China has had a flair for using periods of strengthening global growth to introduce reforms that brought about near-term growth pains in an attempt to foster longer-term structural gains. Supply-side and shadow banking reforms, for instance, were instituted at times when global GDP was heating up. After uncomfortable periods of slowing, China has tended to spring into “net” stimulus mode, just in time.
Throughout 2021, as world growth was heating up, China once again issued a raft of policy reforms. The government targeted technology platform companies with policies to protect consumer data and end these companies’ blockage of emerging competition, while essentially banning for-profit education, placing stern limits on the time children could spend gaming, and – critically – taking a hard line on highly leveraged property developers whose financials had previously crossed China’s regulatory “red lines.” With real estate speculation and associated construction of residential property typically accounting for roughly 25% of the country’s growth, restraints on developers’ ability to finance has led to an abrupt slowdown inside China virtually everywhere except exports, which have held overall “net” growth just barely at the low end of their tolerance band. Yet this “net” itself is still slowing. The question now becomes, has China reached the point of discomfort that historically has triggered “net” stimulus reversals?
At least with respect to the property sector, we do not believe the government wishes to do more than stabilize the downturn by the first quarter of 2022 at today’s level of activity. Over time, too much of the nation’s savings poured into real estate speculation, creating excessive financial leverage and inequality. ‘Not to let a good downturn go to waste,’ China’s government looks set to make an example of property developers that did not abide by the regulators’ guidance, by incrementally establishing several more precedents for defaults. Allowing Evergrande to default may be part of that example, for all to see. Ongoing real estate projects will be moved from privately owned “red line crossers” to state-owned property developers to keep retail investors in those projects whole and construction workers employed.
Yet China has been trying to introduce the concept of default to its debt markets since the 2014 supply-side cuts that closed down inefficient polluters with overcapacity, which produced the first mini wave of selective defaults. Alongside news of Evergrande’s pending default, Premier Li Keqiang is indicating that banking system liquidity will be increased through cuts in banks’ reserve requirement ratio. This follows the People’s Bank of China (PBOC) changing its hawkish guidance one week ago to more neutral language. Whispers have emerged that property developers which haven’t crossed the red lines will soon be allowed to access securitization markets and issue once again in the domestic market. Finally, local governments are reportedly being encouraged to issue debt in the first quarter, in time to put selective fiscal stimulus to work in the second half.
Is this the beginning of a policy-driven upturn marked by “net” stimulus, with the downward policy effects on property developers soon to be more than offset by general stimulus elsewhere? Or will we see “net neutral” stimulus, which would be a departure from past patterns? The 20th Party Congress in October of next year is one reason the markets expect “net” stimulus to revive growth. However, President Xi doesn’t appear to need evidence of a firmer tone in the second half to secure his third term.
Xi has been shifting China’s focus away from the sheer quantity of growth to prioritizing its more equitable distribution. Policies aimed at dampening real estate speculation by the wealthy to make housing more affordable to the middle class to actually live in, despite the slowdown, are nonetheless very popular in China’s hinterlands; so too are policies that lighten the load on China’s students and rein in a few companies’ exploitation of consumer data. While growth is down, President Xi’s popularity and control are high and rising. If China’s growth can be maintained at global norms without further ratcheting financial leverage, why rock that boat?
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.
Markus Schomer, CFA
Global Economic Strategy
CS 2.75 (unchanged)
Stance: Unchanged this month and last, our CS should stay above neutral for a while on expectations that global GDP growth will remain above its long-term average over the next 12 months and return to trends that persisted before the pandemic. But with global macro volatility again increasing, especially with uncertainties related to the new Omicron Covid variant, the confidence interval around our base case is widening.
Backdrop: On the growing strength of emerging markets (EM), global purchasing managers’ indices (PMIs) rebounded in October. The US economy slowed in the third quarter, but the most recent data show a fourth-quarter rebound. In Europe, the latest Covid wave is threatening renewed shutdowns. Supply constraints weighing on global industrial activity aren’t easing and will keep inflation pressures elevated. The result is a change in expectations regarding the speed of monetary policy normalization.
Outlook: The prospect of more broad-based monetary tightening increases risks to overvalued markets. Offsetting that risk is the prospect of a smoother fiscal-stimulus slowdown following the latest US fiscal package and the prospect of another before spring. Japan’s new government is ready to launch another package of its own, and Europe‘s Recovery Fund will support growth next year. Another offset is the prospect of supply constraints easing next year, possibly suggested by the improving PMIs.
Risks: With central bankers no longer able to ignore the inflation surge, the adjustment in rate-hike expectations has started, though Omicron concerns may influence this calculation. A further acceleration in inflation could prompt banks to act too rashly.
Portfolio Manager, Developed
Markets Investment Grade
CS 4.00 (unchanged)
A few noteworthy events happened in November. The 20-year/30-year swap curve inverted, which is the first swap curve inversion I have ever seen. The second, which plays into the first, is a 30- year Treasury auction with a tail of 5.2 basis points (bps). That is almost one point of miss and a sign of either extreme illiquidity or the unwillingness of primary dealers to put bonds on their balance sheet without concessions. Neither possibility is good. Nor are the current disruptions in the European repo market or the 4.1% eurozone inflation print. Will the European Central Bank (ECB) succumb to the pressure to begin fighting inflation? The emergence of the Omicron Covid variant could also weigh on this determination.
