Macro

US Secretary of State Mike Pompeo has discovered the South China Sea. UK Foreign
Secretary Dominic Raab has discovered Xinjiang. Both are greatly upset about the threat
that the Chinese Communist Party poses to the world. Both do not seem to know that
Iraq or the Yemen exist and that they are to blame for the carnage that has gone on in
both places for the last decade. We should assume that they both know where Hong
Kong is but their lack of interest in that place for the last 23 years might suggest
otherwise. 

Biden still remains on course for victory. But vulnerable on China, he has proposed a 30.8% corporate tax rate for companies that outsource manufacturing/services overseas. The improving economy will help Trump tighten the polls in October, and Biden is likely to lose ground after the three debates. Delayed postal/absentee ballots will likely mean an uncertain outcome on Election night, raising the likelihood of a protracted dispute about the result that makes 2000 seem tame. We recommend taking profits on equities by early-October, and being underweight equities through November. 

As expected, the presidential polls narrowed after the party conventions, particularly after the more slick Republican convention (much of it held in person with several speeches from the White House), which President Trump used to change the conversation from Covid-mismanagement to “law and order”, particularly the issue of urban protests (against the killings by police of largely innocent black men) turning toward violence, vandalism and looting. Both conventions sought to reach out to the centrist voter, Biden by showcasing Republican supporters (ex-Gov. John Kasich, who was Trump’s last rival in the 2016 race, ex-Secretary of State Colin Powell, and the family of the late Sen. John McCain), and Trump unusually showcasing black and women supporters in an unorthodox bid to appeal to centrists who may have thought he was racist/sexist. The actual polling “bump” that Trump received from the convention was modest (about 2 percentage points, albeit better than Biden’s bump of less than 1pp in the average poll), but the betting odds narrowed sharply in the week after the Republican convention (with Trump coming within 1pp of Biden).

Since then, however, the race has returned to where it was in mid-August, with Biden having a handsome lead (average over 7.5 percentage points) in nationwide polls (and the betting odds), and retaining a solid lead in battleground states (Pennsylvania, Michigan, Wisconsin, Arizona, North Carolina, Florida) that Trump won in 2016. Trump leads narrowly in Ohio. But Biden has built a sizable lead in Arizona (where his closeness to late Sen. John McCain (R-Az) — highlighted in the Democratic convention — has helped) and North Carolina; the latter has been carried by a Democrat only twice in the last 52 years, the former only once in the past 72 years. If the election were held today, Biden would win by a wide margin in the Electoral College and popular vote. 

However, the race will likely tighten in October, as the economy continues to recover (with a big QoQ rebound likely in 3Q 2020 GDP growth, announced at October-end), the US Covid curve continues to flatten (new-case numbers have averaged 39K in the past week, from a peak of 69K in the final week of July), and Trump gains a bit from the debates. Biden, vulnerable on the fact that China-trade was omitted from his convention, has a rash plan to impose a 30.8% corporate tax rate on companies that outsource manufacturing/services overseas (likely to hit all large companies). Biden remains likely to win; but first, there will be uncertainty on Election night because postal/absentee ballots likely will not be counted that day — exaggerating Trump’s vote share, and seemingly tightening the election even more in the swing states. The uncertainty will make for a more volatile November in markets: with the likely winner calling for a 30.8% corporate tax rate, amid calls for insurrection from the losing side, we now expect an even larger sell-off (7-10%) in the market in November amid the growing uncertainty.   

Much of the market focus in recent months has been on major reserve currencies, namely:

• The US Dollar which, contrary to bearish expectations and in line with our benign Dollar view, has treaded water in the past six weeks and since the Fed’s tweak on 27^th August to its dual inflation and employment mandate;
• The Euro’s rapid appreciation in July, its more prosaic performance in August and the first half of September and speculation that the European Central Bank would try to jawbone the currency weaker. Instead the ECB as its policy meeting on 10^th September resorted to verbal intervention “light”, in line with our core scenario that Brazen ECB verbal intervention against Euro was unwarranted and unlikely (9^th September 2020).
• Sterling’s collapse last week and only partial recovery in the past four trading sessions. We are sticking to our view that the UK economy and Sterling face four potential headwinds in coming months, including i) fiscal stimulus measures being unwound, ii) a no-deal Brexit, iii) higher taxes and iv) a further re-tightening of lockdown measures in coming months (see UK & Sterling facing potential quadruple whammy, 4^th September 2020).

Conversely, Asian currencies have seemingly fallen under the radar screen, for good reason. They have exhibited little directionality within very narrow ranges in the past month, particularly relative to high-yielding emerging market currencies.

We think this is the result of Asian central banks’ ability and willingness to keep their currencies on a tight leash, in order to minimise their disinflationary impact and maintain export competitiveness while at the same time capping the cost to governments, corporates and households of servicing sizeable foreign-currency denominated debt.

The Renminbi Nominal Effective Exchange Rate’s 2% appreciation in the past month, while unspectacular, is noteworthy and will be the topic of a forthcoming report.

Despite their mixed record in correctly anticipating election results in recent years, financial markets are discounting a very benign form of de-coupling between China and the US. Equity investors in the US have not embraced the possibility of a Biden victory in the Presidential Election and, consequently, the prospect of higher taxes and greater regulation.

The initial fears of supply chain dislocation due to forced on-shoring by US corporations under the Trump Administration have failed to subsequently materialise. China has spectacularly built up her productive capacity for information technology products, a feat which neighbouring countries will struggle to replicate in the near future.

• The BoE MPC voted unanimously in favour of no policy change at its September meeting, while focusing on the economic impact of Covid and Brexit ahead of the November meeting. I still expect another QE extension announcement then.
• I assume the pace will be unchanged into 2020, with the MPC only mentioning an increased scenario. An operational probe of negative rates starts in Q4, likely keeping that outcome off the table in Nov, and still not likely later, in my view.

• UK inflation data delivered another upside surprise in Aug-20 as restaurant prices were resilient again. Puny pass-through of EOHO and VAT should unwind in Sep-20 and Feb-21 respectively with the expiration of those schemes.
• A failure of airfares to seasonally increase for the summer holidays offset the other upside news for the RPI. Airfares no longer have the normal room to decline in September. The risk of flat yearend seasonal factors increases on this behaviour.
• Inflation and many “core” measures will remain highly volatile during these shocks, but the median is smoothly trending higher. Underlying levels are still consistent with below-target inflation over policy-relevant horizons, thereby easing more QE.

The past few weeks have seen a break (or pause) in the relentless march of TIPS inflation breakevens higher coming out of the depths of COVID-19 lockdowns.  We text-mine the global media for a wide range of inflationary & deflationary expressions, constructing diffusion indexes and sentiment indicators suggesting inflation expectations may have peaked for the time being.  Unlike past inflections, the current source of weakness (which remains theoretical) appears to originate in US coastal rental markets, but is now also aided by the downshift in crude oil.  As consensus has formed around elevated long-term inflation, dissonance with potentially shifting short-term data may test some of these notions.

• The unemployment rate increased to 4.1% in July but not because of falling employment. Normalisation in the labour force participation rate meant supply increased faster than demand. Low vacancies should drive the UR toward 7.5%.
• Average weekly earnings have followed the “real-time” median and surged, with ex-bonus pay almost back to pre-Covid levels in July. The end of furlough for many workers raises hours and pay ahead of slack bearing down on the latter’s growth.

China News That Matters

• Chinese Communist Party wins again 
• Just keep shopping, instructs Beijing
• US blocks Chinese scholars; cotton ban looming
• All grown up and savin’ China
• Will Beijing expel all foreign journalists?

In light of the recent market weakness, we have been asked about downside equity risk. Is this the start of a significant downdraft? How far can stocks fall from current levels?

There are growing, but unconfirmed, signs that large-cap growth and NASDAQ stocks are weakening. The NASDAQ 100 recently breached its rising trend channel, but its performance compared to the S&P 500 remains in a relative uptrend. It is possible that the high-flying NASDAQ stocks are undergoing the beginning of a crash.

Our base case downside risk for the S&P 500 is 2000-2300, with a possible overshoot to about 1700 if the market were to really panic. This does not necessarily mean that the market will fall that far as it is based on the assumption of a NASDAQ and large growth stock crash.  U.S. equity investors can be largely insulated from the downdraft and find opportunity in cyclical and value stocks. Global investors will find more upside potential in non-U.S equities, with a particular focus on emerging markets.

The SEBI announement dated 11th September is likely to storm into the dynamics of mutual fund sector, as the multi-cap funds will how be required to allocate a minimum of 25% of their total assets into Mid-caps and small caps each. We further talk about the likely scenarios that might occur regarding the entire MF ball game.

India is not technically in recession – defined as two back-to-back quarters of negative growth- and it plausible that one might be narrowly avoided. However any post-lockdown is likely to be weak at best and probably temporary. There is no getting away from the fact that the outlook is darkening. 

• UK GDP grew by 6.6% m-o-m in July, broadly matching the Consensus expectation. Nonetheless, activity is still 11.8% below February levels, with only 54% of the decline recovered. That is worrying when most sectors had reopened by then.
• Retail reopened relatively early, so GDP’s recovery is naturally lagging by about a month. However, it is also languishing, with the lagged ratio of growth rates slowing from 0.7 to 0.47. Slowing so soon is disappointing for the demand outlook.

US labour market conditions continue to heal as testified by a declining unemployment rate and a rising labour force, thereby helping to allay fears of supply-side impairment due to the COVID-19 pandemic. The pace of labour market improvement will slow, particularly if there are disputes about the outcome of the Presidential Election.

In the aftermath of last year’s Fed Listens meetings, Chair Powell outlined that labour conditions in socially-disadvantaged communities will impact future policy conduct. Aggregate labour market slack is greater than perceived due higher unemployment rates in socially-disadvantaged communities and, consequently, the Fed should allow the civilian unemployment rate to dip even further below its natural rate.

There has been no progress in advancing fiscal policy support at the federal level due to the Congressional summer recess, but there are risks of a government shutdown at the end of the month. Fiscal policy at the state level, notably in California and New York, could be tightened to bridge budget gaps that could be detrimental to state economies.

US retail investors have increasingly participated in the post-March equity rally, although historically this has been a warning signal of an impending market peak. Options have become a favoured conduit to participate in rising equity prices, but this practice has also contributed to higher volatility in the stock prices of market leaders.

US equity bulls are convinced the next decade will herald a new wave of technological innovations, analogous in their impact to those that transformed the 1920s. Historically, technological innovations have benefited the household sector via lower selling prices as opposed to higher corporate profit margins, but a looming decade of innovation implies downward pressure on inflation and, consequently, a return to 20th Century interest rate levels will be highly unlikely.

With the rest of the world still in various stages of lock-down, China has returned to its traditional export- and investment-driven economy — fueled by a surge of TSF (which rose 56.9% YoY faster in Jan-Jul 2020), implying a new burst of shadow-financing. Exports rose 9.5% YoY in August, and China’s steel production rose 9.1% YoY (while the rest of the world’s declined 16.1% YoY) in July. So it is worth staying Overweight China for now. But its imports contracted 2.1% YoY in August, and retail sales have declined YoY each month of 2020, illustrating the continuing slump in domestic demand; once the rest of the world has no need to absorb the massive new capacities China has added in the past 4 months, China’s imbalances will become a major dampening factor for its financial system in 2021.   

China’s total social financing (TSF) has increased by RMB22.39 trillion  (US$3.26 trillion) in January-July 2020, 56.9% faster than for the same period in 2019, with shadow-banking seeing a powerful rebound. This boosted FAI (fixed asset investment), albeit mainly public FAI (+3.8% YoY in the year-to-date), while private FAI declined 5.7% YoY. But after a severe decline in 1Q 2020, FAI began growing in April, and was up 9.3% YoY in April-July 2020, resuming its role as the main driver of China’s economy. Retail sales, meanwhile, declined YoY in every month of 2020. 

As the originator of Covid-19 (or the “Wuhan Coronavirus”), China had a two-month headstart on dealing with the crisis, and was able to contain it within Hubei province (of which Wuhan is the capital), the only part of China that was fully locked down in January and much of February. Once the rest of the world began to lock down, China was in position to reopen, and its exports have consequently accelerated steadily, growing 7.2% YoY in July and 9.5% YoY in August 2020. The rebound in FAI is, for now, being partly validated by the rebound in global demand for China’s exports, at a time when much of the rest of the world is partially locked down.  This is well illustrated in the steel industry, where China’s output has increased 5.9% YoY in the past 3 months (May-July 2020) while the rest of the world’s steel output has declined 20.5% YoY. 

As long as the rest of the world’s economy remains in various stages of lock-down, China’s relatively undisrupted economy will gain global market-share. During this phase (likely to last at least through October 2020), investors should remain Overweight China. The weakness of private consumption means that any setback to China’s exports (likely once the rest of the world’s supply-chains begin normal functioning by November-December 2020) will be impossible to counter with domestic demand. The imbalances of excess capacity built up over the past 4 months of strong FAI (particularly public FAI) will then rebound on China. 

Implications of NPS Incorporating More ESG Criteria on Domestic Investments (Bonds & Stocks)

• Negative Impact on VICE industries 
• Positive Impact on Renewable Energy Industries
• Negative Impact on Coal & Oil Industries
• Greater Representation of Women in Senior Management Team/BOD