Michael Cembalest Chairman of Market and Investment Strategy for J.P. Morgan Asset & Wealth Management Jul 13, 2021
Economy & Markets
Thy Brother's Keeper
- Cain after killing his brother Abel. Henri Vidal, 1896. Jardin des Tuileries (Paris, France)
Topics: Delta variant; the Fed as firefighter and arsonist; US-China economic divorce picks up steam; a unified theory of the US, China, wages, inflation, the WTO, opioids and investment portfolios for 2022 and beyond
COVID and Thy Brother’s Keeper
“If you’ve ever desired a vacation on a ventilator in the ICU, then not getting vaccinated is probably for you”
Craig McCoy, former paramedic and president of Mercy Springfield Communities Hospital, Springfield Missouri
I led an internal discussion recently on the Delta variant for our asset management business. The details can be found in Section 1 on our virus portal here. Main messages: while the Delta variant has caused a small number of breakthrough hospitalizations and deaths for vaccinated people, the main risks overwhelmingly affect unvaccinated and immunocompromised people with no or insufficient antibody responses. From an investor’s perspective, developed world equities should be able to withstand the Delta variant; a chart we added on economic throw-weight (trade, FDI and portfolio flows), vaccination and mortality by country explains why.
One important chart to watch is the first one from the UK: so far, a large spike in Delta infections has not led to a surge in overall hospitalization or mortality. However, this masks what’s happening to unvaccinated people over 50 in the UK: 14% of such Delta infections ended up in the hospital and almost 4% died1 figures which are 4x higher than for vaccinated people over 50. The good news: in the UK, 96% of people over 50 are vaccinated, reducing the size of its at-risk unvaccinated population. However, in the US age 50+ vaccinations are ~75% nationwide (lower in many rural counties), resulting in larger populations of at-risk people; and in hotspot states (AR, FL, LA, MO, NV, WY), hospitalizations are rising more rapidly than in the UK.
Even so, my primary message to the group was that the US reopening train has left the station and that the Delta variant is unlikely to have a durable impact on US equity markets. Federal and local governments are unlikely to reimpose mobility restrictions to protect a cohort that is mostly unprotected by its own volition. The policy borrows from Genesis 4:9: “you are not thy brother’s keeper if he chooses to expose himself to COVID”, irrespective of whatever his reasoning may be. A February NYT article2 described how younger generations are bearing unacceptable sacrifices to protect older ones. I doubt the NYT would have published this while Trump was President, for fear of being seen as aligning itself with his Administration’s views. But with a new administration in DC, I suppose it’s safer to make one’s intergenerational prosperity preferences clearer.
Charts: 96% vaccination rate of people over 50 explains the gap between UK infections and deaths; in the US, the reopening train has left the station irrespective of Delta variant outbreaks
Line chart shows daily infection and hospitalization levels on the left axis and daily deaths on the right axis. Infection levels have been rising since May and are currently at almost 30,000 infections per million people. So far, hospitalization and death levels have not followed suit, and remain very low.
Line chart shows lockdown stringency for the US, UK and Europe. The US has returned to a level of about 10, with 100 being the highest level of lockdown strictness. The UK and Europe have also eased lockdown strictness and are currently at levels of about 50.
The Fed as firefighter and arsonist at the same time
I read something recently which referred to the Fed as both firefighter and arsonist. That’s a good description: resuscitating private sector demand while simultaneously destroying decades of underwriting and investment discipline in the process. The firefighting resources the Fed is using: the easiest monetary policy in US history other than during wartime; and a symbiotic relationship with the US Treasury which now entails the Fed buying the entire stock of net Treasury issuance. You have to see it to believe it.
Bar chart shows 5 year average real yields on cash since 1830. Average yields in 2015 and 2020 have been the lowest since 1830, with the exception of during periods of war.
Line chart shows Fed Treasury purchases as well as Treasury net issuance. The Fed is now buying the entire stock of net issuance.
During the March 2009, 2012 and 2020 selloffs, the right question to ask was “what could go right”. When markets reach all-time highs and are close to the highest valuations on record (as they are now), the right discipline is to focus on risks as well. The US and global economy are set for a powerful recovery as pent-up corporate and household demand is unleashed. In the US, for example, household debt service ratios are close to the lowest levels in 40 years, suggesting a sustainable expansion in consumption. Even so, markets are pricing a lot of that in. As the world resets closer to trend growth in 2022, I envision modestly higher inflation in which industrials, energy, financials and other reflation plays outperform; and a market in which earnings growth drives equity returns, rather than rising valuations.
Line chart shows the price to forward 2 year earnings per share for the S&P 500 Index from 1990 to now. The P/E ratio remains elevated compared to historic levels at about 20x.
Line chart shows the price to earnings ratio on trailing 10 year average inflation adjusted earnings, representing a cyclically adjusted P/E ratio. This metric remains elevated compared to historic levels at about 37x.
In any case, here are some ashes that can be laid in part at the doorstep of the Fed and its policies: a collapse in the spread on high yield bonds, a locust-like scourge of secondary equity offerings from unprofitable companies, a rise in the market cap share of unprofitable companies, a surge in home prices and perhaps most concerning, a collapse in loan underwriting standards. Even when compared to the free-wheeling credit environment of 2007, lenders have discarded any discipline they used to have regarding covenants, restricted payments clauses, protections against layering and subordination, mandatory payments from asset sales, etc. This kind of thing is never a problem until you hit the bumpier part of the business cycle.
Line chart shows the US corporate high yield bond index spread over 10-year Treasury yields. The spread is currently at about 2%, which is near all-time lows.
Line chart shows net secondary offerings as a percentage of the US stock market, subtracting unprofitable firm offerings from profitable firm offerings. The current level is below 0, demonstrating that unprofitable companies have flooded the market with secondary offerings
Line chart shows the market cap of young unprofitable companies as a percentage of total stock market cap. Young unprofitable companies currently make up about 3.5% of the market, which is the highest percentage since the early 2000’s.
Line chart shows the year over year change in the US home price appreciation index from 2013 to 2021, for both the low to medium price tier and the medium to high price tier. Both price tiers have appreciated at their highest rates during the time period shown.
Line chart shows the loan covenant quality score from 2012 to 2021, where 5 equals the worst possible score. The quality score is now at the highest level shown in this time period, representing a collapse in underwriting standards.
Bar chart shows the loan covenant quality scores by risk area, comparing 2007 scores to 2019-2020 scores. The scores are weaker in 2019-2020 than they were in 2007 across all categories, including restricted payments clauses, layering and subordination, mandatory payments from asset sales, etc.
US-China economic divorce picks up steam, but is that what’s negatively affecting Chinese tech stocks?
The 25% decline in Didi’s stock has refocused investors on the US-China economic divorce. However, it’s important to understand that there’s still plenty of normalcy in the US-China economic relationship. China’s share of US imports is only modestly below 2018 levels, US stocks exposed to the trade war are doing fine vs the market, US semiconductor exports to China are still rising despite Huawei, US investors continue to accumulate more Chinese stocks and bonds, and unlike Russia, China has not engaged in economic warfare via its US Treasury holdings. Only bilateral FDI flows appear to be suffering from changes in national security policy.
Line chart which displays the share of total US imports by country. The chart includes a series for Europe, China, Mexico, Canada, Japan, Korea, Vietnam and Taiwan. As of May 2021, China’s share of US imports is only modestly below 2018 levels.
Line chart which shows the relative performance of companies with high US-China trade war exposure versus the S&P 500. The chart is indexed to 100 on January 2018. The index gradually declined from 2018 to 90 by year end 2019. The S&P 500 continued to outperform the first half of the year, causing the index to drop to ~75 in June 2020. Since June, companies with high exposure to the trade war have outperformed and the index has almost completely rebounded. The index is currently at 95.
Line chart which shows US semiconductor exports to China since 2015. Semiconductor exports trend upwards from $550 million in 2015 to a value of almost $1 billion in early 2019. The US placed export controls on Huawei and its affiliates on May 16th, 2019 and semiconductor exports to China declined to ~$800 million. US semiconductors exports increased significantly in 2020 until August 17 when the US put more restrictive export controls on Huawei. Since then semiconductor exports have recovered and are now at close to $1.2 billion.
Area chart which shows US holdings of Chinese stocks and bonds. The chart shows that US holdings of Chinese stocks and bonds have gradually increased from approximately $150 billion in 2018 to $300 billion as of April 2021.
Line chart which shows China and Russia’s ownership of US treasuries since 1995. The chart shows that unlike Russia, China has not engaged in economic warfare via its US treasury position. China still holds $1.1 trillion of US Treasuries.
Bar chart which displays Chinese foreign direct investment into the US and US foreign direct investment into China by year. Chinese foreign direct investment into the US starts to pick up in 2010 from around 5 billion dollars to above 45 billion dollars in 2016. After 2016, there has been a sharp decline in China’s foreign direct investment into the US. Similarly, US yearly foreign direct investment into China has hovered at around 15 billion dollars since 2013; however, in 2020, the US foreign direct investment into China was below 10 billion dollars.
That said, the Biden administration has unleashed an alphabet soup of China-targeted policies:
Executive Orders restricting China’s access to US sensitive data via consumer apps and restricting US investment in Chinese companies affiliated with its military; Holding Foreign Companies Accountable Act (de-listing of Chinese companies non-compliant with SEC data requirements); CHIPS Act and 5G Emergency Appropriations ($ for US semiconductor companies); Endless Frontier Act ($ for STEM R&D); Strategic Competition Act (CFIUS oversight of mergers and gifts by Chinese entities to US institutions); Homeland Security and Governmental Affairs Committee Provisions (“Buy America” requirements for iron and steel in US infrastructure projects); Meeting the China Challenge Act (sanctions for cyberattacks, IP theft and economic espionage); Uyghur Forced Labor Prevention Act (sanctions on US and Chinese companies knowingly using forced labor or conducting surveillance)
China’s possible partnership with the Taliban in Afghanistan won’t play well in DC either. Even so, many US initiatives are meant to boost US competitiveness and only a couple target Chinese companies in the MSCI China index, and usually impact smaller ones. In fact, the largest risks facing Chinese tech stocks and ADRs come from China rather than the US. Chinese regulators have implemented guidelines aimed at curbing monopolistic practices, limiting lax underwriting activities, policing data privacy, censoring content, addressing worker mistreatment and reforming entire industries like fintech and education. While the timing of enforcement actions on Didi suggest that there’s a message to US politicians in there as well, domestic policy concerns were the driving factor behind China’s decision to order mobile stores to remove Didi’s ride-hailing app.
On top of all that, China just proposed new rules to require companies with more than 1 million users seeking to list in foreign countries to undergo a cybersecurity review due to the risk that data and personal information could be “affected, controlled, and maliciously exploited by foreign governments”. This review will look into possible national security risks as well.
Whether new risks facing Chinese tech stocks are due to the US-China policy war or to Chinese domestic policy actions, large Chinese tech stocks now face hurdles that suggest the need for lower valuations than their US counterparts (they now trade at roughly the same level, as illustrated below).
Bar chart which shows the YTD total return for Chinese equity indices and MSCI subcomponents. The chart plots the YTD return of MSCI China A shares, B shares, P chips, red chips, Shenz composite, Shang composite, HK Hang Seng, CSI 300, FTSE China, MSCI China, HS China Enterprises, Hang Seng Tech, FTSE China Tech, and China ADR Index. The chart shows that China tech stocks have underperformed so far this year.
Line chart shows US and China tech valuations since 2017. The chart shows that since 2020, US and China tech have traded at roughly the same valuations.
I don’t think Biden's China agenda has the capacity to derail China’s economy from whatever trajectory it’s on. That said, a decline in globalization and a rise in US national security enforcement argue for slightly higher inflation in the years ahead, which we discuss next.
Line chart shows the globalization index since 1970. The index of is composed of global trade, portfolio flows and foreign direct investment as a % of global GDP, with 100 representing 2010. The chart shows that the globalization index peaked around 2008, and since COVID the index has declined to 80, its lowest level since around 2000.
Stacked bar chart which shows the number of CFIUS notices and investigations. The chart shows that CFIUS cases have more than doubled since 2010. In addition to the bars, the chart shows the amount of China specific cases. Since 2016, China has accounted for approximately 20% of all CFIUS cases.
The Pig and the Snake: a unified theory of the US, China, wages, jobs, inflation, opioid use, the WTO and investment portfolios for 2022 and beyond
The US economy is booming: capital spending and hiring tailwinds should last a few more months at least. There are some wacky inflation readings on the high side, but most professional economic forecasters and market-based inflation expectations are looking past them (the spike in used car prices is one example).
Bar chart which shows capex growth and an estimate of capex growth based on underlying demand by sector. Typically stronger demand leads to higher business investment. The chart shows that, outside of tech and medical equipment, most sectors still need to catch-up.
Line chart on US CEO hiring plans. The chart illustrates that CEO hiring expectations are at the highest level since 2005.
Line chart shows the core consumer price index since 2001, shown as the percent year-over-year change. Chart shows a recent spike from around 1.5% in early 2021 to its most recent point at around 4.5%.
Line chart shows used car prices shown as an index where 100 represents the 2012 level. From 1985 to the early 2000s, used car prices increased from an index value of around 65 to almost 110, then steadily declined until 2020 to around 80. Most recently, the index level of used car prices has spiked from around 80 to 115.
On goods, services and commodity prices, I think benign inflation expectations for 2022 are right. In a few months, the pig will move through the snake and these price measures should be within the Fed’s comfort zone. However, I’m less convinced about wage inflation. There’s a lot riding on the assumption that expiration of COVID unemployment benefits this fall will loosen tight labor markets. Perhaps it will. But the exhibits below show a lot of momentum beyond COVID unemployment payments: price hike intentions outstripping wage hikes, wages rising faster than employment, the highest number of “hard to fill” job openings and wage increases on record, more people who don’t want a job vs people who do, and a high “reservation wage” reflecting the cost of luring employed and unemployed persons to new jobs.
Bar chart shows workers using unemployment benefits since May 2021, shown in millions of people and broken out between the Pandemic Unemployment Assistance program, regular extended benefits programs, PEUC extended benefits and regular state programs. From June 2021 to August 2021, around 3 million people will lose benefits. However, in early August, almost 15 million people will lose benefits, which are almost evenly split among the Pandemic Unemployment Assistance, PEUC extended benefits and regular state programs, with less than a million people losing regular extended benefits programs.
Line chart showing total private employment vs wages since 2019 shown as an index where 100 represents Feb 2020. Both wages and employment dropped to lows of 87 and 85 respectively in mid-2020, but have since steadily increased. At its most recent value, the index value for employment is around 95 and the value for wages is almost 105.
Line chart shows small businesses planning to raise worker compensation and prices, shown as the % of small business survey respondents. At its most recent value, the % of small business survey respondents planning to raise prices is at its highest level at nearly 45%, and the % of small business survey respondents planning to raise worker compensation is at its highest level since around 1990, at 25%.
Line chart shows the % of the 16+ population not in labor force who want a job vs don’t want a job. Chart shows that the % of the population not in the labor force that wants a job was between 2-3% from 2000 to 2020 at which point the level spiked to almost 4%, but has since decreased to 2% at its most recent level. The % of the 16+ population not in labor force that does not want a job has steadily risen since 2000 to around 35% in 2020, then sharply increased to 36% in 2020, and has remained at that level through 2021.
Line chart shows small business with “hard to fill” job openings, shown as the % of small business survey respondents. Since 1985, the % of small businesses has oscillated between 5-30%, but at its most recent point has spiked to an all-time high of almost 50%.
Line chart shows the reservation wage i.e. the lowest wage respondents are willing to accept for a new job, shown as an index in which 100 represents Q4 2019. One series shows the reservation wage among respondents in households with income less than $60k and another series shows the reservation wage among respondents in households with income greater than $60k. Most recently in 2021, the reservation wage for <$60k households spiked to its highest level since 2014 (index level of around 125) while the reservation wage for >$60k households slightly declined below 2019 levels, though is still at its highest level since 2014.
To be clear, rising wages are a positive development for the US economy but there are levels at which the Fed’s zero rate policy becomes inconsistent with them. To bring the whole US-China-wage-inflation discussion full circle consider the following, illustrated below:
- In 2001, the West allowed China into the World Trade Organization…
- After which China immediately launched a massive and unprecedented intervention in its currency markets to prevent appreciation and boost its manufacturing and export shares….
- Which allowed China to mount the greatest economic boom in post-war history…
- Flooding the US with cheap goods (the US import price index from China is at the same level as in 2004)…
- But which contributed significantly to an acceleration of US manufacturing job losses…
- And a collapse in the US of the share of gross profits accruing to labor vs capital…
- Whose aftershocks include the opioid epidemic, rising polarization and growing wealth inequality
With wages now rising, the US labor share of profits is finally getting closer to its post-war average, something the Fed will be VERY reluctant to interfere with. As a result, if wage pressures remain my guess is that the Fed will not do much at first, creating more reasons to favor reflation strategies in portfolios in 2022 and beyond.
Line chart shows the 10-year % change in US manufacturing jobs since 1960 vs Chinese FX intervention, shown as the 12-month average of Chinese FX reserves as a % of GDP. Chart shows that after China joined the WTO in 2000, its FX reserves increased at the same time that its manufacturing jobs decreased. However, since around 2010, manufacturing jobs have increased and FX intervention has declined.
Line chart shows the 10-year % change in US manufacturing jobs since 1960 vs the US labor share of non-financial gross profits. Chart shows that after China joined the WTO in 2000, the US labor share of profits declined at the same time that its manufacturing jobs decreased. However, since around 2010, manufacturing jobs have increased as has the US labor share of profits.
Line chart shows the 10-year % change in US manufacturing jobs since 1960 vs opioid prescriptions per capita. Chart shows that after China joined the WTO in 2000, opioid prescriptions increased at the same time that its manufacturing jobs decreased. However, since around 2010, manufacturing jobs have increased and opioid prescriptions have decreased.
Bar chart shows China’s economic transformation, shown as the largest 30 year increase in real per capita GDP by country. Chart shows that China saw the largest 30 year increase in real per capita GDP from 1981-2011 with a 1450% increase. The next largest increase was in South Korea from 1965-1995 at around 900%. The smallest increase in GDP shown on the chart is Indonesia from 1967-1999 and Cambodia from 1988-2018, both with approximately 400% increases.
1 "The Delta variant in the UK: how is it going?", David Mackie, J.P. Morgan Economic Research, July 6, 2021. See Table 3 for all the Delta impact data by vaccination status and age.
2 https://www.nytimes.com/2021/02/14/world/europe/youth-mental-health-covid.html