December 29, 2020

As 2020 is drawing to a close and research analysts are formulating views for the next year, we take this opportunity to compile an anthology that brings together projections made by our research teams covering various industries and aggregate fields, including macro economy, market strategy, fixed income, and commodities. We hope this almost 116,000-word book can serve as a useful reference for investors. The constant theme in our investment strategies for 2021 is the analysis of economic cycles to forecast their next phase. A new factor that has to be taken into account is COVID-19, as it has temporarily altered the driving mechanism of economic cycles.

Generally speaking, the key driver behind economic cycles is demand fluctuation triggered by changes in inflation and debt. An excessive increase in inflation implies the economy is overheated, which induces policy tightening and leads to a subsequent fall in demand. When deflation replaces inflation as the main risk, the government may adopt expansionary policies again, resulting in a demand recovery. On the other hand, excessive debt may give rise to asset bubbles and financial risks, prompting the government to strengthen macro-prudential management. As a result, credit tightens, asset prices fall, and demand declines. However, subsequent re-adoption of expansionary policies may provide the economy with new momentum to enter another upward cycle.

However, the economic cycle under the impact of COVID-19 is quite different from the two typical endogenous cycles described above. COVID-19 constrains aggregate labor supply as it is a highly contagious disease with a relatively high mortality rate. Therefore, the pandemic’s initial impact on the economy was a devastating external shock on the supply side, undermining labor income and then weighing on demand. When the pandemic subsides, its physical constraints on economic activities would fade away, leading to the recovery of production and supply, the rebound of employment and income, as well as an increase in demand.

The unusual economic cycle driven by exogenous supply shocks still underlies our thoughts on the economic outlook, macro policies and asset allocation strategies for 2021. However, we believe a key difference in 2021 will be an increase in endogenous forces, which include not only the supply recovery’s boost to and multiplier effects on demand, but also the lagged effect of government policies adopted in 2020 to cope with the COVID-19 outbreak. Under this framework, we will discuss how the “disconnect” between financial markets and the real economy will evolve going forward, as well as its implications for investment strategies. We believe three issues merit special attention.

I. Maintaining supply or demand? China and the US’s different routes to economic recovery

The COVID-19 pandemic in 2020 confronts humanity with a fundamental question: Can we put a price on human life? As the pandemic wreaks havoc around the world, we have seen a tradeoff between the value of human lives and economic interests from the society's perspective as a whole. Life is invaluable from a personal perspective, but the social value of life can be calculated. When COVID-19 spreads like wildfire, the quantity of labor that workers are willing to provide declines regardless of labor price. Mechanisms of price and market fail completely under extreme conditions, such as a total lockdown. Given the strong externalities of individual activities, the government should intervene to safeguard public interests. A critical issue for the government, however, is how to intervene.

Looking at various governments’ responses to the COVID-19 outbreak, we see clear differences between China’s approach and that taken by US and Europe. Different government actions have produced different results. As the first country in the world to identify the COVID-19 virus, China faced difficulties at first as it had no experience in dealing with the new pathogen. However, the Chinese government took decisive, unprecedented action to lock down a mega city with more than 10mn residents, and mobilized the whole country to impose quarantine measures. While these measures resulted in enormous short-term costs to the economy, they have protected human lives to the largest extent. From an economic perspective, protection of human lives is equivalent to protecting aggregate supply capacity, reducing expected infection rates and mortality rates, and mitigating the pandemic's impacts on aggregate supply. As China effectively brought the pandemic under control, production activities have resumed at an accelerated pace in China, and the country’s economic recovery has been the fastest among the world’s major economies.

The focus of government intervention in developed economies, such as Europe and the US, is markedly different from that of China. Although Europe and the US also took quarantine measures at an early stage, these measures were much less stringent than restrictions imposed in China. As a result, the pandemic lingered on and rebounded in Europe and the US. A second wave of COVID-19 outbreak hit the US in 3Q20 and Europe in 4Q20, impeding the recovery of supply capacity. However, Europe and the US provided unprecedented financial relief to cope with the pandemic. A key measure to support such financial relief programs is the monetization of fiscal deficit. Thanks to generous financial relief, consumer demand has remained relatively strong in these economies.

Should the government choose to maintain supply or demand? Both options have pros and cons. Policymakers in the US seem to believe that benefits from sustained economic growth can eventually offset, or even exceed, economic losses caused by the climbing death toll, as long as the aggregate demand stimulus is strong enough and economic growth is rapid enough. However, the reality is that China’s supply-maintaining policies have effectively protected both the economy and human lives despite initial economic losses. In contrast, resurgence of the pandemic forced major European economies to re-impose extensive lockdowns and social distancing measures, which led to another round of financial market fluctuations and threatened to derail the economic recovery.

How to explain the difference in policy results? The multiplier effect of supply shocks may shed some light. In endogenous economic cycles, supply cannot automatically create demand due to the three fundamental psychological laws mentioned by John Maynard Keynes or the problem of unfair distribution highlighted by Karl Marx. In other words, Say’s Law does not work and there is no automatic transmission mechanism between aggregate demand and aggregate supply in endogenous economic cycles. However, the economic cycle amid COVID-19 is primarily driven by exogenous shocks rather than endogenous imbalance. In such an unusual economic cycle, supply does create demand to some extent. This is the root cause of the multiplier effect of supply shocks.

The magnitude of the multiplier effect is determined by the length of supply shocks. If the shock is one-off or very brief, it is possible to break the vicious cycle between falling supply and shrinking demand by boosting aggregate demand. However, things are different when the supply shock is protracted or repeated, as intertemporal and cross-product substitution would magnify the negative multiplier effect on the supply side.

For example, when a sector is hit by a supply shock and suffers from unemployment, it is possible to stimulate demand to create a new sector that absorbs the unemployed and mitigates the multiplier effect of the supply shock. However, if the pandemic persists, the new sector's production and employment capacity would face significant supply-side constraints. As for intertemporal substitution, people’s willingness to consume may not rise much amid the lingering pandemic. In addition, the protracted pandemic also reduces the effectiveness of measures to alleviate forced savings, such as shopping vouchers.

Therefore, policy intervention that aims to maintain demand would be more effective only if the pandemic is short-lived. Unfortunately, COVID-19’s unusually high infectiousness will probably cause multiple waves of outbreak. Before effective vaccines become available, the number of new COVID-19 cases may rise exponentially if policymakers fail to make a quick decision as they ponder over the tradeoff between the economic cost of quarantine measures and the value of human lives threatened by the pandemic. When the accumulated number of COVID-19 cases reaches a certain threshold, the healthcare system may collapse again, pulling the whole country back into a massive lockdown. If policymakers attempt to minimize economic losses resulting from quarantine measures by sacrificing human lives, they will probably end up losing both human lives and the economic recovery, in our view.

Looking ahead, our macro team expects effective vaccines to become available in early 2021, implying that the effect of demand-maintaining policies may gradually become more visible. More importantly, effective vaccines may turn the negative supply-side multiplier into a positive one. Under impacts from COVID-19, the driver of economic cycles is on the supply side. A positive multiplier effect on the supply side means recovering supply would automatically create demand. For example, workers would have stronger motives to get new jobs or return to their original jobs when the pandemic subsides. An increase in household income would generate additional demand. Moreover, consumption postponed amid the pandemic no longer needs to be delayed when the pandemic fades away. We may even see compensatory intertemporal substitution, i.e. increased consumption in advance to compensate for consumption postponed due to the pandemic.

We believe economies around the world may recover concurrently in 2021 thanks to the multiplier effect of supply-side recovery and the lagged effect of demand stimulus introduced earlier. How strong will the recovery be and how long will it last? As the pandemic’s exogenous shock to the economy subsides, endogenous forces return as the primary driver of the economic cycle. Therefore, we should revert to the traditional theoretical framework of economic cycles to analyze hindrances to the economic recovery, namely debt and inflation risks.

II. Hindrances to recovery: Inflation or debt?

As discussed above, inflation and debt are the main triggers of endogenous economic cycles. As a matter of fact, inflation and debt are not independent of each other. Instead, the two factors are very likely to affect each other and result in a downturn of the debt cycle. We believe that China, the US and even emerging economies may face the risk of a debt cycle downturn in 2021.

To mitigate impacts from COVID-19, the US government has provided four rounds of fiscal relief, including higher unemployment benefits and direct cash payment to residents. The total amount of these relief packages reached US$3trn, or 14% of the country’s 2019 GDP. The unusual fiscal expansion was backed by the Federal Reserve’s unprecedented unlimited QE, and a skyrocketing M2 growth rate second only to the peak recorded during World War II. The super-easing of monetary policy, especially the monetization of fiscal deficits, have led to a rather abnormal economic phenomenon: Although 20mn Americans were jobless, the US’s household disposable income actually increased and effectively supported a consumption recovery.

The US’s fiscal deficit monetization is no doubt successful in maintaining demand. As fiscal deficit is essentially government debt denominated in the domestic currency, we believe the sustainability of the US’s fiscal deficit depends primarily on the country’s inflation rate. Most people, including policymakers at the Federal Reserve, believe that the US does not face the risk of a sharp upsurge in inflation. Therefore, the Fed has shifted its inflation management approach from the “target inflation” system, which has been in effect for decades, to an “average inflation targeting” framework. The shift signals that the Fed gives priority to employment and does not worry about inflation.

The Federal Reserve’s recent moves are reminiscent of its policy stance shortly after the Second World War. According to Fed Research Director Emanuel Goldenweiser (1883–1953), policymakers at the central bank believed that “a much more serious and lasting problem... will be the problem of finding jobs for people released from the services and from war industries."[1] In spite of the exceedingly strong money supply growth during the war, most people believed that the main challenge after the war was deflation and recession rather than inflation. They argued that “the wartime accumulation of liquidity was… providing a highly desirable source of postwar purchasing power. The sole role assigned to monetary policy was to keep interest rates low.”[2] If we replace the word “war” with “pandemic”, these claims and arguments are quite similar to the logic behind the Fed’s switch to the “average inflation targeting“ framework.

In A Monetary History of the United States, 1867–1960, Milton Friedman provided insightful comments on what happened next: “Events belied expectations. Country after country was bedeviled by inflation”[3]. “The combination of uncertainty on the part of the monetary authorities about their role and about the consequences of their actions, together with unmatched public attention to the course of economic events... induced a tendency to move slowly in either direction”[4]. According to Friedman, the effect of monetary policies often lagged behind their implementation, but the lag and its results were often neglected and hence accumulated over time. When the accumulated results became visible in the form of rising prices, the Federal Reserve was forced to reduce the growth rate of money stock[5].

While the above analysis does not necessarily mean that inflation in the US will skyrocket in 2021, we should not ignore the risk of a stronger-than-expected rise in the inflation rate due to accelerated economic recovery, as effective vaccines are quite likely to become available in early 2021. Rising inflation may expose debt problems in the US, and signs of this risk might have already emerged. Along with the monetization of fiscal deficits, the US dollar index has depreciated, pushing up import prices. If the US’s economic recovery surprises the market on the upside and the expectation for inflation picks up, the rise of long-term interest rates in the US may also beat market expectations. This may expose debt risks and drive up financial market fluctuations in emerging market economies with large amounts of debt denominated in the US dollar.

If the US’s yield curve steepens in 2021, a direct impact on China might be the narrowing of the interest rate spread between the two countries, which may dampen the momentum of money flows into China. Even if the US's rising inflation rate does not exceed market expectations, we still think that the renminbi exchange rate's strong performance in 2020 may not continue in the next year. The depreciation pressure results from a possible weakening of China’s terms of trade, as the availability of effective vaccines would accelerate the recovery of production capacities in foreign countries.

It is worth noting that China’s private sector, just like other emerging economies, is a net borrower of foreign debts. Currency depreciation means credit tightening for industries with large amounts of foreign debt, such as real estate. Therefore, real estate investment may lose steam in 2021 despite gaining strong momentum in 2020. Adverse currency movements may expose debt problems in the real estate industry in 2021.

In fact, real estate is not the only sector that may face debt risks in 2021. China launched large-scale monetary expansion in 2020 to combat COVID-19. From the perspective of assets in the banking system, the monetary expansion was achieved primarily by raising the financial leverage of non-government sectors. Our macro team found that the corporate sector’s debt-service burden rebounds 4–6 quarters after large-scale credit expansion. The increased debt-service burden, in turn, may result in credit tightening. Our macro team also estimated that the private sector’s debt-service burden in the current debt cycle is higher than in the previous three cycles. In addition, the ratio of principal/interest repayment to new credit seems to have bottomed out recently.

Generally speaking, borrowers may spend less and save more to cope with the rising debt-service burden. However, aggregate demand may shrink if a large number of borrowers cut spending to repay debts, as lenders usually have a lower marginal propensity to spend than borrowers. On the other hand, borrowers may also sell assets to repay debts, but asset prices may plunge if a large number of borrowers do so. Even if borrowers’ assets are insufficient to cover debts, they may still avoid a default through financing from external sources. However, falling net assets and deteriorating debt-service ability may result in stricter conditions for refinancing. For example, lenders may ask for higher risk premiums or even require additional collateral for existing debts.

In a nutshell, debt sustainability may deteriorate if a large number of borrowers cut spending or sell assets to repay debts, resulting in a vicious cycle that will eventually cause defaults, in our view. When a large number of defaults occur, lenders may require higher risk premiums and financing conditions may tighten, leading to financial market fluctuations and contractions in the real economy.

III. Investment strategy: Continue to overweight general-purpose assets or invest more in specific-purpose assets?

Our macro team’s view on debt risks in 2021 is largely consistent with our fixed income team’s concern about a rising risk premium next year, which is negative for asset allocation to corporate bonds. From a more general perspective on asset allocation, we saw that performance of financial assets and the real economy diverged in both China and the US this year. As of October 30, the total capitalization of the US stock market rose 4.7%, the S&P 500 Index grew 1.2%, and the NASDAQ Index increased 22%. Meanwhile, the A-share market’s total capitalization grew 21%, the CSI 300 Index gained 15%, and the ChiNext Index surged as much as 48%. In contrast to the bullish stock markets, recovery of the real economy remained lackluster in both China and the US.

How to explain the sharp divergence? We think it might be attributable to an increase in people’s expectations for future uncertainties due to the COVID-19 pandemic. When uncertainties rise, people prefer assets with low specificity (“general-purpose assets”) to those with high specificity (“specific-purpose assets”)[6]. Cash has the lowest specificity as it can be easily converted into other assets at any moment. Financial assets have the second lowest specificity. Although financial assets are backed by physical assets for production purposes, securitization can give financial assets higher liquidity and lower specificity than underlying physical assets. Non-production physical assets, such as land and housing, have lower liquidity and higher specificity than financial assets, but their specificity is lower than other physical assets, such as industrial plants and machinery. Physical assets for production purposes have the highest specificity and poor liquidity, as it is quite costly to adapt these assets to other purposes.

Investors’ preference for general-purpose or specific-purpose assets changes along with uncertainties in the economy. Uncertainties were at their highest in March, when COVID-19 spread rapidly across the world and governments responded with extensive lockdowns. As a result, investors preferred cash as it has the lowest specificity, and prices of almost all other assets fell. However, economic uncertainties declined thanks to government intervention to mitigate impacts from COVID-19. This led to the rebound in stock prices, as stocks have relatively higher specificity than cash. Economic uncertainties further declined as the age distribution of COVID-19 deaths became increasingly clear. Hence, stock markets rebounded at an accelerated pace, and prices also began to rise for real estate, a physical asset with relatively low specificity. 

As COVID-19 is still wreaking havoc around the world, the economic recovery still faces significant uncertainties, and there is no sign of a substantial increase in investors’ preference for specific-purpose assets. We compared our strategy and sector teams’ 2021 outlook reports with their 2020 views, and found that they have become more optimistic on cyclical sectors (e.g. commodities and banking) and the relatively cyclical consumer discretionary sector. However, analysts have become more cautious on the 2021 outlook of the relatively defensive consumer staples sector. These sector views are based on an implicit assumption that the recovery will continue, i.e. effective vaccines will be available in early 2021, further reducing economic uncertainties. This implies possible changes in investors’ current strategy of overweighting general-purpose assets and underweighting specific-purpose assets.

As a global catastrophe for the entire human race, COVID-19 shattered many conventional beliefs about economies, government policies and asset allocation in 2020. Looking ahead, we expect the pandemic’s exogenous impacts to gradually subside in 2021. The multiplier effect of demand-creation by supply may drive the economy back to the trajectory of endogenous cycles. Debt and inflation may again become main triggers of economic cycles, implying that the asset allocation strategy for 2021 may also change. In this preface, we provide initial thoughts under our base-case assumptions. More detailed analyses, investment strategies and risk alerts are available in the rest of this report. 

For more details, please see our report Economic and financial cycles to converge in 2021 published in December 2020.