In the wake of the 100th anniversary of the founding of the Chinese Communist Party (CCP), the nation has sprung into rapid-fire regulatory tightening reminiscent of the 2014-2015 supply-side reductions and 2018’s crackdown on shadow banks, both of which caused China’s economy to slow. Yet this time, with regulatory resets in so many industries all at once, many observers are searching for the common thread, as well as insight into how far it will go. New regulations range from restrictions on technology platform companies’ use of data, prohibitions against for-profit tutoring, and limits on time spent gaming for children. They also include stepped-up restrictions on credit flowing into real estate, price controls on residential real estate in certain cities, limits on overseas equity listings for data-rich firms, and new work rules and compensation practices for ride-hailing companies.
Many in the West have labeled these moves as “crackdowns” on the private sector, with some even asserting a return to Maoism. While the raft of regulations may be a step in that direction, we view it more as a course correction in the balance between sectors that will remain market driven while others become more regulated, and do not see it as a return to a planned economy. As in the US, economic inequality has risen in China over the past 30 years. The common thread in the new regulations is a rebalancing that alleviates resulting pressures on the middle class, to be paid for by placing more expectations on the privileged.
This means deciding which sectors that were previously market-oriented need more regulatory intervention in seeking President Xi’s view of “common prosperity” across multiple facets. These include high-quality public education, technological innovation that is shared more broadly and is not allowed to block competition, and preventing the bidding up of multiple homes for the privileged, which pushes prices out of reach for most young families and diverts so much of the nation’s capital. Moreover, those who have reaped fortunes will be firmly nudged to give back in the form of charitable donations.
While more lies ahead, in our view, a second trigger (the first being the 100th anniversary) appears to have been an important demographic study that shined a light on China’s population, which appears set to shrink. After unsuccessfully trying to reverse the impact of its one-child policy, in place from 1980-2015, policymakers now see rising inequality given the high and rising cost of raising families as a key factor blunting efforts to stabilize population growth. Thus, many of today’s regulatory changes are attempting to lower the cost of housing, education, and healthcare to young families. Others, perhaps inspired by the 100th anniversary of the CCP, aim to shrink the gap between the middle class and the wealthy to boost China’s overall quality of life.
Given the sheer scope of regulatory tightening, this time around the government appears more willing to forego some measure of economic growth in the short term to achieve its policy goals. Uncertainty from past regulatory crackdowns has depressed growth, with partial alleviation from required reserve ratio (RRR) cuts and policy-oriented bond issues to support investment in targeted areas for growth. This time will repeat that pattern, aimed at slowing down the slowdown.
The government would like to see much less credit flowing into second homes (and third, fourth, and fifth homes for the ultra-privileged) and more flowing into new supply chains to increase their self-sufficiency in various technologies. However, this is easier said than done. The CCP learns and adjusts. Over time, they have learned that state-owned enterprises are heavier users of credit and less efficient in creating growth. Other initiatives will be necessary to incentivize new ventures knowing that debt-to-GDP keeps rising. One obstacle to success is the perception that incentives are being reduced. To date, wealth has been asked to contribute more, trying to balance and mitigate the impact on incentives. Yet time will tell.
In the offing over the medium term could be more public housing, possibly funded through a gradual introduction of property taxes, which now exist only in trial programs. To improve the nation’s health generally, the government is likely to continue directing and encouraging capital flows to innovative high-tech and greener alternatives to older, less-efficient, and dirtier manufacturing and power-generation facilities. This is in line with the government’s plan to reach peak carbon emissions by 2030 and to be carbon-neutral by 2060. The move also conforms with plans to accelerate the upward path of the nation’s manufacturing capacity along the value chain. Stay tuned.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Global Economy
Markus Schomer, CFA
Chief Economist,
Global Economic Strategy
CS 2.50 (unchanged)
Stance: With well-above-average global GDP growth likely to continue over the next 12 months, our score should remain above neutral. The direction of macro fundamentals is still pointing to a possible score downgrade in the fall, but things haven’t changed enough over the past month to warrant a change now.
