Emerging Markets

Highlights Analysis on the Chinese property market is available below. In the Philippines, domestic demand is set to accelerate at the hands of the government’s fiscal boost. The current account deficit will widen and the peso and local bonds will likely sell-off. This warrants an underweight stance in this interest rate-sensitive bourse. A new trade: Pay 2-year swap rates. The outlook for China’s property market and construction activity is downbeat. Financial market plays leveraged to mainland construction activity remain at risk. The Philippines: The Cycle Is Turning The relative performance of Philippine equities against the EM benchmark is moving inversely to the direction of relative (Philippines minus EM) local bond yields (Chart I-1). When local Philippine bond yields drop versus those of other EMs, this bourse outperforms, and vice versa. Likewise, Philippine share prices in absolute terms exhibit a negative relationship with local bond yields (Chart I-2). The rationale behind this high sensitivity in share prices to local interest rates is the large presence of banks and property stocks in the Philippines' bourse. Banks account for 20% and real estate stocks another 21% of the local stock exchange. These sectors benefit in a falling interest rate environment and suffer during periods of rising rates. Chart I-1Philippines Vs. EM: Relative Stock Prices And Bond Yields Chart I-2Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Our underweight position in Philippine equities has not played out because the economy has slowed much more than we had expected, which has also coincided with collapsing US Treasury bond yields. Consequently, Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Chart I-3Philippine Growth Slowed Due To A Slump In Government Spending Chart I-4Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit The growth rate of the Philippines has decelerated markedly due to sharp slowdowns in both government spending and bank loan growth (Chart I-3). In fact, the combined bank loan and fiscal spending impulse has plunged, leading to a major slowdown in domestic demand, which in turn has stabilized the current account (Chart I-4). The latter effect has supported the currency and allowed the central bank to cut rates. A budget deadlock on a number of items delayed the approval of the 2019 budget, causing government spending to plunge in the first half of 2019. In short, it was unintended fiscal tightening that has wrong-footed our view on the direction of the macro cycle, and consequently Philippine financial markets. Government spending has been instrumental in driving fixed capital formation since President Rodrigo Duterte came to power in May 2016. Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Going forward, the macro cycle is set to reverse: Chart I-5Philippines: Signs Of A Growth Rebound Government expenditure will rise substantially – infrastructure spending in particular – lifting imports. The 2019 budget was approved back in April, and the House of Representatives has given the green light to extend the shelf-life of the current 2019 budget. Moreover, the fiscal 2020 budget, now approved by Duterte, entails 12% nominal growth in government expenditures in general and 14% growth in capital/infrastructure spending in particular. Duterte will oversee 100 flagship infrastructure projects estimated to cost 4.3 trillion Philippine pesos, or 24% of GDP. More than half of these projects are either ongoing or will commence construction in the next six to eight months. The larger infrastructure expenditure will encourage bank lending. Overall, domestic demand will revive considerably, causing the current account deficit to widen. Importantly, the expected fiscal boost will come on top of already strong consumer spending. The marginal propensity to spend among households and companies is already improving, confirming domestic growth acceleration (Chart I-5, top panel). In particular, both vehicle and machinery sales are recovering (Chart I-5, middle panel). Narrow and broad money impulses have bottomed (Chart I-5, bottom panel). Stronger imports amid still-depressed exports due to sluggish global demand will lead to a widening of the current account deficit. We expect the peso to resume its depreciation. Renewed currency weakness and a domestic demand revival will put a floor under inflation. The central bank is headed by Governor Benjamin Diokno, the former Budget Secretary and an associate of populist President Duterte. The odds are that the central bank will not hike interest rates in the face of a rising current account deficit and modestly rising inflation. This will reinforce currency depreciation. Finally, domestic bond yields are set to rise. A widening fiscal deficit has historically coincided with higher domestic bond yields (Chart I-6). Odds are it will not be different this time. Besides, Philippine banks have been relentlessly purchasing government bonds because credit demand from companies has been sluggish (Chart I-7). As private credit demand begins to recover and banks accelerate their loan origination, they will become net sellers – or will at least ease their pace of government bond purchases – pushing yields higher. Chart I-6Rising Fiscal Deficit Is Bad News For Bonds Chart I-7Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Bottom Line: Unintended fiscal tightening has slowed domestic demand, narrowed the current account deficit, supported the currency and induced a drop in local bond yields. This has allowed the Philippines’ interest rate-sensitive bourse to outperform the overall EM equity index. Going forward, the macro cycle is set to reverse. This cycle is about to reverse due to strong fiscal expansion: Domestic demand and imports will grow briskly, and the current account deficit will widen considerably. Widening twin deficits will lead to material currency depreciation and higher domestic bond yields. Investment Recommendations Continue shorting the Philippine peso versus the US dollar. 