Emerging Markets
Dear Client, Owing to BCA’s 40th Annual Investment Conference at the Grand Hyatt in New York City next week, there will be no report on Wednesday, September 25. We will return to our regular publication schedule on Wednesday, October 2. I look forward to meeting China Investment Strategy clients in person at our conference. Please do not hesitate to say hello. Best regards, Jing Sima China Strategist Highlights China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in the coming few months if the economy slows further, but policymakers will be reactive rather than proactive. Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy. Over a 6-12 month time horizon, investors should continue to overweight Chinese stocks versus the global benchmark in currency hedged terms, but the risk of further underperformance over the near-term is high. Feature Chinese economic growth continues to weaken. The Caixin manufacturing PMI for August, along with the New Export Orders component of the manufacturing PMI released by China’s National Bureau of Statistics, registered small gains in August from July. However, any hopes pinned on this being an emerging sign of turnaround in the Chinese economy soon faded. A slew of August data showed continued sluggishness in exports, an even worse domestic-demand picture, and further deflation in ex-factory producer prices. Most importantly, we continue to witness “half-measured” stimulus. In explaining past and existing economic weakness, many investors point to the trade war with the U.S. However, Charts 1 and 2 serve as an important reminder that domestic weakness predates U.S. protectionism. The trade war tensions and tariffs are magnifying this weakness, but China’s slowdown is, at its core, policy driven. Chart 1Weakness In Chinese Economy Predates The Trade War... Chart 2…And Has Been A Byproduct Of Financial De-Risking Campaign Given this, investors should be more focused on identifying signs of a major reversal in policy. So far Chinese policymakers have been firmly holding their line in keeping credit growth somewhat in check. Policy-Induced Economic Stabilization: A Tough Forecast To Make Our baseline view is that the current scale of stimulus should be sufficient to stop economic growth from decelerating further. Two factors support our baseline view: The direct impact from tariffs on the Chinese economy is limited. Growth in China’s exports to the U.S. in 2019 is likely to be somewhere close to a 9% contraction, down from the 10.8% increase registered in 2018. Based on a simple calculation with all else being equal, this is likely to shave 1.6 percentage points off China’s total export growth and 0.3 percentage points off nominal GDP growth in 2019. This is not trivial, but arguably not devastating to China’s aggregate economy either. There is anecdotal evidence suggesting some Chinese exports have been re-routed to peripheral countries such as Vietnam and Taiwan in order to avoid the U.S. import tariffs on Chinese goods (Chart 3). This suggests that real growth in Chinese exports to the U.S. could be stronger than the current data suggests. Chart 3Exports Finding Alternative Routes? Chart 4Bottoming in the economy In Sight? Credit growth has picked up since the beginning of this year. Based on the historical relationship between China’s credit impulse (measured by the 12-month change in BCA’s adjusted total social financing as a percentage of nominal GDP) and domestic demand, the economy should bottom out at some point before the end of the year (Chart 4). Although, import growth, a key measure of China’s domestic demand, remains in deep contraction, some of its components that usually lead industrial activities are showing signs of improvement (Chart 5). Chart 5Early Signs of Improved Domestic Demand Chart 6Manufacturing Investment Growth In Contraction However, our level of confidence that the existing stimulus will be sufficient to stabilize economic growth is lower than it otherwise would be. This is due to the fact that the challenges facing the Chinese economy are unprecedented in nature. For one, the indirect impact of the trade war on China’s economy through business sentiment and manufacturing investment has yet to be fully revealed in the data. As Chart 6 shows, manufacturing investment is already deteriorating, particularly in export-intensive sectors. The ultimate impact on investment from the trade war is still uncertain, and can pose significant downside risks to the Chinese economy in the coming year. More importantly, as Chart 7 suggests, a weak credit impulse will at best lead to a very subdued economic recovery even if growth does indeed bottom. In terms of the link between policy and the economy, Chart 8 points out a key difference between the current slowdown and previous down cycles: Monetary conditions have been ultra-loose for more than a year, but current economic conditions remain on a downward trend – much more so than in the previous cycles. This huge gap and lag in economic response to monetary stance can only be explained by an impaired policy transmission mechanism. An expansionary monetary stance has not proportionally translated into credit expansion or economic recovery. This challenges the effectiveness and timeliness of future monetary loosening in terms of its ability to revive the Chinese economy. Chart 7Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Chart 8An Impaired Monetary Policy Transmission The scale and timing of the current stimulus measures have been “behind the curve.” Therefore, the historical relationship between China’s credit impulse and the turning points in the economy may not apply to the current cycle. Bottom Line: China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. An Unusually Prudent Policy Bias For some, the recent slew of announcements on upcoming stimulus qualified as a major shift in policy bias. Our analysis suggests otherwise. The bank reserve requirement ratio (RRR) cuts announced late in August have been among the most cited policy announcements, with the PBoC stating that the new cuts will release RMB 900 billion of fresh liquidity.1 In our view, this measure is more about maintaining liquidity in China’s large commercial banks than adding to it (on a net basis). Chart 9RRR Cuts May Not Be That Stimulative Chart 9 shows that, in previous episodes of meaningful RMB depreciation against the U.S. dollar, in order to prevent the RMB from falling at an undesirable pace, PBoC has had to intervene in the spot market by selling U.S. dollars. The selling of U.S. dollars in this round of RMB depreciation has been much more muted than in 2015-2016, but we suspect some intervention has taken place following each bout of escalation in the trade war. This has had a liquidity tightening effect on banks, as selling central bank foreign-exchange reserves reduces liquidity in the banking system. It is very likely that following the PBoC’s defense of the RMB in the last two months, the RRR cuts were a measure aimed at preventing a liquidity crunch ahead of the September tax season. If true, this hardly qualifies as net new stimulus for the economy. There were also two important announcements that came out of the September 5th State Council meeting: The entire 2019 quota for local government special project bonds must be issued by the end of September, and all money raised from the bonds must be disbursed to projects by the end of October. This too is not exactly “stimulative,” as over 90% of the 2019 local government special-project bond quota has already been issued. This leaves less than 10% of the quota outstanding, an 80% decline from what was issued last September. On a quarterly basis, special-bond issuance in the third quarter of 2019 will end up being 30% lower than the same period last year. It was also announced that, in order to meet the local needs for construction of key projects, part of 2020’s special bonds quota will be allocated in advance to ensure that the funds are available for use at the beginning of next year.2 While the announcement did not indicate how much in the way of special-purpose bonds local governments are allowed to frontload through the remainder of this year, we maintain our view that this is not a policy shift towards materially larger stimulus than we have seen so far this year: Without an additional quota, local government special-purpose bond issuance would essentially fall to zero in the fourth quarter as the 2019 target would be hit by the end of September. Thus, the frontloading of next year’s bond issuance will only “fill the gap” between now and year-end. As special-purpose bond issuance only accounts for 15% of total funding for local governments’ infrastructure spending, the new measure alone is unlikely to meaningfully accelerate investment growth.3 We have noted in previous reports that in order for local governments to accelerate spending within the current fiscal budget framework, one of three things must occur: more direct funding from the central government, an acceptance by policymakers of more shadow bank lending, or a larger quota for bond issuance. So far we have not seen any of the above-mentioned shifts in policy. Chart 10Local Governments Tightening Belt This Year The only positive sign for local government spending has been a pickup in land sales in Q2, which makes up more than 70% of local government revenues. But, it is far from making up the shortfalls in local governments’ budgets (Chart 10). Local governments are facing considerable fiscal pressure as annual tax revenue growth has fallen to near zero. Critically, the government’s regulatory stance on local government budgets has continued to tighten: Local governments have been ordered by the Ministry of Finance to liquidate state-owned assets to fund their budget deficits this year.4 This austerity measure is also being met with explicit reiteration from the Ministry of Finance on the central government not bailing out local governments, and that local government officials are held responsible for their own borrowing and spending.5 Bottom Line: Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in early 2020 if the economy slows further in Q4, but policymakers will most likely continue their reactive approach rather than proactive. RMB Depreciation: A Plus Or Peril? The RMB’s renewed depreciation since August initially raised fears among global investors that an uncontrolled decline might occur, but these fears have subsided over the past several weeks. Even though the USD-CNY exchange rate has broken the psychological 7 threshold, it is not forming a linear downward trend. Unlike after the August 2015 devaluation, it appears that the PBoC can successfully enact countercyclical measures to guide the RMB’s value higher following each large depreciation (Chart 11). Chart 11PBoC Not Panicking Over RMB Depreciation Fears of uncontrolled capital outflows following the depreciation are also abating. We presented a dashboard for monitoring short-term capital outflows from China in our March 20 Special Report,6 and an update of these indicators suggests that China’s heightened capital controls are holding – i.e., outflows have not escalated as they did in 2015 (Chart 12). Chart 12No Major Capital Outflow Chart 13RMB Depreciation Partially Offsets Tariffs Thus, the conclusion is that Chinese policymakers appear to be in control of the currency. The reduced risk of an uncontrolled decline has allowed policymakers to (passively) provide meaningful stimulus to the domestic economy via depreciation. Indeed, the RMB has not only depreciated against the USD, but also against many Asian currencies including direct trade competitors such as Vietnam and Taiwan (Chart 13). This is helping offset the negative impact of U.S. tariffs on Chinese exporters. But currency devaluation can come with a price tag – in particular for corporations that have borrowed heavily in U.S. dollar-denominated debt. We estimate that $440 billion of U.S. dollar debt will be maturing over the coming two years, for Chinese companies and banks in the aggregate.7 A 12% depreciation in the RMB since April 2018 means that debt servicing costs will be 12% higher for unhedged debtors. This is particularly painful for real estate and financial services companies, two of the largest holders of U.S. dollar-denominated loans, and the weakest sectors in the current economic downturn. Most importantly, while currency devaluation ease the slowdown, it cannot be counted on to stabilize Chinese economic activity on its own. For example, while our earnings recession model suggests that the decline in the RMB since May has reduced the odds of a major decline in economic activity by roughly 20%, the model also shows that such an event is still highly probable (current odds are roughly at 70%). Bottom Line: Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy if a further slowdown occurs. An Update On Corporate Earnings Against a backdrop of what may turn out to be insufficient policy support, the earnings picture is providing one modest positive for equity investors. While the growth rate in investable earnings per share has slowed significantly over the past year (Chart 14), it has merely fallen to zero and not deeply into negative territory, as what seemingly occurred in 2015-2016. In our view, the risk of a similar collapse in earnings per share (EPS) has been an important factor weighing on Chinese investable equities’ relative performance since June 2018. In reality, a closer examination of MSCI China Index earnings reveals that a huge decline in EPS this year was never really a threat, because the apparent collapse in 2015-2016 did not actually transpire. Changes to the composition in the MSCI China Index that took effect in November 2015 and June 2016 had the effect of depressing index EPS, due to the sizeable inclusion of a set of richly valued stocks. Chart 15 presents BCA’s calculation of “break-adjusted” EPS for Chinese investable stocks, which shows that EPS growth bottomed out at -10% in late-2016, as opposed to the -28% implied by the unadjusted series. Chart 14Investable EPS Has Yet To Contract Meaningfully Chart 15The Potential Downside For Earnings Is Less Than Many Fear Chart 16A Cyclical Recovery In Earnings Has Not Yet Begun The existence of less downside potential for earnings is certainly positive for investable stocks at the margin, but it does not alter the outlook for equity fundamentals over the coming year. We have shown in several previous reports that there is a strong and reliable link between investable EPS growth and China’s coincident economic activity,8 and the continued slowing in the latter does not suggest that a bottom in earnings is imminent. In addition, Chart 16 highlights that while net earnings revisions have recovered from their early-year lows, they remain in negative territory and have stopped rising over the past few weeks. Twelve-month forward EPS momentum, also presented on a break-adjusted basis, is modestly negative, and has recently weakened (panel 2). Bottom Line: The downside risk to earnings for Chinese investable equities is less than many investors fear. But absent stronger credit growth, it remains too early to confidently project a cyclical earnings recovery. Investment Conclusions The historical relationship between credit growth and economic activity suggests that the latter should soon stabilize, which is our base case view for the coming few months. Still, the risk of a further, meaningful deceleration in growth is elevated, given the unprecedented circumstances surrounding the ongoing slowdown. For equity investors, less potential downside risks to earnings than previously feared is a positive at the margin, but the fundamental outlook still hinges on a durable pickup in economic activity. Over a 6-12 month time horizon, this implies that one of two scenarios will unfold: The economy will stabilize in response to the easing that has already occurred (i.e. our base case view). The economy slows further in the near-term, prompting a more significant policy response that leads to an even sharper pickup in activity. Chart 17Investable Stocks: An Overshoot To The Downside? In the first scenario, investable stocks have probably overshot to the downside versus the global benchmark and thus will very likely outperform from current levels. Near-term performance is likely to be flat-to-down, as investors await hard evidence of a sequential improvement in growth (Chart 17). In the second scenario, investable stocks are at potentially acute near-term risk, but will likely eventually outperform global stocks once activity begins to pick up sharply. In this scenario, the outperformance of Chinese equities will commence later, but would likely still occur by the tail end of our cyclical investment horizon (6-12 months). As a final point, we are not ruling out the possibility of a temporary trade deal between the U.S. and China, as both sides have the incentive to avoid a further escalation and are now showing goodwill towards constructive negotiations. This may change our tactical view on Chinese stocks, but our cyclical view remains focused on China’s domestic policy and economic fundamentals. Jing Sima China Strategist JingS@bcaresearch.com Footnotes 1 PBC Official: The RRR Cut Aims at Bolstering Real Economy, September 6, 2019 2 China to accelerate the issuance and use of special local government bonds to catalyze effective investment, China State Council, September 4, 2019 3 Please see Emerging Markets Strategy Special Report, “Chinese Infrastructure Investment: A Ramp-Up Ahead?”, dated August 1, 2019, available at ems.bcaresearch.com 4 China’s Local Governments Sell Assets to Make Up for Revenue Loss, Caixin, September 3, 2019 5 http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201909/t20190906_3382239.htm?mc_cid=eb2b199651&mc_eid=9da16a4859 6 Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 7 Please see Emerging Markets Strategy Special Report, “China’s Foreign Debt, And A Secret Weapon”, dated September 12, 2019, available at ems.bcaresearch.com 8 Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2):Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
The situation in Saudi Arabia is still unfolding following the weekend’s drone strikes that removed ~5.7 mm barrels per day from the global oil market. The price of Brent crude oil spiked yesterday, from $61 to $68, and depending on how long it takes Saudi…
The authorities (state banks or the central bank) could hypothetically support the yuan by selling unlimited amounts of dollars in the forward market. Unlike the sale of U.S. dollars from the People’s Bank of China’s FX reserves, this would entail neither a…
China’s central bank has about $3 trillion of foreign exchange (FX) reserves that can be used to intervene in the spot market. However, the authorities are highly reluctant to use these reserves. These FX reserves are equal to only 12% of broad money supply…
Following drone attacks on critical oil infrastructure in the Kingdom of Saudi Arabia (KSA) over the weekend, which removed ~ 5.7mm b/d of output, the U.S. is likely to conduct a limited retaliatory strike. In addition, the U.S. will continue to build up forces in the Persian Gulf to deter Iran and prepare for a larger response if necessary. After this initial response, the Trump administration will likely seek to contain tensions, as neither Trump nor the United States has an immediate interest in launching a large-scale conflict with Iran. But that does not mean that one will not happen – indeed, the odds are now higher that this risk could materialize. If the oil-price shock caused by these attacks becomes prolonged and unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the negative impact on the global and U.S. economy will grow. Faced with a recession – which is not our base case but is possible – the incentive for Trump to engage war with Iran will rise sharply. Attack On KSA Will Prompt U.S. Retaliation If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions. Over the weekend, Houthi rebels in Yemen claimed responsibility for attacks on two critical oil assets in Saudi Arabia, removing ~ 5.5% of world crude output – a historic shock to global oil supply, and the largest unplanned outage ever recorded (Chart 1).1 U.S. Secretary of State Mike Pompeo accused Iran of being behind the attacks and said there was no evidence that Houthis launched them from Yemen. As we go to press, neither Saudi Arabian officials nor President Trump have confirmed Iran was the culprit, although the sophistication of the attack’s targeting and execution suggest that they will. President Trump said the U.S. is “locked and loaded depending on verification” and offered U.S. support to KSA in a call to Crown Prince Mohammad Bin Salman.2 Chart 1Oil Supply Disruption + Volume Lost A direct missile strike from Iran is the least likely source, as the Iranians have sought to act through proxies this year, in staging attacks to counter U.S. sanctions, precisely in order to maintain plausible deniability and avoid provoking a full-blown American retaliation. If Iran is confirmed as the base, it will limit Trump’s options and ensure that any retaliation leads to a greater escalation of tensions, relative to a situation where militant groups in Iraq or Yemen (or even in Saudi Arabia) are found to be responsible. Assuming the strike came from outside Iran, the U.S. and Saudi Arabia would presumably retaliate against its proxies in those locations – e.g., the Houthis in Yemen, or the Shia militias in Iraq. Washington is certain to dial up its military deterrent in the region and use the attacks to gain greater worldwide support for a tighter enforcement of sanctions to isolate Iran. This deterrence includes a multinational naval fleet in the Strait of Hormuz, at the entrance to the Gulf, where ~ 20% of the world’s crude oil supply transits daily. Electoral Constraints Facing Trump There are several reasons President Trump will not rush to a full-scale conflict with Iran. First, the attack did not kill U.S. troops or civilians. Miraculously, not even a single casualty is reported in Saudi Arabia. Yet, unlike the Iranian shooting of an American drone, which nearly brought Trump to launch air strikes on June 21, the latest attack clearly impacted critical infrastructure in a way that threatens global stability, making it more likely that some retaliation will occur. Second, Trump faces a significant electoral constraint from high oil prices. True, the U.S. economy is not as exposed to oil imports as it was (Chart 2). Also, global oil producers and strategic reserves including the U.S. Strategic Petroleum Reserve (SPR) can handle the immediate short-term loss from KSA (Chart 3). However, the duration of the cut-off is unknown and further disruptions will occur if the U.S. retaliates and Iranian-backed forces attack yet again. Third, there is still a chance to show restraint in retaliation, contain tensions over the coming months, limit oil supply loss and price spikes, and thus keep an oil-price shock from tanking the U.S. economy. Chart 2U.S. Imports Continue Falling But as tensions escalate in the short term, they could hit a point of no return at which the economic damage becomes so severe that President Trump can no longer seek re-election based on his economic record (Chart 4). At that point the incentive is to confront Iran directly – and run in 2020 as a “war president” intent on achieving long-term national security interests despite short-term economic pain. Chart 3Key SPRs Are Still Adequate Chart 4An Oil Price Shock Lowers Trump's Re-Election Chances U.S.’s Volatile Attempt At Diplomacy What triggered the attack and what does it say about the U.S. and Iranian positions going forward? Ever since Trump backed away from air strikes in June, he has become more inclined to de-escalate the conflict he began with Iran by withdrawing from the 2015 Joint Comprehensive Plan of Action (JCPOA), designating the Islamic Revolutionary Guard Corps (IRGC) as terrorists, and imposing crippling sanctions to bring Iran’s oil exports to zero. Even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions. What prompted this backtracking was Iran’s demonstration of a higher pain threshold than Trump expected. President Hassan Rouhani, and his Foreign Minister Javad Zarif, were personally invested in the 2015 nuclear deal with the Obama administration, which they negotiated despite grave warnings from the regime’s conservative factions that they would be betrayed. Trump’s reneging on that deal confirmed their opponents’ expectations, while his sanctions have sent the economy into a crushing recession (Chart 5). Chart 5U.S. Sanctions Hammer Iran's Economy With Iranian parliamentary elections in February 2020, and a consequential presidential election in 2021 in which Rouhani will seek to support a political ally, the Rouhani administration needed to respond forcefully to Trump’s sanctions. Iran staged several provocations in the Strait of Hormuz to warn the U.S. against stringent sanctions enforcement (Map 1). And recently, even as Rouhani and Trump publicly mulled a summit and negotiations, Rouhani insisted that any negotiations with the United States would require Trump to rejoin the JCPOA and remove all sanctions, a very high bar for talks. Map 1Abqaiq Is At The Very Core Of Global Oil Supply Realizing the large appetite for conflict in Tehran, and the ability to sustain sanctions and use proxy warfare damaging global oil supply, Trump took a step back – he withheld air strikes in late June, discussed a diplomatic path forward with French President Emmanuel Macron, and subsequently fired his National Security Adviser John Bolton, a known war hawk on Iran who helped mastermind the return to sanctions. The proximate cause of Bolton’s ouster was reportedly a disagreement about sanctions relief that would have been designed to enable a meeting with Rouhani at the United Nations General Assembly next week. Such a summit could possibly have led to a return to the pre-2017 U.S.-Iran détente. If Trump had compromised, Iran could have gone back to observing the 2015 nuclear pact provisions, which it has only gradually and carefully violated. Moreover the French proposal to convince Iran to rejoin talks by offering a $15 billion credit line for sanctions relief was gaining traction. Apparently these recent moves toward diplomacy posed a threat to various actors in the region that benefit from U.S.-Iran conflict and sanctions. Hardliners in Iran want to weaken the Rouhani administration and prevent further Rouhani-led negotiations (i.e. “surrender”) to American pressure. On August 29, three days after Rouhani hinted that he might still be willing to talk with Trump, Supreme Leader Ayatollah Ali Khamenei’s weekly publication warned that “negotiations with the U.S. are definitely out of the question.”3 The IRGC and others continue to benefit from black market activity fueled by sanctions. And Iranian overseas militant proxies have their own reasons to fear a return to U.S.-Iran détente. Saudi Arabia and Israel also worry that President Trump will follow in President Obama’s footsteps with Iran and strategic withdrawal from the Middle East, which has considerable popular support in the United States (Chart 6). Both the Saudis and Israelis have been emboldened by the Trump administration’s support and have expanded their regional military targeting of Iranian-backed forces, prompting Iranian pushback. The hard-line factions know that a full-fledged American attack would be devastating to Iranian missile, radar, and energy facilities and armed forces. The Iranians remember the devastating impact on their navy from Operation Praying Mantis in 1988. But with the Trump administration’s “maximum pressure” sanctions cutting oil exports nearly to zero, Iran’s economy is getting strangled and militant forces may feel they have no choice. Chart 6Americans Do Not Support War With Iran Moreover Trump’s electoral constraint – his need to make deals in order to achieve foreign policy victories and lift his weak approval ratings ahead of the election – means that foreign enemies have the ability to drive up the price of a deal. This is what the Iranians just did. But negotiations may be impossible now before 2020. Rouhani may be forced to play the hawk, Supreme Leader Khamenei is opposed to talks, and the hard-line faction is apparently willing to court conflict with America to consolidate its power ahead of the dangerous and uncertain period that awaits the regime in the near future, when Khamenei’s inevitable succession occurs. Bottom Line: We argued in May that the risk of U.S. war with Iran stood as high as 22%, on a conservative estimate of the conditional probability that the U.S. would engage in strikes if Iran restarted its nuclear program outside of the provisions of the JCPOA. Recent events make the risk even higher. This does not mean that Rouhani and Trump cannot make bold diplomatic moves to contain tensions, but that the risk of widening conflict is immediate. Supply Risk Will Remain Front And Center The risk to supply made manifest in these drone attacks will remain with markets for the foreseeable future. They highlight the vulnerability of supply in the Gulf region, and, importantly, the now-limited availability of spare capacity to offset unplanned production outages. There’s ~ 3.2mm b/d of spare capacity available to the market, by the International Energy Agency’s reckoning, some 2mm b/d or so of which is in KSA (Chart 7). These drone attacks highlight the need to risk-adjust this spare capacity. When the infrastructure needed to deliver it to markets comes under attack, its availability must be adjusted downward. Chart 7Limited Availability Of Spare Capacity To Offset Outages Chart 8Commercial Inventories Will Draw ... In the immediate aftermath of the temporary loss of ~ 5.7mm b/d of KSA crude production to the drone attacks, we expect commercial inventories to be drawn down hard, particularly in the U.S., where refiners likely will look to increase product exports to meet export demand (Chart 8). This will backwardate forward crude oil and product curves – i.e., promptly delivered oil will trade at a higher price than oil delivered in the future (Chart 9). Chart 9... Deepening Forward-Curve Backwardations We expect the U.S. SPR to monitor this evolution closely. It is near impossible to handicap the level of commercial inventories – or backwardation – that will trigger the U.S. SPR release, given the unknown length of the KSA output loss, however. Worth noting is the fact that U.S. crude-export capacity is limited to ~ 1mm b/d of additional capacity. Thus, the SPR cannot be directly exported to cover the entire loss of KSA barrels. Other members of OPEC 2.0 will be hard-pressed to lift light-sweet exports, which, combined with constraints on U.S. export capacity, mean the light-sweet crude oil market could tighten. Interestingly, these attacks come as the U.S. has been selling down its SPR. The sales to date have been to support modernization of the SPR, but, for a while now, the Trump administration has been signalling it no longer believes they are critical to U.S. security. That likely changes with these events. The EIA estimates net crude-oil imports in the U.S. are running at 3.4mm b/d. The SPR is estimated at 645mm barrels. There are 416mm barrels of commercial crude inventories in the U.S., giving ~ 1.06 billion barrels of crude oil in the SPR and commercial inventory in the U.S. This translates into about 312 days of inventory in the U.S. when measured in terms of net crude imports. China has been building its SPR, which we estimated at ~ 510mm barrels. As a rough calculation using only China imports of ~ 10mm b/d, and production of ~ 3.9mm b/d, net crude-oil imports are probably around 6mm b/d. With SPR of ~ 510mm barrels, the public SPR (i.e., state-operated stocks) equates to roughly 85 days of imports.4 Members of the IEA – for the most part OECD states – are required to have 90 days of oil consumption on hand. The IEA estimates its SPR totals 1.54 billion barrels, which consists of crude oil and refined products. Together, the IEA’s SPRs plus spare capacity likely could cover the loss of KSA’s crude exports, but the timing and coordination of these releases will be tested. KSA has ~ 190mm b/d of crude oil in storage as of June, the latest data available from the Joint Organizations Data Initiative (JODI) Oil World Database. If the 5.7mm b/d of output removed from the market by these oil attacks persists, these stocks would be exhausted in 33 days. Based on press reports, repairs to the KSA infrastructure will take weeks – perhaps months – which means the longer it takes to repair these facilities the tighter the global oil market will become. This is exacerbated if additional pipelines or infrastructure in KSA come under attack or are damaged. Critical Next Steps How the U.S. follows up Pompeo’s accusations against Iran will be critical. The next steps here are critical: Tactically, the Houthis or other Iranian proxies could continue with drone attacks aimed at KSA infrastructure. They’ve obviously figured out how to target Abqaiq, which is the lynchpin of KSA’s crude export system (desulfurization facilities there process most of the crude put on the water in the Eastern province). The Abqaiq facility has been hardened against attack, but these attacks show the supporting infrastructure remains vulnerable. In addition, militants could target KSA’s western operations on the Red Sea, which include pipelines and refineries. The Bab el-Mandeb Strait at the bottom of the Red Sea empties into the Arabia Sea. More than half the 6.2mm b/d of crude oil, condensates and refined-product shipments transiting the strait daily are destined for Europe, according to the U.S. EIA.5 In addition, the 750-mile East-West pipeline running across KSA terminates on the Red Sea at Yanbu. The Kingdom is planning to increase export capacity off the pipeline from 5mm b/d to 7mm b/d, a project that will take some two years to complete.6 During a July visit to India, former Energy Minister Khalid al-Falih stated importers of Saudi crude and products, “have to do what they have to do to protect their own energy shipments because Saudi Arabia cannot take that on its own.” On top of all this, Iran could ramp up its threats to shipping through the Strait of Hormuz once again. These actions could put the risk to supply into sharp relief in very short order. Even Iranian rhetoric will have a larger impact in this environment. In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage. How the U.S. follows up Pompeo’s accusations against Iran will be critical. Whether the deal being brokered with France – and the $15 billion oil-for-money loan from the U.S. that goes with it – is now DOA, or is put on a fast track to reduce tensions in the region will be telling. It is entirely possible the U.S. launches an attack on Yemen to take out these drone bases and to neutralize the threat there. If Iraq is identified as the source of the attacks, the U.S., along with Iraqi forces, likely would stage a special-forces operation to take out the bases used to launch the drone attacks. The U.S. has significant forces in theater right now: The U.S. 5th Fleet is in Bahrain, with the Abe Lincoln aircraft carrier and its strike force on station at the Strait of Hormuz; and the USS Boxer Amphibious Ready Group (ARG) and 11th Marine Expeditionary Unit (MEU) are on patrol in the Red Sea under the command of the U.S. 5th Fleet (Map 2). In addition, the U.S. also deployed B52s earlier this year to Qatar to have this capability in theater. Map 2U.S. Navy Carrier Battle Group Disposition, 9 September 2019 Bottom Line: In the immediate aftermath of the drone attacks on critical KSA infrastructure, markets will be hanging on every announcement coming from the Kingdom regarding the duration of the outage that removed 5.7mm b/d of crude-processing capacity from the market and damaged one Saudi Arabia’s largest oil fields. We expect the U.S. will conduct a limited retaliatory strike, and will continue to build up forces in the Persian Gulf to prepare for a larger response if necessary. While neither President Trump nor the United States has an immediate interest in a large-scale conflict with Iran, the risk of such an outcome has increased. If the oil-price shock caused by these attacks becomes unmanageable – either because of additional attacks against Saudi Arabian or other regional infrastructure, or direct Iranian action to restrict the flow of oil from the Persian Gulf – the risk of recession increases. While this is not our base case, it could push Trump to adopt a “war president” strategy going into the U.S. general election next year. Matt Gertken, Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 The massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil field, which produces close to 2mm b/d, were attacked on Saturday, September 14, 2019. Since then, press reports claim the attack could have originated in Iraq or Iran, and could have included cruise missiles – a major escalation in operations in the region involving Iran, KSA and their respective allies – in addition to drones. Please see Suspicions Rise That Saudi Oil Attack Came From Outside Yemen, published by The Wall Street Journal September 14, 2019. 2 Please see "Houthi Drone Strikes Disrupt Almost Half Of Saudi Oil Exports", published September 14, 2019, by National Public Radio (U.S.). 3 See Omer Carmi, "Is Iran Negotiating Its Way To Negotiations?" Policy Watch 3172, The Washington Institute, August 30, 2019, available at www.washingtoninstitute.org. 4 China is targeting ~500mm bbls by 2020, and is aiming to have 90 days of import oil cover in its SPR. 5 Please see The Bab el-Mandeb Strait is a strategic route for oil and natural gas shipments, published by the EIA August 27, 2019. 6 Please see "Saudi Arabia aims to expand pipeline to reduce oil exports via Gulf," published by reuters.com July 25, 2019.
