A positive outlook for the sportswear industry; A widening transatlantic yield spread and a dual circulation growth strategy for China’s economy

It’s Halloween, time for ‘Trick or Treat’, a little fright and some delight: The sportswear industry is among the rare sectors currently thriving, you’ll be pleased to see some optimistic figures for a change. Our second topic is the widening yield spread between the U.S. and the Eurozone and why market participants need to price in higher inflation uncertainty, i.e. reassess the risk of deviation from their long-term inflation expectations. And: Double, double toil and trouble: President Xi’s growth strategy prioritizes the ‘domestic circulation’ in order to boost domestic demand, striving to make the country less reliant on factors beyond China’s control; we’ve looked at the two key challenges the Chinese economy is facing in the long run: the declining potential growth and a deteriorating external environment. Plus: An updated sector report for the automotive industry. Happy Halloween!

Retail: Healthier Tomorrows? Sporting Goods are a rare bright spot in Covid times

Sporting goods are one of the rare winners from the Covid-19 outbreak amid a decimated discretionary retail industry: We expect U.S. retail sales of sporting goods to hit an all-time high of USD48bn in 2020. After falling in March and April because of state-wide retail restrictions, U.S. retail sales of sporting goods recovered significantly in May, boomed in June and have kept growing at double-digit rates ever since amid growing enthusiasm for sporting activities. From January to August, they were up +9.9% year-on-year. The segment’s strong performance does not entirely come as a surprise. Over the past twenty years, sales had already displayed strong growth of about +2.9% per annum, second only to e-commerce. The increasing demand for performance gear among amateurs, the progressive casualization of the work dress code as well as the more recent “athleisure” trend (sports-wear as fashion wear) have proven strong tailwinds in a country home to leading sportswear brands Nike and Under Armor. We believe this momentum could last well into 2021 for three main reasons:

• Sporting goods sales are largely inelastic to GDP – correlation to GDP stands at 0.29 vs 0.74 for fashion stores and the segment came out largely unharmed from past recessions.
• We anticipate a K-shaped recovery for the U.S. economy , with strong dispersion in growth between economic sectors. This will typically translate into reduced consumer spending for activities that are seeing limitations and restrictions, freeing up purchasing power for goods and services that are both available and in demand.
• Anecdotal evidence suggests the sanitary crisis has prompted a fraction of the population to adopt healthier lifestyles – including more time dedicated to sporting activities.

What may have taken the industry by surprise is precisely the pace at which consumers have adapted to the new normal. Though several large fitness chains have gone bankrupt since March and restrictions remain on collective sporting activities, sports enthusiasts seem to have maintained and even increased their routine. Looking at search data for sporting activities that can typically be done from home using a popular video streaming service, we observe a peak in demand related to fitness workouts in Spring, with interest still up 40% to 80% from last year as of October 2020. The same survey conducted in January and late July 2020 also shows a significant increase in sports engagement even after the most severe restrictions on activity were lifted.

What does this mean for companies? Because sportswear accounts for an estimated 20-30% of the wider apparel market, its resilience is good news for textile manufacturers – Asian countries host the majority of contract manufacturers working for Western sportswear brands. Together with personal protection equipment (face masks, etc.), it is a rare bright spot for an industry plagued with collapsing demand from fashion brands. Looking at two peer groups comprising leading international sportswear and sporting goods retailers, and leading fast-fashion retailers, we observe a huge divide on the expected pace of recovery – the majority of sports specialists should be close to or above their 2019 sales levels by 2021 already, while it would take at least one more year for fashion specialists. Much like in other segments of the retail and consumer goods industries, we believe the ongoing sanitary crisis is also contributing to widening the gap between best performers and followers as regards the adoption of multichannel business models. Nike and Dick’s Sporting Goods, which will both hit record revenues this year, were able to navigate through times of store closures thanks to e-commerce, whose sales grew by triple digits under lockdown. In contrast, fast-fashion heavyweight Inditex hopes it will reach 25% by 2022 at best. Looking beyond sportswear, we anticipate more and more household goods companies to follow the example set by companies such as Dyson (household appliances) or Apple (consumer electronics), which also boast strong direct-to-consumer activities. The incentive for sportswear brands to push their own retail operations is even stronger as it allows them to fend off competition from internet pure-players and capture the market shares from defunct or ailing retailers, in particular department stores. Please find the full report here.

Capital Markets: The Transatlantic spread - Pricing in inflation (un)certainty

The transatlantic yield spread between the U.S. and the Eurozone narrowed by 81bp until mid-September but has re-widened by 20bp lately. In the first phase of the Covid-19 crisis, nominal yields in the U.S. and the Eurozone showed a common downward trend responding to the expected deflationary shock and coordinated monetary easing. With the Fed making full use of its greater scope for lowering interest rates, the transatlantic spread had narrowed by 81bp for the 10y maturities by mid-September. Now, a diverging trend in U.S. and Eurozone nominal yields arises, especially for longer maturities. The economic momentum is in favor of the U.S. as the Eurozone is heading for a double dip. With the increasing pandemic risk and the subsequent containment measures, the Eurozone should fall back into recession in Q4 2020. This weakness in the Eurozone could even continue into Q1 2021 as we see a rising risk of a stimulus gap. Political tensions in some member states may make it difficult to maintain adequate fiscal measures. In addition, there is uncertainty about the timing and extent of the payments from the EU recovery fund. In the U.S., on the contrary, expectations are for a new stimulus as market participants seem to be positioning themselves for a Democratic victory in the presidential election.

We find that the recent widening of the transatlantic spread is due to inflation expectations, more precisely to a repricing of the inflation risk premium in view of the Fed’s average inflation target (AIT). If economic momentum really was the main driver of the recent transatlantic yield divergence, one would expect rising real yields in the U.S. and somehow stagnating real yields in the Eurozone. However, by decomposing the nominal yields into the real yield and the market-based inflation expectation (inflation swap), we observe that for the 10y maturity real yields in the Eurozone have indeed stagnated since mid-September, but declined by 10bp in the U.S. This is due to a significant increase in market-based inflation expectations, which nominal yields only partially followed. Thus, the recent widening of the transatlantic spread is not explained by the real yield component but the inflation expectation component. In the U.S., the inflation risk premium has risen by 18bp since mid-September. It is thus responsible for almost the entire upward movement of nominal yields we have seen during that period. We think the reason for this repricing of the inflation risk premium in the U.S. is the redesign of the Fed’s inflation target. Moving to an average target (AIT) actually implies the possibility of longer periods of inflation overshooting. Market participants therefore need to price in higher inflation uncertainty, i.e. reassess the risk of deviation from their long-term inflation expectations. The transatlantic spread could continue to rise up to 140bp in the coming months. Structurally, the Fed’s AIT exerts a steepening effect on the U.S. yield curve via the inflation risk premium. It could rise further the more volatility the realized inflation is going to exhibit. Naturally, the difference in the impact of QE on the nominal yields remains the most important factor to explain the transatlantic spread. Would a symmetrical inflation target by the ECB narrow the transatlantic spread? Some upwards repricing of the inflation risk premium would be likely. But the magnitude of this should be limited, as the scenario of an inflation overshoot in the Eurozone is less credible when viewed from the past. However, the main factor for the transatlantic spread remains the extent of QE and the compression of the nominal term premium. Here the ECB is more aggressive than the Fed. For the 10y maturity, we currently estimate the compression at 185bp in the Eurozone vs 130bp in the U.S. As long as this difference persists, the structural tendency for the transatlantic spread is set for more divergence. You can find the full report here.

Growth strategy: Dual circulation – China’s way of reshoring?

Over the long run, the Chinese economy is facing two key challenges: declining potential growth and a deteriorating external environment. Our growth potential model suggests China’s GDP growth is likely to average between +3.8% and +4.9% over the coming decade (after +7.6% in the 2010s), due to declining labor supply and slowing productivity and capital investment. Meanwhile, China is also bracing for a long-term standoff with the U.S., which is currently its top export destination and the most innovative country at the global level. Looser economic ties with the U.S. will thus pose additional risks to China’s slowing economy. In this context, the “dual circulation” strategy is likely to take center stage in China’s 14th five-year plan as a way towards more sustainable growth, making the country less reliant on factors outside of its control. First introduced by President Xi Jinping in May 2020, this strategy prioritizes “domestic circulation” (increasing domestic demand and lowering dependence on foreign inputs), while “international circulation” (maintaining export market shares and liberalizing capital flows) works as a complement. While rebalancing towards domestic demand is not a new principle in China’s economic planning, China will aim in the long run to use domestic production to provide for increasing domestic demand, rather than imports. Taiwan, Malaysia, Singapore, Thailand and Chile are set to incur the most potential losses in the medium run as China moves towards industrial autonomy. Conversely, goods from the U.S., Japan and Germany are exposed to very limited risk of being substituted by Chinese goods in the medium term, thanks to their technological advancement. Losses for the Eurozone overall could amount to up to 0.9% of GDP in the medium run, with machinery & equipment, construction, agrifood and electronics the most exposed sectors. China is likely to increase direct investment into innovating emerging economies, such as the electronics sector in Indonesia, India, Thailand, Mexico and Chile. Chinese outward investment has slowed but not stopped in the past years, and the Belt and Road Initiative remains part of Chinese authorities’ long term vision. Implementation challenges (e.g. related to financial risks) mean that Chinese policymakers are likely to aim for outward direct investment to be more disciplined around national economic targets (e.g. industrial autonomy). Long-term risks include rising debt, zombification and slow technological advancement. China’s R&D spending relies far more on government funding compared to the U.S., Japan and Germany. Strong government intervention could risk leading to overcapacity issues and resource misallocation towards the overall less profitable and less innovative state-owned enterprises. You'll find the full report here.

Updated sector reports

Our latest report for the following sector: Automotive: Rated S (sensitive risk for enterprises): Covid19-related historical slump is adding pressure on top of structural challenges.