2-year swap rates are 48 basis points below the policy rate (Chart I-8). The market will price out rate cuts as the business cycle recovers and the currency depreciates. We recommend a new trade: pay 2-year swap rates. Dedicated EM fixed-income investors should underweight the Philippines in their EM domestic currency bonds and sovereign credit portfolios. Chart I-8The Market Is Expecting Rate Cuts Chart I-9Philippine Equity Market Is Not Cheap     Does an upcoming growth revival warrant an overweight stance in Philippine stocks within an EM equity portfolio? As shown in Charts I-1 and I-2, this equity market is more sensitive to interest rates than growth. The growth deceleration did not prevent this stock market from outperforming its EM peers. Hence, higher local bond yields amid renewed currency depreciation will likely lead to a period of underperformance. Finally, Philippine stocks are not cheap in absolute terms or relative to the EM benchmark (Chart I-9). Hence, they will not respond well to rising interest rates. Chart I-10Philippine Property Stocks Will Suffer As Interest Rates Rise Within this bourse, underweight/short property stocks. These stocks are the most vulnerable to rising bond yields (Chart I-10). The key risks to our strategy are lower global bond yields and continuous flows of foreign capital into EM assets in general, and local bonds in particular.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   China: Making Sense Of The Property Market Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2).  Chart II-2China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction   All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise.   Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1    The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature We spent the past two weeks visiting and exchanging views with our clients in Asia. We presented our view that the ongoing stimulus measures are beginning to bear fruit in terms of stabilizing China’s economic activity, and that we expect the economic slowdown to bottom early next year. In addition, Chinese policymakers are signaling their willingness to accelerate stimulus on both monetary and fiscal fronts, which should mitigate the downside risks and help the economy regain traction in 2020. Interestingly, our view sparked divergent responses: clients outside of China were more upbeat about the state of the Chinese economy than clients from mainland China.  While few investors we spoke to showed concerns over an imminent “hard landing” in China’s economy or systemic risk from China’s financial system, our mainland Chinese clients remain skeptical that the ongoing stimulus will be sufficient to revive the economy. They were also worried that financial regulations may be too restrictive to generate the amount of money growth needed for the economy. Another interesting observation was that while being pessimistic about the economy, our mainland Chinese investors share our assessment that Chinese domestic stocks still have some upside in the coming year. On the other hand, global investors, who are more sanguine about China’s economic recovery, prefer to wait on the sidelines before favoring Chinese investable stocks (Chart 1). Chart 1AA Tale Of Two Markets: Onshore Outperforms Global Markets... Chart 1B...While Offshore Underperforms Below we present some of the top questions that were posed by investors during our trip, along with our answers. We recap the conclusions of our view, and draw out the investment implications of the differences between the sentiments towards China’s equity markets, in the last question of the report. Q: Recent economic data suggests a weakening Chinese economy. Why do you think the economy will reach a bottom in 2020? Historically, China’s credit formation has consistently led economic activity by about three quarters (Chart 2).  Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start of 2019. This suggests that economic activity should turn around within the next two quarters. Chart 2Expecting A Turn In Q1 2020 Chart 3Emerging Green Shoots   Furthermore, despite weakening headline economic data, some underlying components indicate promising improvements (Chart 3): Growth in infrastructure investment has ticked up modestly in the past couple months, and is set to improve further. The State Council mandated local governments to allocate the proceeds from special-purpose bond sales to infrastructure projects by the end of October. This, combined with a frontloading of next year’s local government bonds, should lend support to infrastructure spending in the coming months. After fluctuating in and out of contraction for a year, growth in auto manufacturing production picked up in August and remained positive through October. This improvement is due to less contraction in auto sales and a faster reduction in auto inventories. Moreover, electricity output surged in October, which also indicates that growth may be gaining momentum. Chart 4Trade Should Improve Into 2020 Lastly, global financial conditions have eased significantly and credit growth has picked up worldwide, which should help support global demand. Even though Sino-US trade negotiations are ongoing, our baseline view is that a “Phase One” trade deal will be inked in the next couple months. Eased trade tensions and even some rollbacks in the existing tariffs on Chinese