In the immediate aftermath of the drone attacks on Saudi Arabia's massive 7-million-barrel-per-day processing facility at Abqaiq and the Khurais oil fields, which produces close to 2mm b/d, markets will be hanging on every announcement coming from the Kingdom…
Highlights Trump is now clearly retreating from policies that harm the economy and reduce his reelection chances. Geopolitical risks are abating for the first time since May – a boon for financial markets amid global policy stimulus. The U.S. and China are containing tensions in the short term – though we remain skeptical about a final trade agreement. The U.S. election cycle is a rising source of political risk even as global risks fall – but Warren is not a reason to turn cyclically bearish. Book gains on our long spot gold trade. Feature President Trump is staging a tactical retreat from his “maximum pressure” foreign and trade policies. As a late-cycle president with an election looming, his decision to escalate conflicts with China and Iran in May revealed a voracious risk appetite. This “war president” mentality – the idea that Trump would reconnect with his political base ahead of 2020 at the risk of undermining his own economy – led us to recommend a defensive position over the course of the summer, even though we remained cyclically bullish. Now with Trump’s backpedaling this tactical narrative is starting to turn. The shift adds policy support to the recent up-tick in critical risk-on indicators (Chart 1). While U.S.-China fears have played a much greater role than Brexit in the political tailwind behind global government bond yields (Chart 2), the collapse of Boris Johnson’s no-deal gambit is also helping geopolitical risk to abate. Chart 1Risk-On Indicators Flash Green Chart 2China Political Risk To Ease (Brexit Is Nice Too) Unfortunately, it is too soon to sound the all-clear: The U.S. election cycle still warrants caution. As we highlighted in July, the rise of the progressive wing of the Democratic Party, particularly firebrand Senator Elizabeth Warren of Massachusetts, is causing jitters in the marketplace. Warren is on the cusp of displacing Vermont Senator Bernie Sanders as the second-place candidate behind former Vice President Joe Biden. Biden remains the frontrunner – which helps to support a constructive cyclical view – but the progressives have a tailwind and his status could change. Moreover, the entire primary process and U.S. election cycle will engender policy uncertainty and “black swan” risks. Trump’s pivot could come too late to save the bull market. There are still significant risks to our House View that equities will be higher in a year’s time. If a bear market and recession become a foregone conclusion, then Trump will have to return to a war footing. This means escalating the conflict with China or confronting Iran in a desperate bid to get voters to rally around the flag. This is a substantial political risk given that the odds of a recession are elevated and rising. Despite these risks, it is significant for the global macro view that President Trump is making a last ditch effort to save the business cycle while it can still be saved. This supports BCA’s House View that investors should maintain a cyclical risk-on orientation. How Do We Know Trump Is In Retreat? Here are the critical signs that Trump is downgrading his administration’s level of aggression after another summer of “fire and fury”: The U.S. and China are now officially easing tensions. Trump has delayed the October 1 tariff hike (from 25% to 30% on $250 billion worth of goods), while China has issued waivers for tariffs and promised to increase purchases of U.S. farm goods in advance of talks. Talks are resuming with the principal negotiators set to meet face-to-face after China’s National Day celebration on October 1. Critically, the two sides are reportedly picking up the nearly completed draft text of a trade agreement that was abandoned in May when divisions over compliance and tariffs resulted in a breakdown. Trump and Xi Jinping have an occasion to meet in Santiago, Chile in November, which is the best time for a signing if the talks progress well. Trump fired his hawkish National Security Adviser, John Bolton. Bolton was a supporter of the president’s “maximum pressure” foreign policy toward rivals, including China as well as Iran and North Korea. Oil prices dropped on the expectation that U.S. relations with Iran could improve, easing oil sanctions and increasing supply (Chart 3). But ultimately the signal is bullish for oil. The real significance is not Bolton himself but rather that Trump is changing tack to reduce geopolitical risks to economic growth. Whoever replaces Bolton is far less likely to be an uber-hawk (Bolton had cornered that market). A trade deal with Japan has been agreed in principle and may be signed in late September. U.S. relations with Europe are marginally improving. Trump even sent Secretary of State Mike Pompeo on a trip to discuss a diplomatic “reset” with the EU’s new crop of leaders set to take power in November and December. These improvements are tentative. Trump still explicitly rejects the idea that he should court Europe to apply unified pressure on China. But his administration has agreed to a beef export deal with the EU and, as long as China talks are ongoing, he is unlikely to slap tariffs on European cars. This decision will likely be postponed beyond November 14. All of the above confirms that Trump is focused on reelection. But how can we be sure this less-hawkish policy turn will last longer than five minutes? Rising unemployment is the most deadly leading indicator of a president’s approval rating. Economic data is alarming for a sitting president. Following a drop in business sentiment and investment, consumer sentiment is now suffering (Chart 4). Manufacturing – the sector Trump was ostensibly elected to defend – has slipped into outright contraction and loans and leases are shrinking in the electorally vital Midwestern states (Chart 5). Chart 3Bolton Bolting Is Bullish For Brent Chart 4A Reason For Trump To De-Escalate Fortunately for Trump, the job market is showing signs of resilience, with initial unemployment claims dropping hard (Chart 6). Chart 5Another Reason For Trump To De-Escalate Chart 6Good News For Trump Chart 7U.S. Consumer Should Prevent Recession BCA does not expect a recession within the next 12 months. The American consumer remains buoyant and median family incomes are strong (Chart 7). Nevertheless, Trump cannot assume anything. The proliferation of the “R” word has a negative psychological effect on businesses and consumers that could create a negative feedback loop. It also raises the risk of an equity selloff that tightens financial conditions and exacerbates the slowdown (Chart 8). Trump’s Democratic opponents and much of the news media will amplify negative economic news. Chart 8Trump Needs To Change The Topic While Trump cares about the stock market, his election ultimately rests on voters, not investors. Even if recession is avoided, a rising unemployment rate would be the most deadly leading indicator of a sitting president’s approval rating (Charts 9A & 9B). It is a far more telling variable than income growth or gasoline prices, for example. Chart 9APresidential Approval... Chart 9B...Follows Unemployment As Charts 9A & 9B demonstrate, unemployment and presidential approval are not always tightly correlated. Rather, for all recent presidents, the direction of unemployment ultimately prevailed over the approval rating by the time of the election – it pulled approval up or down in the final lap of the term in office. Moreover Trump, a bull-market president, is one of the cases where the approval rating is indeed tightly correlated with unemployment, as with Bill Clinton. And he is particularly vulnerable because his approval is historically weak and the unemployment rate can hardly fall much further from today. Granting that Trump is now going to adopt a more pro-market foreign and trade policy orientation, the next question is: what will that entail? Bottom Line: Trump’s tactical policy retreat is materializing which means that geopolitical risk stemming from U.S. foreign and trade policy is declining on the margin. While Trump is unpredictable, his sensitivity to the drop in his polling and weakening economy shows he wants to be reelected. Hence policy will have to moderate. Bolton Bolts – Geopolitical Risks Abate Trump’s ousting of his National Security Adviser Bolton is an important sign of the less-hawkish shift in administration policy. The ouster itself is not surprising in the least. Trump ran for office on a relatively isolationist foreign policy of non-intervention, withdrawal from long-running wars, and eschewing regime change and foreign quagmires to focus on America’s commercial interests. By contrast Bolton is perhaps the Republican Party’s most outspoken war hawk – a neo-conservative of the Bush era who advocated regime change in North Korea and Iran. This position was always at odds with Trump’s eagerness to negotiate and strike deals with the world’s dictators in the name of trade and riches rather than war and expenses.1 Chart 10Will Xi Sell Pyongyang For Washington? The immediate implication is that the U.S. and Iran will reduce tensions. We will address this topic at length next week, but the gist is that Trump is much more likely to relax sanctions and hold a summit with Iranian President Hassan Rouhani now than before. This is in keeping with our view that the China trade war is a far greater geopolitical risk than the U.S.-Iran tensions post-withdrawal from the 2015 nuclear pact. However, Bolton’s firing is bullish for oil prices. Iran may still stage low-level provocations that threaten supply, but Saudi Arabia has also appointed a new energy minister in preparation for an OPEC 2.0 strategy that aims to bolster prices in the advance of the initial public offering of Aramco.2 At the same time, Trump’s softening foreign policy stance portends an improvement to the global economy. Nowhere is this clearer than with North Korea and China. Kim Jong Un has explicitly demanded Bolton’s replacement to get talks back on track – Trump has now met this demand. North Korea has also been an integral component of the U.S.-China negotiations throughout Trump’s administration. If Trump’s diplomacy succeeds with North Korea, markets will rightly conclude that U.S.-China tensions are falling. China has an interest in denuclearizing the peninsula, which ultimately entails getting rid of U.S. troops, so it has shown it can comply with U.S. sanctions (Chart 10). A third Trump-Kim summit that results in a nuclear deal of any kind would be a concrete policy win for Trump and a strategic win for China. The North Korean threat itself is not market-relevant – war risk peaked in 2017 (Chart 11). But an official agreement would provide an “off-ramp” for U.S.-China trade tensions. It would boost trade talks enough to improve global sentiment, and it could even increase the chances that the two countries conclude a deal involving tariff rollback. A Trump-Kim agreement would provide an “off-ramp” for U.S.-China trade tensions. Bolton’s ouster could also smooth U.S.-China tensions over Taiwan – he was an outspoken hawk on this front as well. His presence encouraged fears in Beijing that the Trump administration was planning a significant upgrade in Taiwan relations. These apprehensions were already high from the moment Trump accepted President Tsai Ing-wen’s congratulations on his election in 2016. It remains to be seen whether Trump will delay an $8 billion arms sale that will be the biggest since 1992 (Chart 12) – China has threatened to sanction U.S. defense firms if it goes ahead. But postponement is more likely now than before. This would help along the trade talks. Chart 11North Korea: 'Off-Ramp' For US-China Tensions Chart 12Will Trump Sell Taipei For Beijing? The direction of Taiwan in the near term partly depends on the direction of Hong Kong. Bolton likely advised a hard line in defense of the mass pro-democracy protests, which Trump was inclined to neglect for the sake of the trade talks with Beijing. Unless a mainland intervention and bloody security crackdown occurs – which is still a risk, and would make it politically impossible to conclude a trade deal with China – Trump will probably continue to sideline this Special Administrative Region. The jury is still out on whether protests will escalate after China’s National Day celebration, but Bolton’s absence and Hong Kong’s concessions to the protesters (which are backed by Beijing) are both positive signs. All of these factors suggest that the odds of a U.S.-China trade deal by November 2020 should rise. But is that really the case? For now we are maintaining our view that the odds are 40% by November 2020, though the risks are to the upside. Chart 13Trump Can Partially Offset China Tariffs While Trump and Xi can certainly make an executive decision to agree to a deal – any deal – we maintain our high-conviction view that it will lack durability due to uncertainties regarding compliance on China’s side and faithfulness on Trump’s side. And a shallow deal may be politically untenable if markets and the economy rebound. Crucially, neither China’s economic data nor U.S. financial conditions are forcing either side to capitulate entirely. Trump’s policy retreat entails the removal of trade risks from Canada, Mexico, and Japan first and foremost, and likely the European Union. This will offer some consolation to markets even though the small increase in U.S. exports in the near-term will not offset the sharp drop in exports to China (Chart 13). Combined with a de-escalation and containment of tensions with China, and worldwide monetary and fiscal stimulus, markets will face a substantial policy improvement. This will actually reduce the incentive for a final trade deal. If financial and economic pressure intensify and the U.S. heads toward a technical correction or bear market, Trump will need to capitulate. This will require significant tariff rollback. At that point, Xi Jinping will have the opportunity to agree to a short-term deal based on China’s current concessions and nothing more (Table 1). This would demonstrate to the whole world that it does not pay to coerce China: China operates on mutual respect and win-win agreements. This would be acceptable to Xi Jinping since it would at least buy some time until the inevitable second round of the strategic conflict in 2021. But we are not at full capitulation yet. Table 1China’s Offers Thus Far In The Trade War Bottom Line: Trump’s policy retreat includes the ouster of Bolton, which deescalates geopolitical risk on several fronts. Nevertheless, none of these risks – Iran, China, North Korea, Hong Kong, Taiwan – is fundamentally resolved. A U.S.-China trade agreement is not even necessary if the two political leaders are sufficiently supported by positive global macro developments. We continue to believe North Korea will lead to Trump diplomatic successes. De-escalation could lead to a breakthrough in trade talks pointing toward a deal, but it could also simply create an “off ramp” for the U.S. and China to contain tensions without having to capitulate on the trade front. Warren Still Warrants Caution While geopolitical risk has some room to abate, domestic political risk in the U.S. will pick up the slack. The entire American election cycle will trouble the markets over the coming 12 months – particularly due to the high chances of significant social unrest. Yet the greatest risks are frontloaded in the form of the Democratic Primary contest. This is because Warren will continue to do well in the early primary debates and therefore could soon morph into the biggest market risk of the entire election cycle. To be clear, her position as the frontrunner in the online betting markets is not validated by the national or state-level opinion polling. Biden remains dominant (Chart 14). If he stays firm above a 30% support rate, with double-digit leads over his nearest competitors in a range of important states, his chances of winning will rise over time and market uncertainty will fall. Chart 14Biden Still The Frontrunner In Democratic Primary While Biden’s election would be market-negative on the margin due to the outlook for tax hikes and re-regulation, Trump’s reelection is not as market-positive as some may believe since he will be unbridled in his second term and more capable of pursuing his aggressive protectionism. Ultimately, the choice between Trump and Biden is a choice between two candidates whose policies and flaws are well known and relatively digestible by markets. If Warren or Sanders come close to the Oval Office, the equity market will go through a re-rating. On the contrary, if Warren surpasses Sanders and takes the lead, uncertainty will skyrocket regardless of Trump’s advantages in the general election. This is not unlikely, as the leftward lurch within the party continues to propel the progressive candidates upward in the contest (Chart 15). If Warren or Sanders are seen as coming within one step from the Oval Office, the equity market will have to go through a re-rating. These progressive populists are proposing an onslaught of laws and regulations against banks, health insurers, oil and gas drillers, and the tech oligopoly. The agenda is inherently negative for corporate earnings in these sectors, as Peter Berezin of BCA’s Global Investment Strategy shows in a recent report.3 Chart 15Progressive Consolidation Would Increase Market Angst Chart 16Stocks Will Start To Trade On Polls Health stocks are clearly reacting to Warren’s surge in the online betting markets (Chart 16), so any convergence of the polling of real voters to these probabilities will cause a reckoning in this sector as well as in other sectors she has targeted, like financials, technology, and energy. The saving grace for now – a reason we remain cyclically bullish – is that Biden has not yet broken down in the polling. He is the least market-negative of the top three candidates, yet the most electable from the point of view of the swing state polling and electoral-college calculus. Warren is the most market-negative yet least electable of the top three. She must decisively surpass Sanders in order to create lasting volatility. Yet this will be hard to do because his electoral-college path to the presidency is clearer than Warren’s, judging by head-to-head polls with Trump, and he has the machinery and motivation to slog through the primary race for a long time – which undercuts both him and Warren versus Biden. Warren and Sanders are also less likely to lead the Democrats to victory in the senate even if they take the White House due to their lack of appeal in key senate races like Arizona and Georgia. Without a majority in the senate, their radical policy agenda will have to be left at the door. Investment Implications We are booking gains on our long spot gold trade at 16% since initiation. The thesis remains sound and we will reinitiate when appropriate. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Bolton’s tenure with Trump began with an incredible faux pas in which he advocated “the Libyan model” for the administration’s North Korean policy – prompting Trump to overrule him and reject that model. No comment could have been more inappropriate for a president trying to build trust with Kim Jong Un to sign a denuclearization deal. Libyan dictator Muammar Gaddafi was killed by enemy militias in Libya after NATO warplanes bombed his convoy – NATO’s intervention occurred despite Gaddafi’s having abandoned his nuclear weapon program in the wake of the September 1, 2001 attacks to avoid conflict with the U.S. and its allies. 2 See BCA Commodity & Energy Strategy Weekly Report, “Ignore The KSA-Russia Production Pact, Focus Instead On Their Need For Cash,” September 8, 016, ces.bcaresearch.com. 3 See BCA Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” September 1, 2019, gis.bcaresearch.com.
Please note that this abbreviated weekly report complements today’s Special Report titled China’s Foreign Debt, And A Secret Weapon published in collaboration with BCA’s China Investment Strategy service. Feature A major rotation has commenced in recent days in global financial markets: beaten-down value companies have begun outperforming richly-priced U.S. growth stocks. This has cogently coincided with the rise in U.S. bond yields. Further, U.S. small caps have also begun outpacing U.S. large caps. Do these signals mean that EM will start outperforming DM in general and U.S. in particular? We do not think it is likely to occur on a sustainable basis. We agree that certain trends in global financial markets have become over-extended and a mean-reversion is overdue. U.S. bond yields have probably dropped much more than justified by U.S. economic strength. Although U.S. manufacturing, exports and capex have been extremely week/contracting, consumer spending is expanding at a decent clip. We believe fears of a full-blown U.S. recession are presently exaggerated. It is also critical to gauge what is the underlying cause of this financial market rotation. Is it receding fears of U.S. recession or China’s recovery or both? We believe that the rotation is caused by unwinding of recessionary fears in the U.S., not a revival in the Chinese economy or a recovery in global trade and manufacturing. Unwinding U.S. recessionary fears will not be sufficient to produce a strong and lasting rally in EM risk assets and currencies even if it leads to a breakout in DM share prices in absolute terms. EM risk assets and currencies are much more sensitive to China and global growth rather than to the U.S. economy. Watch The Dollar For Clues Chart I-1EM Relative Equity Performance Correlates With U.S. Dollar Whether the sell-off in global safe-haven bonds and outperformance of global cyclical vs. defensive equity sectors is due to a genuine recovery in China or the U.S. will be revealed in the trend of the U.S. dollar (Chart I-1). If the dollar continues grinding higher, it would entail that the recent financial markets rotation is due to amelioration in U.S. growth expectations and that there is little recovery in the Chinese economy as well as global manufacturing and trade. In this scenario, EM risk assets will underperform. On the contrary, if the greenback begins exhibiting persistent and broad weakness, it would signify that the reversal in global safe-haven bond yields and global cyclical stocks is due to a revival in Chinese demand. In such a case, a lasting recovery in global manufacturing and trade are likely. This would be consistent with a durable EM rally and outperformance. Chart I-2Bullish Technicals For U.S. Dollars So far, the greenback has remained well bid (Chart I-2). In addition, industrial commodities prices remain weak and have failed to rebound (Chart I-3). These entail that the recent spike in U.S. bond yields and outperformance of cyclical equity sectors is primarily due to unwinding of pessimism on U.S. growth rather than a reflection of growth amelioration in China. Notably, cyclical data out of China and global trade/manufacturing remain dismal. Chinese overall imports are contracting (Chart I-4). Chart I-3Breakdown Remains In Play Chart I-4Shrinking Chinese Imports Global semiconductor sales and car purchases continue shrinking at a rapid pace (Chart I-5). China’s credit and money growth and impulses appear to be rolling over, having failed to rise as much as in the previous stimulus episodes (Chart I-6). Finally, the pace of EM corporate EPS contraction is accelerating (Chart I-7). Any rally in EM share prices will be unsustainable without a bottom in EM EPS growth. Chart I-5No Improvement In Global Growth Chart I-6Chinese Credit Impulse Is Weak Chart I-7EM EPS & Share Prices Bottom Line: The U.S. dollar has failed to sell off despite the optimism in global equity markets. This entails that any rebound and outperformance in EM risk assets and currencies will prove to be short-lived. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations