Currencies
Highlights President Trump is as protectionist as Candidate Trump; USD shortage to tighten global financial conditions; Go Long MXN/RMB as a tactical play on U.S.-China trade war; Brexit risks are now overstated; EU will not twist the knife. EUR/GBP is overbought; go short. Feature "We assembled here today are issuing a new decree to be heard in every city, in every foreign capital, and in every hall of power. From this day forward, a new vision will govern our land. From this moment on, it's going to be America First." U.S. President Donald Trump, January 20, 2017, Inaugural Address What are the investment implications of an "America First" world? First, it may be useful to visualize the "America Second" world that President Trump is looking to leave in the rear-view mirror. Chart 1 shows the cost of hegemony. Since the Nixon shock in 1971, the U.S. has seen its trade balance deepen and its military commitments soar, in absolute terms. For President Donald Trump, the return on American investment has been low. Wasteful wars, crumbling infrastructure, decaying factories, stagnant wages, this is what the U.S. has to show for two decades of hegemony. Chart 1United States: The Cost Of Hegemony On the other hand, the U.S. has enjoyed the exorbitant privilege of its hegemonic position. In at least one major sense, America's allies (and China) are already paying for American hegemony: through their investments in U.S. dollar assets. Chart 2 illustrates this so-called "exorbitant privilege." Despite a deeply negative net international investment position, the U.S. has a positive net investment income.1 Chart 2The "Exorbitant Privilege" Being the global hegemon effectively lowers U.S. borrowing costs and domestic interest rates, giving U.S. policymakers and consumers an "interest rate they do not deserve." That successive administrations decided to waste this privilege on redrawing the map of the Middle East and giving the wealthiest Americans massive tax cuts, instead of rebuilding Middle America, is hardly the fault of the rest of the world! Foreigners hold U.S. assets because of the size of the economy, the sustainability and deep liquidity of the market, and the perceived stability of its political system. More importantly, they hold U.S. assets because the U.S. acts as both a global defender and a consumer of last resort. If Washington were to raise barriers to its markets and become a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and decide to diversify more rapidly. Investors can interpret Trump's "America First" agenda broadly as an effort to dramatically reduce the U.S. current account deficit. Certainly we see his statements on renegotiating NAFTA, facing off against China on trade, and encouraging U.S. exports with tax legislation as parts of a broad effort aimed at improving the U.S. trade balance. If the U.S. were to pursue these protectionist policies aggressively, the end result would be a massive shortage of U.S. dollars globally, a form of global financial tightening. The rest of the world is not blind to the dangers of an America focused on reducing its current account deficit. According to the reporting of Der Spiegel magazine, Chancellor Angela Merkel sent several delegations to meet with the Trump team starting in 2015! No doubt Berlin was nervous hearing candidate Trump's protectionist talk, given that Germany runs one of the largest trade surpluses with the U.S. (Chart 3). In the last such meeting, taking place after the election was decided, Trump's son-in-law and White House advisor, Jared Kushner, asked the Germans a point-blank question, "What can you do for us?"2 In the 1980s, the U.S. asked West Germany and Japan the same question. The result was the 1985 Plaza Accord that engineered the greenback's depreciation versus the deutschmark and the yen (Chart 4). Recent comments from Donald Trump suggest that he would like to follow a similar script, where dollar depreciation does the heavy lifting in adjusting the country's current account deficit.3 Chart 3Trump's Black List Chart 4The Impact Of The Plaza Accord The Trump administration may have dusted off the Reagan playbook from the 1980s, but the world is playing a different game in 2017. First, the Soviet Union no longer exists and certainly no longer has more than 70,000 tanks ready to burst through the "Fulda Gap" towards Frankfurt. President Trump will find China, Germany, and Japan less willing to help the U.S. close its current account deficit, particularly if Trump continues his rhetorical assault on everything from European unity to Japanese security to the One China policy. Second, China, not U.S. allies Germany and Japan, has the largest trade surplus with the U.S. It is very difficult to see Beijing agreeing to a coordinated currency appreciation of the RMB, particularly when it is being threatened with a showdown over Taiwan and the South China Sea. Third, even if China wanted to kowtow to the Trump administration, it is not clear that RMB appreciation can be engineered. The country's capital outflows have swelled to a record level of $205 billion (Chart 5) and the PBoC has continued to inject RMB into the banking system via outright lending to banks and open-market operations (Chart 6). Unlike Japan in 1985, China is at the peak of its leveraging cycle and thus unwilling to see its currency - and domestic interest rates - appreciate. At best, Beijing can continue to fight capital outflows and close its capital account. But even this creates a paradox, since the U.S. administration can accuse it of currency manipulation even if such manipulation is preventing, not enabling, currency depreciation!4 Chart 5China: Unrecorded Capital Outflows Chart 6PBoC Injects Massive Liquidity To conclude, the world is (re)entering a mercantilist era and sits at the Apex of Globalization.5 The new White House is almost singularly focused on bringing the U.S. current account deficit down. It intends to do this by means of three primary tools: Protectionism: The Republicans in the House of Representatives have proposed a "destination-based border adjustment tax," which would effectively subsidize exports and tax imports. (It would levy the corporate tax on the difference between domestic revenues and domestic costs, thus giving a rebate to exporters who make revenues abroad while incurring costs domestically.)6 While the proponents of the new tax system argue it is equivalent to the VAT systems in G7 economies, the change would nonetheless undermine America's role as "the global consumer of last resort." In our view, it would be the opening salvo of a global trade war. Dirigisme: President Trump has not shied away from directly intervening to keep corporate production inside the U.S. He has also insisted on a vague proposal to impose a 35% "border tax" on U.S. corporates that manufacture abroad for domestic consumption. (Details are scant: His Treasury Secretary Steven Mnuchin has denied an across-the-board tax of this nature, but has confirmed that one would apply to specific companies.) Structural Demands: Trump's approach suggests that he wishes to force structural changes on trade surplus economies in order to correct structural imbalances in the American economy - and in this process he is not adverse to lobbing strategic threats. While he holds out the possibility of charging China with currency manipulation, in fact he can draw from a whole sheet of American trade grievances not limited to the currency to demand major changes to their trade relationship. The fundamental problem for the global economy is that in order to reduce the U.S. current account deficit, the world must experience severe global tightening. Dollars held by U.S. multinationals abroad, which finance global credit markets, will come back to the U.S. and tighten liquidity abroad. And emerging market corporate borrowers who have overextended themselves borrowing in U.S. dollars will struggle to repay debts in appreciating dollars. These structural trends are set to exacerbate an already ongoing cyclical process. As BCA's Emerging Markets Strategy has recently pointed out, global demand for U.S. dollars is rising faster than the supply of U.S. dollars.7 Our EM team's first measure of U.S. dollar liquidity is "the sum of the U.S. monetary base and U.S. Treasury securities held in custody for official and international accounts." The second measure "is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents." As Chart 7 and Chart 8 illustrate, both calculations indicate that dollar liquidity is in a precipitous decline already. Meanwhile, foreign official holdings of U.S. Treasury securities is contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart 9). Chart 7Dollar Liquidity Declining... Chart 8... Any Way You Look At It Chart 9Components Of U.S. Dollar Liquidity Chart 10It Hurts To Borrow In USD Concurrently, U.S. dollar borrowing costs continue to rise (Chart 10). Our EM team expects EM debtors with U.S. dollar liabilities to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Near-term U.S. dollar appreciation will only reinforce and accelerate the mercantilist push in the White House and Congress. President Trump and the GOP in the House will find common ground on the border-adjustment tax, which Trump recently admitted he did not understand or look favorably upon. The passage of the law, or some such equivalent, has a much greater chance than investors expect. So does a U.S.-China trade war, as we argued last week.8 How should investors position themselves for the confluence of geopolitical, political, and financial factors we have described above? The world is facing both the cyclical liquidity crunch that BCA's Emerging Markets Team has elucidated and the potential for a secular tightening as the Trump administration focuses its efforts on closing the U.S. current account deficit. Five investment implications are top of our mind: Chart 11Market Response To Trump Win On High End Chart 12Market Is Priced For 'Magnificent' Events Buy VIX. The S&P 500 has continued to power on since the election, buoyed by positive economic surprises, strong global earnings, and the hope of a pro-business shift in the White House. The equity market performance puts the Trump presidency in the upper range of post-election market outcomes (Chart 11). However, with 10-year Treasuries back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is pricing none of the political and geopolitical risks of an impending trade war between the U.S. and China, nor is it pricing the general mercantilist shift in Washington D.C. (Chart 12). As a result, we recommend that clients put on a "mercantilist hedge," like deep out-of-the-money S&P 500 puts, or VIX calls. For instance, a long VIX 20/25 call spread for March expiry. Long DM / Short EM. Mercantilism and the U.S. dollar bull market are the worst combination possible for EM risk assets. We therefore reiterate our long-held strategic recommendation of being long developed markets / short emerging markets. Overweight Euro Area Equities. Investors should overweight euro area equities relative to the U.S. As we have discussed in the 2017 Strategic Outlook, political risks in Europe this year are a red herring.9 We will expand on the upcoming French elections in next week's report. Meanwhile, investors appear complacent about protectionism and what it may mean for the S&P 500, which sources 44% of its earnings abroad. European companies, on the other hand, could stand to profit from a China-U.S. trade war. Chart 13Peso Is A Buy Versus Trump's Enemy #1 Chart 14Peso As Cheap As During Tequila Crisis Long MXN/RMB. As a tactical play on the U.S.-China trade war, we recommend clients go long MXN/RMB (Chart 13). The peso is now as cheap as it was in early 1995, at the heights of the Tequila Crisis, as per the BCA's Foreign Exchange Strategy model (Chart 14). While Mexico remains squarely in Trump's crosshairs on immigration and security, the damage to the currency appears to be done and has ironically made the country's exports more competitive. In addition, Trump's pick for Commerce Secretary, Wilbur Ross, has informed his NAFTA counterparts that "rules of origin" will be central to NAFTA re-negotiation. This can be interpreted as the U.S. using every tool at its disposal to impose punitive measures on China, including forcing NAFTA partners to close off the "rules of origin" loophole.10 But the reality is that the U.S. trade deficit with its NAFTA partners is far less daunting than that with China (Chart 15). Meanwhile, we remain negative on the RMB for fundamental reasons that we have stressed in our research. Small Is Beautiful. We continue to recommend that clients find protection from rising protectionism in small caps. Small caps are traditionally domestically geared irrespective of their domicile. Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, also points out that small caps in the U.S. will benefit as the new administration follows through with promised corporate tax cuts, which will benefit small caps disproportionally to large caps given that the effective tax rate of multinationals is already low. Moreover, small companies will benefit most from any cuts in regulations, most of which have been written by multinationals in order to create barriers to entry (Chart 16). Of course, we could just be paranoid! After all, much of Trump's proposed policies - massive tax cuts, infrastructure spending, major rearmament, the border wall - would increase domestic spending and thus widen the current account deficit, not shrink it. And all the protectionism and de-globalization could just be posturing by the Trump administration, both to get a better deal from China and Europe and to give voters in the Midwest some political red meat. Chart 15China, Not NAFTA, In Trump's Crosshairs Chart 16Small Is Beautiful But Geopolitical Strategy analysts get paid to be paranoid! And we worry that much of Trump's promises that would widen U.S. deficits are being watered down or pushed to the background. Yes, we have held a high conviction view that infrastructure spending would come through, but now it appears that it will be complemented with significant spending cuts. The next 100 days will tell us which prerogatives the Trump Administration favors: rebuilding America directly, or doing so indirectly via protectionism. If the former, then the current market rally is justified. If the intention is to reduce the current account deficit, look out. Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Brexit: A Brave New World Miranda: O brave new world! Prospero: 'Tis new to thee. — Shakespeare, The Tempest The U.K. Supreme Court ruled on January 24 that parliament must have a say in triggering Article 50 of the Lisbon Treaty, which enables the U.K. to "exit" the European Union. This decision, as well as Theresa May's January 17 "Brexit means exit" speech, caught us in London while visiting clients. Reactions were mixed. The pound continues to rally. January 16 remains the low point in the GBP/USD cross since the vote to leave on June 23 last year (Chart 17). Chart 17Has Brexit Uncertainty Bottomed? Should investors expect more downside to the pound or do the recent events mark a bottom in political uncertainty? The market consensus suggests that further volatility in the pound is warranted for three reasons: Europeans will seek to punish the U.K. for Brexit, to set an example to their own Euroskeptics; Prime Minister May's assertion that the U.K. would seek to exit the common market is negative for the country's economy; Legal uncertainties about Brexit remain. We disagree with this assessment, at least in the short and medium term. Therefore, the pound rally on the day of May's speech was warranted, although we agree that exiting the EU Common Market will ultimately be suboptimal for the country's economy. First, by setting out a clean break from the EU, including the common market, Prime Minister May has removed a considerable amount of political uncertainty. As we pointed out in our original net assessment of Brexit, leaving the EU while remaining in its common market is illogical.11 Paradoxically, the U.K. stood to lose rather than regain sovereignty if it left the EU yet remained in the common market (Diagram 1). Diagram 1The Quite Un-British Lack Of Common Sense Behind Soft Brexit Why? Because membership in the common market entails a financial burden, full adoption of the acquis communautaire (the EU body of law), and acceptance of the "Four Freedoms," including the freedom of movement of workers. Given that the Brexit vote was largely motivated by concerns of sovereignty and immigration (Chart 18), it did not make sense to vote to leave the EU and then seek to retain membership in the common market. Apparently May and her cabinet agree. Chart 18It's Sovereignty, Stupid! Second, now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe, à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. An FTA arrangement will be beneficial to EU exporters, who want access to the U.K. market, and it will send a message to Euroskeptics on the continent that there is no alternative to full membership. Leaving the EU means leaving the market and falling back - at best - to an FTA-level relationship that the EU shares with Mexico and (most recently) Canada. Third, leaving the EU and the common market are political, not legal, decisions, and the lingering legal battles are neither avoidable nor likely to be substantive. Theresa May had already stolen thunder when she said that the final deal with the EU would be put to a vote in parliament. The Supreme Court ruling - as well as other legal hangups - could conceivably give rise to complications that bind the government's hands, but most likely parliament will pass a simple bill or motion granting permission for the government to invoke Article 50. That is because the referendum, and public opinion since then, speak loud and clear (Chart 19). The Conservative Party remains in a comfortable lead over the Labour Party (Chart 20), which itself is not opposing the referendum outcome. In addition, the House of Commons has already approved the government's Brexit timetable by a margin of 372 seats in a 650-seat body - with 461 ayes. That is a stark contrast with a few months ago when around 494 MPs were said to be against Brexit. Chart 19No 'Bremorse' Or 'Bregret' Chart 20Tories Still Triumphant The bigger question comes down to the parliamentary vote on the deal that is to be negotiated over the next two years. Could the Parliament vote down the final agreement with the EU? Absolutely. However, it is unlikely. The economic calamity predicted by many commentators has not happened, as we discuss below. Bottom Line: The combination of the Supreme Court decision and Prime Minister May's speech has reduced political uncertainty regarding Brexit. The EU will negotiate hard with the U.K., but the main cause of consternation - the U.K. asking for special treatment with respect to the common market - is now off the table. Yes, the EU does hold all the cards when it comes to negotiating an FTA agreement, and the process could entail some alarming twists and turns (given the last-minute crisis in the EU-Canada FTA). But we do not expect EU-U.K. negotiations to imperil the pound dramatically beyond what we've already seen. Will Leaving The Common Market Hurt Britain? Does this mean that Brexit is "much ado about nothing?" In the short and medium term, we think the answer is yes. In the long-term, leaving the EU Common Market is a suboptimal outcome for three reasons: Trade - Net exports rarely contribute positively to U.K. growth (Chart 21) and the trade deficit with the EU is particularly deep. As such, proponents of Brexit claim that putting up modest trade barriers against the EU could be beneficial. However, the U.K. has a services trade surplus with the EU (Chart 22). While it is not as large as the trade deficit, there was hope that the eventual implementation of the 2006 EU's Services Directive would have opened up new markets for U.K.'s highly competitive services industry and thus reduced the trade deficit over time. As the bottom panel of Chart 22 shows, the U.K.'s service exports to the rest of the world have outpaced those to the EU, suggesting that there is much room for improvement. This hope is now dashed and the EU may go back to putting up non-tariff barriers to services that reverse Britain's modest surplus with the bloc. Free Trade Agreements rarely adequately cover services, which means that the U.K.'s hope of expanding service exports to a new high is probably gone. Chart 21U.K. Is Consumer-Driven Chart 22Service Exports At Risk After Brexit Foreign Investment - FDI is declining, whether for cyclical reasons or because foreign companies fear losing access to Europe via the U.K. It remains to be seen how FDI will respond to the U.K.'s renunciation of the common market, but it is unlikely to be positive (Chart 23). The U.K.'s financial sector will also be negatively impacted since leaving the common market will mean that London will no longer have recourse to the EU judiciary in order to stymie European protectionism.12 This is unlikely to destroy London's status as the global financial center, but it will impact FDI on the margin. Labor Growth - The loss of labor inflow will be the biggest cost of Brexit. A decrease of immigration from the EU could reduce the U.K.'s labor force growth by a maximum of two-thirds, translating to a 25% loss in the potential GDP growth rate (Chart 24). While the U.K. is not, in fact, closing off all immigration, labor-force growth will decline, and potential GDP with it. Chart 23FDI To Suffer From Brexit? Chart 24Labor Growth Suffers Most From Brexit In addition, the EU Common Market forces companies to compete for market share in the developed world's largest consumer market. This competition is supposed to accelerate creative destruction and thus productivity, while giving the winners of the competition the spoils, i.e. a better ability to establish "economies of scale." In a 2011 report, the Bank of International