export goods, coupled with improved global demand, should provide some tailwinds to China’s external sector (Chart 4). Q: What is your outlook on China’s economic policy for 2020? The Chinese economic growth model remains reliant on credit formation and capital investment. Therefore, the sustainability of an economic recovery depends on whether Chinese policymakers are willing to keep the stimulus wheel turning. Chart 5A Sign Of A Policy Shift For investors favoring China-related assets, the good news is that there has been an increasing urgency in policymakers’ tone to support economic growth since September. Capex growth from state-owned enterprises (SOEs) has increasingly outpaced the private sector, which is significant:  A sustained rotation in the pace of SOE vis-à-vis private sector capex marked a turning point in the 2015-2016 cycle, when Chinese policymakers’ imperative to supporting growth outweighed their desire to continue with structural reforms (Chart 5).  We do not expect a 2016-style drastic rise in SOE capex growth next year, because the current economic slowdown is not as severe or prolonged as in 2015. Nonetheless, the rotation in capex growth is an important signal that Chinese policymakers may be more willing to stimulate the economy by again allowing the state sector to upstage the private sector. In the meantime, we expect that some pro-growth “policy adjustments” will be deployed in 2020: Chart 6Infrastructure Investment Likely To Rise Monetary policy will incrementally ease, with one to two 10-15bps loan prime rate (LPR) cuts in the next 3-6 months. At the same time, China’s central bank (PBoC) will keep bank liquidity ample and commercial banks’ funding costs relatively low, by continuing frequent liquidity injections to stabilize the interbank rate. A further cut in the reserve requirement ratio (RRR) is also highly likely. Keeping banks well capitalized will partially mitigate the pressure commercial banks face from falling profit margins and rising credit defaults. Accommodative monetary conditions will also support more stimulus on the fiscal front. We expect that the National People’s Congress in March 2020 will approve higher quotas on the issuing of local government bonds. Chinese state-owned commercial banks will continue to be the main buyers for local government bonds.  A portion of 2020 local government special-purpose bond issuance will be frontloaded to the remainder of 2019 and into the first months of next year. Relaxed capital requirements will likely boost local governments’ infrastructure project funding and expenditures. Our model suggests infrastructure spending should pick up from the current 3.3% year-on-year, to close to 7.5% in the second and third quarters next year (Chart 6). There are subtle signs that the government is starting to relax restrictions on the real estate sector. Land sales by local governments have increased since mid-2019, and the trend will continue into 2020 (Chart 7).  Income from land sales accounts for 70% of local government revenues, thus allowing more land sales should help fund a larger local government spending budget next year. Declining government subsidies to shantytown renovation (namely the Pledged Supplementary Lending, or PSL) have recently abated and will likely continue to improve (Chart 8). Chart 7Some Improvement To Come In The Real Estate Sector Chart 8Government Subsidies Will Continue   December’s Central Economic Work Conference (CEWC) will set policy priorities for the following year. We think Chinese policymakers will make economic growth a top priority for 2020. Credit growth swelled in the first quarter of 2019 following the December 2018 CEWC, and we expect a surge in early 2020 as well.Due to the unusually high credit growth in January this year and the seasonal factor next year (Chinese New Year will fall in January 2020), the surge in credit growth, on a year-over-year basis, will more likely be muted until towards the end of the first quarter and into the second quarter. Investors should overweight Chinese investable stocks in the next 6-12 months, but need to watch for more positive signs to upgrade tactical stance. Beyond the second quarter, however, the outlook gets cloudier as tension from the US election heats up and President Trump may change his trade negotiation strategies with China.1 This may have implications on China’s domestic policies. But for now, our baseline view is that Chinese policymakers will incrementally accelerate the pace of economic stimulus throughout next year. Q:  Monetary policy has been accommodative for more than a year, but capex this year has fallen below market expectations compared with past cycles. How will further stimulus help to revive investment and economic growth next year? In short, our answer is this: interest rate cuts alone will not be enough to boost economic growth in China. Capex, and growth more generally, will only revive through synchronized policy support from the Chinese authorities. In a previous report2 we discussed that the lack of response to monetary easing has been due to a less effective monetary policy transmission mechanism, a reactive and reluctant central bank, and a debt-loaded corporate sector. More importantly, the “half-measured” stimulus has been preferred by Chinese authorities in this cycle, as they prioritized financial de-risking over growth and have significantly tightened financial regulations since 2016. Given the expected policy pivot to a more pro-growth stance in the coming year, the following underlines our conviction that capex should pick up in 2020.  