Outlook: The spread of the Delta variant is having an adverse economic impact. The latest purchasing managers’ indices (PMIs) show slower growth in the UK and the US, while Australia and other countries in Asia are contracting. However, episodes of virus resurgence haven’t lasted and were followed by strong rebounds. The continued Covid impact also should lower the odds of meaningful reductions in global monetary stimulus this year. Inflation pressures appear to be peaking, removing another reason to reduce monetary policy accommodation. Furthermore, labor markets remain extremely tight. That once held back growth, but in the future could provide a strong boost once people return to the labor force.
Risks: The decline in sentiment shouldn’t pose a significant downside risk; recessions aren’t self-fulfilling prophecies. Policy errors could be a risk, but the Fed is unlikely to start tapering now, and we still await the size of the next US fiscal package. China’s slowdown has reignited a debate over the veracity of Chinese economic data. Yet this recovery, unlike the previous one, is not driven by China. My risk score, therefore, points toward financial markets and a possible sudden rise in bond yields or a sudden fall in equity prices that could affect investment and consumption.
Rates
Gunter Seeger, CFA
Portfolio Manager, Developed
Markets Investment Grade
CS 3.50 (-0.50)
Prior to 7 August, the Fed seemed determined to announce its taper program in September, then begin its work in some form in October or November. But the spread of the Delta variant and the mess in Afghanistan have postponed the taper into next year, even if the Fed doesn’t say so publicly. Expect continued volatility in Treasury markets and the delay of the $1 trillion infrastructure bill and the $3.5 trillion Democratic spending bill to push more spending into 2022.
Credit
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 2.75 (unchanged)
Our CS holds steady due to credit fundamentals remaining favorable and heavy seasonal supply, not credit concerns, behind the lack of additional spread tightening. Spreads have been moving inversely to Treasuries, resulting in limited price impact, which we expect will continue. We do not foresee any form of taper tantrum. Valuations remain marginally attractive, with investment grade (IG) in the mid-80s, high yield (HY) near +315, and emerging market (EM) spread widening concentrated in Chinese credits. We anticipate that developed market (DM) credit spreads will tighten should new-issue supply pause later this year. Default rates are plunging toward historically low levels, and upgrades are materially outpacing downgrades. Overall, we prefer to be overweight leveraged finance spreads over IG, and EM over DM, though the latter differential could widen further if China-specific concerns increase.
Currency
(USD Perspective)
Anders Faergemann
Senior Sovereign Portfolio
Manager, Emerging Markets
Fixed Income
CS 3.00 (+0.25)
The US dollar has strengthened in recent months due to the US economic recovery and increased talk of Fed taper. While the US dollar should remain well supported by robust fundamentals, triggers for further strength are less evident. With positioning now less obviously underweight the US dollar, the market seems to have found a temporary equilibrium around our year-end forecast of 1.1750. In EM, positive real yield, hawkish central banks, and near-peak inflation in several major nations should provide near-term currency support. We expect EM foreign exchange (FX) to benefit from the normalization of monetary policy well ahead of DMs, and several Latin American currencies appear attractive compared with Asia and Eastern Europe. We have identified a wide range of EM currencies offering compelling value, such as the Brazilian real, Colombian peso, Chilean peso, and Mexican peso.
Emerging Markets
Fixed Income
Chris Perryman
Senior Vice President, Corporate
Portfolio Manager and Head of
Trading, Emerging Markets
Fixed Income
USD EM (Sovereign and Corp.)
CS 2.50 (unchanged)
Local Markets (Sovereign)
CS 2.25 (unchanged)
We expect China growth to stabilize around 5.5% next year, following growth of 8.1% this year. EM growth should find equilibrium of around 5.2% in 2022, remaining above the long-term average. We maintain our current bullish stance in US dollar-denominated and local debt with our various scenario weights: “Bright Future” at 35%, “Fly High” at 5%, our central “Cruise Along” at 60%, and 0% in our bearish scenarios. Overall, we expect strong underlying fundamentals and our positive outlook to continue well into 2022, with sovereign balance sheets improving and corporate leverage returning to its lowest level in the post-financial-crisis period. The bright outlook is leading to greater institutional inflows, and we anticipate more strategic allocations.
Multi-Asset
Sunny Ng
Managing Director, Portfolio
Manager, Global Multi-Asset
CS 2.85 (+0.10)
Despite being in the midst of what is likely a multi-year reflationary expansion, we are becoming less bullish over the coming nine to 18 months. We see a gradual deceleration of global growth toward pre-Covid norms, longer-lasting transitory inflation, and today’s loose monetary policy to become less accommodating, with tapering to begin in early 2022. As a result, we revised our score again, from 2.75 to 2.85, now barely above neutral. New on the world stage are significant policy changes in China, affecting many private-sector industries, including private education, home delivery, e-commerce, and real estate. Similarly abrupt policy changes in previous years triggered drops in consumer spending and private investment. While monetary accommodation in China is likely to stem the pace of the slowdown, it will nevertheless be an important offset to rising global pricing power.
Real Estate
Gregg Gilbert
Principal, Real Estate
The focus on ESG has intensified over the past six to 12 months. While environmental issues have long been a concern, as property and construction sectors account for about 40% of all carbon dioxide emissions globally, the industry is grappling with how to measure social and governance factors, which had been largely neglected. Currently, changing use patterns are exacerbating dramatic undersupply issues in logistics, institutional rented residential, senior living, and student housing, sectors that are attracting capital. Risks include funding gaps due to hesitancy from traditional banks to finance development, profit erosion due to rising costs, and inflation-related interest rate increases, which would cause substantial value erosion.
Global Equity
Ken Ruskin, CFA
Senior Vice President, Senior
Research Analyst and Head of
Sustainable Investing – Equities
CS 3.00 (unchanged)
Commentary accompanying second-quarter results was positive on demand, with many companies seeing sales above pre-pandemic levels and most reluctant to forecast the duration of the sales strength beyond a quarter or two. Cost pressures are rising, though most companies are able to manage the impact in the near term. Sell-side estimates have largely caught up with buy-side sentiment, and valuation levels are higher than historical norms. We have still been able to uncover investment opportunities with a medium- to long-term perspective with sufficient upside, though this is becoming more difficult.
Global Emerging
Markets Equity
Gustavo Pozzi, CFA
Senior Vice President,
Portfolio Manager,
Global Equities
CS 2.50 (unchanged)
We maintain our score at 2.50 as we see most of our companies beating estimates while valuations are down with recent market volatility. In India, the impact of the second Covid wave on bank asset quality and on other financials has been less than what the market feared. Sentiment, based on several encouraging signs, is positive. In China, travel-related companies have been under pressure due to Covid-related reductions in summer demand. While the equity risk premium is higher due to regulatory uncertainty, valuations are down to more supportive levels. In Latin America, our quality names in consumer and e-commerce/fintech continue gaining market share while reporting strong second-quarter results. In emerging Europe, strong market performance is supported by robust fundamentals.
Quantitative Research
Peter Fwu
Quantitative Strategist,
Quantitative Fixed Income
Our US Market Cycle Indicator (MCI) continued its decline from a March peak, mainly due to a flatter yield curve (by 15 bps). BBB rated option-adjusted spreads widened 5 bps to 112 bps in July. Credit spreads looked rich in IG and HY, where the long end presented more opportunities. In industry selection, we kept our cyclical sector tilt, but to a less pronounced degree, favoring REITs, energy, and basic industry over utilities, communications, and insurance. Our global rates model continued to forecast slightly lower yield and a flatter curve. The rates view expressed in our G10 model portfolio was overweight global duration, being about neutral in North America and overweight Europe versus underweight in Japan. Along the curve, we are still positioned on flattening and are overweight the long end.