• GB Davis

Cross-currents (8/1/20)

There are some important reads in here, if you are interested in global financial markets. We had some good earnings calls last week including: shorting $FFIV, long $PG, long $EA, long $MDLZ, short $CAT, long $AAN (a big one for us). We remain short $TXT here – if this were such a great company (here-and-now on valuation), Buffett would be buying this hand over fist and not $BAC, as he is. We are short $LEA and $ARMK coming into the week as well. We don’t see much demand for $LEA products short-term and $ARMK, we don’t see how they aren’t forced to cut their dividend in order to preserve cash this coming week (they should have done so much earlier – and these are the types of insights one has being trained as an investment banker by CIBC World Markets). Speaking of dividends: on June 28, 2020, we indicated several financial names we thought will have to cut their dividends, starting with $WFC – which did, in fact, cut very shortly thereafter. Another name we highlighted on that short-list of June 28, 2020 was Capital One ($COF), and they SLASHED their dividend this week – it’s almost like I have a lot of Wall Street experience, a high IQ and am a graduate of top-ranked U.S. university (i.e. Cornell University)

OFF THE WIRES

Franklin Resources, Inc. $BEN has completed its $4.3 bil ($50.00 per share in cash) acquisition of Legg Mason, Inc. $LM

Financial Times with an article on US CMBS, “Pimco warns ‘significant pain’ still lies ahead for malls and hotels” – we highlighted this brewing issue early (in March), specifically in regard to Hotel and Retail. Article here à https://www.ft.com/content/dddf1e5b-92cd-4fd8-9b22-ed4ad22456a7

Managing Expectations – U.S. 2Q20 Earnings. “$SPX is reporting a decline in earnings of -35.7% for Q2, which would be the largest earnings decline reported by the index since Q4 2008 (-69.1%). 63% of the companies in the S&P 500 have reported actual results for Q2 2020. In terms of earnings, the percentage of companies reporting actual EPS above estimates (84%) is above the five-year average. If 84% is the final percentage for the quarter, it will mark the highest percentage of S&P 500 companies reporting a positive EPS surprise since FactSet began tracking this metric in 2008. In aggregate, companies are reporting earnings that are 21.8% above the estimates, which is also above the five-year average. If 21.8% is the final percentage for the quarter, it will mark the largest earnings surprise percentage reported by the index since FactSet began tracking this metric in 2008. Looking ahead, analysts predict a (year-over-year) decline in earnings in the third quarter (-22.9%) and the fourth quarter (-12.1%) of 2020. However, they also project a return to earnings growth in Q1 2021 (13.4%). The forward 12-month P/E ratio is 22.0, which is above the five-year average and above the 10-year average. During the upcoming week, 129 S&P 500 companies (including one Dow 30 component) are scheduled to report results for the second quarter.” (FactSet) “Surprise, surprise! The Q2 earnings season has generally been one big positive surprise with almost 80% of S&P 500 companies beating expectations. Even if earnings are a surprise to analysts, they don’t really come as a big surprise to markets that have already partied ahead of the earnings season, and it is pretty safe to say that earnings are NOT a leading indicator of equity performance in the current environment with flatlining to slightly negative price action despite positive earnings surprises, maybe with the FANG-tastic Nasdaq index as the sole exception.” (Nordea, 7/31)

Nordea on Short-term Drivers for Equity Risk. “More importantly, short-term drivers for equities will likely include: i) the scope of a new fiscal stimulus deal in the US, ii) whether soft data will continue to see sequential improvements and iii) mitigation strategies of a second COVID-19 wave in the US/Europe/China and iv) whether the material USD liquidity withdrawal seen over the summer will prove transitory or not. Overall, we are modestly negative on i), ii) and iv), but clearly less pessimistic on iii). We will get back to why in this publication but the bottom line is that risk appetite could have 4-6 tricky weeks ahead.” (Nordea, 7/31)

Nordea on UST Curve and we indicated, first by the way, that Yield Curve Control (YCC) will be announced at the September FOMC (note: a flat (hopefully not inverted) curve, and formal YCC allows the Fed to target renewed UST asset purchases (i.e. QE) to the belly of the curve 2-7yr, and in this case, out to 10yrs now given technical nuances in order to create term structure – that is the goal and a tenet of capitalism. “Developments at the far end of the USD curve have turned technically interesting over the past weeks as substantial technical damage has been done for bond bears. The 10Y Treasury yield has broken to the downside technically and the curve has flattened markedly. Rates markets remain reactive to the macro environment (stalling high frequency data are behind the drop), while it is more debatable whether equities listen at all. We highlighted several reasons why flatteners looked “yummy” in early July, which has so far been a good call. We keep the call intact for the coming 4-6 weeks as i) the USD liquidity momentum remains poor, ii) activity is levelling off and iii) YCC steepener bets are already VERY consensus-like.” (Nordea, 7/31)

Nordea on the Unemployment Benefit Political Situation and Massive Amounts of Liquidity at the US Treasury (aka a “bazooka”, or in this case a nuclear arsenal) “US politicians are yet to agree on a prolonged fiscal package by the time of writing. Lawmakers remain split on how to progress even if three relief programs are on the verge of ending (Enhanced unemployment benefits, eviction protection and small business relief). The enhanced unemployment benefit (600$s a week) has been a cornerstone in the rebound in consumption that was seen during May and June, why a failure to prolong the program will likely add fuel to the stalling fire. It is not as if Steve Mnuchin and the US Treasury have not prepared for another round of MASSIVE stimulus as roughly $1800bn is parked at the US Treasury cash balance at the Fed. If policymakers fail to agree on a substantial new package it could mean that the US Treasury instead decides to slow issuance (markedly) to bring down the cash balance flooding commercial banks with USD liquidity in the process” (Nordea, 7/31)

MACRO MORSELS

New York Federal Reserve Nowcast for 3Q20: The advance estimate from the Commerce Department of real GDP growth for 2020:Q2, released on July 30, was -32.9%. The latest New York Fed Staff Nowcast for 2020:Q2 was -13.7%. The New York Fed Staff Nowcast stands at 16.8% for 2020:Q3 News from this week’s data releases increased the nowcast for 2020:Q3 by 3.5 percentage points. Positive surprises from manufacturers’ shipments of durable goods, wholesale inventories, and personal consumption data drove most of the increase for 2020:Q3.

Economic Cycle Research Institute (ECRI), U.S. Weekly Leading Indicators increased again in the week ending July 24, 2020, as reported July 30, 2020, to -6.5% from -7.0%, while its absolute level declined from 134.0 to 133.6.

Dallas Federal Reserve Monthly Personal Consumption Expenditures (PCE) for the month of June 2020. The Trimmed Mean PCE inflation rate over the 12 months ending in June was 1.8 percent. According to the BEA, the overall PCE inflation rate was 0.8 percent on a 12-month basis and the inflation rate for PCE excluding food and energy was 0.9 percent on a 12-month basis (note: the lowest reading since the index was created on Jan. 1960). 1-mo (June) PCE accelerated to 4.5% from 1.4% (May), 1-mo PCE excluding food and energy increased from 1.9% to 2.5%, while the 1-mo trimmed mean PCE accelerated from 1.5% to 1.7%. We have not reviewed the individual components as of yet that were trimmed in and out and various changes in the sub-indices. This is our favorite measure of inflation to monitor.

Mexican Pension System Reform Proposal to Address Key Shortfall (Fitch Ratings-Monterrey-31 July 2020)

Fitch Ratings views the proposed contribution rate increase to 15% from 6.5% for the Mexican Pension System (SAR) as a positive development that would address one of the SAR's biggest challenges in meeting its long term objectives. The targeted 15% contribution rate would also mean that Siefores' investment returns and glide paths would take on increased influence in differentiating performance. Moreover, as investment portfolios become increasingly sophisticated, the investment management capabilities of Afores would have a greater influence on the overall outcome of the SAR. Fitch does not anticipate any immediate ratings impact to Siefores' Investment Management Quality Ratings if the proposal is passed given its gradual implementation. However, Fitch will monitor the industry as it adapts to the environment created by the proposal's passage.

The reform proposal was presented on July 22 by Mexican President Andres Manuel Lopez Obrador and Secretary of the Ministry of Finance, Arturo Herrera. It is expected to be presented to the regulatory authorities in the near future.

In past publications about the SAR and its reforms, Fitch has pointed out that an increase in pension contribution rates would be one of the most important and fundamental drivers of higher projected income replacement rates (RRs), and has identified the SAR's current contribution rate of 6.5% as one of the biggest impediments against the system's ability to meet its long term objective of providing adequate salary replacement for beneficiaries. If the reform proposal is approved, mandatory contributions will progressively rise from 6.5% to 15% from 2023 through 2030, which would place Mexico at the upper end of the range of pension contributions compared to other Latin American countries. Such a contribution level would significantly improve projected RRs in the long run. Additionally, Fitch believes that a target contribution level of 15% is a robust level as long as Siefores are able to achieve sufficiently high net returns above inflation over the working life of their beneficiaries. The magnitude of the benefit will not be uniform, however, with younger and future generations benefiting the most as they will have more time to contribute at the higher rates, whereas beneficiaries that are closer to retirement at the start of the implementation period will not `be able to fully capture this benefit.

With a contribution rate of 15%, the most significant variable driving the SAR's ability to meet its long term objectives would shift to investment performance. This would require greater use of riskier investment options within the investment regime, which Fitch has historically considered to be underutilized, and an accelerated adoption of a differentiated glide path, which will lead to more sophisticated investment portfolios.

At the same time, assets under management would grow faster, making their efficient deployment and the achievement of adequate returns increasingly challenging. To alleviate this pressure, it will become increasing necessary for Siefores to access other investment options. In particular, Fitch has previously commented on the need for greater access to international investments and this need will likely grow from here. Additionally, alternative investments have been considered as another source of diversification and potentially higher returns, and while this may provide such benefits, Fitch has commented that they bear greater risks and therefore require more resources and considerations for the decision-making process (transparency, valuation, due diligence, etc.).

Moreover, as the need for more sophisticated investments grows so will the importance of robust investment processes and resources for supporting the optimal deployment of these investments, achieving adequate returns, and differentiating Siefores. As a consequence of this, the selection of Afore may become one of the most impactful financial decisions for beneficiaries over their lives, and this increases the need for transparency and understanding of the Afores' investment management capabilities.

There are other important aspects of the proposal that will require further evaluation to assess both expected and unintended consequences. For instance, the 15% contribution will be derived from a restructured framework in which the employer's share will progressively increase to 13.785% from 5.15%,for employees that exceed defined salary thresholds. How much of this additional cost employers will absorb or pass on will have to be observed over time. Additionally, the reform includes a reduction in the required number of weeks contributed in order to be eligible for a full pension to 750 from 1,250 over the short term (going back up to 1,000 weeks at some point in the future), which would allow an additional 40% of the working population to access a minimum guaranteed pension (MGP) through a new progressive framework aimed at benefiting lower waged workers. This reduction in required weeks implies that the government will supplement pensions up to the MGP amount for a wider base of workers which will likely increase the government's pension liability in the short term. However this could potentially be more than offset by a reduction in the future MGP liability as a result of the 130% increase in the contribution rate that will lead to higher account balances at retirement, and if employment formalization increases over time. These aspects of the proposal, however, will be further evaluated once the proposal is presented to the regulatory authority, is published, and more details become available.

US Pipeline Cancellation, Delays Underscore Regulatory Challenges (Fitch Ratings-Chicago-31 July 2020)

The cancellation of the Atlantic Coast Pipeline (ACP), an adverse court ruling for the Dakota Access Pipeline (DAPL) and a court-ordered halt to Keystone XL (KXL) in early July underscore the regulatory and legal risks facing oil and gas pipeline projects in the US, particularly in an election year, says Fitch Ratings. Rating changes due solely to these challenges are not anticipated but there are broad implications to credit quality, given factors such as significant capital investment and potentially higher transportation costs for oil and gas producers.

Pipeline construction is sometimes delayed due to permitting, construction and environmental-related litigation. With the DAPL ruling, the industry faces its first instance of having an operating pipeline threatened with shutdown due to environmental regulation. The Trump administration supports pipeline projects but uncertainty could rise if the presumed Democratic nominee, Joe Biden, becomes President given the previous opposition by the former Obama administration. A change to a Democratic controlled Senate could also usher in legislation that is more restrictive.

Fitch affirmed its rating on Dominion Energy (BBB+/Sable) but positively revised the company’s Environmental, Social and Governance (ESG) Relevance Score to ‘3’ from ‘4’ for Exposure to Social Impacts upon Dominion’s announcement it cancelled the ACP joint venture with Duke Energy. The cancellation removes litigation risk, reduces capex and eliminates the overhang of environmentalists’ opposition. Based on an early 2022 in-service date, ACP's last cost estimate was $8.0 billion compared with an original 2014 estimate of $4.5 billion-$5.0 billion and late 2019 in-service date.

EQM Midstream’s (BB/Negative) Negative Rating Outlook reflects execution risk with the Mountain Valley Pipeline (MVP) project that has experienced multiple delays and cost overruns due to regulatory and environmental challenges. MVP with an estimated cost of approximately $5.6 billion has significant bearing on EQM's credit profile due to the substantial investment made thus far and a deleveraging plan that hinges on an early 2021 in-service date.

MVP is in the Appalachian region, as was ACP. Cancellation of ACP will increase the value of capacity of remaining pipeline projects in the region, such as MVP, which should benefit current shippers on the project. EQT (BB/Outlook Positive), an anchor shipper on the project, is in discussions with multiple parties about the potential sell down of capacity, which may benefit its realizations.

The US District Court of DC ruled that an Environmental Impact Study (EIS), which could take up to 13 months, for DAPL was required and ordered the crude oil pipeline, which has been operating for more than three years, to be emptied and shut down by August 5. The pipeline was subsequently granted an order to stay the ruling.

DAPL is operated and approximately 36% owned by Energy Transfer (BBB–/Stable) whose rating is unaffected as we await the outcome of the appeal. If DAPL shut downs for an extended period and Energy Transfer does not take steps to improve its balance sheet, leverage could exceed its negative rating trigger.

A DAPL closure could affect upstream Bakken producers such as Hess (BBB-/Stable), Marathon Oil (BBB/Negative) and Continental Resources (BBB-/Negative), as a shutdown would result in higher transportation costs. Fitch expects delivery by rail would lower netbacks out of the basin by about $4.00/barrel on a run-rate basis, given higher rail costs. Operating efficiencies might eventually help offset a portion of this higher cost.

TC Energy’s (A-/Negative) KXL project was unable to obtain a Presidential Permit required when pipelines cross the US border under the Obama administration for climate change reasons but was granted the permit when Trump took office. In July, a Federal District Court judge found that the water permit was defective and halted a program for efficient processing of paperwork for permits. Fitch believes TRP can and will walk away from the project without credit implications due to financing arrangements for the $12 billion project that mitigates the risk of delays.

2Q Respite for U.S. Credit Card ABS Likely Short Lived (Fitch Ratings-New York-31 July 2020)

The coronavirus will hamper borrowers' ability to pay off their U.S. credit card debt, though the full ripple effect of the pandemic fallout was not evident this past quarter, according to Fitch Ratings in its latest quarterly index.

Monthly payment rates (MPRs) rebounded somewhat in second-quarter 2020 (2Q20; 27.18%) after falling to a five-year low of 26% in May. 'MPR is a key metric we are watching to understand how the pandemic is affecting consumers and is likely to be the first hit as recovery stalls,' said Senior Director Ian Rasmussen. 'A reversion to lower levels can indicate households are stressed and reverting to smaller payments to conserve cash.'

Chargeoffs also stabilized this past quarter and are now only 1.35% higher for 2Q20 compared with 3.15% in 2Q19. 60+ day delinquencies also held steady at an average of 1.09% in 2Q20, compared with 1.12% in 1Q20. That said, the somewhat resilient performance this past quarter is likely to be tested in coming months. Late stage delinquencies are subject to sharper increases in the coming months as consumers that were utilizing financial relief programs were generally not considered delinquent.

'Elevated unemployment pressures delinquencies and chargeoffs to increase from current levels,' said Rasmussen. 'Consumers may be nearing the end of temporary payment relief programs and fee waivers granted by issuers across loan types, which coupled with the end of the unemployment boost from the CARES Act set to expire today, will challenge low-income households to meet payments to avoid delinquency and ultimate default.' Fitch revised its asset performance outlook for U.S. credit card ABS to negative from stable earlier this year due to the coronavirus pandemic, which has caused the economy to contract sharply and unemployment numbers to spike.

Adequacy of Enormous 2Q US Bank Reserve Builds Uncertain (Fitch Ratings-Chicago-31 July 2020)

Most of the largest U.S. banks reported substantial provisions to their respective allowance for credit losses (ACLs) in the second quarter of 2020 (2Q20) on news of the growing negative impact of the coronavirus induced economic downturn on credit, according to the latest quarterly banking report from Fitch Ratings. The large provisions ultimately reduced earnings performance but remained within Fitch's expectations.

"As expected, earnings were pressured during the second quarter of 2020 due to material provisions for credit losses and margin pressure," said Bain Rumohr, Senior Director, Fitch Ratings. "Results reflected a challenging operating environment that we expect to persist into 2021 and are supportive of our Negative Sector and Negative Rating Outlook for U.S. Banks."

While Fitch anticipated material reserve builds during the quarter, it is still too early to tell if they will ultimately be ample enough to absorb credit losses expected to transpire later in 2020 and into 2021. Overall provision levels remain well below their 1Q10 peak of the last financial downturn. The comparison is somewhat challenging, however, given the different accounting standards in place in 2010 and now with Current Expected Credit Loss (CECL) standard.

Stimulus and forbearance programs are also aiding credit performance, particularly in consumer credit. This could change however as forbearance programs come to an end or are reduced. In commercial portfolios, nonperforming loans continued to march upward in 2Q20 as the economic impact of the pandemic has broadened to touch nearly every sector. While credit losses have been manageable thus far, in some sectors banks are taking credit losses due to collateral shortfalls on top of expected deterioration in cash flows. A number of banks, including Regions Financial (BBB+/Stable), Huntington Bancshares (A-/Negative) and JPMorgan Chase & Co (AA-/Negative) pointed to energy credit losses during quarterly calls or earnings presentations. In addition, CIT Group's (BBB-/Rating Watch Negative) 2Q20 results included a $73 million net charge-off related to the bankruptcy of a single factoring customer in the retail industry.

The Fed rate cut also significantly weighed on 2Q20 bank margins on a sequential basis. For the largest U.S. banks, net interest margin (NIMs) declined 28bps quarter-over-quarter at the median.

"Bank NIMs could show some resiliency in the coming quarters as banks will likely be able to more easily institute floors into loan pricing and as promotional deposits raised in the latter part of 2019 continue to roll off. We have already seen deposit pricing adjust significantly over the last two quarters," added Rumohr.

Aiding profitability was capital markets revenues at the five major U.S. banks, which jumped 63% to $44.9 billion in 2Q20 compared to the year prior, propelled by a rush for corporates to raise cash. For more on those results, see Fitch's press release "Capital Markets Boom Will Subside in Second-Half 2020."

Debt Service Relief for Low-Income EMs May Be Extended into 2021 (Fitch Ratings-Hong Kong-31 July 2020)

An extension of the G20 Debt Service Suspension Initiative (DSSI) for low-income emerging markets (EMs) is likely, possibly at the G20 meeting in November 2020, Fitch Ratings says. An extension, which could cover the whole of 2021 or only part of the year, would amplify the benefits available under the scheme.

The G20 agreed in July to consider a possible extension of the DSSI, which offers relief to 73 eligible low-income countries on debt service payments (principal and interest) due between May and December 2020. The payments covered are suspended, not forgiven, but with a repayment period of three years, a one-year grace period and a net-present value neutral structure. The G20 has emphasised that the DSSI is intended primarily to address liquidity issues that constrain countries' spending on coronavirus pandemic relief. Debt sustainability problems, which are also gaining in prominence, would need to be addressed separately.

As of mid-July, 42 countries had applied to participate in the initiative. Among Fitch-rated sovereigns, 12 of 22 eligible countries are known to have applied. We believe the number of applicants may increase if the benefits of participation are boosted, for example by an extension of the initiative, or if creditors in some cases decline to engage in bilateral re-structuring negotiations outside of the DSSI framework.

According to data on scheduled debt service payments published by the World Bank, only five of the 22 Fitch-rated DSSI-eligible sovereigns - Angola, Mozambique, the Republic of Congo, Pakistan and Laos - would see their external financing requirement for 2020 reduced by 1% of GDP or more through participation. The benefit to Angola, at 4.3% of GDP, is by far the highest. Of these five, only Laos has not applied for participation. Laos has not requested IMF financing, which is a precondition of application for the DSSI.

An additional eight Fitch-rated sovereigns would see a benefit of at least 0.5% of GDP. For nine sovereigns, the benefit in 2020 would be less than 0.5% of GDP; participation in the programme is lowest in this group. Although the external financing benefit is smaller for these 17 countries, debt service relief would free up funds for healthcare. Relative to existing public healthcare spending, which is low in many of these countries, the amounts involved could be significant.

The G20 has encouraged private-sector investors to provide debt service relief along lines similar to the bilateral relief provided under the DSSI, but it has not made this a requirement for participation. So far, none of the DSSI-eligible countries has said publicly that they would seek equivalent treatment from private-sector creditors, partly reflecting concerns about compromising their market access.

The DSSI focuses only on debt to official creditors, which under Fitch's rating criteria is not covered by our default definition. If sovereigns request debt service suspension from private creditors, this could qualify as a distressed debt exchange and lead to the rating being revised to 'RD' if Fitch judges it is necessary to avoid a traditional payment default.

Even if the private sector is not participating, a request by a sovereign to participate in the DSSI could be a signal of distress, amid broader pressures associated with the pandemic that could negatively affect ratings. However, in most cases the signalling effect will be limited, given the typically small size of the relief, and ratings already reflect the stress from the initial pandemic shock. Meanwhile, suspension of debt service to official creditors may also relieve near-term liquidity pressures faced by sovereigns participating in the scheme.

China Corporates Snapshot - July 2020: High-End and Frugal Consumers Support Consumption During Pandemic (Fitch, Fri 31 Jul, 2020)

Pandemic Fuels Consumer Spending Trends

China’s diverging trend of consumer spending, rendered by variance in household income and debt levels, has been more pronounced during the pandemic-led economic downturn. Household disposable spending dropped by 8% yoy in 1H20, against 2% growth in disposable income, with lower income families the most affected. Better-off families, which are more financially resilient, have been able to maintain consumption habits to uphold their social status. The trend was evident in year-to-date consumer sub-sector performance, with luxury products outperforming the overall market. Meanwhile, lower-income families, who are inclined to save rather than spend, lifted demand for value-for-money goods. The outperformance of the luxury sector was also bolstered by companies’ focus on producing affordable products; for example, luxury car brands have rolled-out low-spec models that are attractive to price-sensitive customers who desire quality goods. Fitch Ratings believes that high-end brands and discount products that represent value-for-money are better-positioned to capture China’s consumption trends. In comparison, brands and products with little appeal to high-end or frugal consumers are more vulnerable to the economic downturn.

Chinese consumers have exhibited diverging spending habits amid the COVID19 pandemic, as lower-income urban households trade down to value-for-money brands, while wealthy families with resilient finances continue to spend on luxury brands, says Fitch Ratings. This leaves brands/products failing in the middle underperforming the broad consumer sector.

Disproportionate Household Asset and Debt Distribution

Asset distribution in China has shown an uneven pattern demographically. A 2019 survey by the People’s Bank of China revealed that the top 1% of urban households own 17% of the urban population’s net asset value, versus only 2% by the bottom 20%. Property, the largest asset category, accounted for 59% of household assets. Households’ average gearing ratio rose to 9% in 2019, from 6% in 2010, but remained lower than the 12% in the US. However, lower income families face higher debt repayment pressure; the average debt/asset ratio of households with assets of less than CNY100,000 – representing 3% of households – was 111%, while those with asset of between CNY100,000–1 million – which represented 28% of households – had a ratio of 25%. The statistics also indicate that blue-collar and SME owners bear the highest debt burdens, as do households where the home owner is aged between 26-35 years. This is due to mortgage and childeducation related spending. That said, this group shows more willingness to spend than to save. The variance in asset value is correlated with differential access to debt financing. Richer families have better access to bank facilities and are less vulnerable to economic cycles, while the bottom 20% show higher reliance on private lending, which accounted for 9% of their debt in 2019, against the national average of 2%.

Lower-income urban households' diminishing purchasing power and rising debt repayment pressure has led them to increase savings and cut discretionary purchases. China's household disposable income was up by 2% yoy in 1H20, against 8% in 2019, but disposable spending dropped by 8% in 1H20.

The purchasing power of wealthier families has been less affected by the pandemic due to their large asset base. The top 1% of households owned 17% of national net asset value in 2019, versus only 2% by the bottom 20%. We expect higher-income households to maintain their consumption habits to uphold their social status. Some may even increase their purchases of domestic products due to the difficulty of traveling overseas, especially since the tax differential between onshore and offshore purchases has narrowed.

China's uneven household asset and debt distribution, accentuated by the 2020 pandemic and stock-market boom, has sparked a divergence in consumer spending, with luxury segments outperforming the overall market. For example, 1Q20 sales of high-end liquor brands, such as Kweichow Moutai and Wuliangye, rose by 13% and 15% yoy, respectively, while sales of low-end names declined. International luxury brands, such as LVMH, also saw a sharp rebound in Chinese sales of more than 50% in April, following a 15% drop in 1Q20. Meanwhile, luxury SUV sales rose by 9% yoy in 1H20, against a 5% yoy drop in the sales of luxury sedans and a yoy plunge of 22% in passenger-vehicle sales. However, the outperformance of luxury auto brands was partially attributable to the launch of more affordable low-spec models to appeal to price-sensitive middle-class buyers.

Discounted products with value-for-money appeal also delivered superior market performance as consumers turned more selective in their purchases. Pingduoduo, the Chinese e-tailing platform offering large price discounts, reported 2.1pp and 1.3pp higher year-to-date monthly active user growth than its competitors, Tmall and JD.com, respectively, as more consumers turned to budget shopping. The trend saw Fitch revise its Outlook on Vipshop Holdings Limited (BBB+) to Stable, from Negative, in June 2020, following management guidance of a rebound in revenue growth of up to 5% in 2Q20, following a 12% drop in 1Q20. This will see the company outperform peers due to its strategy of offering deep discounts on selected merchandise.

Euro-area Macro Flash: Collapse and a misleading jump (Nordea, 7/31/20)

Euro-area GDP expectedly plunged, but core inflation surprisingly jumped. The jump in inflation is likely mostly due to volatility and underlying price pressures remain muted. Easy ECB policies will continue.

Euro-area GDP collapsed by 12.1% q/q in Q2, pushing the y/y contraction to a massive 15%. Needless to say these are the by far the weakest numbers ever recorded in the age of quarterly GDP numbers, but the size of the contraction was no surprise at this point anymore. In fact, the q/q change was exactly equal to the Bloomberg median analyst consensus.

Euro-area July inflation, in turn, surprised the upside. Headline inflation climbed from 0.3% y/y to 0.4%, but the big surprise was the jump in the core measure from 0.8% to 1.2% y/y. Especially in these exceptional circumstances, monthly data can be volatile. The increase in core inflation was due to a jump in non-energy industrial goods, and very likely overstates the underlying prices pressures. Non-energy industrial goods prices exhibited elevated inflation also after the global financial crisis and during the Euro-area debt crisis in 2010-2011. Services inflation actually fell from 1.2% to 0.9%, which is probably a better indication of the underlying prices pressures, which should remain muted.

On the GDP front, after Germany published its own 30-day estimate for the first time yesterday, preliminary numbers are now available from all the biggest Euro-area countries. GDP plunged by a massive 18.5% q/q in Spain, followed by 13.8% in France, 12.4% in Italy and 10.1% in Germany. The data overshot expectations in France and Italy, while falling short in Germany and Spain.

The German Destatis commented that activity was very weak in all sectors apart from government consumption. In France, all the main components recorded sharp declines.

Q2 GDP numbers are history and it is clear that GDP contracts heavily, when big parts of the economy remain closed. While the restrictions have been clearly eased since, a resurgence of COVID-19 cases has made many countries rethink their policies, and many European countries have re-imposed some restrictions, albeit at a more lenient form compared to the spring. Q3 GDP numbers will surely be better than Q2, but a quick recovery is not a realistic prospect.

These numbers will do nothing to make the ECB change its assessment of a continued need for easy policies.

Bond Watch: Next generation EU bonds (Nordea, 7/30/20)

· The European Union is set to become the dominant EU-level bond issuer in the coming years, offering investors another type of safe EUR asset. EU issuance will increase as early as in the autumn.

· The financing of the EUR 750bn recovery fund and the EUR 100bn SURE programme will make the EU a big player in European bond markets.

· New EU bonds will help satisfy the demand for safe EUR assets and should support the functioning of European bond markets.

· It will probably take some time for the EU to increase issuance volumes significantly and the highest annual volumes may not be seen until 2022.

· The new bonds will have maturities of 3 to 30 years.

· The demand for EU bonds should be strong and the EU has the potential to become the dominant EU-level issuer.

· The targets for the recovery fund should also enable significant issuance of green bonds.

· The EU is slightly short of the highest credit ratings.

A new supranational issuer is about to enter the European financial markets. After the EU summit was finally able to agree on a EUR 750bn recovery fund, or Next Generation EU (NGEU), financed by new debt, the borrowing needs of the European Union will balloon.

Technically, the issuer is not new, since the EU has been borrowing via financial markets for a long time, but the current outstanding amount of EU bonds of just over EUR 50bn is relatively modest. The new borrowing needs will make the EU one of the largest bond issuers in Europe, following the largest sovereigns. It will be larger than the current EU/Euro-area supranational issuers, the European Investment Bank (the EIB), the European Financial Stability Facility (the EFSF) and the European Stability Mechanism (the ESM).

From a financial market perspective, a true EU-level safe asset has been needed for a long time. A true safe asset would also help in improving the functioning of the European financial markets. German bonds have been the go-to safe haven in the Euro area in the past, but the size of the German bond market is rather limited compared to the size of the Euro-area economy. While the planned EU issuance will be another step towards an EU-level safe asset, at least for now the size of EU-level debt will not be enough for EU bonds to take the place of German bonds in the Euro-area government bond markets.



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