South Africa
Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow Chart I-4A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Chart 6Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.
Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Chart I-7Slowdown In ##br##China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights There are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. EM/China narrow money (M1) growth points to relapse in their growth and profits in the second half this year. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. The South African rand has considerable downside and local bond yields will rise further. Stay short ZAR versus the U.S. dollar and MXN. Downgrade this bourse from neutral to underweight. Stay long MXN on crosses versus ZAR and BRL. Continue overweighting Mexican local currency bonds and sovereign credit within their respective EM universes. Feature Chart I-1EM Narrow Money Growth ##br##Signals Trouble Ahead Emerging market (EM) assets have been the beneficiary of large inflows this year and have delivered solid gains in the first quarter, causing our defensive strategy to miss the mark. In retrospect, it was a mistake not to chase the market higher last year. At the current juncture, however, with investor sentiment on risk assets very bullish, valuations rather expensive or at least not cheap1 and investor expectations for global growth elevated, the question is whether being contrarian or chasing momentum is the best strategy. Weighing the pros and cons, our view is that investors who now adopt a contrarian stance will be rewarded greatly in the next six to nine months. In this vein, we recommend reinstating a short EM stocks / long 30-year U.S. Treasurys trade. Review Of Market Indicators Following is a review of some specific EM market indicators: EM narrow money (M1) impulse - change in M1 growth - points to a potential major top in EM share prices (Chart I-1, top panel). In fact, M1 growth leads EM EPS growth by nine months and heralds a reversal in the months ahead (Chart I-1, bottom panel). We use equity market cap-weighted M1 growth to ensure that the country weights in the M1 aggregate are identical to those in the EM equity benchmark. The M1 impulse has rolled over decisively, not only in China as shown in Chart I-9 on page 6 but also in Taiwan, heralding a major top in the latter's stock market (Chart I-2). The Taiwanese bourse is heavy in technology stocks that have been on fire in the past year. We continue to hold the view that tech stocks will do better than commodity plays or banks. In short, we continue to recommend overweighting tech stocks within the EM universe. However, if tech stocks roll over as per Chart I-2, the EM equity universe will be at major risk. Global mining stocks have lately been struggling while EM share prices have been well bid (Chart I-3). Historically, these two correlate strongly. In this context, the latest rift between the two is unsustainable. Our bet is that EM stocks will converge to the downside with global mining stocks. Chart I-2Taiwan: Narrow Money ##br##Points To Top In Share Prices Chart I-3A Rift Between Global ##br##Mining And EM Stocks We are well aware that technology and internet stocks now account for 25% of the EM MSCI benchmark, thereby reducing the importance of commodities prices to EM. However, technology stocks are much overbought and could be at risk of a selloff too, as per Chart I-2 on page 2. On a more general level, we expect that if commodities prices relapse EM risk assets will sell off as well. Consistently, commodities currencies seem to be topping out, which also raises a red flag for EM stocks (Chart I-4). Various commodities prices trading in China are also exhibiting weakness, likely signaling a reversal in the mainland's growth revival (Chart I-5). Finally, all of these factors are occurring at a time when investor sentiment toward U.S. stocks is elevated relative to their sentiment on U.S. Treasurys, and the U.S. equity-to-bonds relative risk index is also at a level that has historically heralded stocks underperforming Treasurys (Chart I-6). Chart I-4An Unsustainable Gap Chart I-5Commodities Prices In China Chart I-6U.S. Stocks-To-Bonds: ##br##Relative Sentiment And Risk Profile Bottom Line: While global economic surveys and data still allude to firm growth conditions, there are a number of market signals and indicators that are denoting opening cracks in the reflation trade in general and EM risk assets in particular. It is important to note that this is the view of BCA's Emerging Markets Strategy team, which differs from BCA's house view. EM/China Growth Outlook Global and EM manufacturing PMIs are elevated and they will roll over in the months ahead. Yet, a top in economic and business surveys at high levels does not always warrant turning bearish. Our negative stance on EM/China growth stems from our fundamental assessment that these economies have not yet gone through deleveraging, i.e., credit excesses of the boom years have not been worked out. This is the reason why we believe the EM/China growth rebound of the last 12 months is unsustainable and sets the stage for another major downleg. There are preliminary indications that the one-off boost from last year's fiscal and credit push in China is waning. In particular, the number and value of newly started capital spending projects have relapsed dramatically (Chart I-7). This is consistent with our view that the 2016 fiscal push that boosted Chinese growth is passing. Meanwhile, private sector investment expenditures remain weak (Chart I-7, bottom panel). A renewed slump in capital spending will have negative ramifications for mainland imports of commodities. With the monetary authorities tightening liquidity and interest rates rising (Chart I-8), odds are that credit and money growth will decelerate, thwarting the recent amelioration in economic growth. Chart I-7China: 2016 Fiscal Stimulus Is Waning Chart I-8Beware Of Rising Rates In China We continue to emphasize that even marginal policy tightening amid lingering credit and property bubbles could have a disproportionately dampening impact on growth. Notably, China's narrow money (M1) impulse - the change in M1 growth rate - reliably leads industrial profits. It is now indicating a relapse in industrial profit growth in the months ahead (Chart I-9). There are also some early clues that global trade volumes may soon weaken, as evidenced by the recent drop in China's container shipment freight index (Chart I-10, top panel). Chart I-9China: Industrial Profits And Narrow Money Chart I-10Global Trade Volumes To Roll Over This is further corroborated by the most recent survey of 5000 industrial enterprises in China, which portends a top in overseas new orders (Chart I-10, bottom panel). Finally, Taiwan's M1 impulse leads the country's export volume growth, and currently alludes to potential deceleration in export shipments (Chart I-11). We are not suggesting that U.S. or euro area growth is at major risk. On the contrary, our sense is that the main risk to EM and global stocks from the U.S. and the euro area is higher bond yields in these regions in the near term. Importantly, the recent strength in EM trade has largely been due to Chinese imports, not the U.S. or Europe, as evidenced in Chart I-12. Korea's shipments to U.S. and Europe are rather weak, while sales to China have been very robust. In a nutshell, 27% of Korean exports go to China, while only 13% go to the U.S. and 12% to the EU. Chart I-11Taiwan: Narrow Money And Export Volumes Chart I-12Korea's Exports By Regions Furthermore, combined exports to the U.S. and Europe make up 35% of China's total exports and 7% of its GDP. In turn, China's capital spending amounts to 40-45% of GDP. Hence, investment expenditures are much more important for China than exports to the U.S. and Europe combined. In the meantime, the largest export destination for Asian and South American countries is China rather than the U.S. or Europe. Therefore, as China's growth slumps, its imports from Asian/EM as well as commodities prices will decline. Bottom Line: Risks to EM/China growth are to the downside, regardless of growth conditions in the advanced economies. Reinstate Short EM Stocks / Long 30-Year Treasurys Trade We took a 24% profits on this trade on July 13, 2016 and now believe the risk-reward is conducive to re-establish this position. Back in July2 we argued that EM stocks might be supported in the near term while DM bond yields would rise, justifying booking profits on this trade. Looking forward, the basis for reinstating this trade is as follows: Fundamentally, both market indicators as well as the rising odds of a relapse in EM/China growth per our discussion above support this trade. The relative total return on this position is facing a formidable technical support, and we believe it will hold (Chart I-13). The difference between the EM equity dividend yield and the 30-year Treasury yield is one standard deviation from its time-trend (Chart I-14). At similar levels in the past, this indicator heralded significant EM share price underperformance versus U.S. bonds. Chart I-13Reinstate Short EM Stocks-Long ##br##30-year U.S. Treasurys Chart I-14Relative Value Favors ##br##U.S. Bonds Versus EM Equities Chart I-6 on page 4 reveals that sentiment on stocks versus bonds is bullish. From a contrarian perspective, this invites a bet on stocks underperforming bonds in the months ahead. This trade will pan out regardless of whether a potential selloff in EM share prices is accompanied by rising or falling U.S. bond yields. Even if U.S. bond yields rise (bond prices decline), EM stocks will likely drop more than U.S. Treasury prices. Our base case remains that there is likely more upside in U.S. bond yields in the near term, but this trade is poised to deliver solid gains so long as EM share prices drop. That said, we believe that U.S. bond yields will likely be at current levels or lower by the end of this year when EM/China growth slowdown unleash new deflationary forces in the global economy. Bottom Line: Reinstate a short EM stocks / long 30-year Treasurys trade with a six-nine month time horizon. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Equity Valuations Revisited", dated March 29, 2017, link available on page 18. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View", dated July 13, 2016, link available on page 18. South Africa: Back To Reality Political risks have not risen in South Africa with the dismissal of Finance Minister Pravin Gordhan. They had never declined in the first place. The markets have, however, ignored them in the past 12 months. Investors have failed to recognize the fundamental problem underpinning the disarray in the ruling African National Congress (ANC): growing public discontent with persistently high unemployment and income inequality. Despite a growing body of evidence that political stability has been declining for a decade, strong foreign portfolio flows have papered over the reality on the ground and allowed domestic markets to continue "whistling in the dark." Investors even cheered the poor performance of the ANC in municipal elections in August 2016, despite the fact that by far the biggest winners of the election were the left-wing Economic Freedom Fighters (EFF), not the centrist Democratic Alliance. This confirms BCA's Geopolitical Strategy's forecast that the main risk to President Jacob Zuma's rule is from his left flank, led by the upstart EFF of Julius Malema, and by the Youth and Women's Leagues of his own ANC.3 As such, it was absolutely nonsensical to expect Zuma to pivot towards pro-market reforms. Unsurprisingly, he has not. But could the Gordhan firing set the stage for an internal ANC dust-up that gives birth to a pro-reform, centrist party? This is the hopeful narrative in the press today. We doubt it. First, if the ANC splits along left-right lines, it is not clear that the reformers would end up in the majority. Therefore, the hope of the investment community that Deputy President Cyril Ramaphosa takes charge and enacts painful reforms is grossly misplaced. Second, Zuma may no longer be popular, but his populist policies are. While both the Communist Party (a partner of the Tripartite Alliance with the ANC) and the EFF now officially oppose his rule, they do not support pro-market reforms. Third, ethnic tensions are rising, particularly between the Zulu and other groups. These boiled over in social unrest last summer in Pretoria when the ruling ANC nominated a Zulu as the candidate for mayor of the Tshwane municipality (which includes the capital city). As such, we see the market's reaction as a belated acceptance of the reality in South Africa, which is that the country's consensus on market reforms is weakening, not strengthening. It is not clear to us that a change at the top of the ANC, or even a vote of non-confidence in Zuma, would significantly change the country's trajectory. In addition, the political tensions are growing at a time when budget revenue growth is dwindling and the fiscal deficit is widening (Chart II-1). To placate investor anxiety over the long-term fiscal outlook, the government should ideally cut its spending. However, it is impossible to do so when there are escalating backlashes from populist parties and from within the ruling Tripartite Alliance. Odds are that the current and future governments will resort to more populist and unorthodox policies. That will jeopardize the public debt outlook and erode the currency's value. Needless to say, the nation's fundamentals are extremely poor -- outright decline in productivity being one of the major causes (Chart II-2). Chart II-1South Africa: Fiscal Stress Is Building Up Chart II-2Underlying Cause Of Economic Malaise We believe the rand has made a major top and local currency bond yields reached a major low (Chart II-3). We continue to recommend shorting the ZAR versus both the U.S. dollar and Mexican peso. Traders, who are not short, should consider initiating these trades at current levels. Investors who hold local bonds should reduce their exposure. Dedicated EM equity investors should downgrade this bourse from neutral to underweight (Chart II-4). Chart II-3South Africa: Short ##br##The Rand And Sell Bonds Chart II-4Downgrade South African ##br##Equities To Underweight Finally, EM credit investors should continue underweighting the nation's sovereign credit within the EM universe and relative value trades should stay with buy South African CDS / sell Russian CDS protection. 3 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 2, 2015, and Strategic Outlook, "Strategic Outlook 206: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Mexico: Stay Long MXN On Crosses And Overweight Fixed-Income Mexico's central bank could still hike interest rates by another 50 basis points or so because inflation is above the target and the recent raise in minimum wage could keep inflation/wage expectations elevated (Chart III-1). Even if further rate hikes do not materialize, the cumulative monetary tightening will depress domestic demand but support the peso, especially versus other EM currencies. We continue recommending long positions in MXN versus ZAR and BRL. Higher borrowing costs will squeeze consumer and investment spending in Mexico. Notably, household expenditures have so far remained very robust. We suspect consumers have brought forward their future demand due to expectations of higher consumer prices. In short, consumer spending will tank as there is very little pent-up demand remaining and higher borrowing costs will start biting very soon (Chart III-2). Chart III-1Inflation Expectations To Stay Elevated For Now Chart III-2Mexico: Domestic Demand To Buckle As household spending and investment expenditure relapse and exports to the U.S. revive, Mexico's current account will improve considerably. In the meantime, Brazil's current account deficit will widen as the economy recovers. Chart III-3 illustrates that the relative current account dynamics are turning in favor of the peso versus the real. The economic recovery that will eventually happen in Brazil this year will come too late and be too weak to stabilize the nation's public debt. We remain concerned about Brazil's public debt dynamics. In contrast, we are not concerned about Mexico's fiscal situation. Mexican policymakers have been very orthodox and we do not expect that to change much. In regard to valuation, the peso is cheap versus the U.S. dollar and is extremely cheap against the BRL and ZAR (Chart III-4). Chart III-3Mexico Versus Brazil: ##br##Current Account And Exchange Rate Chart III-4Mexican Peso Is Cheap Finally, investors have flocked from Mexico to Brazil last year amid the deteriorating political outlook in Mexico and stabilization in Brazilian politics. We believe such a positioning swing is overdone and our bet is that Mexico will be getting more investor flows this year compared with Brazil. Investment Conclusions Chart III-5Mexican local Bonds Offer Value Maintain long positions in MXN versus BRL and ZAR. The outlook for the latter is discussed in a section above. We are reluctant to initiate a long MXN/short U.S. dollar trade because we are negative on the outlook for EM exchange rates. It is not impossible but it will be hard for the peso to appreciate against the U.S. dollar if most EM currencies depreciate and oil prices drop, as we expect. Fixed-income investors should continue overweighting Mexican local currency and sovereign credit within their respective EM benchmarks. Mexico's fixed-income assets offer good value (Chart III-5). Relative value traders should consider the following trade: sell Mexican CDS / buy Indonesia CDS protection. Finally, dedicated EM equity portfolios should maintain a neutral allocation to Mexican stocks. The currency will outperform but share prices in local currency terms will underperform their EM peers. The Mexican bourse is tilted toward consumer stocks that are expensive and at risk of a major downturn in household spending as discussed above. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices Chart I-4BGold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too Chart I-6BGold Led Copper Prices Too In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Chart II-4Banks Prefer Consumers We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations