Thy Brother's Keeper

• Cain after killing his brother Abel. Henri Vidal, 1896. Jardin des Tuileries (Paris, France)

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MR. MICHAEL CEMBALEST:  Good afternoon and welcome to the July "Eye on the Market" podcast. We start this week with a discussion about the delta variant with some comments on the Fed; in wake of what's going on with DD; we talk about the U.S./China economic divorce. And then we conclude with a unified theory of a whole bunch of things:  the U.S., China, wages, jobs, the World Trade Organization and investment – and implications for investment portfolios in 2022 and beyond.

So let's start with the delta variant. I think at this point the information that's out there is doing a good job of summarizing the facts and research on the ground. There are a small percentage of breakthrough hospitalizations and deaths for people that are vaccinated taking place in the Western world. But the main risks are overwhelming affecting unvaccinated and immunocompromised people that either have no or insufficient antibody responses.

From an investor's perspective I think the developed world equity market should be able to withstand this delta variant, and we added a chart on our virus web portal to explain why it looks at vaccination, mortality by country, along with its economic throw weight. And what you can see is that the places that have the highest levels of mortality and low vaccination tend to have very low global economic throwaway in terms of trade, FDI portfolios and stuff like that.

And in some ways the most important chart to watch is the one from the U.K. where there is a massive spike in delta infections that has not led to a surge in overall hospitalization and mortality.

This masks what's going on underneath, which is that the unvaccinated people over 50 in the U.K. are suffering substantially – 14 percent of the delta infections ended up in the hospital and almost four percent of them died. But it doesn't show up in the overall numbers because in the U.K. 96 percent of all people over 50 are vaccinated. So the cohort of at-risk, unvaccinated people over 50 is pretty small. In the U.S. that figure that was 96 percent over 50 vaccinations in the U.K.; in the U.S. that number is 75 percent; lower in a lot of places. And in the emerging world obviously the percentages are much lower than that.

Even so, my primary message to the group was that the train has left the station in the U.S. and a lot of other Western countries and the delta variant is going to have a large impact on certain individuals but not on markets themselves. Most federal and local governments in the West are unlikely to reimpose mobility restrictions, particularly since we're dealing with a cohort that's exposed that are mostly unprotected by their own volition.

And the policy seems to be – this is not my point of view – but the policy seems to be you are not "thy brother's keeper" if he chooses to expose himself, irrespective of whatever his reasoning might be. I thought it was interesting that even the New York Times, which I was surprised to see, published a piece on how younger generations are bearing unacceptable sacrifices to protect older ones. I really doubt The Times would have published this while Trump was president for fear of being seen as aligning themselves with Trump, but with the new administration in DC it's now safer to make your intergenerational preferences clearer.

So the bottom line is that there is a substantial number of unvaccinated people over 50 who are at risk in the developed world, but given the shrinking size of that cohort I don't think that you're going to see governments do that much permanent about them that affects markets.

We had a reasonably optimistic stance heading into this year, mostly based on the notion that there's a lot of pent-up household and corporate demand that's going to have to be met through increased spending, increased hiring, increased investment, and all of that's playing out. But boy, a lot of that is priced in. We're now halfway through the year; the markets have done extremely well.

And when we take stock of things like massive number of secondary offerings from unprofitable companies, a collapse in high-yield bond spreads to tightest levels on record, surging home prices, and then just really bad underwriting discipline in things like the loan markets. It seems like we're getting closer to the edges here of where the Fed has wrung every bit of investment aggressiveness that they can have priced into financial markets.

And so a couple things from here:  I think earnings growth is going to be the driver of markets; we've run out of room for multiple expansion. And I think the risks are more balanced from here, whereas over the last 18 months it was pretty clear that you were going to be getting a stimulus-related boost to overall markets. And so the risks appear a little bit more two-sided right now.

We also get into a discussion of DD, the 25 percent decline in the stocks since China announced its enforcement actions has refocused a lot of people on the risk of Chinese tech stocks and the U.S. economic divorce with China.

Before getting into the details on that, however, this is an example where there's a little bit too much attention being paid to a couple of stocks that have gotten hit and not enough to some of the broader context. The China share of imports into the U.S. is only a little bit below the 2018 pre-trade war levels. The U.S. stocks that are exposed to the trade war are doing fine versus the market. Semiconductor exports to China are still rising, despite the situation with Huawei. U.S. investors continue to accumulate Chinese stocks and bonds. And there's no sign that China, like Russia did, is engaged in any kind of economic warfare via its treasury holdings.

So there's a bunch of stuff that's more normal than abnormal as it relates to the U.S.-China relationship. The clearest thing that you could say is suffering is when you look at the bilateral foreign direct investment data in both directions it's slowed down pretty substantially from where it was let's say in 2016 and 2017.

That said, the Biden Administration has unleashed an alphabet soup of China-targeted policies related to U.S. data:  consumer apps, U.S. investment in Chinese companies affiliated with the military requiring the delisting of Chinese companies that don't comply with SEC data requirements, throwing tons of money at U.S. semiconductor and stem companies, congressional oversight of mergers involving China and gifts by any Chinese entities to U.S. institutions. Buy America requirements for infrastructure projects, in terms of iron and steel, sanctions on China for cyberattacks, intellectual property theft, the sanctions on U.S. and Chinese companies knowingly using forced labor. It actually got to the point where some Progressives went to the Biden Administration and said, "Hey, can you please cool it on some of this stuff? Because we may lose China as a partner in climate discussions." In any case – and then on top of that China may have a possible partnership with the Taliban in Afghanistan; I can't imagine that would play well in DC either.