Modern Money Theory (MMT), with Chinese characteristics:3 local governments will ramp up debt again, and this quasi-fiscal stimulus will be a key support to the economy in 2020. During the 2015-2016 cycle, aggressive interest cuts did not result in a significant uptick in credit growth. Bank lending was not the core driver for economic recovery in 2016. The economy only bottomed following an unprecedented issuance of local government bonds after mid-2015 (Chart 9).  Chinese authorities will keep a “back door” open: even though overall tight financial regulations will remain intact, we expect the PBoC to allow a more moderate contraction in shadow banking (Chart 10). This will provide smaller banks and enterprises access to tap into bank credit. Importantly, this means the government will acquiesce to local governments in providing extra funding through shadow banking. We already see local government financing vehicles (LGFV) making a comeback in recent months. Chart 9A Chinese Version Of MMT Chart 10The "Back Door" May Open Wider     Small- and medium-sized enterprises (SMEs) will benefit from lowered financing costs through the new LPR system. As we pointed out in our previous report,4 the new LPR regime is not intended as much to expand bank credit as to help struggling SMEs survive economic hardships. This, along with tax cuts, should provide SMEs some relief from capital constraints. Q. CPI has been rising sharply and is above the government’s inflation target of 3%. Will inflation prevent the PBoC from maintaining an easy monetary policy? Chart 11PBoC Likely To Capitulate To Producer Deflation No. We think deflationary pressure in the industrial sector (measured by producer prices) poses a bigger threat to the economy, and that PBoC is more likely to loosen monetary policy than to tighten (Chart 11). Chart 12 shows that the recent surge in headline consumer prices has almost been entirely driven by soaring pork prices. There is compelling evidence from historical data that, unless core consumer price inflation also rises, climbing food prices alone will have a limited impact on PBoC policy (Chart 13). We think this approach is justified, as the necessity of “core feedthrough” is also what most central banks in the developed world look for when confronted with a detrimental supply shock. Chart 12Rising Pork Prices Have Driven Up Headline Inflation... Chart 13...But Won't Be Driving Up Interest Rates Chart 14A Wild Year For The RMB Core CPI has been trending downwards since February 2018, and there is no evidence to suggest that food prices will drive up core CPI inflation (Chart 13, bottom panel).  This, in combination with deflating producer prices, means that the probability of tighter monetary policy over the coming 6-9 months is extremely low. In fact, we expect, with high conviction, that the PBOC will guide the LPR lower in the coming months. Q: What is your view on the RMB for 2020? The RMB depreciated by 5% against the US dollar from its peak in February this year, mostly driven by market expectations of US tariffs imposed on Chinese export goods. Interest rate differentials, short-term capital flows, and economic fundamentals all have played much smaller roles in the RMB’s value changes (Chart 14). The depreciation in the CNY/USD this year has pushed the RMB close to two sigma below its long-term trend (Chart 15). As we expect a “Phase One” trade deal to be signed and trade tensions abating at least in the near term, the RMB will face upward pressure through the first half of 2020. The appreciation will also be supported by, although to a lesser extent, China’s improved domestic economy, rising demand for RMB-denominated assets, and a weakening US dollar (Chart 16). According to our model, the USD/CNY exchange rate can return to a 6.8-7.0 range, if a significant portion of the existing tariffs is rolled back (Chart 17).  This range seems to be within the “fair value” of the RMB, justifiable by the current China-US interest rate differential (Chart 14, bottom panel). Chart 15Has The RMB Gone Too Far? Chart 16Demand For RMB Assets On The Rise, Despite The Trade War However, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors.  The large differential in the China-US interest rates would allow PBoC to cut interest and/or RRR rates, to ease upward pressure on the RMB.   Chart 17Tariff Rollbacks Will Push Up RMB   Q: How should equity investors position themselves towards China over the coming year? We are bullish on Chinese investable stocks in the next 6 to 12 months, based on our view that the Chinese economy will bottom in the first quarter next year, policy will be incrementally more supportive, and a “Phase One” trade deal will be signed soon. In the very near term, however, we think downside risks to Chinese equities are not trivial. We remain a neutral tactical stance, but will continue to watch for the following signs before upgrading our tactical call from neutral to overweight.5 Chart 18A (top panel) shows that cyclical stocks remain very depressed relative to defensives, underscoring investors’ lack of confidence in the Chinese economy and trade negotiations. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards Chinese economic growth. An uptick in the relative performance of industrials and consumer staples (Chart 18A, bottom panel). The negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance between the two sectors may be a reflationary barometer for China’s economy. The relative performance trend remains off its recent low, which suggests that China’s existing policy stance has not yet turned more reflationary. A technical breakdown in the relative performance of healthcare and utility stocks (Chart 18B) would also be a bullish sign. Investable health care and utilities stocks have historically led China’s economic activity, core inflation and stock prices by 1-3 months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a bottom in China’s economy. As we mentioned at the outset, we observed an interesting divergence in sentiment among our domestic versus global investors. This divergence is reflected in both the onshore and offshore stock markets; year to date, onshore A shares have outperformed global benchmarks by 5.6% (Chart 1, on page 1 of the report). Chart 18AWaiting For A Telltale Sign... Chart 18B...Before A Tactical Upgrade However, all of the outperformance in A shares occurred before end April, when the trade talks broke down and domestic credit expansion significantly slowed from the first quarter. Since May, the relative performance of A shares in US dollar terms has been mostly flat, reflecting the fact the markets were not expecting a significant stimulus forthcoming.  Chinese investable stocks, on the other hand, have been trading heavily on the day-to-day news surrounding the trade negotiations and have significantly underperformed both domestic A shares and global benchmarks. Therefore, our base case view of a trade truce coupled with an improved Chinese economy and more supportive policy near year, warrant a cyclical overweight stance favoring Chinese investable stocks over their domestic peers. Earnings from both onshore and offshore markets will benefit from a modest improvement in economic activity, but we think the investable market will benefit more from the trade truce and more upside growth potential. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see Geopolitical Strategy Special Report, "Is China Afraid Of The Big Bad Warren?" dated October 25, 2019, available at gps.bcaresearch.com 2Please see China Investment Strategy Weekly Report, " Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10 2019, available at cis.bcaresearch.com 3We call it a “MMT” because China’s state-owned commercial banks own approximately 80% of local government bonds. The commercial banks are essentially backed by China’s central bank, which has a fiat currency system and can make independent monetary policy decisions. 4Please see China Investment Strategy Weekly Report, "Mild Deflation Means Timid Easing," dated October 9, 2019, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report, "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Saudi Aramco likely will IPO 1-2% of the company next month on its local bourse; retail investors reportedly will get up to 0.5%. The IPO will value Aramco within a range estimated at less than $1 trillion to more than $2 trillion. China’s interest in Aramco goes back almost four years to when the IPO was first proffered. It reflects an economic and geopolitical calculus encompassing more than an equity claim on the world’s largest, lowest-cost, most profitable oil company. Investing in Aramco gives it a stake in producing oil it desperately needs at home – as its imports from KSA attest – and supports its goal of filling some of the power vacuum left by the US pivot away from the Middle East (Chart of the Week). For the Kingdom of Saudi Arabia (KSA), stronger ties with China will ground its Asian marketing efforts, and deepen China’s stake in the unimpeded flow of its exports. With tensions in the Gulf remaining high, this is crucial. In addition to the mutuality of KSA’s and China’s interests, “patriotic participation” by Saudi investors will help push Aramco’s valuation close to $2 trillion. A post-IPO let-down – not unusual by any stretch – is likely. Feature Chart of the WeekChina’s Oil Production Stagnates, While Imports From KSA Surge Dear Client, This week, BCA Research’s Geopolitical Strategy and Commodity & Energy Strategy explore the Saudi Aramco IPO scheduled for next month and its larger implications for the global economy. In keeping with our tradition, we take a multidimensional approach – financial, economic and geopolitical – consistent with our unique analytical endowment. We trust you will find this report’s approach and analysis useful in shaping your convictions. Matt Gertken and Bob Ryan The Kingdom of Saudi Arabia (KSA) is in an all-out sprint to diversify its economy away from a near-total dependence on oil exports by 2030 (Chart 2). Time is short. The IPO of Saudi Aramco is the sine qua non of this effort, as it will fund the investment required to effect this transformation’s ambitious goals (Table 1, Chart 3). Investing in KSA’s production and refining capabilities is attractive to China. Table 1Vision 2030 Highlights Chart 2Breaking Oil Dependency... China is engaged in an all-out effort to become self-sufficient in oil and gas production, given the vulnerabilities in its hydrocarbon-supply chain.1 Chart 3...Drives KSA's Vision 2030 Local oil-industry executives doubt this is even remotely attainable, which is one reason we believe investing in KSA’s production and refining capabilities via the Aramco IPO is so hugely attractive to China. It helps explain why policymakers sanctioned an investment of up to $10 billion in the IPO by various state-owned enterprises and funds.2 Given our expectation the IPO will value Aramco closer to $2 trillion than not, a 1-2% float would amount to between $20-$40 billion, meaning China – via its state-owned Silk Road Fund, Sinopec Group and China Investment Corp., et al – could account for as much as a quarter of the IPO if it prices out as we expect, and these state-owned investors pony up the full $10 billion being discussed in the press.3 Aramco’s Red Herring Released November 9, the Aramco Red Herring is as interesting for what it includes as what it leaves out.4 In the first six months of this year, Aramco production amounted to 13.2mm b/d of oil equivalent, 10.0mm b/d of which was crude oil and condensates. This was down slightly from the 13.6mm b/d of oil equivalent produced last year. The company notes that in 2016-18, it accounted for 12.5% of global crude output, and that its proved liquids reserves were “approximately five times larger than the combined proved liquids reserves of the Five Major IOCs,” or independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world (Chart 4). For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Investors will not know how that translates to a dividend yield until the actual number of shares floated is known. Chart 4Aramco Profitability Is Huge Chart 5Aramco Absorbs Most Of OPEC 2.0’s Production Cuts, Outside Iran, Venezuela The Red Herring foresees a compound annual growth rate in demand for the Kingdom’s oil, condensate and natural-gas liquids output of 0.9% p.a. between 2015 and 2025. Demand growth is expected to level off some time around 2035. In this baseline scenario, Aramco sees itself gaining market share globally over this period. In an alternative scenario, the company notes that if there is “a more rapid transition away from fossil fuels,” which sees demand for its hydrocarbons starting to decline in the late 2020s, “the Kingdom’s share of global supply is also expected to increase through 2050.” Saudi Arabia and Russia are the putative leaders of OPEC 2.0, the producer coalition formed at the end of 2016 to manage global oil supply growth, following a market-share war launched by OPEC in 2014. The coalition has an agreement in place to keep 1.2mm b/d of production off the market until the end of 1Q20. The Kingdom, via Aramco, has been shouldering the lion’s share of OPEC 2.0’s production restraint, outside of Iran and Venezuela, which have seen their production and exports slide due to US sanctions (Chart 5). On Wednesday, KSA informed OPEC (the original Cartel) the IPO of Aramco would not affect its commitments under the OPEC 2.0 deal.5 The IPO Will Bring KSA And China Closer China has been keen to invest in Aramco since the IPO was first floated almost four years ago. This reflects an economic and a geopolitical calculus encompassing more than simply securing an equity claim in the world’s largest, lowest-cost, most profitable oil company. An Aramco investment gives China a stake in producing oil it critically needs at home. China’s oil demand has been growing while its domestic production has been stagnating for the most part, despite the new-found emphasis on becoming self-sufficient. This is reflected in surging imports – totaling just over 10mm b/d in September, an 11% increase over August levels. China’s oil demand is expected to grow ~ 3.5% this year and next, averaging ~ 14.8mm b/d. China National Petroleum Corp. (CNPC) estimates China’s oil demand will peak in 2030 at 16.5mm b/d.6 China’s vulnerability to oil imports – caused by its rising import dependency and US maritime supremacy – has prompted President Xi to order increased exploration and production domestically. The trade war and US sanctions on Iran and Venezuela – two long-time crude-oil suppliers to China – drove this point home: Imports from Iran fell 46% y/y in the January – September period to 357k b/d, while imports from Venezuela fell 15% to 306k b/d.7 For its part, KSA views China as one of its primary growth markets, as its Red Herring attests. It will be investing in additional refining capacity there and view the market as key to its petchems growth. “The Company’s strategy is to continue increasing its in-Kingdom refining capability and expand its strategically integrated downstream business in high-growth economies, such as China, India and Southeast Asia, while maintaining its current participation in material demand centers, such as the United States, and countries that rely on importing crude oil, such as Japan and South Korea.” Both KSA and China would benefit from deeper economic engagement. Net, both KSA and China would benefit from deeper economic engagement, which the IPO will foster. It is not inconceivable representatives from Chinese state-owned or –affiliated entities could sit on Aramco’s board, which would provide even “greater assurance over its crude oil and refined product supplies going forward,” as we noted in a Special Report published in November 2017.8 This is a critical concern for China, with domestic production stagnating and demand for crude oil, refined products and petchems increasing. Evolution Of China’s Middle East Role While China’s involvement in the Middle East has steadily been growing in energy, trade and investment generally, it has espoused “a vision of a multipolar order in the Middle East based on non-interference in, and partnerships with, other states – one in which the country will promote stability through ‘developmental peace’ rather than the Western notion of ‘democratic peace’,” according to a recent paper from the European Council on Foreign Relations.9 China’s growing interest in the Middle East is fundamentally supportive of the Gulf Arab reform agendas. But geopolitical risk is still elevated in this region (Chart 6), especially over the one- to three-year time frame. This is primarily due to the far-from-settled conflicts between the US and China and the US and Iran. First take the US-China conflict as it pertains to the Middle East. As China’s economy has boomed, so has its import dependency. Over the past two decades Beijing's reliance on Middle Eastern crude oil has ballooned (Chart 7). The result is a deep strategic vulnerability for China. Economic and political stability depend on sea lanes that are, from China’s perspective, implicitly threatened by the United States and its allied maritime powers. Chart 6Geopolitical Risk Is Elevated In The Middle East Chart 7Beijing's Reliance On Middle Eastern Oil Has Ballooned Hence Beijing has devoted ever greater efforts over the past two decades to building a blue-water navy charged with securing its “lifeline” running from the Persian Gulf through the Strait of Malacca and the South China Sea to China’s hungry coastal cities (Map 1). This naval development is a disruptive process, as the US, Japan, Australia and others are seeking to maintain control of the Indo-Pacific seas along with China’s rivals like India. Map 1The Belt And Road Program Until recently, Beijing proceeded carefully in order not to galvanize efforts to oppose its growing influence. It has only timidly begun establishing forward military bases abroad — namely in Djibouti, Africa — and its activity at key civilian ports such as Gwadar, Pakistan, and Hambantota, Sri Lanka, is developing only gradually. The creation of a new “maritime Silk Road” is a long, drawn-out affair. However, slowly but surely Beijing aims to lessen its vulnerability to the US at strategic chokepoints like Malacca and the Persian Gulf. The US and allies will respond — and this will generate geopolitical risk. Thus naval conflict is a persistent “Black Swan” risk. China’s chief obstacle is America’s strategic dominance in the region. Second comes the US-Iran conflict as it pertains to China. In response to US sanctions against Iran, China has had to increase its oil imports from Arab Gulf states. Beijing — inherently a continental power — is seeking overland routes of trade and investment to acquire Siberian, central Asian, and Middle Eastern resources, which cannot be interdicted by the US. Hence the Belt and Road Initiative (BRI). US Still Limits China’s Middle East Options The BRI is the umbrella term for a process that began in the 2000s. China recycles its large current account surpluses into land and resources in the rest of Asia so as to maximize supply lines and diversify its savings away from US Treasurys (Chart 8). This is also a way for Beijing to export its industrial overcapacity, particularly in construction. This BRI process faces an important limitation in that Beijing’s current account surpluses have drastically declined (Chart 9). Even so, this decline will result in greater concentration on strategic targets. The Middle East is vital both because its energy could someday be accessed overland and because it could serve as an export market in itself. It could also become a way-station for greater trade to Europe and all of Eurasia. Chart 8China Is Diversifying Its Savings Away From US Treasurys Chart 9China's Falling Current Account Surplus Limits BRI Investments The instability of BRI countries delays China’s plans for regional investment, construction, transportation, and logistics. And China lacks the appetite for overseas political and military intervention necessary to shape the domestic environment in the relevant countries — especially given that the US remains the dominant power. China’s limited agency in Iraq is case in point. It is even severely limited in allied countries like Pakistan. And it has rocky relations with some of the key regional powers, such as Turkey. Chart 10 Yet the chief obstacle is America’s strategic dominance in the region and specifically its conflict with Iran. US foreign policy keeps Iran isolated and frequently forces China to impose sanctions. Since the Trump administration imposed “maximum pressure” on Iran, in May 2019, Beijing has drastically reduced oil imports and withdrawn from the $5 billion South Pars natural gas project (Chart 10). This was partly prompted by Washington’s use of secondary sanctions that threatened to cripple China’s leading tech companies for violating Iranian sanctions. Iran’s inability to open up to the outside world prevents China from fully executing its broader overland strategy. China is not yet capable of confronting Washington over Iran. The 2020 US election is therefore a critical juncture — the re-election of the Trump administration would likely prolong the current conflict with Iran. It is unlikely to lead to full-scale war, but that scenario cannot be fully ruled out given Trump’s lack of constraints in a second term. Whereas a new Democratic administration would almost certainly return to the Obama administration policy of détente with Iran, aimed at containing the country’s nuclear program in exchange for economic opening. Either way, Beijing faces a multi-year period in which it must prepare for US pressure on the high seas and possibly also in Iran. GCC’s Attraction To China The above considerations provide a clear reason for Beijing to deepen its relations with the Gulf Arab states, particularly Saudi Arabia and the UAE. These states are increasingly attracted to China not only as an energy customer and investor but also as a provider of high-tech goods, arms, and telecom equipment that is necessary for their productivity and useful for their surveillance and repression of domestic dissent. Deepening its trade relationship with KSA via a meaningful equity position in Aramco would present the perfect opportunity for China to take a meaningful step toward establishing the yuan as a global reserve currency. If KSA and the other GCC states begin accepting yuan as payment for their oil and products, and they begin spending their yuan on Chinese-made goods and services, two-way trade could expand significantly and rapidly. The RMB doesn’t have to be fully convertible to USD or euros for that to happen. Such a yuan-trading bloc would encompass oil and refined products, natural gas and liquids, and goods and services made in the GCC and China. This bilateral trade would provide a base from which to build out the yuan as a global reserve currency. This would neither be a forced evolution nor a hurried one. It would naturally evolve, which would ensure its durability. The US may attempt to prevent China from gaining influence in this way, but that would require a concerted effort. And such an effort is not likely to develop until 2021 or 2022 at the earliest. It will depend on the US election outcome, the 2020-24 administration’s foreign policy, and US-China negotiations. Hence China’s evolving role is positive for its supply security as well as for the reform agendas of the Gulf Arab states as they attempt to shift away from oil dependency. The problem is that China cannot ultimately guarantee the stability of the Arab states while they reform. China and Europe are energy importers that require stability in the Mideast, while Russia and increasingly the US are energy producers that can take actions to destabilize the region — the US by partially withdrawing, Russia by reinserting itself. Chart 11US Reducing Commitments In The Middle East True, the US still broadly shares with China the desire for stable oil prices — but its growing energy independence gives it the ability to reduce its commitments, upset the status quo, and create power vacuums that are detrimental to stability until a new regional equilibrium is established. Both the Obama and Trump administrations have demonstrated this erratic tendency (Chart 11). Russia has gotten closer to China, but it also is regaining strategic influence in the Middle East and has an interest in keeping the region divided and unpredictable. This is advantageous for an oil exporter outside the region with direct overland access to the Chinese market, but not advantageous for China. The above situation encapsulates the Geopolitical Strategy theme of multipolarity, or great power competition. The Middle East is in transition and the US strategic deleveraging ensures there will not be a stable order in the near term. Chinese investment can increase the region’s economic diversification, productivity, and potential GDP. But China’s financial limitations, US foreign policy, Russian foreign policy, and the region’s chronic instability will jeopardize those positive effects. Bottom Line: China’s influence in the Middle East is growing, particularly with the Gulf Arab states. However, this process exists within the context of competition with a number of other powers, ensuring that the Gulf Arab states still face extreme uncertainty and instability in attempting to reform. The US election is a critical juncture for US policy toward Iran and hence for the Mideast and China. While the US conflict with China will wax and wane across future administrations, the 2020 election will determine whether the US conflict with Iran gets better or worse in the next 1 – 3 years. Ultimately, we would expect the US to focus on pressuring China. But its latent strength in the Middle East is a tool for doing so. China’s growing role in the region will not ensure stability.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1High Anxiety: The Trade War and China’s Oil and Gas Supply Security, by Dr. Erica Downs, provides an excellent analysis of President Xi Jinping’s all-out drive to make China self-sufficient in oil and gas. It was published by Columbia University’s Center on Global Energy Policy November 12, 2019. The drive toward oil and gas self-sufficiency is described in local media as a war, as Dr. Downs notes: “In August 2018, (China National Petroleum Corp.) leaders met to discuss Xi’s directive and agreed to launch a ‘major offensive war’ on domestic exploration and development to enhance national energy security.” 2 Please see Chinese state firms mull up to US$10 billion investment in Saudi oil giant Aramco’s IPO published by the South China Morning Post November 7, 2019. The article also notes the Russian Direct Investment Fund also is considering taking a stake in the IPO. 3 $2.27 trillion is the upper end of a range generated by Bank of America. Please see Some banks dealing with Saudi Aramco IPO say company may be worth $1.5 trillion or even less, published by The Japan Times November 4, 2019, for additional estimates from banks involved in the deal. 4 The company’s 658-page prospectus also details business risks including terrorism, the attacks on Abqaiq and Khurais, and market-related financial risks. Not included is the size of the float – presumably that will be sized based on bids received – and how much of it will be allocated to individuals vs. institutions, who will be bidding for shares from November 17th to the 28th, and from the 17th to Dec. 4, respectively, when the issue is expected to price. The shares could be trading on December 11, 2019, on the Saudi stock Exchange, the Tadawul. No mention is made of a listing on an international exchange – e.g., London, Hong Kong, Tokyo, New York. 5 Please see OPEC says Saudi gave assurances Aramco IPO won’t affect commitment to group deals published November 13, 2019, by uk.reuters.com. 6 Please see Glimpses of China’s energy future, published by The Oxford Institute For Energy Studies in September 2019. The Institute summarized CNPC’s 2050 outlook to derive these estimates. 7 Please see footnote 1 above. 8 Please see ضد الواسطة , an Arabic phrase meaning “Against Wasta,” a practice that roughly translates as reciprocity in formal and informal dealings. This Special Report was published November 16, 2017, and is available at ces.bcaresearch.com. 9 Please see China’s Great Game In The Middle East, published by the European Council on Foreign Relations in October. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations