to move rates higher, sooner.


A tight labor market is reviving aggregate wage growth. Even the least skilled workers are getting a raise as the pool of unemployed, low-skilled workers has largely evaporated. The unemployment rate for those aged 25 and over without a high school diploma has halved from nearly 16% in 2010 to just under 8% now, such that this group is experiencing the strongest rise in real median weekly earnings now. To be sure, however, this cohort still has a long way to go to make up for lost earning power, having experienced a cumulative -22% decline in real median wages since 1980, the largest loss of all the labor force constituencies if grouped by educational attainment. No wonder this group voted for Trump’s promise to Make America Great Again. A quote embodying the definition of populism is particularly apt in this context: “I equate the person who vibrantly describes my rage with the person who has the solution to my rage.”


The effectiveness of any fiscal expansion program depends critically on how fully the growth transmission mechanism or fiscal multiplier works. These multipliers can vary widely. The Congressional budget office estimates that large income tax cuts for high income earners or corporate tax relief won’t do much for growth and thus the uneducated factory worker, whereas direct spending by government on outlays such as infrastructure, tends to have a much higher multiplier. Fiscal stimulus can be cumulatively triply stimulative for growth when the economy is operating below potential, versus when it’s operating at potential, because slack usually precludes the need for monetary offset. In an environment where the economy already has momentum, the net fiscal multiplier may be limited, if monetary policymakers respond to the increase in demand from government stimulus by hiking rates more aggressively than they would otherwise.


Emerging Asian economies have benefited the most from 35 years of globalization. Exports have driven a rise in living standards, as measured by per capita gdp growth. We expect Asian currencies to suffer disproportionately from this new round of dollar strength, as Trump’s trade retribution hits these countries the hardest. Compared to the drubbing Latam currencies have endured since the peak in resource prices in 2011, the KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. An appreciating dollar can hurt emerging markets in three ways. First, a stronger dollar can weigh on commodity prices. Second, it can punish emerging market borrowers with significant dollar liabilities. Third, Fed rate hikes are liable to reduce global dollar liquidity, making it difficult for a number of emerging economies to attract enough foreign capital to finance their current account deficits.


The US yield curve has been under relentless flattening pressure over the last 6 years as markets have doubted the durability of the US business expansion amid numerous negative shocks. The yield curve will be a barometer for how much growth candidate Trump delivers as President Trump. The more stimulus is financed by debt, the more Treasuries will be issued and interest will owed, the higher inflation will climb, and the steeper the curve will get. Right now the Fed telegraphs a rate hike in December of this year, and two more hikes in 2017. The Fed will likely want to avoid a rerun of last December’s market riot by offering too much hawkish guidance about next year without visibility on what form Trump’s economic policies are likely to take.


To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s November 17th Webcast.

What’s Next For Risk Assets?

A critical concern for investors remains the extent to which asset price appreciation depends on easier financial conditions, in the absence of convincing evidence that the fundamental corporate profit backdrop is to reaccelerate. A benign interpretation of the recent divergence between bond yields and equity prices is the narrative that central bank commitments to ultra-loose monetary settings have depressed bond yields and stimulated global growth, but that the pickup in growth will be non-inflationary, constituting high octane fuel for stocks because it is benign for bonds. A less comfortable explanation is the dynamic that global QE spawns: the so called ‘TINA’ effect that propels private sector capital out of one exceptionally overpriced asset ( high quality, negative yielding government bonds), into another, (high yielding stocks and income proxy assets), keeping returns positive in a negative rate, slow growth world, at the expensive of assuming more risk. Commodity prices offer no comfort that a synchronized recovery in global growth is at hand, which has important implications for Fed policy and the US dollar. Precious metals are still outperforming industrials, suggesting that the plunge in interest rates globally, not stronger end demand for inputs to the manufacturing complex, has boosted commodity prices since February.


In this zero rate world, marginal shifts in relative monetary policy impart deflation to the US via a stronger dollar, a macro variable that features prominently in the FOMC’s peripheral vision. The 20% appreciation in the value of the US dollar since mid-2014 has indeed keyed off of relative shifts in policy as proxied by 2 year swap rate differentials. But the Fed has only managed one quarter point rate increase so far in this cycle while maintaining a bloated balance sheet, so interest rate differentials shifted in favor of the dollar almost exclusively due to other global central banks easing policy. In the absence of Europe, Japan, or China’s economic momentum demonstrating enough strength to justify a moderation in the level of monetary accommodation deployed to support those economies, any increase in the expected path of US rates will prompt a resumption of the dollar’s appreciation, even as markets fixate on how shallow this tightening cycle is likely to be relative to history.


The reason that asset and currency markets question the Fed’s need and doubt its ability to increase interest rates is that estimates of the equilibrium real rate of interest, the rate allowing an economy to operate at full employment, have dropped so precipitously, implying that current policy isn’t actually that loose. We have been arguing that the real terminal rate is close to zero.


Even if the end point of the tightening cycle will be lower than it has been, investors shouldn’t extrapolate lower for longer to mean zero forever. The Fed is closer to achieving its mandate of full employment and 2% core inflation, than markets discount. While inflation remains below target, it has clearly bottomed for this cycle. The recent acceleration in domestically-geared core service price inflation is a function of faster wage growth, emblematic of receding labor market slack.


The primary lubricant for EM growth and asset prices in recent months has been easier financial conditions, courtesy of the Fed. Any marginal tightening in financial conditions is a recipe for turbulence in EM assets. More broadly, there isn’t much disagreement about monetary policy’s diminishing marginal ability to sustain asset price appreciation from current valuation levels. Global EPS growth appears to be bottoming and our models point to a break into positive territory by the middle of next year, but with very little cushion for any negative shocks.


We acknowledge investors’ need to generate income; missing out on an incremental melt up in risky assets when ownership of low or negative yielding safe haven assets all but guarantees a real loss of purchasing power makes that bugaboo particularly acute. Central bank asset purchases have exhausted their compression of government bond term premia but continue to push high grade corporate spreads tighter. While we reluctantly accept that the search for yield requires identifying the least expensive asset to satisfy that mandate, we have a high conviction that the combination of continued economic expansion, attractive valuation, and a shift away from fiscal austerity support a strategic allocation to US TIPS, and inflation protection in other markets as well, for that matter. A rate hike in the near term will not alter the Fed’s long term cautious approach to policy normalization so TIPS breakeven yields are destined to rebound from today’s depressed levels.


To find out more, click here to listen to BCA Chief Strategist Caroline Miller’s September 8th Webcast.