Steven Oh, CFA
Global Head of Credit and Fixed Income
CS 3.00 (unchanged)
Third-quarter earnings have been largely positive, but forward guidance is less rosy due to margin pressure from rising input costs, particularly labor. Still, default rates continue to decline toward historical lows, with expectations of ultra-low defaults persisting through 2022. Across developed markets (DM), our bias toward high yield (HY) over investment grade (IG) continues but is moving closer to neutral with the BBB-BB spread differential at +90 bps. We continue to favor US over European credit.
As inflation flares, DM credit spreads have remained stable in the face of rates volatility, perhaps due to the well-telegraphed commencement of Fed tapering. The credit markets’ focal point remains China, where default rates are likely to spike materially in 2022. The commencement of liquidity access for better capitalized companies should stabilize the market and result in a more stable entry point for the future survivors that are trading at cheap valuations.
Senior Sovereign Portfolio
Manager, Emerging Markets
CS 2.75 (-0.25)
Diverging Fed and ECB/Bank of Japan monetary policy expectations, which have become more prominent in recent months, as well as trade factors weighing on the euro and the Japan yen, are accentuating support for the US dollar into year-end and beyond. The technical break of 1.1500 in the euro/US dollar has opened the potential for a faster move lower than expected a month ago, but positioning and seasonal factors could trigger a December reversal. Fundamentals and technicals justify an extension of the US dollar appreciation trend, shifting our euro/US dollar 12-month forecast range to 1.10-1.15 from 1.15-1.20 and the US dollar/Japan yen to 112.50-117.50 from 110-115. Aggressive monetary tightening by Latin American central banks has created a policy buffer, which normally would be considered supportive for exchange rates. We forecast significantly lower inflation for the region next year, generating forward-looking positive real rates. Any sign of a peak in inflation, starting with Brazil, could cause markets to readjust their expectations for further monetary policy tightening, creating a good market entry point.
Senior Vice President, Corporate
Portfolio Manager and Head of
Trading, Emerging Markets
USD EM (Sovereign and Corp.)
CS 2.50 (unchanged)
Local Markets (Sovereign)
CS 2.25 (unchanged)
We maintain our unchanged scores for US dollar and local emerging market debt. Overall, our core scenario remains “Cruise Along” at 60%, with our long-term fundamental base case reaffirmed for EM. We see the pockets of volatility due to Latin American politics and the ongoing China property situation as ultimately creating value opportunities. US Treasuries, which will be key to changes in weightings made in HY and IG, remain a main driver of return expectations as EM spreads trade in a narrow range. We see the most compelling 12-month values in local currency debt and don’t anticipate any widespread or persistent increases in market volatility, although the impact of the new Omicron variant could change this calculation.
Managing Director, Portfolio
Director, Global Multi-Asset
CS 3.15 (unchanged)
In China, it’s not yet clear whether the paused regulatory ratcheting will resume once Evergrande-related jitters recede. We’ve begun to see macro policy support in the form of local government bond issuance to finance local projects, though these are sized to slow the slowdown, not restart the credit cycle as in the past.
Despite a few green shoots, supply chain disruptions are not disappearing, worsening inflation as fiscal policies actively boost demand. We see the problem peaking in the first quarter of 2022, with improvement frustratingly slow from there. In the US, we expect passage of a roughly $2.25 trillion fiscal package, which is substantially more expansionary than support in any other major economy. On the monetary side, central bank repricing has been catching up to our expectations. We see volatility in several G10 fixed-income markets: The front end of yield curves in Australia, New Zealand, Canada, and the UK have seen the most rapid higher repricing on record, with central bank pushback not comforting, as they are now viewed, appropriately, as being behind the curve.
Principal, Real Estate
The focus on ESG in real estate has intensified greatly over the past six to 12 months, especially as rapid advancements in technology and post-pandemic preferences have made many properties outdated. While environmental concerns have long been a concern, with property and construction sectors accounting 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. While supply-chain bottlenecks are easing, 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.
Ken Ruskin, CFA
Senior Research Analyst
and Head of Sustainable
Investing – Equities
CS 3.00 (unchanged)
Strong overall demand has buoyed markets against many headwinds, including inflation, supply chain disruptions, various issues in China, and potential central bank taper/tightening. Commentary accompanying corporate earnings reports so far suggests that broad-based strength continues, with backlogs increasing as supply, not demand, is the limiting factor for most industries. We continue to uncover investment candidates, though valuations remain a challenge. Companies that are beneficiaries of increased capex and are increasing their total addressable market are appealing, particularly as overall valuations remain elevated. A balanced, bottom-up portfolio has been key to delivering alpha in this market as numerous debates spark market rotations and volatility.
CS 2.50 (unchanged)
In China, consumption improved in October, but companies are cautious on growth and the real estate sector remains troubled. In India, despite margin pressures from commodity prices and logistical challenges across most sectors, discretionary demand has picked up, in some cases reaching pre-Covid levels. We have lightened some Brazilian holdings due to higher inflation and interest rates, as well as political and fiscal tensions, but retain broad exposure in quality consumer goods, ecommerce, and fintech names. Robust fundamentals support equities markets in Emerging Europe. On the portfolio level, we are looking at alternative energy and electric vehicles as potential sources of long-term secular growth.
Quantitative Fixed Income
Our Market Cycle Indicator has turned less bullish, following the flatter curve. Credit spreads look rich at the short ends of IG and HY. In industry selection, our model favors oil and gas, industrials, and infrastructure and dislikes real estate, pulp and paper, and transportation. Our global rates model maintained its forecast of lower yields and a flatter curve. The rates view expressed in our G10 model portfolio was overweight global duration. It was slightly underweight in North America, being underweight US and overweight Canada, and overweight the UK and Europe while underweight Japan. Along the curve, the model continued to position on flattening and overweighting the long end.