Settlements (BIS) published an econometric study that compared four scenarios: the U.K. remains in the common market as the EU fully liberalizes trade; the U.K. remains in the EU's single market, but does not fully liberalize trade with the rest of the EU; the U.K. leaves the common market; the U.K. enters NAFTA.13 Of the four scenarios, only the first leads to an increase in wealth for the U.K., with 7.1% additional GDP over ten years. U.K. exports would increase by 47%, against 38.1% for its imports. Wages of both skilled and unskilled workers would increase as well. Meanwhile, the report finds that closer integration with NAFTA would not compensate for looser U.K. ties with the EU. In fact, the U.K. national income would be 7.4% smaller if the U.K. tied up with NAFTA instead of taking part in further trade liberalization on the continent. Why rely on a 2011 report for the assessment of benefits of the common market? Because it was written by a competent, relatively unbiased international body and predates the highly politicized environment surrounding Brexit that has since infected almost all think-tank research. And yet the more recent research echoes the 2011 report in terms of the negative consequences of leaving the common market.14 In addition, the BIS study actually attempts to forecast the benefit of further removing trade barriers in the single market, which is at least the intention of the EU Commission. That said, our concerns regarding the U.K. economy are long-term. It may take years before the full economic impact of leaving the common market can be assessed. In addition, much of our analysis hinges on the Europeans fully liberalizing the common market and removing the last remaining non-tariff barriers to trade, particularly of services. At the present-day level of liberalization, the U.K. may benefit by leaving. In addition, we do not expect a balance-of-payments crisis in the U.K. any time soon. The U.K. current account is deeply negative, unsurprisingly so given the deep trade imbalance with the EU and world. However, our colleague Mathieu Savary, Vice-President of BCA's Foreign Exchange Strategy, has pointed out that the elasticity of imports to the pound is in fact negative, a very surprising result. This reflects an extremely elevated import content of British exports. A lower pound is therefore unlikely to be the most crucial means of improving the current-account position. Certainly leaving the common market will not improve the competitiveness of British exports in the EU. Chart 25The U.K.'s Basic Balance Is Healthy But this raises a bigger question: why does the U.K. have to improve its current account deficit? As our FX team points out in Chart 25, despite having a current-account deficit of nearly 6% of GDP, the U.K. runs a basic balance-of-payments surplus of 12%, even after the recent fall in FDI inflows. The reason for the massive balance-of-payments surplus is the financial account surplus of 6.17% of GDP, a feature of the U.K. being a destination for foreign capital, which flows from its status as a global financial center and prime real estate destination. In other words, leaving the common market will not change the fundamentals of the U.K. balance of payments much. The country will remain a global financial center and will still run a capital account surplus, which will suppress the country's interest rates, buoy the GBP, and give tailwinds to imports of foreign goods. Meanwhile, exports will not benefit as they will face marginally higher tariffs as the country exits the EU Common Market. At best, new tariffs will be offset by a cheaper GBP. As such, leaving the common market is not going to be a disaster for the U.K. Nor will it be a panacea for the country's deep current account deficit. And that is okay. The U.K. will not face a crisis in funding its current account deficit. What is clear is that for the time being, the U.K. economy is holding up. Our forex strategists recently argued that U.K.'s growth has surprised to the upside and that the improvement is sustainable: Monetary and fiscal policy are both accommodative (Chart 26); Inflation is limited; Tight labor market drives up wages and puts cash in consumers' pockets (Chart 27); Credit growth remains robust (Chart 28). Chart 26Easy Money Smooths The Way To Brexit Chart 27British Labor Market Tightening Chart 28U.K. Credit Growth Looking Good This means that the political trajectory is set for the time being. "Bremorse" and "Bregret" will remain phantoms for the time being. Bottom Line: Leaving the common market is a suboptimal but not apocalyptic outcome for the U.K. The combination of decent economic performance and lowered political uncertainty in the near term will support the pound. Given the pound's 20% correction since the June referendum, we believe that the market has already priced in the new, marginally negative, post-Brexit paradigm. The Big Picture It is impossible to say whether the long-term negative economic effects of Brexit will affect voters drastically enough and quickly enough for Scotland, or parliament, to act in 2018 or 2019 and modify the government's decision to pursue a "Hard Brexit." It seems conceivable if something changes in the fundamental dynamics outlined above, but we wouldn't bet on it. At the moment even a new Scottish referendum appears unlikely (Chart 29). Scottish voters have soured on independence, perhaps due to a combination of continued political uncertainty in the EU (Scotland's political alternative to the U.K.) and a collapse in oil prices (arguably Scotland's economic alternative to the U.K.). The issue is not resolved but on ice for the time being. Chart 29Brexit Not Driving Scots To Independence (Yet) More likely, the government will get its way on Brexit and the 2020 elections will mark a significant popular test of the Conservative leadership and the final deal with the EU. Then the aftermath will be an entirely new ballgame for the U.K. and all four of its constituent nations. If Britain's new beginning is founded on protectionism and dirigisme - as the government suggests - then the public is likely to be disappointed. The "brave new world" of Brexit may prove to be rather mundane, disappointing, and eerily reminiscent of the ghastly 1970s.15 Hence the Shakespeare quote at the top of this report. The political circumstances of Brexit resemble the U.K. landscape before it joined the European Economic Community in 1973: greater government role in the economy, trade protectionism, tight labor market, higher wages, and inflation. Yet this was a period when the U.K. economy underperformed Europe's. The U.K.'s eventual era of outperformance was contingent on the structural reforms of the Thatcher era and expanded access to the European market (Chart 30). It remains to be seen what happens when the U.K. leaves the market and rolls back Thatcherite reforms. The weak pound and proactive fiscal policy will fail to create a manufacturing revolution. That is because most manufacturing has hollowed out because of automation, not foreign workers stealing Britons' jobs. Moreover, as for the pound, it is important to remember that currency effects are temporary and any boost to exports that the weak pound is generating will be short-lived, as with the case of China in the 1990s and the EU in the past two years (Chart 31). Chart 30U.K. Growth To Lag Europe's Once Again? Chart 31Export Boost From Devaluation Is Fleeting In addition, we would argue that, in an environment of de-globalization - in which tariffs are rising, albeit slowly for the time being (Chart 32) - the EU Common Market provides Europe with a mechanism by which to protect its vast consumer market. The U.K. may have chosen the precisely wrong time in which to abandon the protection of continental European protectionism. It could suffer by finding itself on the outside of the common market as global tariffs begin to rise significantly. Chart 32Protectionism On The March What about the restoration of the "Special Relationship" between the U.K. and the U.S.? Could moving to the "front of the queue" on negotiating an FTA with the world's largest economy make a difference for the U.K.? Perhaps, but as the BIS study above indicates, an FTA with North America or the U.S. alone is unlikely to replace the benefits of the common market. In addition, it is difficult to imagine how a protectionist U.S. administration that is looking to massively decrease its current account deficit will help the U.K. expand trade with the U.S. By contrast, Trump's election in the United States poses massive risks to globalization, both through his protectionism and the strong USD implications of his core policies. This will reverberate negatively across the commodities and EM space. In such an environment, the U.K. may not be able to make much headway in its "Global Britain" initiatives to conclude fast trade deals with EM economies that stand to lose the most in the de-globalization era. Bottom Line: As a trading nation, the U.K. is likely to lose out in a prolonged period of de-globalization. Membership in the EU could have served as a bulwark against this global trend. Investment Implications We diverge from our colleagues in the Foreign Exchange Strategy and European Investment Strategy when it comes to the assessment of political risk looming over Brexit.16 The decision to leave the common market will alleviate the pressure on Europeans to seek vindictive punishment. Earlier, the U.K. was forcing them to choose between making an exception to the rules and demonstrating the negative consequences of leaving the bloc. Now the U.K. is self-evidently taking on its own punishment - the economic burden of leaving the common market - and the EU will probably deem that sufficient. Will the EU play tough? Yes, especially since the EU retains considerable economic leverage over Britain (Chart 33). But the stakes are far smaller now. Furthermore, investors should remember that core European states - especially France and Germany - remain major military allies of the U.K. and will continue to be deeply intertwined economically. As such, we believe that the pound has already priced in the new economic paradigm and that the expectations of political uncertainty ahead of the U.K.-EU negotiations may be overdone. We therefore recommend that investors short EUR/GBP outright. Our aforementioned forex strategist Mathieu Savary argues that, on an intermediate-term basis, the outlook for this cross is driven by interest rate differentials and policy considerations. Due to the balance-sheet operations conducted by the BoE and ECB, interest rates in the U.K. and the euro area do not fully reflect domestic policy stances. Instead, Mathieu uses the shadow rates. Currently, shadow rates unequivocally point toward a lower EUR/GBP (Chart 34). In fact, balance-sheet dynamics point toward shorting EUR/GBP. Chart 33EU Holds The Cards In FTA Negotiation Chart 34Shadow Rates Point To Stronger GBP For full disclosure, Mathieu cautions clients to wait on executing a short EUR/GBP until after Article 50 is enacted. By contrast, we think that political uncertainty regarding Brexit likely peaked on January 16. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com 1 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive a much lower return on U.S. assets while the U.S. benefits from risk premia in foreign markets. 2 Please see Spiegel Online, "Donald Trump and the New World Order," dated January 20, 2017, available at Spiegel.de. 3 In a widely-quoted interview with The Wall Street Journal, Donald Trump said that the U.S. dollar is "too strong." He continued that, "Our companies can't compete with [China] now because our currency is too strong. And it's killing us." Please see The Wall Street Journal, "Donald Trump Warns on House Republican Tax Plan," dated January 16, 2017, available at wsj.com. 4 We would note that the Trump administration and its Treasury Department have considerable leeway over how they choose to interpret China's foreign exchange practices. In 1992, when the U.S. government last accused China of currency manipulation, it issued a warning in its spring report before leveling the accusation in the winter report. The RMB did not depreciate in the meantime but remained stable, and Treasury noted this approvingly; however, Treasury chose 1989 as the base level for its assessment, and found manipulation. The Trump administration could use much more aggressive interpretive methods than this to achieve its ends. 5 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, and Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 14, 2014, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 10 Critics, including Trump supporters, claim that NAFTA sets too low of a threshold for the domestic content of a good deemed to have originated within the NAFTA countries. Goods that are nearly 40% foreign-made can thus be treated as NAFTA-made. This is one of many contentious points in the trade deal. 11 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 12 In 2015, the U.K. took the ECB to court over its decision to require financial transactions denominated in euros to be conducted in the euro area, i.e. out of the City, and won. This avenue of legal redress will no longer be available for the U.K., allowing EU member states to slowly introduce rules and regulations that corral the financial industry - or at least to the parts focused on transactions in euros - out of London. 13 Please see Bank of International Settlements, "The economic consequences for the U.K. and the EU of completing the Single Market," BIS Economics Paper No. 11, dated February 2011, available at www.gov.uk. 14 Please see Her Majesty's Government, "H.M. Treasury Analysis: The Long-Term Economic Impact Of EU Membership And The Alternatives," Cmnd. 9250, April 2016, available at www.gov.uk. and Jagjit S. Chadha, "The Referendum Blues: Shocking The System," National Institute Economic Review 237 (August 2016), available at www.niesr.ac.uk. 15 We were going to use "grey" to describe Britain in the 1970s. However, our colleague Martin Barnes, BCA's Chief Economist, insisted that "grey" did not do the "ghastly" 1970s justice. When it comes to the U.K. in the 1970s, we are going to defer to Martin. 16 Please see BCA Research European Investment Strategy Weekly Report, “May’s Brexit Speech: No Substance,” dated January 19, 2017, available at eis.bcaresearch.com. Geopolitical Calendar
Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs Table I-2Vulnerability To BATs Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Dear client, This week, we are sending you an abbreviated version of our weekly bulletin as we are also publishing a piece written by our colleague Peter Berezin, Senior Vice President for our Global Investment Strategy service. This report, titled “U.S. Border Adjustment Tax: A Potential Monster Issue For 2017”, deals in great details with the Republican tax plans. In this report, Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market if it gets implemented in full, but not one without repercussions. I trust you will find this report very interesting and relevant. Best regards, Mathieu Savary Feature After continuing to sell off, the dollar regained some composure toward the end of the week. Not only did an elevated CPI print for December contribute to this rally, but so did Fed Chair Janet Yellen's comment that the U.S. economy was getting closer to the FOMC objectives and that the Fed was now closer to being capable of raising rates multiple times a year between now and 2019. Chart 1Froth Had Dissipated##br## From Treasury Yields Additionally, we had been expecting a correction in the dollar as we worried that U.S. bond yields would retrace some of their ascent. The pullback materialized and U.S. bond yields traded in line with our fair value estimate earlier this week (Chart 1). This meant that much of the froth in the dollar had dissipated. Based on these developments, is it time to buy the dollar again? On a cyclical basis, the dollar will make new highs in 12-18 months. However, short-term considerations remain complex. There are two President Trump out there: "Good Trump" and "Bad Trump". Good Trump is a president that talks about deregulation and tax cuts as well as various stimulus measures. This is the president that turbo charged the dollar after the election on hopes of a stronger U.S. economy. Bad Trump is the campaign Trump, the populist president that wants to revive protectionism and that promotes acrimonious international relations between the U.S. and the rest of the world, China in particular. The markets had expected Good Trump to be the first Trump to emerge, yet, the new president seems to have elected to present his Bad Trump profile first. In a way, this makes sense. Trump is focusing on the more economically painful parts of his program, campaign promises wanted by his electorate. This way, Good Trump can swoosh in and save the day by helping the economy closer to the mid-term election in late 2018, in the aim of solidifying the Republican control of Congress. With the 10-year yield back above fair value, the VIX near 12, and EM equities near their pre-November high, the market is not pricing in any flare up of tensions with China, nor any deflationary shock that could emanate from such tensions (Chart 2). Investors were hoping that the talks of stimulus and deregulation would come first, instead they are getting a president that bullies corporations and build up tensions in Asia. The deflationary nature of the tension comes from the reality that while the Chinese economy has improved, China remains handicapped by a large debt load and a low demand for credit. It is ill equipped to handle foreign shocks. Moreover, the easing in Chinese monetary conditions will soon lose steam. Chinese monetary conditions eased because Chinese real rates fell from nearly 12% to -2% on the back of a powerful rebound in the Chinese producer prices (PPI) (Chart 3). This improvement in PPI was itself a byproduct of a rebound in commodity inflation. However, this rebound is soon behind us. Commodity prices troughed in Q1 2016, and have recently slowed their pace of ascent. This means that in the coming months, Chinese PPI will rollover as well and Chinese real borrowing costs will rise again (Chart 4). Chart 2All Must ##br##Go Well Chart 3Can Chinese Monetary ##br##Conditions Improve Further? Chart 4The Commodity Rebound Was A Key Factor##br## Behind The Chinese PPI Rebound This could prove problematic for China where loan demand remains very tepid, pointing to a potential down leg in Chinese industrial activity (Chart 5). This also raises the specter of renewed devaluation pressures on the Chinese yuan, as this would create another valve to alleviate deflationary pressures in the Chinese economy (Chart 6). Further RMB weakness would be welcomed neither by Trump, nor by the markets. Chart 5Chinese Loan Demand ##br##Remains Moribund Chart 6The RMB Is Another Relief Value For##br## Chinese Deflationary Pressures Taking all these factors into account, we remain warry of betting on a strong dollar against the euro and the yen in the coming weeks, at least not until bonds become cheap on our fair value gauge, reflecting these Chinese deflationary risks and a higher geopolitical risk premium. Chart 7EUR/GBP Is Misaligned##br## With Fundamentals Also, this means that we could see a dichotomy emerge between the narrow dollar (DXY) and the broad dollar. While lower bond yields are supportive of the euro and the yen, they do very little for EM and commodity currencies. In fact, EM and commodity currencies are highly leveraged to the Chinese economy and will be vulnerable to any flare up of tensions between China and the U.S., especially after currencies like the AUD and the CAD had already rallied 5% and 4% respectively since the last week of 2016. Thus, we would recommend investors favor risk-off currencies like the euro, the Swiss franc, and the yen at the expense of the AUD, NZD, CAD, and NOK. For the GBP, last week, we published an optimistic take on the British economy. We are looking to short EUR/GBP as rate differentials are still widely bearish of that cross (Chart 7). However, we warned that in anticipation of the actual triggering of article 50 of the Lisbon treaty, the GBP could come under duress. A risk-off event would only strengthen this case. Thus, we remain confident in our preferred strategy to short EUR/GBP once it hits 0.93. Bottom Line: The dollar correction is advanced but is now likely to become more differentiated. Tensions created by a protectionist and bellicose Trump are likely to push bonds into expensive territory. While the attending bond rally could support the euro, the Swiss franc, and the yen against the dollar, these same tensions are likely to support the dollar against EM and commodity currencies. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Our immediate reaction to Theresa May's vision of Brexit boils down to three points: You can wish all you want... but what you wish isn't what you get. Do you understand the legal framework? Where does this leave Scotland? Feature You Can Wish All You Want... But What You Wish Isn't What You Get Theresa May essentially set out her wish-list for what Brexit should look like. But it was a vision seen through rose-tinted spectacles. The speech listed all the benefits to the U.K. but conveniently ignored most of the costs. It was a speech to rouse the Conservative Party, rather than to present a thoughtful and sober analysis. Hence, the speech was riddled with intellectual inconsistencies and impossibilities. For example, she wants "Britain to negotiate its own trade agreements" which would entail departing the Customs Union. But contradicting this, she also wants "cross-border trade to be as frictionless as possible" which would entail retaining some sort of Customs Union. More importantly, there are two sides to every negotiation and so far, we are only hearing one side - May's vision of a future in sunlit uplands. Spokesmen for the EU27 are probably chomping at the bit to reply. But smartly, they have entered a vow of silence until after Article 50. Just like a poker player who has to wait just a little longer to reveal that he carries all the aces... Do You Understand The Legal Framework? Events since the referendum on June 23 show that the U.K. Government was completely unprepared for the No vote. Hence, the government's strategy - in as much as one exists - has been made on the hoof, and quite often with the minimum of research or analysis. Most notably, the government did not understand the legal framework to leave the EU - specifically that the invoking of Article 50 of the Lisbon Treaty might require an Act of Parliament, a precondition on which the Supreme Court will soon opine. Now, Prime Minister May claims that "we will no longer be members of the Single Market", but this may not be simple to deliver. Leaving the EU might not automatically mean leaving the Single Market. This is because the Single Market is not defined by the EU but by the European Economic Area (EEA), consisting of the 28 countries of the EU plus Norway, Iceland and Liechtenstein. Crucially, membership of the EEA is governed by its own Treaty. Therefore, leaving the Single Market will require a careful legal interpretation of Article 126, Article 127 and Article 128 of the EEA Treaty. We will cover this in more detail in a future report. Prime Minister May also promised Parliament a vote on the final deal struck with the EU27. But it was unclear whether losing that vote would mean staying in the EU (as the pound seemed to interpret) or leaving with no deal (more likely). Where Does This Leave Scotland? A clean Brexit would be a pyrrhic victory if it meant the breakup of the United Kingdom - indeed it would effectively become an 'Engexit', rather than a Brexit. But that is the risk, because Nicola Sturgeon has said that leaving the Single Market is a red line that Scotland is unwilling to cross. Thereby, Theresa May's speech has increased the probability of a new referendum on Scottish Independence. In summary, the speech did not reduce the uncertainties around Brexit. It increased them. The U.K. is not out of the woods, it is just about to enter the woods. Hence, the knee-jerk spike in the pound was unwarranted. We anticipate further volatility in the pound and maintain our strategy of 'owning the tails': for example, short pound/euro but with call options at €1.30. As for the FTSE100 relative performance, investment reductionism shows that it is just an inverse play on the pound. As the pound weakens, the FTSE100 outperforms, and vice-versa (Chart of the Week). Chart of the WeekFTSE100 Relative Performance Is Just An Inverse Play On The Pound Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* Pleasingly, our long gold position has hit its profit target in a classic liquidity-triggered trend reversal. There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-2 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights Trump's protectionism supercharges our theme of Sino-American tensions. China is at a stark disadvantage to the U.S. in a trade war. China cannot give concessions easily; it may batten down the hatches. Remain short RMB; but go long "One China," i.e. mainland stocks versus Taiwan/Hong Kong. Feature "Life's short span forbids us to enter on far reaching hopes." - Horace, Odes "Of course, you know, this means war." - Bugs Bunny, Looney Tunes President-elect Trump has said he will not designate China a "currency manipulator" on the first day of his presidency, contrary to what he promised during the campaign. Is this a sign that Trump is "normalizing" after the wild threats of his campaign? What are the real risks of a U.S.-China "trade war"? How should investors prepare? Trade War Is More Likely Than You Think BCA's Geopolitical Strategy has long cautioned investors that geopolitical tensions in East Asia were severely underestimated by the market.1 In 2013, we argued that a Sino-American military conflict was more likely than most of our clients dared to think.2 And over the past several years, in one-on-one conversations and in presentations at numerous conferences, we have stressed that tensions in East Asia could imperil the largest trade relationship. Why so alarmist? We have always based our analysis on three key pillars: Multipolarity: With the U.S. in a relative decline, containing China's rise has become a national security issue. The U.S. "Grand Strategy" operates under the imperative that no regional power is allowed to become a regional hegemon, as that would be a stepping stone to global competition. "Pivot" To Asia: The U.S. geopolitical deleveraging from the Middle East was from the start designed to free up more U.S. resources for Asia. While the Obama Administration pursued the pivot cautiously, it was putting the infrastructure in place for a confrontation with China. Regional dynamics: China is surrounded by neighbors that are cautious about Beijing's intentions for geographic, historical, and strategic reasons. They have therefore sought to balance their increasing economic addiction to China with deeper military and political links to the U.S. Chart 1China, Not NAFTA, In Trump's Crosshairs Trump's victory has made markets considerably less oblivious to the risks we have stressed to clients for the past five years. The idea that a trade war might erupt is now widely discussed. And Trump's repeated statements about Taiwan, North Korea, and the South China Sea have awoken some investors to the reality that a trade conflict could spill over into strategic areas, and vice versa. Nevertheless, judging by the ebullient market reaction relative to previous U.S. presidential transitions, most investors think that cool heads will inevitably prevail. They may be right, but from where we sit it is premature - and imprudent - to bet on it. Make no mistake, China, not NAFTA, will suffer the brunt of Trump's efforts to fulfill his protectionist campaign promises (Chart 1). We see 70% odds that a "crisis event" will affect U.S.-China trade patterns in a significant way over the next four years. How Did We Get Here? The Global Financial Crisis caused a sharp break in Sino-American relations: It interrupted the economic symbiosis between China and American households refused to keep re-leveraging, forcing China to become more internally driven economy (Chart 2). With final demand in the U.S. declining, China decided to re-leverage with credit, injecting its existing overproduction and overcapacity with steroids. But this only accelerated China's capture of global export market share, while supercharging the deflationary global effects (Chart 3). On top of its credit policies, China has struggled to internationalize the RMB. So now, it is not only still washing the world with its industrial overcapacity but also inadvertently - or not so innocently - reducing the prices of its goods with the weakening of its currency (Chart 4). Chart 2U.S.-China Symbiosis Has Died Chart 3China's Historic Export Grab Chart 4China Still Exporting Deflation U.S.-China trade disputes have a long history. China's WTO entrance was agreed only with the stipulation that China be treated as a "non-market economy" for 15 years. Punitive trade bills almost passed through Congress in 2005 and 2010-11, for instance, but were held back at the last minute.3 Since 2009, in particular, protectionist policies have emerged. President Obama began his term with an unprecedented use of the authority under Section 421 of the 1974 Trade Act to punish China for "market distorting" exports of car tires, and with protectionist "Buy America" provisions in his economic stimulus package. After that, a sequence of tit-for-tat punitive measures took place affecting a range of goods on both sides, attempted Chinese investments in the U.S., and American companies operating in China. China's meteoric rise, surging trade surpluses with the U.S., and the rapid loss of U.S. manufacturing jobs was the main cause of tension (Chart 5). Americans benefited from China's rise, namely from cheaper goods and lower interest rates, but it caused significant economic dislocations.4 Meanwhile Chinese protectionism discouraged American elites that had endorsed China's rise on the hopes of gradually unfolding market access. Amid the heightened political risks of the global recession and its aftermath, China intensified intellectual property theft, non-tariff barriers, indigenous innovation policies, and cyber-attacks.5 The saving grace, for markets, was that the aforementioned tensions always remained within bounds. The WTO was a mutually recognized adjudicator. Also, the rival American and Chinese commercial authorities played a slow, step-by-step, predictable game, with the punitive measures being mostly proportional. When pressures flared in the U.S., the executive branch stayed Congress's hand; meanwhile China's government could steamroll any internal opposition to its trade policies. No more. Hillary Clinton might have helped contain trade tensions, but the outlook has darkened irrespective of Trump. Notably, American multinational corporations have increasingly decried Chinese protectionism and lobbied for the U.S. government to help persuade China to give them greater market access and a better legal-regulatory climate (Chart 6). As the Obama administration exited the stage in December 2016, the U.S., Japan and others refused to accept China's "market economy" status despite the fifteen-year deadline coming due. This means the U.S. and its allies explicitly wanted to reserve the power to impose anti-dumping duties more easily on China, which is what "Non-Market Economy" status entails (Chart 7).6 China considers this delay an outright violation of U.S. commitments under WTO. Chart 5A Tale Of Two Manufacturers Chart 6American Business Under Pressure In China Chart 7China's Non-Market Status A Liability Further, Clinton had promised to create a special prosecutor for trade disputes and to triple the number of enforcement officers. More broadly, she wanted to continue Obama's "Pivot to Asia" policy that had roiled U.S.-China strategic relations. Bottom Line: U.S.-China trade relations had already turned sour as a result of the divergence of interests following the Global Financial Crisis. China has emerged as a trade juggernaut and the U.S. corporate and political establishments have become far more anxious about it recently. Now Trump has supercharged the situation. Will Trump "Normalize" In Office? With Trump, the U.S. is likely to undergo a "regime change" in terms of how trade policy is conducted - the only question is how long-lasting it will be. U.S. presidents have very few constraints on trade and foreign policy (Table 1). Ignore Trump's statements and look at his team: Incoming Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer.7 This group, especially Navarro, is stridently hawkish on China and appears ready to bring the full weight of the United States' economic and strategic advantages to the table in order to negotiate a new framework of relations. Table 1Trump Is Not Constrained On Trade Policy The model is the renegotiation of trade relations with an ascendant Japan in the 1980s. And China looks ripe for a crackdown by this yardstick. The penetration of Chinese exports meet or exceed Japan's position at its peak in the 1980s (Chart 8). Meanwhile the RMB has not appreciated nearly as much as the yen had done by this time (Chart 9). Ultimately the two resolved their differences because Japan acceded to major U.S. demands, strengthening its currency after the 1985 Plaza Accord and accelerating financial liberalization. It helped that the two were staunch allies without genuine security tensions (unlike the U.S. and China today). Chart 8China Has Gotten Away ##br##With More Than Japan Did Chart 9Reagan Forced Faster ##br##Appreciation On Japanese Yen From the Trump administration's point of view, the standard trade remedies have failed given that U.S. trade deficits have deteriorated all along. True, China has made considerable structural adjustments in recent years (Chart 10). But relative to the U.S., China has not really changed its ways. In fact, the current account surplus, which has collapsed from 10% to around 2% since 2008, is now roughly equal to the trade surplus with the United States (Chart 11). Chart 10China's Economic Rebalancing Under Way Chart 11China's Trade Surplus With U.S. Indispensable Therefore we do not put much stock in Trump's claim that he will not call China a currency manipulator on day one - this does not signal a "normalization" or softening of Trump's protectionist line. There was always a technical issue with this pledge that made the timing awkward.8 The manipulator charge will remain a Sword of Damocles hanging over China this year and next, but it is also only one tool in Trump's toolkit - and not the most intimidating one either (Diagram 1). Diagram 1Calling China A Currency Manipulator: The Process At a minimum, Trump could easily do what Obama did in February 2009 on tires - simply approve recommendations from his own Treasury Department for tariffs on specific goods. At a more aggressive level, he has the example of Richard Nixon before him. Nixon imposed a 10% surcharge on all dutiable goods in 1971. We would not put it beyond Trump to take arbitrary actions within the four-year term if international economic conflicts heat up dramatically. (We will be especially leery in the lead-up to the 2018 or 2020 elections if Trump's touted deal-making is not going his way.) Congress is not likely to prove a major constraint, at least not at first. Trump's election is a strong signal that the U.S. populace wants more protectionist policies. Congressional Republicans are limited, given the laws empowering the president on trade, and they will face the reality that his electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. Democrats, in these and other competitive states, have to perform verbal gymnastics to oppose Trump's positions on trade that substantially echo their own. And as mentioned, U.S. multinationals are not likely to "domesticate" Trump - rather, they will lobby for relative moderation or tactfulness within his general framework. Bottom Line: Trump is relatively unconstrained on trade policy. We expect his administration to begin with a "shot across the bow" in the first 100 days - a mostly but not entirely symbolic punitive measure against China - and then to seek high-level negotiations toward a framework for the administration's relations with China over the next four years. We expect the initial shot to rattle markets, then for a calming period to ensue, which will give a false sense of security. But given the lack of constraints on Trump, we are not optimistic. What Are China's Options? In a trade war with the U.S., China is outgunned on every front. Its economy is far more vulnerable to a disruption of exports to the U.S. than vice versa (Chart 12). It does not have ready alternatives to the U.S., given that U.S. imports of Chinese goods are roughly equal to Japanese, South Korean, German, Vietnamese and British imports combined. And China is most competitive in goods that the U.S. can easily source elsewhere (Chart 13). Chart 12The Numbers Favor The U.S. In A Trade War Chart 13The U.S. Can Find Substitutes For China Yes, China can disrupt the supply chain for the iPhone, but no, the Trump administration is not going to confuse Apple's interests with what it views as the "National Interest." Certainly China will favor non-American companies - Airbus over Boeing, etc - but the U.S. growth model is not reliant on exports, so it is not clear that the Trump administration will heed Boeing's cries about long-term competitiveness. The states most exposed to Chinese retaliation - Alaska, Oregon, Washington, Louisiana, and South Carolina - will not harm his electoral base. His Midwestern Rust Belt states could suffer, according to some research, but voters there may approve of his protectionist measures and Trump's other economic policies may blunt the short-term impact of Chinese retaliation.9 Looking at major Chinese export categories to the U.S., like textiles, electrical machinery, and equipment, suggests that 30 million Chinese jobs could be affected - perhaps ten times as many as the comparable U.S. jobs at risk from Chinese retaliation (far more than proportional given population). There is one factor that stands in China's favor. The history of trade wars says something different than the raw balance of trade. Like all wars, trade wars seek political ends, and a government's internal unity and resilience can be critical to its ability to bear out the worst.10 Politically, it is not clear that the U.S. has a better stomach for a full trade war than China: The U.S. remains divided - Polarization will worsen under Trump given his low approval ratings, low favorability, narrow popular victory margin, and controversial policy inclinations. Though China-bashing and economic patriotism can win some support, and we do not expect Congress or the corporate lobby to prevent Trump from launching a trade crusade if he wishes, nevertheless we see a fair chance that Trump would lose credibility and be forced to moderate his stance once negative trade consequences began to be felt at home. China is relatively unified - Xi has set himself up to be the "core" of power in the Communist Party in anticipation of worsening domestic conditions.11 It is worth remembering that the original use of the "core leader" moniker emerged in the wake of the Tiananmen Square crackdown when the Western world imposed sanctions on a newly liberalized China and it was forced to retreat into its shell from 1989-1992 (Chart 14). China's leadership wants to make the country less dependent on the U.S., and more autarkic, but is having difficulty imposing austere changes on itself. Trump may hasten the reforms while giving Chinese leaders a convenient "foreign devil" to distract the populace from the pain of restructuring. Chart 14China Rode Out Western Pressure In 1989 The above should not suggest that China wants a trade war, however. Trump is threatening to kick the export leg out from under its growth model at a time when the other leg - investment - stands at risk from domestic credit excesses.12 But the recent case study of Russia and economic sanctions is instructive. President Vladimir Putin used sanctions to blame all of the economic ills that befell Russia on the West, even though the Kremlin was often at fault. That policy largely worked. Bottom Line: China stands to suffer the most economically in a trade war with the United States. Chinese policymakers may therefore choose to ride out the economic costs of a trade war while blaming the U.S. for the pain. But closing its economy today would derail global growth and cause a dramatic spike in geopolitical risk, unlike in 1989. Strategic Spillover Trump's approach is likely to increase geopolitical risk because he wants to use the strategic disagreements plaguing Sino-American relations as leverage to get concessions on trade. The three hot spots are: Taiwan - Tensions with Taiwan spiked when Trump revealed that his administration considers the "One China" policy to be up for negotiation. China has engaged in serious saber-rattling in response, both around Taiwan and in the South China Sea. By linking trade disputes with Taiwan, Trump likely made it harder for Xi to compromise on the former without looking weak on the latter. Trump's negotiating style may work in business, but will not work with China on Taiwan, which is a matter of sovereignty and a clear red line. North Korea - Trump has said North Korea will not manage to test an Intercontinental Ballistic Missile (ICBM), which it is preparing to do. He is threatening to hold China to account for not curbing the North's violations of UN resolutions on nuclear proliferation and missile development. This would likely mean an expansion of the practice adopted under Obama of sanctioning Chinese entities for dealing with North Korean partners. This situation would likely shake up markets that have normally been able to ignore North Korea. South China Sea - Trump has repeatedly signaled that China has militarized the South China Sea, and his incoming Secretary of State Rex Tillerson suggested that China be deprived of access, a policy that would trigger a shooting war if operationalized. Persistent tensions here are unlikely to go away anytime soon and could spark a diplomatic crisis or naval conflict (if not with the U.S. then with regional players like Vietnam). Thus Trump's administration is likely to make serious demands on China regarding its strategic situation and national security even while demanding an overhaul of trade policies that will force difficult economic reforms on China. Bottom Line: China's political strengths at home make it unlikely to compromise on Trump's major strategic demands. Contrary to adding leverage in trade negotiations - where the U.S. already has the upper hand - using these issues as negotiating tools is likely to cause China to fear for its security and thus become more defiant. Risks To The View The risk to this view would be that the U.S. and China manage to negotiate a new framework and actually improve relations, with the U.S. giving more respect to China's legitimate rights and regional initiatives in exchange for Chinese concessions. But is China capable of conceding significantly on Trump's major demands? RMB appreciation? No. Many commentators have pointed out that Trump's view of the RMB is outdated - the PBoC is now propping it up, not suppressing it. The driver of RMB weakness is China's excessive monetary and credit expansion, weakening productivity growth, domestic investors' desires to move capital out, corporate deleveraging, the need for stimulus, tightening Fed policy, and rising geopolitical risks. While it is possible that the PBoC will defend the RMB to the hilt, the near-term path of least resistance is down, and that sets China on a collision course with the Trump administration. Market access and dumping? Yes. Trump complains that China taxes U.S. imports unfairly and dumps goods into the American market, killing jobs. To appease the U.S., China could take concrete steps to remove non-tariff barriers and open wider investment avenues for U.S. businesses - it has recently suggested it might do so.13 Less likely, it could accelerate overcapacity cuts and reduce subsidies to state-owned enterprises. These moves would fit with its avowed reform goals and strengthen Chinese self-sufficiency in the long run, and Xi's administration likely has the power to do them. China could also improve intellectual property protections and declare a ceasefire on cyber-attacks on companies. All of this is possible, but clearly extremely difficult to achieve. Strategic concerns? Maybe. It is conceivable but unlikely that China could de-escalate matters in the South China Sea and agree to a "freedom of navigation" guarantee for the United States, which is not a party to the territorial disputes. A significant compromise on North Korea would be even less likely, since China is unwilling to move beyond the usual, ineffective management and impose real hardship on the regime for its violations of UN resolutions and improving nuclear and missile capabilities. One impetus for China to concede on these points is that it is fearful of creating instability in a politically sensitive year in which it will oversee a major five-year leadership rotation at its National Party Congress. Trump may deliberately threaten to disrupt the transition in order to extract concessions. Bottom Line: We operate on a constraint-based methodology: Trump has very few constraints on trade policy, China has major constraints on making these concessions, so there is no basis for assuming that the two countries will skip conflict and go directly to a new level of cooperation. Investment Recommendations We remain short the RMB. The currency has fallen by 5.62% since we initiated this trade. The trade itself has suffered a bit since the end of last year as a result of the PBoC's efforts to fight speculation. But monetary expansion sans productivity improvements continues apace in China, and we expect USD strength to persist, so we think there is room for the RMB to fall further. In the near term, however, the USD could experience further pullback as investors start pricing the negatives of the Trump administration. Therefore we are closing our long USD/EUR trade for a 4.55% gain. We remain somewhat positive on China relative to EM - because of the relative unity and centralization of its government and financial resources at its disposal - but we would not recommend investing in Chinese assets in the absolute due to the heightened internal and external risks outlined above. Hence we propose going long the "One China" policy, i.e. long Chinese mainland stocks versus Taiwan and Hong Kong (Chart 15). This enables us to play the fact that mainland valuations are depressed while the global trend of de-globalization and the conflicts within Greater China and with the U.S. are likely to increase uncertainties about Hong Kong and Taiwan. These two are particularly vulnerable to tighter regulations or sanctions from Beijing. Yan Wang, Senior Vice-President at BCA's China Investment Strategy, argues that while there is no case for a clear directional move in Chinese stocks - especially given the ongoing tightening of policies on the property sector - nevertheless they should be favored relative to global equities, given that growth is improving, fiscal policy will remain accommodative, and valuations are depressed (Chart 16).14 Meanwhile our negative outlook on China in absolute terms supports a globally negative outlook on cyclical equities relative to defensives. Cyclicals move with EM in general and China in particular. Anastasios Avgeriou, Vice President in charge of U.S. Equity Strategy, notes that EM performance does not warrant the sharp rise in U.S. cyclicals versus defensives, nor that in globally oriented versus domestically oriented stocks (Chart 17).15 This creates the opportunity for a tactical short. Chart 15Chinese Stocks Are Cheap Chart 16China Trades With Cyclicals Chart 17Go Long The 'One China Policy' Finally, we caution investors about investing in companies with major exposure to China (Table 2). We would recommend that clients short a "China, Inc" Index of the top 20 S&P 500 stocks exposed to trade with China relative to the rest of S&P 500. The "China, Inc" stocks have been outperforming the market for a while (Chart 18). We fear that China may retaliate against some of these firms as the trade war with the U.S. heats up. Table 2'China, Inc.' May Suffer From Trade War Chart 18Short 'China, Inc.' Relative To Market Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President, marko@bcaresearch.com Jesse Anak Kurri, Research Analyst 1 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see Imad Moosa, The U.S.-China Trade Dispute: Facts, Figures And Myths (Northampton, MA: Edward Elgar, 2012). 4 For prominent research on this topic, please see David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning From Labor-Market Adjustment To Large Changes In Trade," Annual Review of Economics 8 (2016), pp. 205-40, available at www.annualreviews.org; Autor et al., "Foreign Competition And Domestic Innovation: Evidence From U.S. Patents," NBER Working Paper No. 22879, December 2016, available at www.nber.org. 5 Please see BCA Geopolitical Strategy Special Reports, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 6 Scholars have shown that countries granting China market economy status have subsequently initiated fewer antidumping cases against it. Please see Francisco Urdinez and Gilmar Masiero, "China And The WTO: Will The Market Economy Status Make Any Difference After 2016?" The Chinese Economy 48:2 (2015), pp. 155-172. Technically speaking, the difference in duty rates can be substantial between market and non-market economies; please see the U.S. Government Accountability Office, "U.S.-China Trade: Eliminating Nonmarket Economy Methodology Would Lower Antidumping Duties For Some Chinese Companies," GAO-06-231, January 2006, available at www.gao.gov. 7 Ross has criticized China more heavily since joining Trump; Navarro is the author of Death By China: Confronting The Dragon, A Global Call To Action (Pearson, 2011); together they criticized China in a paper for Trump's campaign, "Scoring The Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts," dated September 29, 2016, available at assets.donaldjtrump.com. Lighthizer worked on Ronald Reagan's Treasury Department's team that engaged in the tough trade negotiations with Japan in the mid-1980s. 8 The existing statutory procedure, now enshrined in Title VII of the Trade Facilitation and Trade Enforcement Act of 2015, involves the Treasury Department making semi-annual assessments and potentially initiating bilateral or multilateral negotiations. According to the more or less standard time frame since 1988, any charges of currency manipulation would occur in the April report at earliest, and more likely in the October report or thereafter. For Trump to have designated China a manipulator on day one, he would either have had to issue a simple statement of intent or an executive directive that bypassed the formal foreign exchange review process. 9 Please see Andy Kiersz, "Here's Every State's Biggest International Trading Partner," Business Insider, October 20, 2016, available at www.businessinsider.com. See also Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 10 Serbia "defeated" the much larger Austria-Habsburg in their "Pig War" in the early 1900s, while Ireland won most of its key demands from England despite losing the "Economic War" of the 1930s. Russia's attempts over the past decade to bully Ukraine into submission have not succeeded in achieving Russia's political aims. In each of these cases, a far greater economic disparity existed than currently exists between the U.S. and China, and yet even then the weaker country's popular support, and the willingness of neighbors to exploit the new trade opportunities that opened up, enabled the weaker country to win the political clash of wills. 11 Please see "China: Xi Is A "Core" Leader... So What?" in BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 12 Please see BCA Emerging Markets Strategy Special Report, "Misconceptions About China's Credit Excesses," dated October 26, 2016, available at ems.bcaresearch.com. 13 Please see "China unveils new plan to further open economy to foreign investment," Reuters, January 17, 2017, available at www.reuters.com. 14 Please see BCA China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017, available at cis.bcaresearch.com. 15 Please see BCA U.S. Equity Strategy Weekly Report, "2017 High-Conviction Calls," dated January 9, 2017, available at uses.bcaresearch.com.
Highlights Barring major external disruption, Chinese GDP growth will likely continue to accelerate into the first half of 2017. The overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. Trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. The dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. Shorting the CNH/USD is not much different from a direct bet on the dollar index. Aggressive directional bet on Chinese shares is not warranted in the near term. Strategically favor Chinese equities over their global peers. Feature China has rung into 2017 with strengthening growth momentum that has been building in recent months, but the New Year clearly brings new challenges. China is on the receiving end of two major external uncertainties - namely, the anti-globalization backlash from the U.S. under President-elect Donald Trump and the outlook for the U.S. dollar, both of which are completely beyond its control. 2017 will also be a highly charged year in Chinese politics, as the ruling Communist Party prepares for a generational leadership reshuffle. This means the Chinese leadership will be more sensitive to perceived "provocations" from abroad, making political risk between the U.S. and China even less predictable. The Chinese authorities will remain highly vigilant about economic and financial stability. Meanwhile, the government will continue to mobilize the public sector and fiscal resources to support the economy, as external uncertainties mount. Domestic Demand Should Remain Buoyant Most of the recent data releases coming out of China have surprised to the upside, and the regained strength appears rather broad-based (Chart 1). Some indicators that are highly sensitive to industrial activity such as transportation freight, electricity generation and construction machine sales have rebounded sharply, partly due to last year's low base. Meanwhile, the consumer sector has remained buoyant, with strong expansion in durable goods sales such as cars and air conditioners. Looking forward, we expect the economy to continue to improve, at least in the next two quarters. Leading indicators are still strengthening. The latest PMI figures, both manufacturing and non-manufacturing, have continued to climb, and remain above the boom-bust threshold. The labor market is on the mend. The employment component of the PMIs has been rising in recent months, indicating increased hiring as the economy picks up (Chart 2). This could lead to a self-feeding virtuous cycle where an improving labor market leads to rising income growth and strengthening aggregate demand, which further boosts overall business activity and the labor market. Chart 1Broad-Based Recovery Chart 2Labor Market On The Mend The corporate sector is recovering. Inventories are exceptionally low, setting the stage for inventory restocking, which could further boost production (Chart 3). Profit growth among both private and state-owned enterprises has continued to accelerate. Rising profits are easing financial stress, particularly for debt-laden, asset-heavy sectors. This is also reflected in banks' asset quality; banks' non-performing loan accumulation has slowed sharply of late (Chart 4). In addition, recovery in the corporate sector should also bode well for investment, which is still subdued. The housing crackdown since early October has once again set the stage for negative surprises. Home sales have already begun to slow, and the government appears determined to check housing demand. A key difference between now and previous rounds of housing crackdowns is that developers have been quite cautious throughout the current cycle1: confidence has been downbeat, and housing starts have remained quite weak. Consequently, housing inventories have been quickly depleted nationwide. The demand crackdown has dashed hopes for a housing-led growth recovery, but low inventories and sluggish housing construction has also reduced the risk of another housing-led investment bust, which has typically followed previous housing tightening campaigns. Chart 3Inventory Restocking Will ##br##Further Boost Production Chart 4Corporate Sector Recovery ##br## Also Helps Banks Our model shows that Chinese GDP growth likely accelerated notably in the final quarter of the year, and the momentum will probably carry forward into the first half of 2017, assuming no major external disruption (Chart 5). The inauguration of Donald Trump next week marks the biggest uncertainty for China's growth outlook in recent history due to his well-publicized anti-globalization stance, especially his proposed harsh anti-China trade policies. Chart 5Growth Should Continue To Improve The Trump Wildcard Speculation on President-elect Trump's forthcoming China policies run amok, ranging from pragmatic deal-making, simmering frictions and tit-for-tat retaliation, to the inevitability of a full-fledged trade war and even to a geo-strategic alliance with Russia against China. It is impossible to tell at the moment where reality will eventually end up, but what is clear is that trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. Low-profile trade tensions and punitive barriers will prove damaging to specific sectors and industries, but should not have a major macro impact. Chinese products that are likely to be subject to American punitive tariffs are some heavy industries such as metals. The usual suspects that may fall victim to Chinese retaliation are American transportation equipment and agricultural products - two main American export items to China. At the macro level, however, China's export sector performance should improve on a cyclical basis, especially if "Trumponomics" successfully lifts U.S. economic growth this year (Chart 6). As one of the major beneficiaries of globalization, China stands to suffer if the broad globalization trend reverses. The saving grace is that exports as a share of the Chinese economy have already almost halved to below 20%, a level comparable to the early 2000s before China joined the World Trade Organization (Chart 7). In other words, China's "globalization dividends" have already diminished to some extent. Moreover, Chinese exports depend more on the U.S. market than the other way around. Therefore, it is in China's best interests to avoid an escalation of trade frictions with the U.S., simply because it has more to lose.2 Nonetheless, it goes without saying that no country gains in a trade war, and the world risks a deep economic recession if the two largest economies engage in an all-out trade battle. Geo-strategic containment of some kind further darkens the outlook for both China and the world. A "cold war" between China and the U.S. would mark a drastic break from the global environment of the past four decades that allowed China to focus solely on economic development. One can only hope that a "clash of the titans" will not drag the world into a self-destructive downward spiral. Chart 6Trumponomics Should Also ##br##Help Chinese Exports Chart 7Globalization Dividends ##br## Have Already Diminished In short, it is too early to evaluate the impact of America's new trade policy on China's growth outlook. We suspect the near-term impact should be limited, as it is unlikely that trade tensions will immediately erupt once Trump takes office. Nonetheless, the situation needs to be monitored closely going forward. Policy: Fiscal Takes The Helm We expect the Chinese authorities will further downplay the significance of the annual GDP growth target as a binding policy constraint. Growth recovery and improvement in labor market conditions reduce the need for further pump-priming, but the overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. On the monetary policy front, the case for further interest rate cuts has diminished (Chart 8). The People's Bank of China (PBoC) recently reiterated that its monetary stance will stay decisively "neutral." In our view, this means the PBoC will continue to fine-tune interbank liquidity, but any symbolic policy move in either direction can be ruled out, unless the economic situation takes a sudden turn. In contrast, fiscal policy will be more stimulative. The annual budget deficit will likely be further increased in the March session of the People's Congress. Moreover, some high-profile investment plans have been released in recent weeks, meaning policy-led investment spending will remain elevated going forward. The country aims to invest RMB 2 trillion, or US$290 billion, in tourism between 2016 and 2020. This would translate into annual growth of more than 14% in direct investment in the industry. China's National Energy Administration (NEA) plans to invest RMB 2.5 trillion (US$360 billion) to develop the nation's energy sector over the next five years, with a focus on renewable resources. Installed renewable power capacity including wind, hydro, solar and nuclear is expected to contribute to about half of new electricity generation in five years, which will boost growth and reduce pollution. The government continues to promote private-public partnerships (PPPs) to build infrastructure. The published PPP proposals so far amount to a whopping RMB 12.5 trillion, with a heavy concentration on the transportation network and urban development (Chart 9). Chart 8Expect No Change In Policy Interest Rate Chart 9Fiscal Takes The Helm It is worth noting that recent growth improvement has been accompanied by a notable slowdown in fiscal spending, leaving room for reacceleration going forward (Chart 10). In short, fiscal spending and policy-led investment will remain the key tools for the Chinese government to stabilize the economy. Chart 10Fiscal Spending Is Set To Reaccelerate Chart 11Weak RMB Or Strong Dollar? The RMB: Which Way Will The Wind Blow? Since the New Year, offshore RMB (CNH) liquidity has tightened dramatically, which has led to a massive surge in the Hong Kong Interbank Offered Rate (HIBOR) of the RMB and a sharp rebound in the CNH/USD cross rate. This is widely viewed as a successful short squeeze engineered by the PBoC to punish speculators. It is certainly true that the authorities "allowed" offshore RMB liquidity to dry up, but the sharp spike in the HIBOR rate also closely resembles a classic emerging market currency crisis: speculative attacks on the exchange rate forces the monetary authorities to dramatically jack up interest rates to maintain exchange rate stability - a textbook example of the "Impossible Trinity" thesis at work. In China's case, however, the offshore HIBOR rate bears no relevance on the funding cost of the Chinese corporate sector. As such, the PBoC couldn't care less about periodic tightening in CNH liquidity, as it has no consequence on the domestic economy. This bodes poorly for the internationalization of the RMB, but is a low-cost tool for the PBoC to maintain control over the exchange rate. Two observations can be made from this episode: It is unlikely that the PBoC will completely give up control over the RMB exchange rate, especially in this politically charged year. Sharp depreciation in the RMB/USD may be viewed as a sign of systemic financial risk and economic weakness, a taboo ahead of the Party Congress later this year. Since the New Year, the Chinese authorities have further tightened capital account controls to restrict capital outflows - a reflection of the PBoC's determination to maintain exchange rate stability. There is now an almost universal consensus that the U.S. dollar will strengthen further this year, and that the RMB will decline. It is of course foolish to blindly bet against consensus, but it also means shorting the CNH/USD has already become a very crowded trade. The sharp rebound of the CNH/USD a few days ago is a classic example of a market stampede where investors rush to a narrow exit when conditions change. All this has made the risk-return profile of shorting the RMB against the dollar unfavorable, as the PBoC, with its formidable resources, could unexpectedly hit back at any time. Indeed, the performance of the CNH/USD cross rate has closely tracked the broad U.S. dollar index over the past two years, a situation unlikely to change going forward (Chart 11). The bottom line is that the dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. For investors, shorting the CNH/USD is not much different from a direct bet on the dollar index. What To Do With Chinese Stocks? Chart 12Chinese Shares Valuation Perspective Chinese stocks will likely range-bound in the near term. The downside is limited by accommodative policy, stable/improving growth and depressed valuation, especially for H shares (Chart 12). The upside is capped by the ongoing macro concerns and brewing tension with the incoming U.S. administration. Chinese shares may also be vulnerable if the more frothy global bourses correct. Therefore, aggressive directional bet is not warranted in the near term. From a big picture point of view, however, we remain convinced that market concerns on China's macro conditions are overdone, and Chinese equities have been unduly punished. Investors with longer-term horizons should hold H shares. Strategically we favor Chinese equities over their global peers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations