Emerging Markets

Special Report

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights Analysis on Indonesia starts below. The U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle. Ongoing weakness in the global economy – which is emanating from China/EM – will support the dollar in the coming months. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. A new trade: Long gold / short equal amounts of copper and oil. Feature Chart I-1The Dollar's Technicals Are Still Positive As we argued in last Week’s Report, emerging markets are facing a make-it-or-break-it moment. The U.S. dollar will serve as a litmus test. If the dollar pushes higher, EM risk assets will sell off. Conversely, if the greenback breaks down, EM risk assets will stage a sustainable cyclical rally. The basis of why the dollar will be a litmus test for EM risk assets is because the greenback is a counter-cyclical currency. It appreciates when global growth is relapsing and depreciates when global growth is reviving. In contrast, EM risk assets are pro-cyclical.  Hence, the negative correlation between EM risk assets and the dollar stems from their opposite-reaction functions to the global business cycle. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. In particular, the dollar’s advance-decline has also been holding above its 200-day moving average (Chart I-1, top panel). Critically, our composite momentum indicator for the broad trade-weighted dollar has not declined below zero (Chart I-1, bottom panel). All of the above affirm the U.S. currency’s relative resilience. When a market exhibits resilience relative to the headwinds it is facing, it is often a bullish sign. Our EM strategy takes its cues from the fact that the greenback has softened but has not broken down. An upleg in the trade-weighted dollar is consistent with our view of a pending relapse in EM risk assets. The Dollar: Review Of Indicators There are a wide range of indicators that herald further U.S. dollar appreciation: Liquidity in the U.S. dollar interbank market has been tightening. The top panel of Chart I-2 demonstrates that the effective fed funds rate has exceeded the interest rate that the Fed pays to banks on excess reserves (IOER) for the first time since 2009 (herein the difference between the two is referred to as the spread). The bottom panel of the same chart illustrates that in the periods when this spread is rising, the dollar tends to appreciate, and when the spread is flat or falling (the shaded intervals), the greenback weakens. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. A positive, rising spread reflects a shrinking supply of U.S. dollar liquidity in the interbank market relative to demand. Notably, Chart I-3 illustrates that the dollar - inverted in this chart - is more strongly correlated with U.S. banks’ excess reserves at the Fed than with interest rates. This implies that the argument that lower rates will drive down the value of the greenback is exaggerated. Chart I-2Another Dollar Positive Factor Chart I-3Do U.S. Rates Drive The Dollar? Chart I-4Investors Are Long EM Currencies Vs. Dollar One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback (Chart I-4). Remarkably, various emerging market currencies have rebounded to major technical resistance levels but have not yet broken out, despite a dramatic decline in U.S. interest rates and the risk-on phase in global financial markets (Chart I-5). It remains to be seen whether they can stage a decisive breakout. We have our doubts. Chart I-5AEM Currencies Have Not Yet Broken Out Chart I-5BEM Currencies Have Not Yet Broken Out   Finally, one aspect where we differ from the consensus is in terms of currency valuations. The U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value (Chart I-6). Often financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. Bottom Line: BCA’s Emerging Markets Strategy service maintains that the path of least resistance for the dollar is still up. Global Growth Conditions Are Still Conducive For Dollar Strength As discussed previously, the U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle (Chart I-7). Meanwhile, it is only loosely correlated with U.S. interest rates, as shown in the bottom panel of Chart I-3 on page 3. Chart I-6The U.S. Dollar Is Only Moderately Expensive Chart I-7The U.S. Dollar Is Counter-Cyclical   The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. Yet, this scenario would be dollar bullish. In this case the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. So far, neither economic data nor the performance of cyclical segments within financial markets are signaling a meaningful amelioration in the global business cycle: Global cyclical sectors’ relative performance against the global overall equity index is lingering close to its December lows (Chart I-8). This measure of global cyclicals is composed of equal-weighted share prices of global industrials, materials and semiconductors. Further, this global cyclical equity index has not outperformed 10-year U.S. Treasurys (Chart I-9). It is difficult to envision a looming global economic recovery when global cyclical equities are failing to outperform even government bonds. Chart I-8Global Cyclical Sectors Have Not Outperformed Chart I-9Global Cyclical Sectors Versus U.S. Bonds   The Chinese manufacturing PMI import sub-component – a leading indicator of Chinese imports – foreshadows renewed weakness in the EM ex-China, Korea and Taiwan currencies (Chart I-10). In turn, the Korean won and Taiwanese dollar are also vulnerable as China is by far their largest export destination, and their shipments to the mainland continue to shrink rapidly. Further, odds are high that the RMB will depreciate, dragging down the KRW and TWD along with it. Japanese foreign machinery tool orders and German industrial orders are in deep contraction, and have not improved even on a rate-of-change basis (Chart I-11, top and middle panels). Meanwhile, China’s imports of capital goods are contracting at a double-digit pace (Chart I-11, bottom panel). Chart I-10Chinese Imports Are Key To EM Currencies Chart I-11Global Trade Is Shrinking At A Fast Rate   Chinese auto sales improved dramatically in June, but almost entirely due to hefty price discounts. Such bulky price discounts (up to 50% in certain cases) cannot go on indefinitely. Auto sales will soon tumble as these incentives to purchase expire. While U.S. growth has slowed, it is still holding up better than the rest of the world. Consistently, not only have U.S. large caps been outperforming their global counterparts, but America’s equal-weighted equity index has also been outpacing that of its global peers (Chart I-12). Broad-based U.S. equity outperformance in local currency terms versus the rest of the world denotes U.S. growth outperformance, and heralds another upleg in the greenback. Bottom Line: Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. We continue to recommend a short position in a basket of currencies such as ZAR, CLP, COP, IDR, MYR, PHP and KRW against the dollar. We believe gold has made a major breakout. The biggest risk to our dollar-bullish view is not the dollar’s fundamentals, but China’s decision to diversify away from U.S. dollars and U.S. President Donald Trump’s determination to weaken the greenback. We discussed the latter at great length in our August 30, 2018 Special Report, and will deliberate on the former below. Buy Gold / Short Copper And Oil Despite our positive view on the dollar, we believe gold has made a major breakout (Chart I-13). Pairing a long position in gold with shorts in copper and oil will likely deliver solid returns with low volatility in the next three to six months and beyond (Chart I-14). Chart I-12U.S. Equity Outperformance Heralds A Stronger Dollar Chart I-13Gold Is In A Bull Market   Chart I-14Go Long Gold / Short Copper And Oil The primary reason to buy gold is not global inflation. Rather, it is due to China’s decision to accumulate the yellow metal. Unhappy with U.S. pressures and import tariffs, Chinese authorities have decided to materially reduce the share of dollars in their foreign exchange reserves. The People’s Bank of China (PBoC) holds 62 million ounces of gold. Hence, gold holdings represent only 2.8% of the $3.1 trillion stockpile of the PBoC’s total foreign currency reserves (Chart I-15). In contrast, U.S. assets account for 52%. In this regard, the Russian experience could act as a roadmap for Chinese policymakers. Hit by U.S. and EU economic and financial sanctions following Russia’s seizure of Crimea in 2014, the country decided to accelerate its diversification away from U.S. dollars into gold. Since then, the Russian central bank has continuously boosted its gold holdings, with the yellow metal now accounting for 22% of its foreign currency assets (Chart I-16). Chart I-15Chinese Central Bank's Gold Holdings Chart I-16Russian Central Bank's Gold Holdings   Even if the PBoC accumulates gold at a slower pace than the Russian central bank, the former’s bullion purchases will exert considerable upward pressure on gold prices due to its sheer size. In short, odds are that China’s central bank will be buying gold on any dips. To accommodate such a large buyer, the gold price will need to surge to discourage potential demand from other buyers. In contrast to gold, China’s demand for copper and oil will be subdued from a cyclical perspective. Copper demand will be tame due to weak capital spending growth. Regarding oil, as we argued in our June 21, 2018 report titled, China’s Crude Oil Inventories: A Slippery Slope, the nation has been importing more oil and petroleum products than it has been consuming. As a result, its crude oil inventories have swelled (Chart I-17, top panel). Adding China’s aggregate crude oil inventories to the OECD’s commercial inventories reveals that global inventories have not really declined since 2017 (Chart I-17, bottom panel). Simply put, crude inventories have moved from the OECD to China. Going forward, given both underlying subdued oil demand and elevated crude inventories in China, its oil imports are likely to expand at a slower pace vs. the past five years (Chart I-18). This combined with high net long positions among global investors in crude oil makes us negative on oil prices. This downbeat view on oil differs from BCA’s house view, which is bullish on the commodity. Chart I-17Oil Inventories: China + OECD Chart I-18China's Oil Demand   While we cannot rule out the risk that geopolitical tensions could escalate in the Middle East, we believe the appropriate strategy for investors should be to sell oil on strength. Besides, pairing this strategy with a long position in gold reduces potential drawdowns in the event of an outburst in U.S.-Iran tensions. Bottom Line: We recommend investors initiate the following position: Long gold / short equal amounts of copper and oil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Treading On Thin Ice Foreign investors have been rushing into Indonesian financial markets on expectations of the Fed cutting rates. As a result, Indonesian financial markets have been more resilient than we expected. While the Fed’s monetary policy is important for Indonesian financial assets, there are other critical drivers of the Indonesian economy and financial markets that investors should take heed of. Namely, global growth and domestic demand. Both factors are currently negative. Cracks are appearing in the Indonesian property market. Persisting exports contraction will keep the country’s current account deficit wide (Chart II-1). A wide current account deficit entails that the rupiah will remain heavily reliant on volatile foreign portfolio inflows. Lesser known but equally important, Indonesia’s domestic demand is anemic. Particularly, the marginal propensity to spend among businesses and consumers is diminishing (Chart II-2). Truck and passenger car sales are contracting, while motorcycle sales are edging closer to contraction (Chart II-3). Chart II-1Indonesian Exports: Double-Digit Contraction Chart II-2Indonesia: Domestic Spending Is Subdued   Critically, cracks are appearing in the Indonesian property market. Residential property prices are rising only by 2% from a year ago in local currency terms (Chart II-4). Additionally, domestic cement consumption is shrinking and revenues of two MSCI-listed real estate companies are also contracting.  Chart II-3Indonesia: Vehicle Sales Are Declining Chart II-4Cracks In Indonesia's Property Sector   Chart II-5Non-Bank Stocks Are Not Rallying Turning to the equity market, Indonesia’s stock market breadth is extremely narrow. The rally of the past several months has been almost entirely led by a few stocks, in particular by Bank Central Asia and Bank Rakyat Indonesia. In fact, these two banks - alone - now account for around 32% of the overall MSCI Indonesia market cap. Meanwhile, the performance of non-financial stocks has been extremely poor (Chart II-5, top panel). As for small cap stocks they are now below their 2016 lows (Chart II-5, bottom panel). This has occurred due to chronically weak profitability among non-financial companies. As for banks, in-line with ongoing deceleration in the real economy, their bad-loan provisions are now rising. Additionally, the aggregate banking system’s net interest margin is still falling. These will hurt banks’ profits. On the whole, the deepening growth slump in Indonesia warrants lower interest rates. Yet, reducing interest rates when faced with a wide current account deficit could trigger currency depreciation. At a certain point – when the frenzy about the Fed’s easing subsides, investors will realize the severity of the ongoing growth downturn in Indonesia and the need for lower rates. When this occurs, the rupiah will depreciate and the currency selloff will spread into equities and bonds. Bottom Line: The risk-reward profile of Indonesian markets is not attractive both in absolute term and relative to their EM peers. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

NOTE: There will be no report on Wednesday, July 17 due to our regular summer break. Highlights Chinese policymakers as well as the People’s Bank of China (PBoC) have historically been reactive, meaning they have typically waited for economic pain to become entrenched before accelerating reflationary measures. The agreement reached at the June G20 Summit to renew trade negotiations with the U.S., while temporary, takes the pressure off the immediate need to further stimulate the economy. While China has the ability to juice the economy, the pain threshold has been raised higher during this cycle, and the country’s leadership has been reluctant to let go of its financial deleveraging campaign. This approach has resulted in a “half measure” stimulus over the past 12 months. The outlook for Chinese stocks is negative over the next three months, as a flip-flop policy approach will increase market volatility.  However, over a cyclical (i.e. six- to 12-month) time horizon, we are maintaining a bullish stance toward Chinese stocks in hedged currency terms. Feature Last week marked the first anniversary of the imposition of tariffs on imports from China by the U.S. – an event that has clearly had a lasting and meaningful impact on global economic activity. Last week was also the first anniversary of a significant monetary easing measure: China’s 3-month interbank repo rate fell 90 basis points on July 3, 2018, 3 days before the first tranche of import tariffs took effect. This decline was just under half of what would ultimately occur (the 3-month repo rate fell from 4.5% in early July to 2.4% in early August), and was taken as a sign by many investors that the PBoC had shifted to a maximum reflationary stance (Chart 1). Chart 1Indecisively Falling Interbank Rate However, several facts underscore that either the PBoC did not, in retrospect, move completely toward a pro-growth stance, or that China’s monetary transmission mechanism is seriously impaired. In our view, it is a combination of both: Despite evidence suggesting it should, the PBoC did not cut its benchmark lending rate. The repo rate declined in the third quarter last year on the back of increased liquidity supply in the interbank market. The weighted average lending rate also fell, but not massively, and not by as much as our model had predicted (Chart 2). A pickup in credit expansion has significantly lagged easing. Excluding local government bonds, the general pickup in credit has been modest. Based on this measure of Total Social Financing, new credit to GDP still remains lower today than at any point during the 2015-2016 downturn (Chart 3). Chart 2Lending Rate: Not Much Easing Chart 3No Strong Re-Leveraging With the conclusion of the G20 Summit temporarily halting the trade war escalation and implementation of additional tariffs, these observations raise important questions: Will the PBoC be proactive in easing policy? What does this mean for investors over the coming year? The PBoC Will Be Reactive Rather Than Proactive Chart 4Shadow-Banking Crackdown Continues In our view, the PBoC’s policy actions last year can at best be described as half-measures, despite the fact that the central bank was quick to reduce interbank interest rates in last July by cutting the reserve requirement ratio (RRR). The reason is that the PBoC clearly maintained macro-prudential/administrative restrictions on shadow banking activity, despite significantly easing liquidity in the interbank market. Chart 4 shows that shadow-banking credit as a share of total adjusted social financing continued to decelerate rapidly throughout 2018. It now accounts for a mere 12% of the stock of total adjusted social financing, by far the lowest point since 2009. This underscores that the PBoC and policymakers more generally have a deep-seated desire to avoid (further) inflating China’s substantial money and credit excesses – a dynamic that we have discussed in previous reports.1 Looking forward, there are three reasons why the PBoC’s reactive nature is unlikely to change in the near term, in addition to policymakers’ concerns about financial system’s excesses. First, the PBoC has historically been a reactive central bank, in a way that goes beyond the now-typical “data dependent” approach of its developed-market peers. Chart 5 provides a close look at China’s previous economic growth cycles and their corresponding credit expansions. The chart highlights that Chinese policymakers tend to stay behind the curve when it comes to monetary easing: In the previous three growth cycles, the first sign of monetary easing (defined as an RRR and/or benchmark lending rate cut) lagged the peak of nominal GDP growth by an average of four quarters. Rate cuts took place not when economic growth peaked, but once economic activity had already weakened considerably (Chart 6). Chart 5Chinese Policymakers Tend To Stay 'Behind The Curve' Chart 6More 'Pain' Needed For Massive Easing The same pattern has applied to other monetary easing tools that the PBoC has deployed in the past, including the Medium Lending Facility (MLF), the Targeted Medium-term Lending Facility (TMLF), the standing Lending Facility (SLF), and the Pledged Supplementary Lending program (PSL) – all of which only took shape after the economy had already shown across-the-board weakness. It will take more widespread and entrenched economic weakness for the PBoC to meaningfully ease further. The local government debt-to-bond swap program was also launched well into the 2015 growth downturn. When widespread and sustained weakness in activity emerged, Chinese policymakers responded by “throwing the kitchen sink” at the economy – by moving forward with multiple rate cuts and often creating new forms of easing in an attempt to catalyze a quick rebound. Since the PBoC has already implemented a series of easing measures, we believe it will take more widespread and entrenched weakness in the real economy for the PBoC to meaningfully ease further. Chart 7Chinese Currency Is Under Pressure Second, the PBoC is likely to be reactive because of the potentially negative effects that proactive rate cuts could cause on sentiment towards the RMB. Chart 7 highlights the close historical correlation between the RRR, interest rate differentials and the USD/CNY. USD/CNY was trading at 7.8 the last time the weighted average RRR was at 11%, which was back in 2007. At the current juncture, interest rate differentials already point to a weaker currency. The PBoC has signaled that USD/CNY at 7 is no longer a line in the sand that must be defended, meaning this level is not a hard constraint that would prevent the central bank from cutting either the RRR or the benchmark lending rates if warranted. In fact, a measured depreciation in the RMB would help mitigate some of the blow from increased tariffs. Nevertheless, in an environment where the currency has already weakened significantly, cutting the RRR or the benchmark lending rates quickly or by a large amount could create self-reinforcing expectations of further depreciation. China has implemented a better counter-cyclical mechanism to defend the RMB than it had in 2015-‘16,2 but the potential for capital outflows remains a serious concern.3 Third, the Trump-Xi meeting at the June G20 Summit in Osaka temporarily averted a further escalation of the trade war and additional tariffs. The agreement to continue trade negotiations lacks tangible progress from either side, and thus the “truce” is likely to be short-lived. Chart 8Markets So Far Unimpressed By Stimulus However, as we pointed out in last week’s report,4 the existence of talks is likely to take some pressure off Chinese policymakers’ immediate need to floor the reflation accelerator. Readouts from recent PBoC leadership meetings indicate that speculative excesses in the financial system remain a top concern for Chinese policymakers. China’s onshore market, after rallying by 2% following the good news from the G20 meeting, has given back all its gain (Chart 8). Given that the onshore equity market is extremely sensitive to China’s credit growth, the short-lived rally since the G20 meeting suggests markets have been unimpressed by the authorities’ reflationary efforts so far. Bottom Line: Chinese policymakers have not fully abandoned their financial deleveraging campaign, which President Xi Jinping initiated two years ago. This implies China’s central bank is likely to maintain its reactive approach in further easing monetary policy, and will likely try to avoid going “all-in” on stimulus for as long as possible. The Reduced Effectiveness Of Monetary Policy The events of the past year have also demonstrated that the effectiveness of Chinese monetary policy has declined relative to past economic cycles. This, in conjunction with the reluctant/reactive nature of the monetary authorities, has clear implications for investors over the coming year. When there is lack of clarity in policy interpretation, Chinese banks tend to stay on the sidelines. Chart 9A Long Delayed Credit Response To Monetary Easing The PBoC has cut the RRR five times since the second quarter of last year, which has freed up a total of 3.35 trillion yuan of liquidity for the banking system5 and has helped spur significant easing in overall monetary conditions. Yet, as we noted earlier, overall credit growth did not pick up until January of this year, lagging the first rate cut by three quarters (Chart 9). Prior to the economic slowdown in 2015-2016, credit growth used to respond to cuts in the RRR almost immediately. In other words, when banking system liquidity was ample, banks historically lent without hesitation. Post-2015, however, this relationship has changed. The PBoC has increasingly been having trouble channeling new liquidity into actual financing for the real economy. A sharp deterioration in reported bank asset quality that began in 2014 is likely part of the explanation,6 but we suspect that more recent extreme policy contradiction – in particular, repeated flip-flopping among authorities between their desire to support growth and their focus on financial stability – has caused economic agents to wait on the sidelines. While monetary conditions eased and the government urged banks to lend (particularly to the private sector) in the second half of 2018, the “prudent” stance coming from Chinese top leaders was little changed, and tight regulations on financial institutions remained in place. This combination did not give banks the confidence to lend. This changed in the first quarter of this year, when new credit creation-to-GDP surged from 23.6% to 25.6%. The surge occurred shortly after the late-December Central Economic Work Conference (CEWC), which sent a clear message that the central government’s policy focus had shifted to “stabilizing aggregate demand.” Incredibly, the tone shifted again in February, when Premier Li Keqiang and the PBoC publicly disputed whether the January credit spike represented “flood irrigation-style” stimulus, something Premier Li made clear was to be avoided.7 Charts 10 and 11 highlight how these shifts impacted credit growth: The first quarter was clearly on track for a 2015-2016-magnitude outcome, whereas April and May saw the path of credit growth return back to a moderate re-leveraging scenario. To get back on track for a 2015-2016 magnitude reflation, we will need to see June’s credit creation at or above 5 trillion yuan – equivalent to January’s credit numbers (Chart 12). Chart 12'Credit Binge' In June Unlikely As we go to press, the number for June’s total social financing has not been officially released yet. But the official reading from the total local government bond issuance in June (including both general bond and special-purpose bond issuance), a key component of our adjusted total social financing series, came in at 900 billion yuan. This is three times more than local government bonds issued in May and twice the size of January’s. Nevertheless, January’s bank lending, particularly short-term lending, was unusually large; an episode highly criticized by Chinese leadership as we mentioned above. As PBoC stated in its defense to this criticism, January is “traditionally the biggest month of the year for bank loans due to seasonal factors”. Therefore, without a clear shift in policy signal from China’s top leadership, we do not expect June’s bank lending number to be a repeat of January’s. Instead, June’s total credit impulse will likely put the cumulative progress in credit growth closer to our 27% of nominal GDP assumption (assuming an 8% nominal GDP growth for the remainder of 2019). This would fall into our “half-strength” credit cycle scenario relative to past reflationary episodes. Bottom Line: Ultimately, we do not doubt that Chinese policymakers will be able to engineer a significant re-acceleration in economic activity should they choose to do so. But in order for policymakers to achieve this goal, policy ambiguity and inconsistency will have to be meaningfully reduced.  Investment Implications Over a cyclical time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms. From our perspective, neither policymakers’ bias towards reluctance nor the reduced effectiveness of monetary policy convincingly argue against our bullish stance towards Chinese stocks over a cyclical (i.e. six- to twelve-month) time horizon, but the tactical implications are clearly negative. Over a cyclical horizon, one of two scenarios is likely to unfold: Either downside risk brought on by current tariffs and weakness in domestic demand is contained enough such that Chinese economic activity does not materially decelerate, or the trade dispute escalates into a full-tariff scenario of 25% on all U.S. imports from China that dramatically impacts Chinese growth. In the first scenario, policymakers will likely to continue providing half-measured responses, and unconstrained “across-the-board” easing will not occur. But Chart 13 highlights that Chinese stocks, particularly the investable market, are priced for a much worse economic outcome, suggesting Chinese relative equity performance would trend higher in these circumstances. Chart 13Chinese Stocks Priced In For A Worse Economic Outlook Chart 14Bullish On A Cyclical Horizon, Bearish In The Near Term In the second scenario, Chinese business and consumer sentiment is likely to collapse and policymakers will be facing high odds of a substantial slowdown in economic activity. This will create the political will necessary for unconstrained “across-the-board” easing, similar to what occurred in 2015-2016. The sharp re-acceleration in economic activity that would result from broad-based stimulus would clearly be positive for listed Chinese earnings per share (Chart 14), meaning the cyclical outlook for Chinese stocks would likely be even more positive than in the first scenario. However, the near-term equity market outlook of the second scenario would be extremely negative, as a financial market meltdown in of itself would likely be required to build the political will necessary to ultimately ease. Bottom Line: For investors with a time horizon of less than three months, we would not recommend a long position in Chinese stocks, neither in absolute terms nor relative to the global benchmark. However, over a strictly cyclical (i.e. six- to 12-month) time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      Please see Geopolitical Strategy Special Report, “China: How Stimulating is The Stimulus?”, dated August 8, 2018, available at cis.bcaresearch.com 2      A series of countercyclical measures China implemented in 2016-2017 includes: tightening controls on capital outflows, reducing offshore RMB liquidity supply, raising offshore RMB borrowing costs, and setting a firmer daily reference point for the RMB’s trading band. 3      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 4      Please see China Investment Strategy Weekly Report, “China Macro and Market Review”, dated July 4, 2019, available at cis.bcaresearch.com 5      According to PBoC announcements. 6      Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 7      Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights So What? U.S.-Iran risk is front-loaded, but U.S.-China is the greater risk overall. In the medium-to-long run the trade war with China should reaccelerate while the U.S. should back away from war with Iran. But for now the opposite is happening. A full-fledged cold war with China will put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. War with Iran or trade war escalation with China are both ultimately dollar bullish – even though tactically the dollar may fall. Feature Two significant geopolitical events occurred over the past week. First, U.S. President Donald Trump declared his third pause to the trade war with China. The terms of the truce are vague and indefinite, but it has given support to the equity rally temporarily. Second, Iran edged past the limits on uranium stockpiling, uranium enrichment, and the Arak nuclear reactor imposed by the 2015 nuclear pact. Trump instigated this move by walking away from the pact and re-imposing oil sanctions. If these events foreshadow things to come, global financial markets should position for lower odds of a deflationary trade shock and higher odds of an inflationary oil shock in the coming six-to-18 months. But is this conclusion warranted? Is the American “Pivot to Asia” about to shift into reverse? If the White House pursued a consistent strategy to contain China, it would bring Americans together and require forming alliances. In the short run, perhaps – but the conflict with China is ultimately the greater of the two geopolitical risks. We expect it to intensify again, likely in H2, but at latest by Q3 of 2020, ahead of the U.S. presidential election. Our highest conviction call on this matter, however, is that any trade deal before that date will be limited in scope. It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Our trade war probabilities, updated on June 14 to account for the expected resumption of negotiations at the G20, can be found in Diagram 1. The combined risk of further escalation is 68%. Diagram 1Trade War Decision Tree (Updated June 13, 2019 To Include G20 Tariff Pause) The risk to the view? The U.S.-Iran conflict could spiral out of control and the Trump administration could get entangled in the Middle East. This would create a very different outlook for global politics, economy, and markets over the next decade than a concentrated conflict with China.  The Missing Corollary Of The “Thucydides Trap” The idea of the “Thucydides Trap” has gone viral in recent years – for good reason. The term, coined by Harvard political scientist Graham Allison, refers to the ancient Greek historian Thucydides (460-400 BC), author of the seminal History of the Peloponnesian War. The “trap” is the armed conflict that most often develops when a dominant nation that presides over a particular world order (e.g. Sparta, the U.S.) faces a young and ambitious rival that seeks fundamental change to that order (e.g. Athens, China).1  This conflict between an “established” and “revisionist” power was highlighted by the political philosopher Thomas Hobbes in his translation of Thucydides in the seventeenth century; every student of international relations knows it. Allison’s contribution is the comparative analysis of various Thucydides-esque episodes in the modern era to show how today’s U.S.-China rivalry fits the pattern. The implication is that war (not merely trade war) is a major risk. We have long held a similar assessment of the U.S.-China conflict. It is substantiated by hard data showing that China is gaining on America in various dimensions of power (Chart 1). Assuming that the U.S. does not want to be replaced, the current trade conflict will metastasize to other areas. There is an important but overlooked corollary to the Thucydides Trap: if the U.S. and China really engage in an epic conflict, American political polarization should fall. Polarization fell dramatically during the Great Depression and World War II and remained subdued throughout the Cold War. It only began to rise again when the Soviet threat faded and income inequality spiked circa 1980. Americans were less divided when they shared a common enemy that posed an existential threat; they grew more divided when their triumph proved to benefit some disproportionately to others (Chart 2).    Chart 1China Is Gaining On The U.S. Chart 2U.S. Polarization Falls During Crisis   If the U.S. and China continue down the path of confrontation, a similar pattern is likely to emerge in the coming years – polarization is likely to decline. China possesses the raw ability to rival or even supplant the United States as the premier superpower over the very long run. Its mixed economy is more sustainable than the Soviet command economy was, and it is highly integrated into the global system, unlike the isolated Soviet bloc. As long as China’s domestic demand holds up and Beijing does not suppress its own country’s technological and military ambitions, Trump and the next president will face a persistent need to respond with measures to limit or restrict China’s capabilities. Eventually this will involve mobilizing public opinion more actively. Further, if the U.S.-China conflict escalates, it will clarify U.S. relations with the rest of the world. For instance, Trump’s handling of trade suggests that he could refrain from trade wars with American allies to concentrate attention on China, particularly sanctions on its technology companies. Meanwhile a future Democratic president would preserve some of these technological tactics while reinstituting the multilateral approach of the Barack Obama administration, which launched the “Pivot to Asia,” the Trans-Pacific Partnership, and intensive freedom of navigation operations in the South China Sea. These are all aspects of a containment strategy that would reinforce China’s rejection of the western order.   Bottom Line: If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective. So far these things have not occurred, but they are logical corollaries of the Thucydides Trap and they will occur if the Thucydides thesis is validated. How Would China Fare In The Thucydides Trap? China would be in trouble in this scenario. The United States, if the public unifies, would have a greater geopolitical impact than it currently does in its divided state. And a western alliance would command still greater coercive power than the United States acting alone (Chart 3). External pressure would also exacerbate China’s internal imbalances – excessive leverage, pollution, inefficient state involvement in the economy, poor quality of life, and poor governance (Chart 4).  China has managed to stave off these problems so far because it has operated under relative American and western toleration of its violations of global norms (e.g. a closed financial system, state backing of national champions, arbitrary law, censorship). This would change under concerted American, European, and Japanese efforts. Chart 3China Fears A Western 'Grand Alliance' Chart 4China's Domestic Risks Underrated How would the Communist Party respond? First, it could launch long-delayed and badly needed structural reforms and parlay these as concessions to the West. The ramifications would be negative for Chinese growth on a cyclical basis but positive on a structural basis since the reforms would lift productivity over the long run – a dynamic that our Emerging Markets Strategy has illustrated, in a macroeconomic context, in Diagram 2. This is already an option in the current trade war, but China has not yet clearly chosen it – likely because of the danger that the U.S. would exploit the slowdown. Diagram 2Foreign Pressure And Structural Reform = Short-Term Pain For Long-Term Gain Alternatively the Communist Party could double down on confrontation with the West, as Russia has done. This would strengthen the party’s grip but would be negative for growth on both a cyclical and structural basis. The effectiveness of China’s fiscal-and-credit stimulus would likely decline because of a drop in private sector activity and sentiment – already a nascent tendency – while the lack of “reform and opening up” would reduce long-term growth potential. This option makes structural reforms look more palatable – but again, China has not yet been forced to make this choice. None of the above is to say that the West is destined to win a cold war with China, but rather that the burden of revolutionizing the global order necessarily falls on the country attempting to revolutionize it. Bottom Line: If the Thucydides Trap fully takes effect, western pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy. This is where the risk of armed conflict rises. Introducing … The Polybius Solution The problem with the above is that there is no sign of polarization abating anytime soon in the United States. Extreme partisanship makes this plain (Chart 5). Rising polarization could prevent the U.S. from responding coherently to China. The Thucydides Trap could be avoided, or delayed, simply because the U.S. is distracted elsewhere. The most likely candidate is Iran. A lesser known Greek historian – who was arguably more influential than Thucydides – helps to illustrate this alternative vision for the future. This is Polybius (208-125 BC), a Greek who wrote under Roman rule. He described the rise of the Roman Empire as a result of Rome’s superior constitutional system. Polybius explains domestic polarization whereas Thucydides explains international conflict. Polybius took the traditional view that there were three primary virtues or powers governing human society: the One (the king), the Few (the nobles), and the Many (the commons). These powers normally ran the country one at a time: a dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator. His singular insight – his “solution” to political decay – was that if a mixture or balance of the three powers could be maintained, as in the Roman republic, then the natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers (Diagram 3). Diagram 3Polybius: A Balanced Political System Breaks The Natural Cycle Of Tyranny And Chaos In short, just as post-WWII economic institutions have enabled countries to reduce the frequency and intensity of recessions (Chart 6), so Polybius believed that political institutions could reduce the frequency and intensity of revolutions. Eventually all governments would decay and collapse, but a domestic system of checks and balances could delay the inevitable. Needless to say, Polybius was hugely influential on English and French constitutional thinkers and the founders of the American republic. Chart 6Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute What is the cause of constitutional decay, according to Polybius? Wealth, inequality, and corruption, which always follow from stable and prosperous times. “Avarice and unscrupulous money-making” drive the masses to encroach upon the elite and demand a greater share of the wealth. The result is a vicious cycle of conflict between the commons and the nobles until either the constitutional system is restored or a democratic revolution occurs. Compared to Thucydides, Polybius had less to say about the international balance of power. Domestic balance was his “solution” to unpredictable outside events. However, states with decaying political systems were off-balance and more likely to be conquered, or to overreach in trying to conquer others. Bottom Line: The “Polybius solution” equates with domestic political balance. Balanced states do not allow the nation’s leader, the elite, or the general population to become excessively powerful. But even the most balanced states will eventually decline. As they accumulate wealth, inequality and corruption emerge and cause conflict among the three powers.  Why Polybius Matters Today It does not take a stretch of the imagination to apply the Polybius model to the United States today. Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits – and this is true even without any historic crisis event to justify it. The rise in polarization has coincided with a rise in wealth inequality, much as Polybius would expect (Chart 7). In all likelihood the Trump tax cuts will exacerbate both of these trends (Chart 8). Even worse, any attempts by “the people” to take more wealth from the “nobles” will worsen polarization first, long before any improvements in equality translate to a drop in polarization. Chart 7Polarization Unlikely To Drop While Inequality Rises Chart 8Trump Tax Cuts Fuel Inequality Most importantly, from a global point of view, U.S. polarization is contaminating foreign policy. Just as the George W. Bush administration launched a preemptive war in Iraq, destabilizing the region, so the Obama administration precipitously withdrew from Iraq, destabilizing the region. And just as the Obama administration initiated a hurried détente with Iran in order to leave Iraq, the Trump administration precipitously withdrew from this détente, provoking a new conflict with Iran and potentially destabilizing Iraq. Major foreign policy initiatives have been conducted, and revoked, on a partisan basis under three administrations. And a Democratic victory in 2020 would result in a reversal of Trump’s initiatives. In the meantime Trump’s policy could easily entangle him in armed conflict with Iran – as nearly occurred on June 21. Iranian domestic politics make it very difficult, if not impossible, to go back to the 2015 setting. Despite Trump’s recent backpedaling, his administration runs a high risk of getting sucked into another Middle Eastern quagmire as long as it enforces the sanctions on Iranian oil stringently. Persian Gulf risks are coming to the fore. But over the next six-to-18 months, U.S.-China conflict will be the dominant market-mover. China would be the big winner if such a war occurred, just as it was one of the greatest beneficiaries of the long American distraction in Afghanistan and Iraq. It would benefit from another 5-10 years of American losses of blood and treasure. It would be able to pursue regional interests with less Interference and could trade limited cooperation with the U.S. on Iran for larger concessions elsewhere. And a nuclear-armed Iran – which is a long-term concern for the U.S. – is not in China’s national interest anyway. Chart 9Will The Pivot To Asia Reverse? Bottom Line: The U.S. is missing the “Polybius solution” of balanced government; polarization is on the rise. As a result, the grand strategy of “pivoting to Asia” could go into reverse (Chart 9). If that occurs, the conflict with China will be postponed or ineffective. Iran Is The Wild Card A war with Iran manifestly runs afoul of the Trump administration’s and America’s national interests, whereas a trade war with China does not. First, although an Iranian or Iranian-backed attack on American troops would give Trump initial support in conducting air strikes, the consequences of war would likely be an oil price shock that would sink his approval rating over time and reduce his chances of reelection (Chart 10). We have shown that such a shock could come from sabotage in Iraq as well as from attacks on shipping in the Strait of Hormuz. Iran could be driven to attack if it believes the U.S. is about to attack. Second, not only would Democrats oppose a war with Iran, but Americans in general are war-weary, especially with regard to the Middle East (Chart 11). President Trump capitalized on this sentiment during his election campaign, especially in relation to Secretary Hillary Clinton who supported the war in Iraq. Over the past two weeks, he has downplayed the Iranian-backed tanker attacks, emphasized that he does not want war, and has ruled out “boots on the ground.” Chart 10Carter Gained Then Lost From Iran Oil Shock Third, it follows from the above that, in the event of war, the United States would lack the political will necessary to achieve its core strategic objectives, such as eliminating Iran’s nuclear program or its power projection capabilities. And these are nearly impossible to accomplish from the air alone. And U.S. strategic planners are well aware that conflict with Iran will exact an opportunity cost by helping Russia and China consolidate spheres of influence. The wild card is Iran. President Hassan Rouhani has an incentive to look tough and push the limits, given that he was betrayed on the 2015 deal. And the regime itself is probably confident that it can survive American air strikes. American military strikes are still a serious constraint, but until the U.S. demonstrates that it is willing to go that far, Iran can test the boundaries. In doing so it also sends a message to its regional rivals – Saudi Arabia, the Gulf Arab monarchies, and Israel – that the U.S. is all bark, no bite, and thus unable to protect them from Iran. This may lead to a miscalculation that forces Trump to respond despite his inclinations. The China trade war, by contrast, is less difficult for the Trump administration to pursue. There is not a clear path from tariffs to economic recession, as with an oil shock: the U.S. economy has repeatedly shrugged off counter-tariffs and the Fed has been cowed. While Americans generally oppose the trade war, Trump’s base does not, and the health of the overall economy is far more important for most voters. And a majority of voters do believe that China’s trade practices are unfair. Strategic planners also favor confronting China – unlike Trump they are not concerned with reelection, but they recognize that China’s advantages grow over time, including in critical technologies. Bottom Line: While short-term events are pushing toward truce with China and war with Iran, the Trump administration is likely to downgrade the conflict with Iran and upgrade the conflict with China over the next six-to-18 months. Neither politics nor grand strategy support a war with Iran, whereas politics might support a trade war with China and grand strategy almost certainly does. China Could Learn From Polybius Too China also lacks the Polybius solution. It suffers from severe inequality and social immobility, just like the Latin American states and the U.S., U.K., and Italy (Chart 12). But unlike the developed markets, it lacks a robust constitutional system. Political risks are understated given the emergence of the middle class, systemic economic weaknesses, and poor governance. Over the long run, Xi Jinping will need to step down, but having removed the formal system for power transition, a succession crisis is likely. China’s imbalances could cause domestic instability even if the U.S. becomes distracted by conflict in the Middle East. But China has unique tools for alleviating crises and smoothing out its economic slowdown, so the absence of outside pressure will probably determine its ability to avoid a painful economic slump. This helps to explain China’s interest in dealing with the U.S. on North Korea. President Xi Jinping’s first trip to Pyongyang late last month helped pave the way for President Trump to resume negotiations with the North’s leader Kim Jong Un at the first-ever visit of an American president north of the demilitarized zone (DMZ). China does not want an unbridled nuclear North Korea or an American preventative war on the peninsula. If Beijing could do a short-term deal with the U.S. on the basis of assistance in reining in North Korea’s nuclear and missile programs, it could divert U.S. animus away from itself and encourage the U.S. to turn its attention toward the next rogue nuclear aspirant, Iran. It would also avoid structural economic concessions. Of course, a smooth transition today means short-term gain but long-term pain for Chinese and global growth. Productivity and potential GDP will decline if China does not reform (Diagram 4). But this kind of transition is the regime’s preferred option since Beijing seeks to minimize immediate threats and maintain overall stability. Diagram 4Stimulus And Delayed Reforms = Socialist Put = Stagflation If Chinese internal divisions do flare up, China’s leaders will take a more aggressive posture toward its neighbors and the United States in order to divert public attention and stir up patriotic support. Bottom Line: China suffers from understated internal political risk. While U.S. political divisions could lead to a lack of coherent strategy toward China, a rift in China could lead to Chinese aggression in its neighborhood, accelerating the Thucydides Trap. Investment Conclusions Chart 13An Iran War Will Bust The Budget If the U.S. reverses the pivot to Asia, attacks Iran, antagonizes European allies, and exhausts its resources in policy vacillation, its budget deficit will balloon (Chart 13), oil prices will rise, and China will be left to manage its economic transition without a western coalition against it. The implication is a weakening dollar, at least initially. But the U.S. is nearing the end of its longest-ever business expansion and an oil price spike would bring forward the next recession, both of which will push up the greenback. Much will depend on the extent of any oil shock – whether and how long the Strait of Hormuz is blocked. Beyond the next recession, the dollar could suffer severe consequences for the U.S.’s wild policies. If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Over the past week, developments point toward the former scenario, meaning that Persian Gulf risks are coming to the fore. But over the next six-to-18 months, we think the latter scenario will prevail.  We are maintaining our risk-off trades: long JPY/USD, long gold, long Swiss bonds, and long USD/CNY.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1      See Graham Allison, “The Thucydides Trap: Are The U.S. And China Headed For War?” The Atlantic, September 24, 2015, and Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Mifflin Harcourt, 2017).  

Highlights The EM equity and currency rebounds should be faded. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. This is the case in EM and China. Our leading indicators for the Chinese business cycle continue to point to intensifying profit contraction in both China and EM. The ratio of global broad money supply to the current value of securities worldwide is at an all-time low. This casts doubt on the “too much money chasing too few assets” hypothesis. Feature Chart I-1EM Share Prices: Decision Time EM share prices are at a critical juncture (Chart I-1). Their ability to hold their recent lows and break above their April highs will signify that a sustainable cyclical rally is in the making. Failure to punch through April’s highs will pose a major breakdown risk. In brief, EM is facing a make-it-or-break-it moment. Fundamentally, the outlook for EM risk assets and currencies largely hinges on economic growth in general and corporate profits in particular. In our June 20 report, we illustrated that the primary drivers of EM risk assets and currencies have historically been their business cycles and profit growth – not U.S. interest rates. Falling interest rates are positive for share prices when profits are expanding, even if at a slower rate. However, when corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Hence, lower global interest rates in of themselves are not a sufficient condition to foster a sustainable cyclical EM rally. As to EM corporate profits, the rate of their contraction will continue deepening. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. That is why BCA’s Emerging Markets Strategy team contends that EM risk assets and currencies, as well as China-plays, face the risk of a breakdown. This differs from BCA’s house view, which is positive on global risk assets in general. Global And Chinese Business Cycles: No Recovery So Far Chart I-2Chinese A-Share EPS Is Heading Into Contraction The rebound in EM risk assets and currencies since last December has occurred despite no improvement in both China’s business cycle and global trade, and despite the deepening contraction in EM corporate profits. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. So far, our baseline economic view has played out – mainland growth has been rather weak, and global trade has contracted. Yet EM financial markets have done better than we had anticipated. China’s domestic industrial new orders lead Chinese A-share earnings per share growth rate by about nine months and point to intensifying profit slump into early 2020 (Chart I-2). Furthermore, China’s adjusted narrow money(M1+)1 growth leads Chinese investable stocks earnings per share (EPS) by about nine months, and is also pointing to further compression (Chart I-3). Finally, Korea’s exports are shrinking, as are EM EPS (Chart I-4, top panel). Chart I-3Chinese Investable Companies' EPS Is Already Shrinking Chart I-4Korean Exports And EM EPS   Notably, both Korean exports values and EM EPS in U.S. dollars terms are on par with their early  2011 levels (Chart I-4, bottom panel). This indicates that neither Korean exports nor EM EPS have expanded sustainably over the past eight years. Chart I-5Global Stocks Did Not Lead Global PMI Historically Is it possible that the current gap between global share prices and global manufacturing is due to the fact that financial markets are forward-looking and lead business cycles? Historical evidence suggests that global share prices have not led the global manufacturing PMI, as exhibited in Chart I-5. In fact, global share prices have actually been coincident with the global manufacturing PMI not only throughout this decade but before that as well. The de-coupling between share prices and the manufacturing PMI is currently also present in EM, albeit in a less-striking form. Chart I-6 illustrates that the EM manufacturing PMI has slipped below 50 line, yet share prices have recently rebounded and sovereign spreads have tightened. In a nutshell, the divergence between global share prices and the global manufacturing PMI is unprecedented. This cannot be explained by falling global bond yields either. The latter were falling in the previous business cycle downtrends (2011-12 and 2015), yet share prices did not deviate from the global manufacturing PMI during those episodes (Chart I-5). Chart I-6EM PMI And EM Risk Assets Chart I-7The Rest Of World's Exports To China Will Continue Shrinking It seems that the global equity and credit markets expect an imminent recovery in the global business cycle in general and in China in particular. As we elaborated in the previous reports, the current global manufacturing recession stems primarily from China. Our leading indicators of the mainland business cycle suggest that more growth disappointments are likely before China’s growth and other economies’ shipments to the mainland hits a bottom (Chart I-7). For example, Korea’s exports to China in June were still dropping by 24% from a year ago. The primary reason for the lack of revival in growth is that China’s stimulus efforts have so far not been large enough, and the marginal propensity to spend among households and companies is diminishing, offsetting the positive effect of the stimulus, as we have discussed in previous reports. Will the recent G20 trade truce between the U.S. and China boost business confidence worldwide and in China? In our view, it is unlikely to produce a quick and meaningful recovery in business confidence among multinational companies and Chinese businesses. Corporate managers have probably come to realize that the U.S.-China row is not about import tariffs but rather geopolitical confrontation between the existing hegemon and a rising superpower. Hence, there is no easy solution that will satisfy both parties. An acceptable resolution for China will be unacceptable for the U.S., and vice versa. Hence, it will be hard to find a formula that gratifies both sides politically and economically. Overall, we reckon there are low odds in the next six months of an agreement between the U.S. and China that removes tariffs, addresses structural issues and satiates both nations. Korea’s exports are shrinking, as are EM EPS. Finally, even though the S&P 500 is hovering around its previous highs, under-the-surface dynamics have been less upbeat. Specifically, the equal-weighted share price index of U.S. high-beta stocks in cyclical sectors such as industrials, technology and consumer discretionary versus the S&P 500 has been tame and has not yet broken above its 200-day moving average (Chart I-8, top panel). The same holds true for the relative performance of an equal-weighted stock index of global cyclical sectors such as industrials, materials and semiconductors against the overall global equity benchmark (Chart I-8, bottom panel). Conversely, despite its recent setback, the U.S. dollar has technically not yet broken down (Chart I-9, top panel). In fact, our composite momentum indicator for the broad trade-weighted dollar has troughed at zero – a sign that downside is limited and another up-leg will likely emerge soon (Chart I-9, bottom panel). Chart I-8Cyclical Stocks Have Been Underperforming Chart I-9The U.S. Dollar Has Technically Not Broken Down   Bottom Line: The EM equity and currency rebounds should be faded. As EM currencies depreciate, sovereign and corporate credit spreads will likely widen. Asset allocators should continue underweighting EM equities and credit markets relative to their DM peers. Too Much Money Chasing Too Few Assets? Many investors identify “liquidity” as the main reason why global equity and credit markets have done so well this year, despite the relapsing global business cycle. Yet there are as many definitions of “liquidity” as there are investors. Many commentators use the term “liquidity” to denote balance sheet expansion by global central banks. As part of their quantitative easing programs, central banks in the U.S., U.K., Japan, the euro area, Switzerland and Sweden have expanded their balance sheets enormously. In line with their asset expansion, their liabilities – the monetary base, consisting primarily of commercial banks’ excess reserves – have also mushroomed. Nevertheless, broad money supply has grown only modestly in these economies.2 The principal reason behind this phenomenon has been a collapse in the money multiplier due to both banks’ unwillingness to boost lending proportionally to their swelling excess reserves, and a persistent lack of demand for credit among households and businesses. This computation casts doubt on the “too much money chasing too few assets” hypothesis. Broad money supply includes all types of deposits at commercial banks and cash in circulation. Crucially, it does not include commercial banks’ excess reserves at central banks. This differentiation between broad money and excess reserves at central banks is vital because excess reserves are not used to purchase goods, services or assets/securities. Hence, a true measure of purchasing power for assets, goods and services is broad money supply. Consistently, the pertinent liquidity ratio for financial markets can be computed by dividing global broad money supply by the value of all securities outstanding excluding those owned by central banks. The top panel of Chart I-10 depicts the ratio of the sum of broad money supply in 12 economies3 - excluding China - to the market value of investable global equities and bonds. The latter is calculated as the market cap of the Datastream World Equity Index plus the market value of the Barclays Aggregate Bond Index, excluding securities owned by central banks (Chart I-11). Bonds include both government and corporate issues. Chart I-10Comparing Global Broad Money And Market Value Of Outstanding Securities Chart I-11Broad Money, Securities Absorbed By QEs And Value Of Outstanding Securities   We exclude China from this calculation because its money supply (deposits) is not internationally “mobile” – i.e., due to capital controls, Chinese residents cannot convert their renminbi deposits to other currencies, or use them to purchase international securities. Likewise, we exclude Chinese on-shore equity and bond markets from the calculation because they are not easily accessible to all foreign investors. This broad money supply-to-asset values ratio can be regarded as a rough proxy for available liquidity for financial markets.4 Our interpretation is that a lower ratio means investors have lower cash balances relative to the value of financial assets they hold, and vice versa. Interestingly, the ratio of global broad money to the current value of securities worldwide is at an all-time low (Chart I-10, top panel). Hence, this computation casts doubt on the “too much money chasing too few assets” hypothesis. By flipping this ratio, we compute the ratio of market value of all investable securities (excluding the ones owned by central banks) to broad money supply (Chart I-10, bottom panel). It is at all-time high entailing that the market value of globally investable publically-traded securities has expanded much more than global broad money supply/deposits. Bottom Line: We recognize that this is a simplistic macro exercise, and a more comprehensive methodology is required to compute global cash balances that are available to purchase securities worldwide. However, at minimum the above casts doubt on the hypothesis that “too much money is chasing too few assets”. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      M1+ is calculated as M1 plus household demand deposits and deposits at third-party payment platforms. 2      Note that when a central bank purchases securities from commercial banks, this operation originates excess reserves, but not a new deposit at commercial banks. However, when a central bank acquires securities from a non-bank entity, such as a pension fund or an insurance company, this transaction creates both excess reserves and a bank deposit that did not exist before. Hence, QE programs have created some deposits but less so than excess reserves. 3      Economies included into this aggregate are the U.S., the euro area, the UK, Japan, Canada, Australia, Switzerland, Sweden, Korea, Taiwan, Hong Kong and Singapore. 4      This calculation does not strip out transactional demand for money, i.e., how much money is required to finance regular  economic activity. Given transactional demand for money is not stable, it is hard to estimate and adjust for it.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Chinese economy slowed in May following two months of improvement, but the June PMI data suggests that the pace of decline is moderating. Still, the economy remains highly vulnerable in a full-tariff scenario. This weekend’s agreement to continue trade talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. Our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. Feature The Caixin PMI decline in June appears to have been preceded by the official PMI in May. No change in the latter in June is thus somewhat encouraging. Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, May’s activity data shows that the economy slowed following two months of improvement, which underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy and is vulnerable to a further deterioration in external demand. The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI. June’s official PMI was flat on the month, which in combination with only a modest further decline in new export orders, implies that the May slowdown in activity noted above did not repeat itself in June (at least not in terms of magnitude) Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks actively outperformed the global benchmark over the past month as the latter rallied. The rally was in response to assurances from the PBoC about the capacity to ease further if needed, and the steadily rising odds over the course of the month that a new tariff ceasefire would be reached at the G20 meeting in Osaka. While this expectation was indeed validated, our view is that the agreement to continue talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. As such, our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Sharp Decline In Electricity Production China’s economy slowed in May according to the Bloomberg Li Keqiang index, after having picked up for two months in a row. While both electricity production and rail cargo volume fell in May, the former fell sharply, almost into negative territory (Chart 1). This underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy, and that economic activity is set to deteriorate meaningfully in a full-tariff scenario. Our LKI leading indicator rose modestly in May, with all six components showing an improvement. Still, the uptrend in the indicator is slight, and is being held back by the money supply components, particularly the growth in M2. Much stronger money & credit growth will be required if Chinese economic activity relapses and no deal to end U.S. import tariffs has occurred, but policymakers are likely to be reactive rather than proactive in this regard. The picture painted by China’s housing data continues to be a story of weak housing demand arrayed against seemingly strong housing construction and stable growth in house prices. However, we noted in a May 9 joint Special Report with our Emerging Market Strategy service that the strength observed in floor space started over the past year reflected a funding strategy by cash-strapped real estate developers.1 Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell property units in order to raise cash in a tight credit environment. On the demand side, the annual change in the PBOC’s pledged supplementary lending injection has strongly predicted floor space sold over the past four years; it remains deeply in negative territory and our measure declined in May for the 8th month in a row. Given that housing construction cannot sustainably decouple from housing demand, we expect floor space started to slow meaningfully over the coming several months absent a major pickup in housing sales. Chart 2The Flat Official PMI In June Is Somewhat Encouraging The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI (Chart 2). The official PMI was flat in June with only a modest further decline in new export orders, which implies that the May slowdown in activity noted above did not repeat itself in June, at least not in terms of magnitude. Chinese stocks have rallied 8-9% over the past month in U.S. dollar terms, outpacing the EM and global equity benchmarks. The rally initially followed comments from Governor Yi Gang that the PBoC had “tremendous” room to ease monetary policy if needed, and was sustained by expectations later in the month of a second tariff truce emerging from the G20 meeting in Osaka. For China-exposed investors, the issue is not whether Chinese policymakers have the capacity to support China’s economy, but rather the willingness to ease materially. From our perspective, the renewal of trade talks with the U.S. does not represent material progress towards the ultimate removal of tariffs. But the existence of talks is likely to give Chinese authorities a reason (for now) to avoid aggressively stimulating the economy, meaning that our 6-12 month investment outlook remains unchanged. Chart 3The BAT Stocks Will Outperform China If Chinese Stocks Outperform Global The significant outperformance of the investable consumer discretionary has been the most meaningful equity sector development over the past month. We have noted in past reports that changes last December to the global industry classification standard (GICS) mean that trends in investable consumer discretionary are now largely driven by Alibaba’s stock price, and Chart 3 highlights that the BAT stocks (Baidu, Alibaba, and Tencent) have indeed risen relative to the overall investable index. We noted in last month’s macro & market review that investors appeared to be wrongly conflating the risks facing Huawei (U.S. supply chain reliance) with those facing the BATs (the outlook for Chinese consumer spending), and the outperformance of the latter over the past month, as expectations mounted of another tariff truce emerging from the G20, would appear to validate this view. This implies that the outlook for the relative performance of the BATs versus the Chinese equity benchmark is likely to be the same as that of Chinese stocks versus the global benchmark: near-term risk, but likely to outperform over a 6-12 month time horizon. Chinese interbank rates fell over the past month, in response to an injection of liquidity by the PBoC following the collapse and takeover of Baoshang bank. The event marked the first takeover of a commercial bank in China since 1998, and has been described by authorities as an isolated event that was caused, in part, by the illegal use of bank funds. Market participants have clearly been concerned that Baoshang is not an isolated event; China’s 3-month interbank repo rate rose nearly 60bps from early-April to mid-June, and the PBoC’s response was intended to help prevent a significant tightening in credit conditions for China’s smaller lenders. While bad debt concerns have clearly impacted the interbank market over the past several weeks, there has been little impact on China’s onshore corporate bond market (Chart 4). Spreads on bonds rated AA+ did rise meaningfully in June, but have since nearly returned to late-May levels. We continue to recommend an overweight stance towards Chinese onshore corporate bonds, on the basis that market participants are pricing in a much higher default rate than we expect over the coming 6-12 months. The risk to Hong Kong is not the stability of the peg, but the impact of higher interest rates on an extremely leveraged economy. Chart 4The Onshore Corporate Bond Market Is Not Concerned By The Baoshang Takeover Chart 5HKD Strength Reflects More Than Just Falling U.S. Rate Expectations The Hong Kong dollar has strengthened significantly over the past month, with USD-HKD having retreated to the midpoint of its band. This has occurred in part because of declining U.S. interest rate expectations, but also because of a sharp rise in 3-month HIBOR versus the base rate (Chart 5). The strengthening in HIBOR seems linked to the anti-extradition bill protests, implying that HKD has strengthened due to anti-capital flight measures by the HKMA. We see no major risk to the currency peg at the moment, but discussed the negative implications of higher interest rates in Hong Kong on the region’s property market and share prices in last week’s joint report with our Emerging Market Strategy service.2   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “China’s Property Market: Making Sense Of Divergences”, dated May 9, 2019, available at cis.bcaresearch.com. 2      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “Hong Kong’s Currency Peg: Truths And Misconceptions”, dated June 27, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations