Economic Outlook: The China Syndrome

BY: Richard Croft
It seems the US Federal Reserve (FED) is flexible when it comes to defining “transitory” inflation. The FED’s base case for 2021 year-over-year inflation was 2.4%. That number was bumped to 3.4% when updated inflation data was released during the second week of June. So too has the timeline for scaling back the US $30 billion per month bond purchasing program, and the FED is now beginning to talk about talking about raising overnight interest rates. FED speak at its best!


It seems the US Federal Reserve (FED) is flexible when it comes to defining “transitory” inflation. The FED’s base case for 2021 year-over-year inflation was 2.4%. That number was bumped to 3.4% when updated inflation data was released during the second week of June. So too has the timeline for scaling back the US $30 billion per month bond purchasing program, and the FED is now beginning to talk about talking about raising overnight interest rates. FED speak at its best!

It now appears that the FED is looking to raise rates twice in 2023 if the economy reaches full employment. A much shorter timeline than previously thought when rates were expected to remain at near zero levels into 2024. That said, Chairmen Powell, backed unanimously by the FOMC[1], believe that we have not cleared the pandemic as the vaccination rate needs to be much higher to avoid the risk of another outbreak.

There is also the possibility that the tightening timeline could be shorter if the jobs data is any indication. While there are 7 million fewer jobs than was the case pre-pandemic, yet certain sectors are having difficulty finding skilled labor to fill specific jobs causing wage demand to spike. The latest data suggests that more than 9 million jobs are going unfilled, which could increase given the updated forecast for 7% growth in GDP.

Part of the problem are pandemic relief programs that support unemployed workers. Most of these programs expire in September. Although 25 States – mostly Republican – have opted out as of the end of June. There are other challenges, not the least of which is finding adequate childcare, which is critical for those looking to return to the workforce. Especially women!

Eventually these frictions will abate, the FED will begin tightening and the financial markets will react. In our view, the severity of the market’s reaction will be governed by FED transparency. To that point, we expect the FED to provide plenty of runway before shifting their focus to avoid another 2013 style “taper tantrum.”

As Treasury Secretary Jane Yellen said in her Congressional testimony, the economy is normalizing with prices moving back “toward normal levels in leisure, hospitality, airfare and the like. In most cases, prices remain below pre-pandemic levels – but they are rising, and that is some of what is going on here. We’re going to monitor this very, very carefully.” As mentioned in previous reports, the year-over -year inflation data (the CPI was up 5.0% in May) is distorted by the fact that prices fell so sharply a year ago. A more meaningful measure of inflation is the month-to-month change in prices, which declined in May versus April.

Interestingly, FED speak is not being reflected in the bond market. Rates on the 10-year US Treasury bonds jumped after the FED’s statement, but quickly receded to levels well below recent highs. Moreover, according to Deloitte, the so-called breakeven rate, an excellent proxy for investor expectations of inflation, remains lower than a few weeks ago and barely budged in response to the FED’s statement.

A recent article from Deloitte Canada noted that “the five-year breakeven rate[2] is higher than the 10-year breakeven. This is an unusual situation and reflects investor expectations that inflation will surge in the short term but revert to a lower level in the longer term, which aligns with the FED’s transitory stance. Thus, investors seem to have bought the Fed narrative, even if headline writers have not. So, it seems that the FED has been successful in anchoring inflation expectations, one of their prime levers of policy.”


Many believe that Chinas’ labor force has significantly influenced global inflation. For more than two decades Chinese citizens have been moving into urban centers resulting in an excess supply of labor in manufacturing facilities. The supply of labor has outpaced demand limiting workers ability to demand higher wages, which has helped keep Chinese export costs in check.

But times are changing! As this urban transition wanes, the demand for labor in the manufacturing sector is beginning to outstrip supply, which typically results in wage increases. Removing one of the pillars that kept prices in check could have long term implications.

Much depends on productivity levels. If the Chinese manufacturers can increase productivity in line with higher wages, then the impact on export costs will be muted. If not, higher wages will eventually flow to the end user. Could this mean higher global inflation in the years to come? Although not our base case, it is a possibility.

Our base case, which emphasizes the transitory aspect of inflation, is a recognition that end users can shift manufacturing to lower cost countries. For example, if clothing retailers were to move manufacturing to Vietnam, it would offset any challenges resulting from higher unit labor costs in China. Similarly, companies in other sectors could strengthen manufacturing ties with production facilities in lower cost countries like India, Indonesia, and Africa.

Another consideration that has been exposed by the post-pandemic surge in demand is the fragility of supply chains. Underpinning China’s manufacturing powerhouse is its’ reputation for on-time delivery with cost certainty. Post-pandemic… not so much!

As a case in point, the Port of Yantian in southern China (the world’s fourth largest container port) became a COVID hotspot that severely limited operations. According to CNBC, at one point in mid-June, there was a backup of approximately 160,000 forty-foot containers waiting to be exported).

Effectively, the COVID outbreak at Yantian impacted global inventory and pressured shipping costs, which are up more than 250% since the beginning of the year and remain well above pre-pandemic levels. Although the Yantian crisis is abating and on time shipping will normalize, it demonstrates the outsized risks associated with stretched global supply chains.

The challenge for China is significant. Supply chain disruptions, increasing wage demands and a stronger Chinese currency will, in time, exert upward pressure on export prices and cause end-users to seek out alternative solutions. Not easy!

Given China’s influence on global trade, any transition intent of dampening inflation expectations would require a massive migration by a swath of end-users. The obvious alternatives for low-cost labor would be India, Indonesia, and Africa. But within these countries, there is limited infrastructure, curbs on trade and investment, and restrictive rules on labor usage. Serious obstacles for companies planning to transition a significant production out of China.


Most of us have a general understanding of the conflict between Jack Ma (The Alibaba founder) and the Chinese Communist Party. Mr. Ma, seen by many as China’s version of Jeff Bezos, challenged the Communist Party’s view on how best to exploit the virtues of capitalism.

Mind you, Ma tends to radiate unbridled enthusiasm when it comes to his corporate babies. He is – or was – passionate about the merits of Ant Group’s (the fintech giant that was spun off from Ma’s flagship company Alibaba Group Holding Ltd.) digitization of currency, which could provide a seamless flow of consumer transactions circumventing China’s antiquated banking system.

Whether Ma’s comments were pre-IPO spin or a subtle shot at communist leaders is fodder for pundits. In the end, Ant’s IPO was squashed, and Ma went into hiding for more than eight months.

The Communist Party’s response was to deploy the nation’s top financial regulators who now demand regular updates from Ant Chief Executive Officer Eric Jing and his staff on the progress of a state-ordered business overhaul. New corporate initiatives must be vetted by officials, which include a government representative installed within Ant’s senior executive ranks to keep tabs on the company.

As western economies look for ways to limit the power wielded by big tech, China may have provided the answer… simply take control.

This is the new world order impacting big tech in China. No more freewheeling, internet-age capitalism and the wealth and influence it brings, but instead more tempered growth strategies that fit within the ambitions of the Chinese Communist Party. The concept known as “rectification” is well under way, and it will influence the finance operations of Tencent Holdings Ltd., Inc., TikTok owner ByteDance Ltd. and ride hailing giant Didi Chuxing[3].

China’s version of control is to force modern fintech companies to behave like antiquated banks. Politically it means re-directing the balance of power away from fintech into the hands of the politically correct state-owned banks that toe the party line.

To validate this gambit, the communist propaganda machine took aim at internet and fintech giants for “abusing their power” over the working class. State controlled media fostered strands of popular resentment toward China’s hyper-wealthy moguls by criticizing companies for encouraging the working class to amass unsustainable debt.

The trick for President Xi is to walk the fine line between restraint and suffocation. New rules to police the payments ecosystem could reduce fintech profitability by as much as 23% over the next five years. On a macro level, impeding online lending (currently estimated to reach 500 million workers) will influence the domestic economy’s wealth effect and ultimately China’s growth trajectory.

The pain is exacerbated for investors who hold Chinese entities. For example, the shares of Alibaba (listed: NYSE, symbol BABA) which holds a significant stake in Ant Group were hit particularly hard (see chart).

There are two takeaways from this: 1) a recognition that investing in Chinese entities is riddled with political risk; and 2) the Chinese Communist Party is incapable of understanding the unintended consequences of wielding such unbridled influence.

As the title suggests, be thankful for the Chinese Communist Party, because domestic economic mismanagement is directly correlated to their waning international influence.


We have talked about our bullish expectations for Canadian bank dividends and stock buyback provisions that should come into effect before the end of the third quarter. Flush with capital, we expect the restrictions that limit dividend increases and stock re-purchase programs to be lifted by regulators, which will allow Canadian banks to release money back to shareholders.

Look for normalization among the big US banks as well. After successfully completing stress tests, the US Federal Reserve is allowing US banks to resume normal levels of dividend payouts and share repurchases as of June 30th. We expect dividend increases to begin in late 2021 or early 2022.

In 2020, US banks bought back US $80.7 billion of their shares with most of those re-purchases coming before the pandemic hit. Next year, we expect the numbers to be higher, which should bolster the performance of financial stocks through the end of 2022.


There is a famous quote from J P Morgan’s CEO Jamie Dimon when asked by his daughter to define a financial crisis. His answer: “It is something that happens every five to seven years.”

In an environment where global economies are in the early stages of recovery and sectors still suffering from the scars of the 2008 great recession, one needs to be mindful that a new crisis could rise at any moment. Two questions come to mind; what will trigger a downturn – unexpected inflation, supply chain challenges, new COVID variants – and given the risks, what is the best way to balance upside potential with downside risk.

The potential for a financial crisis is weighing on the mind of Rob Subbaraman an economist at Nomura Securities. Subbaraman cites the comments from the late academic Rudi Dornbusch who observed that “a crisis takes a much longer time coming than you think, and then it happens must faster than you would have thought.”

To that point, Subbaraman updated his early warning crisis model by examining the risks associated with record-low interest rates and asset purchases by central banks. According to Bloomberg, the model has correctly predicted two-thirds of the past 53 crises in 40 economies since 1990.

The objective is to ascertain whether leverage resulting from cheap money will lead to a debt-fueled asset-price boom that at some point will unwind, perhaps abruptly. To measure that risk, Subbaraman input data on private credit and debt combined with property and equity prices. Using those inputs, Sabbaraman believes that the US, Japan, Germany, Taiwan, Sweden, and the Netherlands are vulnerable to a systemic problem within the next three years.

According to Bloomberg the results were, not surprisingly, heavily influenced by the current low interest rate environment. Given that, Sabbaramans’s stress-test assumed an upward bias to interest rates. In that scenario, the countries in jeopardy remain the same, but France, Hungary, Romania, New Zealand and Portugal also become a concern.


Covered call writing is the most conservative of the basic option strategies: 1) buy calls; 2) sell uncovered calls, 3) buy puts; 4) sell uncovered puts; 5) sell covered calls. Of these five basic strategies, a covered call is the only one in which the investor utilizes the underlying stock.

You can execute a covered call write by buying say, 100 shares of Microsoft at USD $265 per share and writing one (note each option contract is exercisable into 100 shares of the underlying stock) Microsoft September 270 call at US $24.50.

By selling the Microsoft calls you are obligated to deliver to the call buyer 100 shares of Microsoft at USD $270 per share anytime between the time the calls are written (i.e., sold) and the September 16th expiration date.

Writing covered calls does three things for clients. The first is that the premium from the sale of the call option represents tax-advantaged incremental income. The Microsoft example delivers US $2,450 in premium income. For the record, Canada Customs and Revenue Agency (CCRA) treats option premium as capital gains.

Covered call writing also reduces risk as the premium received reduces the original cost of the stock. With Microsoft, the out-of-pocket per share cost to implement the covered call strategy is USD $240.50 (USD $265 to buy the stock less USD $24.50 in premium = USD $240.50). A reduction in the out-of-pocket cost, by definition, reduces risk. The out-of-pocket cost for the covered call write is your starting point when assessing the potential return from a position. In the Microsoft example, upside returns and downside breakeven (dividends are not included) are calculated on the following page:

There are two ways of looking at the strike price of the short call option. The glass half full considers the strike price a reasonable upside target. This can provide a third benefit if the investor uses covered calls as a discipline to take gains on a position when in positive territory.

The glass half empty deems the strike price as a limitation on the stock’s upside potential. That latter point is why some analysts opine that covered call writing is not a good long-term strategy, because you end up losing the best performing stocks in the portfolio. A definite negative for a long-term growth investor.

That does not diminish the value of the strategy when directed by professionals who understand the pitfalls. We use covered call writing as one strategy within a diversified portfolio. We provide exposure to the strategy in our Alternative Strategy and Option Writing pools.

To optimize a covered call program, we use technical indicators such as the Bollinger Bands, created by a California based technical analyst, John Bollinger. These bands are envelopes that frame the current price of the stock at one or more standard deviation intervals above and below a moving average. The width of the Bollinger envelope is based on the historical volatility of the underlying stock, and as such is self-adjusting. As the stock becomes more volatile, the bands widen. When the underlying stock stabilizes, volatility declines, and the bandwidth narrows.

Typically, Bollinger Bands are used to predict market direction. According to Bollinger, price changes tend to occur after the bands tighten. The bands tighten when volatility contracts. When prices move outside the bands, a continuation of the current trend is implied. Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands, imply a reversal in the trend. And finally, a move that originates at one band tends to go all the way to the other band. From our perspective, that makes Bollinger’s Bands a useful tool for projecting price targets that we can use to sell call options.

We use the upper band to establish an exit target, which sets the strike price for the options we are looking to sell. As an example, the accompanying one-year chart for Apple defines the upper Bollinger Band at USD $135 per share. Since we own Apple at USD $102 per share, we recently sold the July 2nd, 2021, 135 strike calls at USD $1.00. If the stock bumps against the upper band at expiration we have two choices: 1) let the stock be called away at the US $135 strike price; or 2) roll up the strike price by re-purchasing the short calls and replacing them with the sale of a call with a higher strike.

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Richard Croft, Chairman & CIO

[1] Federal Open Market Committee
[2] The break-even rate looks at how long the cash flow from shorter term maturities equals the yield available on longer term maturities. Typically it compares the yield on treasury bills versus 5-year treasuries and the yield on treasury bills versus 10-year treasuries.
[3] Interestingly, on Friday July 2nd, the Chinese Communist Party launched an unexpected investigation into DIDI’s business practices. The investigation was announced one day after Didi’s IPO.

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