Equities
Highlights Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. The risk of a protectionist backlash means that monetary authorities are reluctant to intervene aggressively to limit the rise. We recommend that investors stick with our existing long MSCI China / short Taiwan trade, for now. A breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely be a sufficient basis to close the trade at a healthy profit. Feature We last wrote about Taiwan in February of this year,1 when the risk of protectionist action from the Trump administration loomed large. While there have been no negative trade actions levied against Taiwan this year, macro factors, particularly the strength of the currency, continue to argue for an underweight stance within the greater China bourses (China, Hong Kong, and Taiwan). Our long MSCI China / short Taiwan trade has generated an impressive 19% return since its inception in February. The trade has become significantly overbought, but we recommend that investors stick with it, for now. A material easing in pressure on Taiwan's trade-weighted exchange rate appears to be the most likely catalyst to close the trade and to upgrade Taiwan within a portfolio of greater China equities. The Taiwanese Economy In 2017: What Has Changed? Real GDP growth in Taiwan has generally trended sideways in 2017, decelerating in the first half of the year and then recovering in the third quarter (Chart 1). While these fluctuations in its growth profile have been somewhat muted, overall GDP growth has masked a sizeable divergence between domestic demand and export growth. Taiwan is a highly trade-oriented economy, with exports of goods & services accounting for nearly 65% for its GDP, and a recent acceleration in real export volume has positively contributed to overall growth. Over 50% of Taiwan's exports are tech-based, and Chart 1 panel 2 highlights the close link between global semiconductor sales (which have risen sharply over the past year) and Taiwanese nominal exports. But as Chart 1 panel 3 shows, growth in real domestic demand has fallen back into contractionary territory, driven largely by a sharp decline in gross fixed capital formation. This decline in investment is somewhat surprising, given the close historical relationship between Taiwan's real exports and investment (Chart 2, panel 1). But the sharp drop may have been a lagged response to the export shock that occurred during the synchronized global growth slowdown in 2015, as it led to a non-trivial accumulation of inventory (Chart 2, panel 2). The recent acceleration of export growth and a renewed draw in inventories suggests that the severe pullback in investment is likely to reverse in the coming year. Chart 1A Divergence Between Domestic Demand##br## And Exports Chart 2Investment Likely To Rebound Over ##br##The Coming Year The evolution of Taiwanese capital goods imports is likely to provide an important confirming signal about the trend in real investment, given the close historical correlation between the two series. For now, the growth in capital goods imports is rebounding from negative territory (Chart 3), which is consistent with the view that investment is set to recover. Finally, while real consumer spending growth also decelerated in the first half of the year, the acceleration in Q3 has brought consumption back to its 5-year moving average. More importantly, Chart 4 highlights that the consumer confidence index in Taiwan is closely correlated with real spending, with the former heralding a rise in the latter over the coming months. Chart 3Capital Goods Signal An Investment Recovery Chart 4Consumption Also Set To Improve Bottom Line: Growth in the Taiwanese economy has trended sideways this year, but a budding turnaround in weak domestic demand suggests that growth should improve in 2018. The Taiwanese Dollar: Driven By Flows, Not Fundamentals Taiwanese stock prices have underperformed Greater China bourses since the beginning of the year (Chart 5), despite the recent improvement in real export growth and signs of an impending improvement in domestic demand. To us, this underperformance has been largely caused by the strength in the Taiwanese currency. The Taiwanese dollar has appreciated since early-2016, both against the U.S. dollar and in trade-weighted terms (Chart 6). Although the currency retreated from May to August of this year, it has since resumed its uptrend and currently stands between 8-9% higher than last year's low in trade-weighted terms. Chart 5Significant Underperformance Of ##br##Taiwan Vs Greater China Chart 6Material Currency Appreciation##br## Since Early-2016 Crucially, Chart 7 highlights that the rise in the TWD cannot be explained by relative monetary policy or by an improvement in the terms of trade. The chart shows how the USD/TWD began to decouple from the relative 2-year swap rate spread in early-2016, and how the trend in Taiwan's export price index has been negatively correlated with the trade-weighted exchange rate. The best explanation for the recent strength in Taiwan's currency appears to be a surge in capital inflows oriented towards Taiwan's equity market (Chart 8). Foreign ownership of Taiwanese stocks has increased significantly over the past few years and is currently at a record high of 43%. Given that Taiwan's equity market is enormously tech-focused, it appears that global investors have been attracted to Taiwanese stocks as part of a play on the global tech rally. As we will discuss below, this has become somewhat of a self-defeating strategy, at least in terms of Taiwan's relative performance vs Greater China bourses. While it is possible that monetary authorities will attempt to combat the appreciation of the Taiwanese dollar, Chart 9 highlights that there is little room to maneuver. First, Taiwan's policy rate of 1.375% is already extremely low, and is only 12.5 bps above the level that prevailed during the worst of the global financial crisis. Second, panels 2 and 3 suggests that while past central bank intervention was successful at depreciating the TWD, monetary authorities also seem reluctant to allow Taiwan to be labeled as a currency manipulator. Our proxy for central bank intervention is the rolling 3-month average daily depreciation in TWD/USD in the first 30 minutes of aftermarket trading, a period that the central bank has historically used to intervene in the foreign exchange market. The chart shows that periods of intervention have been associated with a subsequent decline in TWD/USD, but that intervention durably ended once Taiwan was added to the U.S. Treasury's watch list of potential currency manipulators (first vertical line). Taiwan was removed from the watch list in October of this year (second vertical line), after central bank intervention ceased. Chart 7Currency Strength Not Supported ##br##By Fundamentals Chart 8Equity-Oriented Capital Inflows##br## Are Pushing Up The TWD Chart 9Little Room For Policy ##br##To Push Down The Exchange Rate Bottom Line: The appreciation of the TWD from its 2016 low reflects investor inflows rather than bullish fundamentals. While there is scope for further central bank intervention to help depreciate the currency, the risk of a protectionist backlash means that monetary authorities are reluctant to act. The Relative Outlook For Taiwanese Equities Table 1 presents a simple performance attribution analysis for Taiwan's year-to-date stock returns relative to Greater China bourses,2 in an attempt to answer the following question: Has Taiwan underperformed because it is underweight sectors that have outperformed, or because its highly-weighted sectors underperformed? To test this question we calculate a "hypothetical" return for the Taiwanese stock market, which shows what would have occurred if Taiwan's tech and ex-tech sectors had earned the benchmark return instead of their own. Table 1Taiwan's Poor Performance This Year Is Due To Its Tech Sector The table clearly shows that Taiwan would have substantially outperformed Greater China in this hypothetical scenario, underscoring that its sector weighting is not the source of the underperformance. While both Taiwan's tech and ex-tech indexes underperformed those of Greater China, it is apparent that most of the gap in performance can be linked to Taiwan's tech sector. Tech accounts for roughly 60% of Taiwan's equity market capitalization, and the sector significantly underperformed Greater China tech this year. Chart 10 highlights that Taiwan's tech sector underperformance is significantly explained by the rise in Taiwan's trade-weighted currency. Panels 2 & 3 of the chart shows Taiwan's rolling 1-year tech sector beta and alpha vs Greater China tech, both compared with the (inverted) year-over-year percent change in the trade-weighted exchange rate. Here, we define alpha using Jensen's measure, which is the difference between Taiwan's tech sector price return and what would have been expected given its beta and Greater China's tech sector performance. The chart clearly shows that the sharp rise in Taiwan's trade-weighted exchange rate caused both a decline in Taiwan's tech sector beta (from a historical average of about 1) as well as a significantly negative alpha over the past year. Chart 10, in combination with the currency-driven downtrend in Taiwan's export prices shown in Chart 7, suggests that Taiwan's equity market has suffered in relative terms due to the outsized appreciation in its currency. This is somewhat ironic, as we noted above that the currency appreciation itself appears to be caused by capital inflow oriented towards Taiwan's tech sector, meaning that global investors have inadvertently contributed to Taiwan's equity market underperformance relative to Greater China bourses. Looking forward, there are cross-currents affecting the outlook for Taiwanese stock prices. Chart 11 shows that technical conditions and relative valuation argue against maintaining an underweight stance; Taiwanese stocks are heavily oversold vs Greater China, and have de-rated in relative terms since the beginning of the year. Taiwanese tech in particular is quite cheap in relative terms. In addition, panel 1 of Chart 10 suggests that Taiwanese tech (in relative terms) may have undershot the appreciation in the currency. Chart 10Taiwan's Tech Underperformance Is Explained By Currency Appreciation Chart 11Taiwan Vs China: Oversold, And Cheaper Than Usual However, Taiwan's tech sector is mostly made up of the semiconductors & semiconductor equipment industry group, and there are signs that the growth rate in global semiconductor sales is in the process of peaking. Chart 12 illustrates the close correlation between the growth of global semi sales and Taiwan's absolute 12-month forward earnings per share, with the recent gap likely having occurred due to the currency impact noted above. The chart suggests that earnings expectations for Taiwan are highly unlikely to accelerate if semi sales growth slows, meaning that Taiwanese stocks, particularly the tech sector, currently lack a catalyst to re-rate. Chart12Taiwan Is Lacking A Re-Rating Catalyst From our perspective, a lasting depreciation in the currency appears to be the most likely catalyst for a re-rating, as it would increase the odds that the relationship shown in Chart 10 would durably recouple. Until then, any exogenous rebound in relative tech sector performance is likely to be met with a self-limiting TWD appreciation. Bottom Line: We recommend that investors, for now, stick with our existing long MSCI China / short Taiwan trade. However, a breakout in relative Taiwanese tech sector performance coupled with a weakening TWD would likely cause us to close the trade, and upgrade Taiwanese stocks to at least neutral within a greater China equity portfolio. Stay tuned. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Lin Xiang, Research Assistant linx@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Taiwan's 'Trump' Risk", dated February 2, 2017, available at cis.bcaresearch.com. 2 We use MSCI's Golden Dragon index to represent Greater China, which includes China investable, Hong Kong, and Taiwanese stocks. Cyclical Investment Stance Equity Sector Recommendations
Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Table 4Capex In The Year After A Corporate Tax Cut Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Table 6...And In The 12 Months After Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations
Dear Client, I recorded a webcast with my colleague Caroline Miller earlier this week. Caroline and I discussed the recent tax legislation in the U.S. and other key investment topics. I hope you will find the time to listen in. I am also happy to announce that going forward, in addition to sending you my regular reports, I will be sharing my thoughts on the economy and markets through Twitter. Best regards, Peter Berezin, Chief Global Strategist Highlights Some profit taking is likely over the next few weeks as U.S. equities discount a more realistic assessment of how lower tax rates will affect corporate cash flows. The cyclical picture for the U.S. and the global economy remains bright, implying that any correction will be short-lived. History suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for equity investors. With another recession still at least a year away, it is too early to get bearish on stocks and other risk assets. Feature Tax Cuts Arrive Early We had expected the Republicans in Congress to deliver on their pledge to cut taxes, but thought that the legislative process would drag on for longer than it did. In the end, the Senate was able to pass a hastily negotiated bill, giving Donald Trump his first major political victory. The question is where things go from here. The Senate and House bills still need to be reconciled. We do not anticipate much drama in that regard, given the broad similarities between the two versions. The bigger issue is how the legislation will affect the economy and markets. The Joint Committee on Taxation (JCT) estimated in mid-November that the original Senate version of the bill would raise the level of real GDP by an average of 0.8% over the ten-year budget window.1 It is reasonable to assume that the final bill will boost GDP by a similar amount. The impact on growth is likely to be somewhat front-loaded, given that several provisions will either expire or be phased out after five years. We expect real GDP growth to be 0.2%-to-0.3% higher in 2018 and 2019 as a result of the legislation. This is not a particularly large effect, which explains why the bond market reaction has been fairly muted. The impact on corporate profits will be more pronounced, but even here, one should keep things in perspective. The final bill is likely to reduce corporate taxes by about $350 billion over the next ten years. The JCT's baseline assumes corporate tax receipts of $3.9 trillion over the next decade. Thus, the bill will probably reduce the effective corporate tax rate by a bit less than two percentage points, taking it down from 19% to 17%. This, in turn, implies an increase in after-tax corporate cash flows of about 2.5% (i.e., 83 divided by 81). The market ran up a lot more than that over the past few months. Thus, we would not be surprised to see some profit-taking over the coming weeks. Cyclical Picture Still Bright If such a stock market correction occurs, it would represent a buying opportunity. Historically, recessions and bear markets have gone hand in hand (Chart 1). Right now, none of our recession indicators are warning of an imminent downturn (Chart 2). Chart 1Recessions And Bear Markets Usually Overlap Chart 2ANo Imminent Risk Of A U.S. Recession Chart 2BNo Imminent Risk Of A U.S. Recession This reassuring conclusion is consistent with the signal from our forthcoming MacroQuant Model, which we will be discussing in greater detail in the months ahead. This ground-breaking model examines dozens of variables, including a number of BCA's proprietary indicators, in order to consistently and accurately project returns across the key asset classes, geographies, and time horizons. Currently, the model is flagging a somewhat elevated risk of a temporary pullback, but continues to give a highly bullish reading on the cyclical (6-to-12 month) outlook (Chart 3). Chart 3BCA's MacroQuant Model Still Likes Equities The model's auspicious assessment largely stems from the strength of recent economic data in the U.S. and around the world. Global growth estimates continue to grind higher (Chart 4). In the U.S., the new orders component of the ISM manufacturing index rose to 64 in November, while the inventory component sank to 47. We have found that the gap between the two is a powerful predictor of stock market returns (Chart 5). The current gap is in the 87th percentile of its historic range. By the same token, core durable goods orders, initial unemployment claims, capex intentions, consumer and business confidence, global PMIs, and most other leading indicators paint a fairly upbeat picture. Chart 4Global Growth Projections Are Trending Higher Chart 5ISM As A Predictor Of Market Returns The euro area and Japan also continue to grow at a robust pace (Chart 6). Somewhat worryingly, China has seen growth tick down a notch in recent months (Chart 7). However, the evidence so far suggests that growth has merely slowed from an above-trend pace back towards potential. Nominal GDP rose by 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation has gone from as low as negative 5.9% in September 2015 to 6.9% at present. Core CPI inflation has also accelerated, rising to 2.3% in October (Chart 8). In this light, recent efforts by the authorities to expedite structural reforms are coming at an opportune time. Chart 6Positive Growth Momentum ##br##In The Euro Area And Japan Chart 7Growth Has Ticked Down##br## In China... Chart 8... But Merely From##br## An Above-Trend Pace Too Early To Bail Out Of Stocks Table 1Stocks And Recessions: Case-By-Case All good things must come to an end. As we discussed in our latest Strategy Outlook, the global economy is likely to fall into recession in late 2019.2 Markets will sniff out a recession before it happens, but in general, the lag time between when markets peak and when recessions begin does not tend to be very long. Table 1 shows that the lag has averaged seven months during the post-war era, with the past three recessions featuring an average gap of only four months. In fact, history suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for investors. The S&P 500 has delivered an average annualized real total return of 14.2% since 1950 in the 13-to-24 months prior to past U.S. recessions (Table 2). This exceeds the average return of 10.1% during business-cycle expansions. The S&P has returned 8% at an annualized pace in the 7-to-12 months prior to past recessions. While this is below the average return during past expansions, it is still well above the average return on bonds and cash during the corresponding periods. Moreover, the performance of stocks in the 7-to-12 month period preceding recessions has improved sharply over the past few business cycles. The S&P 500 generated an annualized real total return of 22.2%, 20%, and 13.6% in the 7-to-12 months prior to the beginning of the 1990-91, 2001, and 2007-09 recessions, respectively. Table 2How Have Stocks Performed Prior To Recessions? Stocks only begin to underperform in a meaningful way in the six months before the recession and continue to underperform in the initial phase of the downturn. Thus, even if one had known with complete certainty that a recession was coming, getting out of stocks more than six months in advance of the downturn would have been a mistake. Bottom line: With another recession still at least a year away, it is too early to get bearish on equities and other risk assets. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see "Macroeconomic Analysis Of The "Tax Cut And Jobs Act" As Ordered Reported By The Senate Committee On Finance On November 16, 2017," The Joint Committee On Taxation, U.S. Congress (November 30, 2017). 2 Please see Global Investment Strategy Outlook, "A Timeline For The Next Five Years," dated December 1, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
In mid-October we penned a Special Report identifying the top five reasons to favor cyclicals over defensives: capital expenditures upcycle, synchronized global growth in general and emerging markets (EM) growth in particular, U.S. dollar softness, risk premia suppression and diverging operating metrics.1 On the EM front in particular, China's recent inflationary impulse suggests that the path of least resistance remains higher for cyclicals versus defensives (top panel). Moreover, the bottom panel of the chart shows that over the past three decades when Chinese nominal GDP outpaces the U.S., EM stocks outperform the SPX and vice versa. In other words when China is firing on all cylinders commodity demand picks up steam and thus the most cyclical parts of the U.S. stock market outperform safe havens. Keep in mind that most cyclical sectors are levered to commodity prices, have high operating leverage and a sizable export exposure. One key risk that will put our cyclicals over defensives preference offside is a policy mistake from Chinese policymakers similar to the August 11, 2015 currency devaluation. However, this is a low probability event. Bottom Line: We reiterate out cyclical over defensive portfolio bent. 1 Please see BCA U.S. Equity Strategy, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com.
Overweight Selected Companies Dear Client, This week I am away visiting clients in Australia, so we are sending you this report written by my colleague Oleg Babanov (Emerging Market Equity Sector Strategy). Oleg identifies select companies in Austria as excellent conduits to emerging market growth whilst maintaining high standards of corporate governance. Oleg also has a list of top stocks in Poland, Russia and Turkey. Please contact us if you would like to see those additional picks. Dhaval Joshi Highlights We are recommending an overweight position in select Austrian companies on a long-term (one year-plus) time horizon. Austrian-listed companies traditionally have high exposure to Central and Eastern Europe (CEE) and other Emerging Markets (EM), while offering superior corporate governance standards, which secures a premium to EM peers. At the same time, geographically diversified revenues stemming from developed and emerging markets support less-volatile earnings growth and outperformance over the long-term. Table 1Single-Stock Statistics On Select Austrian Companies* Austrian Companies - EM Focused... Companies in Austria have traditionally been active in both Western Europe, with a main focus in Austria and Germany, as well as in the CEE region, providing investors with a unique access to both kind of markets. Sectors with high exposure include financials, with around 56% in emerging markets, consumer discretionary, with 46%, and materials with 45%. Furthermore, in terms of company count, pretty much every listed company in the materials as well as the real estate sector has exposure to emerging markets (Chart I-1A, Chart I-1B, Chart I-1C, Chart I-1D, Chart I-1E, Chart I-1F). Chart I-1AGeographical Revenue Breakdown Austria: ##br##Consumer Discretionary Chart I-1BGeographical Revenue Breakdown Austria: ##br##Financials Chart I-1CGeographical Revenue Breakdown Austria:##br## IT Chart I-1DGeographical Revenue Breakdown Austria:##br## Materials Chart I-1EGeographical Revenue Breakdown Austria: ##br##Real Estate Chat I-1FGeographical Revenue Breakdown Austria:##br## Utilities ...And With High Corporate Governance Standards The Austrian ATX equity index has significantly outperformed the MSCI EM index on both a long-term (+21% over five years and +27% over three years) and short-term time horizon (+12%) (Chart I-2A & Chart 1-2B). Chart I-2AFive-Year Performance: ##br##Austrian ATX Index Vs. MXEF Index Chart I-2BYTD Performance:##br## Austrian ATX Index Vs. MXEF Index We believe part of this outperformance is warranted by better corporate governance standards of Austrian companies, which score highly compared to their emerging market peers on all metrics, with the exception of environmental disclosure (Chart I-3A, Chart I-3B, Chart I-3C, Chart I-3D).1 Effectively such companies are offering investors access to emerging markets with less corporate risk, and better management and disclosure standards. Chart I-3AESG Disclosure Comparison Chart I-3BSocial Disclosure Comparison Chart I-3CEnvironment Disclosure Comparison Chart I-3DGovernance Disclosure Comparison Based on the findings above, we have created a portfolio of six companies from the consumer discretionary, financials, real estate and industrials sectors, combining exposure to emerging markets with a high ESG score and sound operational and financial performance (Table I-2). Table I-2Select Overweight Companies And ##br##12-Month Beta Vs. MSCI EM Sector Specifics Price performance over the past five years has been strong, with our overweight basket outperforming the broad MSCI EM index by 53% (Chart I-4). Valuations between Austrian banks and companies from other sectors are diverging. While non-bank companies are trading at a 16% premium to EM peers on a P/E basis, Austrian banks are trading at a 14% discount to the EM Banks Index on a price-to-book comparison (Chart I-5). Chart I-4Select Austrian Companies Outperforming##br## MSCI EM Index Chart I-5Valuations Are Diverging##br## Depending On Sector Nevertheless, Austrian companies display better bottom-line growth dynamics, helped by recovering performance on an operational level, translating into slightly higher profitability (Chart I-6A, Chart I-6B, Chart I-6C). Chart I-6AA Recovery In Operating Margins Of ##br##Austrian Companies In Late 2015... Chart I-6B...Has Helped EPS Growth To Outstrip EM ##br##Companies Since The End Of 2015... Chart I-6C...While Profitability Is Close ##br##To The EM Average Chart I-7ACash Flow Generation Is Subdued##br## Among Austrian Companies... Furthermore, despite negative cash flow generation for the select basket, Austrian companies have comfortable debt levels, and are paying out higher dividends than EM companies (Chart I-7A, Chart I-7B, Chart I-7C). Chart I-7B...With Debt Levels Close To The EM Average... Chart I-7C...And Dividend Yields Higher Than EM Peers The Overweight Basket Erste Group Bank (EBS AV) Erste Group Bank (EBS AV) (Chart I-8). Chart I-8Performance Since October 2016: ##br##Erste Group Bank vs. MSCI EM Erste Group Bank (EBS AV) reported better-than-expected third-quarter 2017 financial results on November 3. Net interest income stabilized, ticking up 1% year over year, mainly driven by the integration of Citigroup's consumer banking business in Hungary. Net interest margin was still under pressure, down 4 basis points year over year to 2.39%. Net fee and commission income expanded by 4%, supported by fee income, but was offset by trading income deterioration. Operating expenses grew by 3% year over year due to regulatory and IT project costs. With the decrease in provisions offsetting declining operating results, the bottom line rose by 8% year over year. Asset quality showed improvement, with the NPL ratio shrinking by a significant 111 basis points year over year to 4.3%. The company's tier-1 ratio grew by 2 basis points year over year to 13.4%. The market is estimating a 0.2% EPS CAGR over the next four years. We believe operating expenses should grow at a slower pace in the coming quarters, positively affected by decelerating regulatory and IT project investments. At the same time, we expect net interest income to continue to expand, driven by strong macro performance in the CEE region and countercyclical measures by the corresponding central banks. Raiffeisen Bank (RBI AV) Raiffeisen Bank (RBI AV) (Chart I-9). Chart I-9Performance Since October 2016:##br## Raiffeisen Bank vs. MSCI EM Raiffeisen Bank International (RBI AV) reported remarkable third-quarter 2017 financial results on November 14, solidly beating market expectations. Net interest income advanced by 4% year over year, with net interest margin up 4 basis points to 2.47%. Net fee and commission income climbed by 8% year over year, boosted by the bank's payment transfer business but offset by sluggish trading income as well as a one-off litigation cost in Slovakia. However, pre-provisional profit surged by 35% thanks to disciplined cost management. As a result, net income soared 46% year over year, substantially beating market expectations. Asset quality improvement was another positive. The NPL ratio came in at 6.7%, down 200 basis points year over year, aided by slower NPL formation and write-offs. The tier-1 capital ratio expanded by 100 basis points year over year to 13.4%. The market is estimating an 18% EPS CAGR over the next four years. We welcome the bank's digital transformation strategy in Romania. We believe the new version of the banking platform to be launched in 2018 will better support customers' needs and optimize the bank's transaction business. Andritz AG (ANDR AV) Andritz AG (ANDR AV) (Chart I-10). Chart I-10Performance Since October 2016:##br## Andritz vs. MSCI EM Andritz AG (ANDR AV) reported weak third-quarter 2017 financial results on November 3. Revenue contracted by 8% year over year, weaker across all business segments, especially in pulp and paper (-13%). This was reflected by a shrinkage in overall order intakes, down 9% year over year. In terms of geographic exposure, Andritz continues its sales expansion in Europe (+6%) and China (+25%). EBITDA fell 9% year over year, mainly dragged down by the materials business, despite this being moderately compensated by the separation business segment. EBITDA margin was also disappointing across the board, down 20 basis points year over year to 7.2%, except for the hydro segment (+154%). As a result, the bottom line declined by 20% year over year, missing market expectations. Andritz is trading at a forward P/E of 16.5x, while the market is estimating a 4.7% EPS CAGR over the next four years. Despite lower-than-expected third-quarter earnings, we remain bullish on the company, given its strong track record of business growth in difficult environments. Earlier this month, the company won a contract from SaskPower to refurbish a hydroelectric power station in Canada, with a total contract value of more than US$104 million. CA Immobilien Anlagen (CAI AV) CA Immobilien Anlagen (CAI AV) (Chart I-11). Chart I-11Performance Since October 2016: ##br##CA Immobilien Anlagen vs. MSCI EM CA Immobilien Anlagen AG (CAI AV) reported better-than-expected third-quarter 2017 financial results on November 22. Revenue increased by 5.6% year over year, helped by a 10% increase in rental income, as occupancy rates increased in all three major regions (Germany, Austria and CEE). On the operating side, expenses fell by 5% year over year, while income jumped by 21.4% year over year, pushing operating margin higher to 45.8% from 39.8% for the same period last year. The EBITDA grew 11% year over year. As a result of strong top line performance and a further decline in costs, bottom line expanded by 25% year over year on adjusted basis. CA Immo is trading at a forward P/E of 19.5x, while the market is estimating a 6% EPS CAGR over the next three years. Among some of the highlights of this quarter was the successful reduction in financing cost (-22% compared to the first quarter 2017). The new property additions in Budapest and Prague have already positively contributed to the results, and focus is now shifting to the future pipeline, which is heavily tilted towards Germany (in terms of projects). We expect the positive earnings momentum to continue in 2018. UBM Development (UBS AV) UBM Development (UBS AV) (Chart I-12). Chart I-12Performance Since October 2016:##br## UBM Development vs. MSCI EM UBM Development reported better-than-expected third quarter 2017 financial results on November 28. Quarterly revenue fell by 66.5% year over year, but nine-month output volume stood 18% higher, while operating expenses contracted by 66.7% year over year, helped by lower material costs. Nevertheless, operating income decreased by 70% compared to the same period last year, while operating margin finished 70 basis points lower at 7.9%. Pretax income was helped by a one off gain from affiliates, as a result, net profit climbed 10% compared to last year, and 24% for the first three quarters. On adjusted basis bottom line finished the quarter in negative territory. UBM Development is currently trading at a forward P/E of 10x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. The company came close to reaching its debt reduction target of EUR 550 million, despite EUR 164 million of investments in the first half of the year. Improvements on the balance sheet should provide the company with cheaper financing in 2018. Furthermore, sales are on track, with another EUR 120 million of cash sales secured after the third quarter reporting period, bringing UBM close to its full achieving its full-year guidance. DO & CO (DOC AV) DO & CO (DOC AV) (Chart I-13). Chart I-13Performance Since October 2016: ##br##DO & CO vs. MSCI EM DO & CO (DOC AV) announced first-half year financial results on November 16. Revenues dropped by 10% year over year, primarily dragged down by the international event catering segment. EBITDA contracted accordingly, down 13% year over year. However, EBITDA margin remained stable in the international event catering as well as the restaurants and lounges segments. The bottom line came in shy of expectations, shrinking by 18% year over year. We believe the inclusion of a new customer - Juventus soccer club - will boost the margin further in the second-half of the year. DO & CO is trading at a forward P/E of 17.5x, while the market is estimating a 7.2% EPS CAGR over the next four years. The company is fairly valued compared to its five-year average, but trades at up to a 30% discount to its international peers. We believe that DO & CO should be able to crystalize the effects of a strong 2018 pipeline, with new clients in the airline segment (e.g. Lufthansa, and Air China) and the opening of new locations in Los Angeles and Paris (and expansions in London and New York). On a longer-term perspective, the positive outcome on possible construction of a third airport in Turkey would also boost performance. How To Trade? The EMES team recommends gaining exposure to this theme through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Erste Group Bank (EBS AV); Raiffeisen Bank (RBI AV); Andritz AG (ANDR AV); CA Immobilien Anlagen (CAI AV); UBM Development (UBS AV); DO & CO (DOC AV). ETFs: iShares Austria Capped ETF (EWO US) provides exposure to all described companies. Funds: Pioneer Funds Austria (VIENTPF AV); 3 Banken Osterrrech-Fonds (3BKOESI AV); Raiffeisen-Oesterreich-Aktien (OSTAKTT AV). Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case On a macro level, we see the main risks stemming from possible asset-purchase tapering by the European Central Bank, which could slow GDP growth in Eastern Europe as well as trigger FX weakness and a slowdown in property markets. Taking into account that exposure to this region is high, such a scenario would most likely cause earnings headwinds for the selected companies, especially in the banking sector. Separately, some of the companies have high exposure to Russia and Turkey. Both countries are prone to geopolitical turbulence, as seen in the past, which in turn can negatively affect economic development and negatively affect companies. Company specific risks include higher rates of projects under construction in the real estate sector, with risks of delays and higher input costs inflating budgets. For Andritz, we see the main risk in the slowdown of capex in the European auto segment (which it seems already happened in the second quarter), and the possible need for additional restructuring in the auto division. We also see some regulatory risk for the banking segment from adverse regulations, such as the bank tax introduction already seen in Hungary, or possible increases in bank taxes in Austria. Oleg Babanov, Associate Vice President obabanov@bcaresearch.co.uk Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 BCA Estimates and Bloomberg Data
Highlights The growth momentum of China's recent mini-cycle has peaked, but the ongoing slowdown is likely to continue to remain benign in nature. A return to 2015-like conditions is not the most likely outcome over the coming year. Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chinese ex-tech stocks have room to re-rate next year in a benign slowdown scenario. Investors should stay overweight Chinese investable equities vs EM and global stocks. Feature BCA recently published its special year end Outlook report for 2018,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week's China Investment Strategy report we expand on the Outlook, by reviewing our three key themes for China over the coming year. Key Theme # 1: A Benign End To China's Recent Mini-Cycle We presented our case that the cyclical slowdown of the Chinese economy will likely be benign in our October 12 Weekly Report. Chart 1 presents a stylized view of the Chinese economy over the past three years that was published in that report, which illustrated our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlighted three possible scenarios for the coming 6-12 months, and noted that our bet was on scenario 2: A re-acceleration of the economy and a continuation of the V-shaped rebound profile A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse) Chart 1A Stylized View Of China's Recent "Mini-Cycle" Since we presented this framework, incoming evidence has been consistent with our call. Chart 2 shows that the Li Keqiang index has now decisively rolled over, but that economic conditions remain well away from their mid-2015 lows. We sketched out the basis for our benign slowdown view in our October 12 piece, but we followed up more formally in a two-part report that addressed the main factors arguing against a return to 2015-like conditions.2 Our view is grounded in the perspective that economic conditions in 2015 were not "normal", and we showed in these reports how a sharp slowdown in the economy was caused by an extremely weak external demand environment and overly tight monetary policy. On the trade front, Chart 3 highlights how Chinese export growth is likely to moderate over the coming several months, which argues against the re-acceleration scenario described above. Since mid-2011, Chinese export growth has lagged what most economic indicators would have predicted, and we noted in part I of our 2015 vs today comparison that this can be traced largely to two factors: a decline in global import intensity and, to a lesser extent, a decline in China's export "market share". Chart 2An Economic Slowdown In China##br## Is Now Underway Chart 3Chinese Export Growth Likely To##br## Converge To Global IP Growth Our analysis in that report suggested that China's 2018 export growth will converge to that of global industrial production, which implies a modest deceleration in the months ahead. Still, export growth of +4% would be a far cry from the significant contraction of exports that occurred in late-2015 / early-2016, which is consistent with a benign growth slowdown. On the monetary policy front, we showed how a monetary conditions approach captured the tightness of China's policy stance from 2012 to early-2015, which led to a material decline in China's industrial sector (Chart 4). Our Special Report last week further supported the view that monetary conditions matter enormously for China's economy; out of 40 macro data series that we tested to reliably predict the Chinese business cycle, only measures of money & credit passed our criteria.3 An aggregate indicator of these 6 series has a similar profile to the Bloomberg Monetary Conditions Index that we have shown in the past (Chart 4, panel 2), and neither suggests that a sharp further slowdown in China's economy is imminent. We will be watching these indicators closely in 2018 for signs of a more aggressive decline than we currently expect. Recently, some investors have pointed to a sharp rise in China's corporate bond yields as a sign that the monetary policy stance is, in fact, tighter than a standard monetary conditions approach would imply. Indeed, China's 5-year AA corporate bond yield has risen 230 bps since late-October 2016, from 3.6% to 5.9%, with most of this rise having occurred due to a rise in government bond yields. Corporate bond spreads have also risen, but relative to spreads on similarly-rated U.S. credit, the rise appears to reflect a rebound from extremely low levels late last year and is not (yet) symptomatic of major concerns over defaults (Chart 5). Chart 4The Ongoing Slowdown Is Likely ##br##To Be Benign Chart 5China's Corporate Bond Spreads ##br##Do Not Yet Look Onerous We are not complacent of the potential risk posed by rising corporate bond yields, and a further significant rise in 2018 could change our view that a benign economic slowdown is the most likely outcome. But for now, the fact that the stock of corporate bond issuance accounts for only 10% of ex-equity social financing suggests that the rise in yields this year is not likely to have an outsized impact on the economy in 2018, beyond the impact that monetary tightening has had on overall average interest rates (which, for now, is material but has not returned rates back to their 2015 levels). Chart 6The Rise In CPI Will Likely Soon Peak Finally, the 85 bps rise in Chinese core consumer price inflation that has occurred over the past year has also fed investor concerns that monetary policy will become even tighter next year. To us, this risk is probably overblown, given that demand-driven inflation lags growth (which has clearly peaked). Chart 6 shows the year-over-year change in Chinese core CPI vs that of the Li Keqiang index, and clearly suggests that the acceleration in core prices is likely to soon abate. Poor communication from the PBOC means that it is not clear how prominently core inflation features into the central bank's reaction function, but given that tighter monetary conditions have already caused a peak in both house prices and growth momentum, we doubt that policymakers will see the recent rise in consumer prices as a basis to aggressively tighten further. Bottom Line: The growth momentum of China's recent mini-cycle has peaked, but a return to 2015-like conditions is not the most likely outcome over the coming year. Key Theme # 2: Monitoring The Pace Of Renewed Structural Reforms We have written several reports concerning China's 19th Communist Party Congress over the past three months, both in the lead-up to the event and as a post-mortem.4 The Congress was significant because it likely heralds stepped-up reform efforts in 2018 and beyond. By "reforms", our Geopolitical Strategy team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. Table 1 presents our geopolitical team's assessment of the likely reform scenarios and probabilities over the coming year. It should be clearly noted that the "reform reboot" scenario as described in Table 1 is likely negative for emerging market equities and other plays on China's industrial sector (such as industrial metals). Table 1Post-Party Congress Scenarios And Probabilities We agree that the "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector and is conducive to the outperformance of Chinese ex-technology stocks. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity in 2018 is a risk to our view that China's ongoing economic slowdown is likely to be benign and controlled. We presented our framework for monitoring this risk in our November 16 Weekly Report,5 specifically our BCA China Reform Monitor (Chart 7). The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching in 2018 for signs that our monitor is rising largely due to outright declines in the denominator. Chart 7Our Reform Monitor Will Help Us Judge ##br##Whether The Pace Of Reforms Becomes Too Burdensome For now, there is no indication that reform risk is affecting the performance of the MSCI China index. Panel 2 of Chart 7 highlights that recent movements in our Reform Monitor have been driven by the "winner" sectors, with the recent selloff largely reflecting a modest correction in global technology stocks sparked by the passage of the U.S. Senate's tax reform plan.6 But we will be watching the monitor closely in 2018, and will adjust it as needed in reaction to additional reform announcements over the coming months. Finally, next year's reform announcements will be highly significant not just because of the "what", but also the "how". It is difficult to see how China's leadership can aggressively pare back heavy-polluting industry and deleverage the financial sector without destabilizing the economy in the near term, but their goal to significantly raise China's per capita GDP and escape the "middle income trap" over the long-term is equally nebulous. We have noted in previous reports that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 8 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income, and living standards. Therefore, the process of industrialization is fundamentally a process of accumulation of capital stock through investment. As shown in Chart 9, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. Conventional economics would suggest that if China wishes to keep progressing on the productivity and income ladder, that it should remain on the path of growing the capital stock through savings and investment. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, the risk that the country will stagnate and fail to advance beyond the "middle income trap" looms large. Chart 8Productivity Is Positively Correlated ##br##With Capital Stock Chart 9China's Catchup Process ##br## Has A Lot Further To Run Chart 10 makes this point from a different perspective. At root, China's leadership is describing the desire to rapidly transition towards an economy with a much higher level of tertiary industry (services) as a share of GDP, but the U.S. experience suggests that this is a long process that is not investment-oriented. The chart shows the evolution of U.S. investment in private services excluding real estate as a share of total private fixed assets since 1947, when the U.S. had only a slightly higher level of real per capita GDP than China today. It has taken almost 70 years for the share of private services ex real estate to rise by 16 percentage points in the U.S., and it has yet to account for the majority of private fixed investment.7 Services activity/investment also typically requires a highly educated workforce as an input, and rate of China's post-secondary educational attainment appears to be too low to fit the bill (Chart 11). In short, crucial details about China's reform plan should hopefully emerge in 2018, which are likely to have both near-term and multi-year implications. Bottom Line: Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chart 10China Cannot Easily Replace 'Hard' Investment Chart 11China's Workforce Is Not Well Equipped To Transition To Services Key Theme # 3: The Relative Re-Rating Of Chinese Investable Ex-Tech Stocks Over the past several years, this publication argued strongly that the valuation discount applied to Chinese equities was unjustified. For the investable benchmark, the past two years of material outperformance vs emerging market and global stocks has removed a significant portion of this discount, and we noted in our August 31 Weekly Report that Chinese equities are no longer "exceptionally cheap".8 However, a good portion of this revaluation has been isolated to the tech sector. Chart 12 shows that while the 12-month forward P/E ratio for Chinese tech stocks is 70% higher than the global average, ex-tech shares still trade at a 37% relative discount. Chart 13 echoes this conclusion by showing the ex-tech price-to-book ratio for every country in MSCI's All Country World index; by this metric China's ex-tech cheapness currently ranks in the 85th percentile, behind only Israel, Colombia, Italy, Jordan, Korea, Russia, and Greece. Chart 12China: Expensive Tech, Extremely Cheap Ex-Tech Chart 13China's Ex-Tech P/B Ratio Among The Lowest In The World Charts 12 and 13 are weighted simply by the remaining market capitalization in each country's market after excluding the technology sector, meaning that the deep discount applied to Chinese banks wields a disproportionate influence (financials would make up 40% of China's MSCI ex-tech "index", if one officially existed). Although we agree that the magnitude of the rise in debt over the past several years warrants somewhat of a P/B discount, we would argue that the risk is more earnings and dilution-related rather than solvency-related. It is highly unlikely that the Chinese government would allow large banks to fail outright in the event of a serious financial crisis, but the potential for a rise in provisioning and significant new capital raising suggests that the risk premium for these stocks should be somewhat higher than what would otherwise be normal. Chart 14China's Banks Can Re-Rate ##br##In A Benign Slowdown Scenario Still, either the Chinese bank risk premium is excessive, or the banking sectors of several major DM countries are significantly overvalued. For example, Chinese investable banks trade at a P/B ratio of 0.8, but Canadian, Australian, and Swedish banks trade at an average P/B ratio of 1.7. If the concern over credit excesses is the source of the higher risk premium applied to Chinese banks, Chart 14 suggests that there is a major inconsistency in pricing; an equally-weighted average of Canadian, Australian, and Swedish private sector debt-to-GDP is higher than that of China's, at 214% vs 211% as of Q2 this year. Our bet is the former: In a world where outsized returns are scarce and U.S. equities are overvalued, a benign growth deceleration and a modulated pace of reforms favor a lessening of the substantial valuation discount currently applied to China's investable ex-tech stocks. Barring a more pronounced slowdown in China's economy than we currently expect, investors should stay overweight the MSCI China investable index in 2018, within both an emerging markets and global equity portfolio. Bottom Line: Chinese ex-tech stocks have room to re-rate in a benign slowdown scenario. Investors should stay overweight Chinese investable stocks in 2018. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy and Geopolitical Strategy Special Reports, "China's Nineteenth Party Congress: A Primer", dated September 14, 2017, "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, and BCA Special Report "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 6 The Senate bill that was passed this week unexpectedly retained 20% alternative minimum tax (AMT) for corporations, which would disproportionately impact U.S. technology companies. Indications currently suggest that the final tax cut bill to be approved by both houses of Congress will repeal the AMT. 7 In 2016, real estate investment accounted for roughly 29% of total private investment in fixed assets, and the sum of primary and secondary industry (agriculture, mining, utilities, construction, and manufacturing) accounted for about 28%. 8 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights We are putting the Indonesian stock market on an upgrade watch list. Indonesia's financial markets' beta relative to EM peers has been declining. As such, Indonesian markets will likely outperform the EM benchmark in a sell-off. Inflation in Mexico is peaking and will drift lower. The Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. However, we still recommend that investors maintain a neutral stance on Mexican assets relative to EM peers until more clarity emerges from the NAFTA negotiations. Feature Indonesia: Putting On Upgrade Watch List Indonesian share prices have considerably underperformed the EM benchmark since February 2016 (Chart I-1). This has occurred despite exports growing at an annual rate of 18% in U.S. dollar terms in 2017. The surge in Indonesian exports has been largely driven by soaring prices for thermal coal, palm oil and copper. Export prices have soared by 24% for coal and copper and 11% for palm oil from their lows in early 2016. Nevertheless, their export volumes have been rather stagnant (Chart I-2). These commodities are large drivers of Indonesia's exports. Thermal coal and palm oil account for around 20% of total exports, while copper accounts for around 4%, in value terms. Chart I-1Indonesian Stock Prices: Relative & Absolute Chart I-2Indonesian Exports: Volume Vs. Prices We expect coal1 and base metals prices to drop considerably in 2018 due to China's meaningful growth slowdown. Having this backdrop in mind, we discuss the outlook for Indonesia's stock market in both absolute and relative terms. We continue recommending a neutral allocation to Indonesian stocks within an EM equity portfolio for now, but are putting this bourse on an upgrade watch list and will wait for the following triggers to go overweight: Chart I-3Chinese & Indonesian Equities: ##br##A Rotating Dance The first trigger is when Chinese H-shares and large-cap tech stocks begin underperforming the EM overall equity index. Interestingly, the relative performance of Indonesian equities and Chinese stocks has been negatively correlated (Chart I-3). Indonesia's stock market's underperformance relative to the EM benchmark can be also partially explained by the manic rise in a small number of EM large-cap tech stocks. Tech stocks are absent from Indonesia's stock exchange and when tech stocks' relative performance does turn south, it will be easier for the Indonesian bourse to outperform the EM benchmark. The second trigger for upgrading Indonesian stocks is when the initial phase of decline in commodities prices (10-15%) occurs. This phase could be the most painful for commodities plays like Indonesia, as nervous investors bail out. In short, we are waiting for the momentum of Indonesia's relative performance to turn up before overweighting the bourse. Domestic Demand And Exports: Parting Ways? The Indonesian economy and its financial markets have historically been highly correlated with commodities prices and exports: a positive external shock would trigger an export boom and foreign inflows would ensue. These inflows would in turn lead to currency appreciation and a subsequent fall in interest rates. The end result was the overheating of the economy and financial markets. Recently, however, Indonesia's economy and financial markets have been slowly disconnecting from exports in general and commodities prices in particular. The top panel of Chart I-4 shows that while exports used to be extremely correlated with the rupiah, these correlations have been breaking down since early 2016. Similarly, a disconnect is occurring between exports and other domestic macro variables like bank loans (Chart I-4, bottom panel). What is also noteworthy is the absence of a notable pickup in domestic demand growth amid the strong recovery in global trade. Chart I-5 shows that car and motorcycle sales are still anemic. Chart I-4Disconnect Between Indonesian ##br##Exports Vs. Rupiah & Bank Loans Chart I-5Indonesia's Domestic Sector Remains Sluggish Below are some of the reasons that help shed light as to why this divergence between exports and domestic demand has been taking place: First, the ratio of Indonesia's commodities' exports to total has fallen more sharply than in other commodities-producing EM nations (Chart I-6). Exports have also become generally less important for the overall Indonesian economy post the global financial crisis. Chart I-7 shows that private non-financial debt as a whole has risen, while exports have fallen as a share of GDP. Chart I-6Indonesia's Commodities ##br##Exports Ratio Has Plunged Chart I-7Private Debt Is A Bigger Driver Of ##br##Indonesia's Economy Than Exports The government has been following cautious and prudent policies. This is another reason why domestic demand growth has been mediocre amid robust exports. Chart I-8 signifies that growth in government expenditures has stalled in nominal terms and contracted in real terms. Indeed, the impulse in the banking system's net domestic assets (the combined aggregate of the central bank and commercial banks) remains negative, albeit improving on a rate of change basis (Chart I-9). Net domestic assets (NDA) measure the banking system's2 credit to the domestic sector - i.e. the government and the private sector. Chart I-8Indonesia's Government ##br##Has Been Prudent Chart I-9Banking System's Net Domestic ##br##Assets & Fiscal Deposit Drain The NDA impulse has been negative because the government has borrowed less from the banking system. In addition, the government has been shifting deposits from commercial banks to the central bank (Chart I-9, bottom panel). This has drained liquidity in the system and has slowed broad money growth and capped commercial banks' reserves at Bank Indonesia. As the potential negative term-of-trade shock transpires, the government will have enough of a buffer to spend by deploying its deposits from the central bank and by borrowing and spending more. That will in turn provide support for the economy when commodities prices fall and the external sector suffers. Chart I-10Central Bank Has Been Building FX Firepower As for the currency, the central bank has recently accumulated plenty of foreign exchange assets, creating commercial bank reserves in the process (Chart I-10). The central bank now has plenty of room to defend the currency by selling foreign assets when the rupiah comes under selling pressure. Bank Indonesia will also have more leeway managing a reasonable balance between a depreciating currency and rising local interbank rates. Bottom Line: Indonesia's domestic demand has been mediocre, despite the surge in exports and commodities prices. Meanwhile, the central bank and the government have used the positive global environment to accumulate firepower. This puts them in a position to act as shock absorbers when the external environment turns hostile. As a result, the Indonesian financial markets' beta to their EM peers will decline. We therefore recommend putting the Indonesian stock market on an upgrade watch list. Consistently, the potential downside in the currency and a sell-off in the domestic bond markets will be smaller than we previously anticipated. While still advocating a cautious/neutral stance on this market, we will be looking to upgrade it to overweight versus its EM peers after the first phase of a potential EM and commodities sell-off transpires. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Mexico: Waiting For A Better Entry Point In Mexico, inflation has very likely peaked and will drift lower as the central bank maintains a tight monetary policy stance: A large part of the rise in inflation in 2017 was caused by depreciation in the peso. The firmness in the peso this year entails that inflation will roll over soon (Chart II-1). Consumer spending and capital expenditure are set to contract as the impact of higher interest rates continue to filter through the economy (Chart II-2). In fact, domestic vehicles sales are shrinking sharply. Chart II-1Mexico: Peso & Inflation Chart II-2Higher Interest Rates Are ##br##Slowing Domestic Spending Furthermore, weak real wage growth will continue to weigh on consumer spending (Chart II-3). In addition, contracting fiscal non-interest expenditures will remain a headwind on economic growth (Chart II-4). Chart II-3Lower Real Wages = Lower Inflation Chart II-4Belt-Tightening By The Government Finally, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of last year - will subside as the base effect of these price increases abates. The inflation rate will in turn moderate. Despite all this, Banxico will continue to keep monetary policy tight due to lingering uncertainty related to NAFTA negotiations. Within the EM currency universe, the Mexican peso is particularly attractive relative to the South African rand and the Brazilian real. We will be looking to reinstate long positions in the MXN versus both the ZAR and the BRL for the following reasons: Relative trade balance dynamics will continue to favor Mexico relative to South Africa and Brazil. Mexican exports are likely to remain robust due to strong U.S. growth (Chart II-5), while South African and Brazilian exports will slow down as China's growth and imports falter (Chart II-6). Chart II-5Mexican Exports Will Remain ##br##Robust Due To Strong U.S. Growth Chart II-6South African & Brazilian Exports ##br##Will Take A Hit As China Slows Furthermore, metals prices will be affected more negatively than oil prices due to China's growth slump. China's share of world consumption in base and industrial metals at 50-55% is much larger than oil (12.5%). This will leave Mexican exports less negatively affected than those of Brazil and South Africa. Mexico does not suffer from rapidly rising public debt like Brazil and South Africa (Chart II-7). Large fiscal deficits and rising public debt burdens in Brazil and South Africa require a higher risk premium in their respective financial markets, leaving further room for the MXN to outperform both the BRL and the ZAR. While Mexico has already gone through some structural reforms, Brazil and South Africa have yet to deliver any substantial efforts on that front. This leaves Mexico in a much better position to attract long-term capital inflows compared to Brazil and South Africa. Finally, on a real effective exchange rate basis, the peso remains cheap relative to the rand and the real (Chart II-8). Chart II-7Public & Private Debt Is Lower In Mexico Chart II-8The Mexican Peso Is Still Cheap We closed our long MXN/BRL and long MXN/ZAR trades on October 25th because at present there is too much uncertainty with respect to NAFTA negotiations that could have a negative impact on the peso. However, with regards to the national general elections, uncertainty in South Africa and Brazil is even greater than in Mexico. In Mexico, the anti-establishment candidate Andres Manuel Lopez Obrador is currently leading the polls, but his new party - National Regeneration Movement (MORENA) - is unlikely to gain a majority in Congress. Investment Conclusions We recommend that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA3 negotiations before going overweight the country's currency and fixed-income markets relative to their EM peers. Mexican stocks have been selling off sharply in absolute terms and have substantially underperformed the EM benchmark. This poor performance is mainly attributed to financials and consumer discretionary stocks. While these two sectors only account for 20% of the total MSCI market cap, the retrenchment in their share price has been large enough to bring the whole market down. We have the following observations on these two equity sectors: The consumer discretionary sector has been underperforming due to disappointing earnings. Our bias is that it is still too early to call a bottom in the consumer cycle in Mexico. With regards to banks, we believe that tight monetary policy will continue to weigh on their share prices. More importantly, the yield curve remains inverted, and until we see it steepen, it will be hard for banks to rally. All in all, we continue recommending a neutral weighting in Mexican stocks within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, the link is available on page 15. 2 Banking system is the sum of the central bank and commercial banks. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
As we near the end of an impressive year for equities, the relationship between price growth and earnings growth and how to best position a portfolio for 2018 bears some reflection. Rather than take a position on inflation or growth, we have endeavored to create a roadmap such that investors can allocate according to their expectations for both and also avoid potential pitfalls and embrace likely winners. The mean reverting nature of S&P 500 earnings growth makes discerning a pattern difficult but, more often than not, there is a positive correlation with rising inflation. Breaking returns down by sector is revealing: first, stock performance tracks earnings growth in all periods, implying that fundamentals lead valuation, as they should. Second, empirical evidence supports sector allocation theory in inflationary boom/bust periods. Please see this week's Special Report for more details, including a deeper look at three of the GICS2 top and two bottom quartile performers when inflation is rising.