Even with all of that alphabet soup of anti-China policies the larger risks facing Chinese tech stocks and ADRs, which have performed pretty poorly over the last few months come from Chinese domestic policy concerns, rather than the U.S. economic conflict with China. Chinese regulators – and some of their actions have been kind of impressive when you think about the regulatory lapses that have taken place in the U.S. over the last 25 years – Chinese regulators have been very active with guidelines aimed at curbing monopolistic practices, limiting lax underwriting activities – that's what canceled the ANT [phonetic] financial IPO, policing data privacy, addressing worker mistreatment, reforming industries.

And so while the timing of the enforcement actions on DD suggests that they also wanted to sense a message to U.S. politicians, the domestic policy concerns were really the driving factor behind this decision to require mobile stores to rule that out.

And then on top of that, over the weekend China proposed new rules requiring companies with more than a million users that want to list in foreign countries to undergo a cybersecurity review to make sure that the data "won't be maliciously exploited by foreign governments," is the way they phrased it, and they'll also look at national security risks as well.

So until very recently Chinese and U.S. tech stocks traded at roughly the same multiple of around 25 times forward earnings. These new risks that are mostly coming from China, rather than from the U.S., suggests that there should be a wider gap between them.

The last section in this week's piece is titled "The Pig and the Snake," and has to do with a unified theory we have of the U.S., China, wages, jobs, inflation, the World Trade Organization, and implications for investment portfolios.

So the U.S., as we mentioned, is booming; capital spending and hiring indicators should give us some tail winds that last a few month. There is some whacky inflation readings that you've probably read about:  used car prices, strawberries, motor vehicle insurance. But most professional economic forecasters and the market-based inflation expectations are looking past them.

And I think that's probably right. I think goods and services and commodity-priced inflation in 2022 will come back down. And the pig will move through the snake, so to speak, and the inflation indicators should be within the Fed's comfort zone.

The thing that's much more concerning is wage inflation. There's a lot riding on the assumption that the expiration of COVID and unemployment benefits this fall will loosen labor markets. And they probably will, to some extent. But when you look at the momentum in labor markets there's a lot going on other than the COVID unemployment payment situation. Price hike intentions are outstripping wage hikes; wages are rising faster than employment itself. You've got the highest number of hard-to-fill job openings and wage increases on record. You have a lot more people who don't want a job versus people that do.

And then there's thing called the Reservation Wage, that reflects the cost of luring employed and unemployed people to new jobs. And that's been going up. And so there's a lot brewing in here that suggests that we're heading into a period of substantially-rising wages at a pace that's faster than what we've seen in a long time.

Now to be clear, rising wages are a good thing, a positive development for the U.S. The challenge is there's a level of wage inflation that's inconsistent with the Fed's zero rate policy. And here's where this whole U.S.-China discussion comes full circle. And so you'll probably want to look at the charts that correspond to this discussion, but let me just walk you through how I see it.

So in 2001 the West finally relented and allowed China into the World Trade Organization. On a dime China immediately launched the most aggressive and unprecedented intervention in its currency markets that anybody's ever seen. The goal was to prevent appreciation of currency in order to boost its manufacturing and export shares. And, boy, did it work. China experienced the greatest economic boom in postwar history, absolutely outstripping the number two country, which is Korea, by a mile in terms of its fastest 30 years of growth.

Unfortunately that Chinese economic boom was not a rising tide lifts all; there were some zero sum games issues in there. Their currency intervention and other policies contributed substantially to a collapse in U.S. manufacturing jobs. They were declining at a slow pace during the '60s all the way through the end of the '90s, but then the U.S. manufacturing jobs completely collapsed after China joined the World Trade Organization.

And then you also had a collapse in the U.S. in labor's share of profits, right? These profits either go to labor or capital and there was a collapse in labor share of profits. And then from that we've got all sorts of aftershocks related to opioids, polarization and growing wealth inequality.

So now wages are finally rising again and labor's share of profits is finally getting closer after a 15- to 20-year lull, to where it was for most of the postwar era. The Fed's going to be really reluctant to interfere with that. And as a result, as the wage pressures build I don't think the Fed's going to do much of anything upfront, and that creates, from an investor's perspective, even more reasons to favor reflation strategies in portfolios in 2022 and beyond. So when you get a chance you can talk to your advisors about that those reflation strategies are. But that's how I see it.

So when you look at what's going on in the labor markets now you can connect, in my view, what the Fed is up to everything, dating back to the decision to allow China into the World Trade Organization in 2001, and what the costs and benefits of that decision was to the United States.

So anyway, thank you very much for listening and we will talk to you next time.

AUTOMATED RECODING:  Michael Cembalest's "Eye on the Market" offers a unique perspective on the economy, current events, markets and investment portfolios and is a production of JPMorgan Asset and Wealth Management. Michael Cembalest is the chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.

For more information please subscribe to the "Eye on the Market" by contacting your JPMorgan representative. If you'd like to hear more please explore episodes on iTunes or on our website.

This podcast is intended for informational purposes only and is a communication on behalf of JPMorgan Institutional Investments, Inc. Views may not be suitable for all investors and are not intended as personal investment advice or as solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research. 

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