Emerging Markets

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 9Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The EconomyThe ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 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Highlights The political economy of oil will become even more complicated, following remarks by Russian Finance Minister Anton Siluanov over the weekend, which suggested policymakers there are considering another market-share war to crash prices to limit the growth of U.S. shales. The logic appears to be that by abandoning OPEC 2.0’s production-cutting deal and pushing Brent prices below $40/bbl once again for a year or so, Russia will severely reduce investment flow to the U.S. shale-oil patch, allowing it to retake global market share ceded mostly to Texas oil producers.1 The threat of a market-share war was proffered on top of stepped-up rhetoric by senior government officials – ranging from Igor Sechin, head of state-owned Rosneft Oil, to Kirill Dmitriev, CEO of the Russian Direct Investment Fund (RDIF) – indicating Russia will be pushing for higher production by OPEC 2.0 in 2H19 at the coalition’s upcoming June meeting. We agree with this assessment: The market will require OPEC 2.0 to lift production in 2H19, given our assessment of supply-demand balances. In our estimation, OPEC 2.0’s position has been strengthened considerably by policy-induced disruptions to the oil market.2 As such, we believe Russia’s threat of a market-share war is a feint, particularly since Russia has benefited greatly from higher prices (see below). Our balances and price forecasts this month are largely unchanged (Chart of the Week). We continue to expect Brent to average $75/bbl this year. For 2020, we expect Brent to average $80/bbl. WTI will trade $7 and $5/bbl lower (Chart 2). The balance of price risk has shifted slightly to the left side of the distribution, driven by policy risk and potential miscalculation by the dramatis personae on the international stage, chiefly leaders in the U.S., Russia and China. Chart of the WeekMarkets Continue To Track BCA Balances... Chart 2...While Prices Continue Tracking BCA Forecasts Highlights Energy: Overweight. Tensions in Libya could keep ~ 300k b/d of supply from reaching global markets via its Zawiya port near Tripoli. We closed our long June 2019 $70/bbl vs. short $75/bbl call spread last Thursday with a gain of 87.7%.3 Base Metals: Neutral. China’s latest credit data confirms our view the country’s credit cycle bottomed earlier this year: March Total Social Financing (TSF) increased CNY 2.8 trillion month-on-month vs. consensus expectation of CNY 1.7 trillion. This will support base metals in the coming months. We continue to expect Chinese authorities to expand credit in 2H19.Our long copper trade is up 0.7% since inception on March 7, 2019. We are closing out our tactical iron-ore trade – long 65% Fe vs. short 62% Fe at tonight’s close; it was up 22.9% at Monday’s close. Precious Metals: Neutral. Gold fell 4% from its February high on easing inflation concerns and as fears of an equity correction subsided. March U.S. PCE ex-food and -energy dropped to 1.79% yoy from 1.95% in February, while global equities rose 14% YTD. Our long gold recommendation is down 2.4% since last week, but is still up 3.6% since inception on May 4, 2017. Agriculture: Underweight. U.S. corn and wheat farmers are behind schedule in their spring planting, according to USDA data. The top four American corn-producing states had not started planting by last week, while spring and winter wheat producing states are 11% and 3% behind schedule, mostly due to weather conditions. While delays in planting are always cause for concern, we are still early in the planting season, which gives farmers time to catch up. Feature Policy uncertainty vis-à-vis global oil supply was elevated by Russian Finance Minister Anton Siluanov’s comments indicating policymakers are considering reviving an oil market-share war directed at U.S. shale-oil producers. Siluanov said prices could fall to $40/bbl or less, in the event. Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now His remarks come on the back of statements from Russian government and oil company officials lobbying for higher output. These comments suggest there is a heavyweight Russian contingent fully supporting these demands for OPEC 2.0 to increase production in 2H19 when it meets in June. Otherwise, the threat implies, Russia will seriously consider leaving OPEC 2.0, and will launch its own market-share war against U.S. shale-oil production, led by the fast-growing Permian Basin in Texas. Thus far, Russian President Vladimir Putin, who, among the policy elites of Russia, remains primus inter pares, has indicated he is satisfied with prices where they are now – nicely above $70/bbl in the Brent market. He also wants to maintain cooperation with OPEC 2.0, particularly its other putative leader, KSA. We continue to believe, however, KSA and Russia become less comfortable with Brent prices moving sharply above $80/bbl.4 Nonetheless, the threat posed by the U.S. shales is non-trivial: In our latest balances estimates, we raised our 2H19 U.S. output estimates to 12.53mm b/d, and slightly decreased our 2020 estimates to 13.35mm b/d”, led by a 1.17mm b/d and 0.84mm b/d increase in shale output this year and next (Chart 3). Chart 3U.S. Oil Production Estimate Higher For Shales However, Russia – and OPEC 2.0 generally – may be overestimating the rate of growth from U.S. shales going forward: In future research, we will be exploring the extent to which capital markets will restrain growth in the U.S. shales, as investors continue to demand higher returns. The days of growing shale production at any cost may be coming to an end. Russia’s Threat Is A Feint We believe Russia’s threat of a market-share war is a feint: A market-share war would damage the Rodina’s economy more than the balance sheets of U.S. shale producers, particularly those that hedge the first year or two of their production. The threat needs to be understood in the context of the deterioration of Russia’s position in Venezuela; the increasing tempo of U.S. military operations in its near abroad; and rapidly evolving global oil and gas trade flows, all of which are working against Russian interests and investments.5 The threat appears to be a not-too-subtle reminder of the havoc Russia still can create globally, should it choose to do so, as Vladimir Rouvinski noted recently re Russia’s Venezuela policy.6 Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. Russia’s GDP elasticity to oil prices is more than twice that of KSA’s, which we demonstrated last week.7 This means, from an economic standpoint, it benefits more from higher prices than the Kingdom, based on our modeling. Russia’s oil is exported to refiners and trading companies who pay whatever price is clearing the market, versus KSA, which relies more on direct investments in end-use markets to serve captive demand, and whose GDP has a higher sensitivity to EM economic growth. Russia almost surely is better off under the production-cutting regime launched by OPEC 2.0 than it would be in another price war. The coalition’s production-cutting deal this year has reduced global supplies by 1.0mm b/d since the beginning of the year, lifting price from below $50/bbl to more than $70/bbl, in line with our forecast. These production cuts have been supported by strong global demand this year this, which, we expect, will persist in 2020. Of course, Russia could abandon the production-cutting deal with KSA, in the hope of severely reducing investment in U.S. shale-oil production. However, it also would accelerate the loss of foreign direct investment (FDI) in its own hydrocarbons sector, along with those of other OPEC 2.0 member states (Chart 4). Bottom Line: A Russian market-share war aimed at U.S. shale producers would run the very real risk of tanking Russia’s GDP and those of the rest of OPEC 2.0’s member states, as these economies lack the resilience and diversification of the U.S.’s GDP, particularly Texas’s. Even if its fiscal balances are in better shape now, Russia’s economy remains highly sensitive to Brent crude oil prices – moreso than KSA’s, and far moreso the U.S.’s (Chart 5).8 Chart 4Another Oil Market-Share War Would Crush OPEC 2.0 In-Bound FDI Chart 5Russia Benefits More Than KSA From Higher Oil Prices BCA’s Balances Mostly Unchanged Our updated balances reflect the lower Venezuelan and Iranian output reported by OPEC’s survey of secondary sources (Table 1). As we have noted previously, we believe OPEC 2.0’s spare capacity is sufficient to cover the loss of Venezuelan output, and the limited losses on Iranian exports imposed by U.S. sanctions (Chart 6). Beyond that, however, the market will be severely stretched if an unplanned outage removes significant production from global supply. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) On the supply side, we continue to expect OPEC and Russia to lift supply in 2H19, following the successful draining of global inventories (Chart 7). We expect OPEC ex-Iran, Libya and Venezuela, led by KSA, will lift 2H19 supply by ~ 400k b/d vs. 1H19 levels, while we expect Russia’s output to rise 200k b/d. Chart 7Lower Inventories Require OPEC 2.0 Supply Increase In 2H19 We continue to expect oil demand to be supported by the renewed easing of monetary policy globally, which will redound to the benefit of EM demand, which also will benefit from the bottoming of China’s credit cycle. Indeed, the EIA added 130k b/d to its estimate of non-OECD demand for this year, on the back of stronger expected growth. We expect demand growth of 1.5mm b/d this year and 1.6mm b/d next year, with EM growth accounting for 1.1mm b/d of growth this year and 1.3mm b/d next year. In levels, global demand will average 101.8mm b/d and 103.4mm b/d in 2019 and 2020. Waivers On U.S. Iran Sanctions Will Be Extended We continue to expect waivers on U.S. sanctions of Iranian oil imports will be extended on May 2, owing to the still-tight supply conditions globally with Venezuela output collapsing and ~ 1mm b/d of Iranian oil already forced off the market. This has, as we’ve noted in our discussions of the New Political Economy of oil, strengthened OPEC 2.0’s hand. This will become apparent when the coalition meets in June to consider whether to increase production in 2H19, in line with our expectation. KSA, Russia and OPEC 2.0 member states will have sufficient data on hand to determine whether and by how much to lift output, in a manner that supports their GDPs. Indeed, on Wednesday, Russian Energy Minister Alexander Novak said, “We should do what is more expedient for us.”9 KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not. We also expect U.S. President Donald Trump to try to jawbone OPEC 2.0 into increasing production again, as he did in 2H18. However, we expect those demands to fall on deaf ears, unless fundamental supply dislocations warrant such action. Bottom Line: OPEC 2.0’s strategy is working – it will have maximum flexibility re how it handles its production in 2H19, following the U.S. decision on waivers to its Iran oil-export sanctions on May 2. As we noted last month, KSA and Russia appear to be managing production in a manner consistent with our forecasts of $75 and $80/bbl for Brent this year and next than not.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com     Footnotes 1      OPEC 2.0 is the name we coined for the OPEC/Non-OPEC oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It agreed in November to remove 1.2mm b/d off the market, in order to balance global supply and demand and reduce inventories.  Please see “Russia, OPEC may ditch oil deal to fight for market share: Russian minister,” published April 13, 2019, for a re-cap of Siluanov’s remarks. 2      Please see “The New Political Economy of Oil,” published by BCA Research’s Commodity & Energy Strategy February 21, 2019; and “OPEC 2.0: Oil’s Price Fulcrum,” published March 21, 2019.  It is available at ces.bcaresearch.com. 3      Please see “Oil steadies as market focuses on supply risks,” published April 15 2019 by reuters.com 4      Please see “Putin Says No Imminent Decision on Oil Output Cuts,” published April 10, 2019, by The Moscow Times. 5      Please see for example, “Pentagon developing military options to deter Russian, Chinese influence in Venezuela,” published by cnn.com April 15, 2019; “Destroyer USS Ross Enters Black Sea, Fourth U.S. Warship Since 2019,” published by news.usni.org April 15, 2019; and “U.S. LNG exports pick up, with Europe a major buyer,” published by reuters.com March 7, 2019. 6      Please see “Russian-Venezuelan Relations at a Crossroads” by Vladimir Rouvinski, published by the Wilson Center’s Kennan Institute in its February Latin American digest. 7      Please see “Sussing Out OPEC 2.0’s Production Cuts, U.S. Waivers On Iran Sanctions,” published by BCA Research’s Commodity & Energy Strategy April 11, 2019.  It is available at ces.bcaresearch.com. 8      We discuss the impact of higher oil prices on Russia’s economy in last week’s report, which is cited in footnote 6 above.  Russia’s GDP in 2017 was ~ U.S. $1.6 trillion, according to the World Bank, while the GDP of Texas was ~ $1.7 trillion, American Enterprise Institute. 9      Please see “Russia’s Novak: early to speak about options for oil output deal,” published reuters.com April 17, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 ​​​​​​​ Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights In China, “helicopter” money and the socialist put are positive for growth in the medium term but will prove harmful for the economy over the long run. In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks. The enormous amount of money supply in China is “the sword of Damocles” on the yuan’s exchange rate. A new equity trade: Short Chinese banks / long U.S. banks. Take profits on our short Chinese property developers / long U.S. homebuilders equity position. Feature Last week’s China credit and money data affirmed that Chinese banks have engaged in another round of massive credit and money injection into the economy. In the first quarter alone, aggregate credit rose by RMB 8.5 trillion (US$1.3 trillion). Aggregate credit growth accelerated to 11.6%, well above first-quarter nominal GDP growth of 8% (Chart I-1). This is in spite of numerous pledges by many of China’s top policymakers that they have no plans to resort to “floodgate irrigation” style stimulus, and that credit/money growth will be kept on par with nominal GDP growth. Our credit and fiscal spending impulse has spiked up, pointing to a potential improvement in economic data in the months ahead (Chart I-2). Chart I-1China: No Deleveraging At All What’s more, there is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Chart I-2China: Leading Economic Indicators   Regarding investment strategy, two weeks ago we put a stop-buy limit on the MSCI EM stock index at 1125. If this index breaks above this level we will turn tactically positive on EM risk assets. There is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Below are the pros and cons of upgrading the EM outlook at the current juncture. Pros The credit impulse in China leads both the mainland’s business cycle and the global manufacturing cycle by an average of nine months. Given its bottom was in December 2018, the trough in the mainland business and global industrial cycles should have been around August 2019 (Chart I-3). Chart I-3Global Manufacturing PMI Has Not Led Global Stocks Our assessment has been that the bottom in EM equities that occurred in late December 2018 was too early. Our basis has been that the Chinese and global manufacturing cycles were not likely to bottom before August 2019, according to their previous relationship with China’s credit and fiscal spending impulse. Consequently, we have been expecting China-related plays in financial markets to experience a setback before a more sustainable buying opportunity emerged. However, as China’s credit recovery is now gaining momentum and infrastructure spending financed by local government special bonds is accelerating, the window of downside risk for share prices is narrowing. There have been no recent major stimulus measures directed at China’s property market, but it appears banks have substantially boosted mortgage loan origination and their financing of property developers by loosening lending standards. Easy financing for both homebuyers and property developers makes a revival in real estate more likely. The property market and construction activity are critical to the mainland’s business cycle. If green shoots in the property market multiply, the odds of an overall growth recovery will rise substantially. Finally, if the EM equity index breaks above our stop-buy limit, it would clear an important technical resistance level, confirming the sustainability of this rally (Chart I-4). Cons EM corporate profit growth is contracting in U.S. dollar terms, and the pace of contraction will deepen into the end of this year. This assessment is based on the previous decline in China’s credit impulse. The latter suggests a bottom in EM EPS in December 2019 (Chart I-5). It is still unclear whether EM share prices can ignore this profit contraction and advance through the entire year without major bumps. Chart I-4EM Stocks Are Facing Technical Resistance Chart I-5EM Profits Will Continue Contracting   As of March, Chinese domestic smartphone sales (Chart I-6), as well as Korean, Japanese, Singaporean and Taiwanese exports to the mainland, are all still shrinking at double-digit rates from a year ago (Chart I-7). Chart I-6China: Consumer Spending In March Was Still Weak Chart I-7Exports To China Contracted At A Double-Digit Rate In March   Our indicators for marginal propensity to consume for Chinese households and companies remain in a downtrend as of March (Chart I-8). An upturn in these indicators is needed to validate that the fiscal and credit stimulus is accompanied by a greater multiplier effect. Chart I-8China: Marginal Propensity To Spend By Consumers And Enterprises Chart I-9Low Vol Precedes A ##br##Regime Shift Finally, financial markets’ aggregate volatility is extremely low (Chart I-9). This is especially true for the currency markets (Chart I-10, top panel). Typically, this is a sign of both complacency and a forthcoming major regime shift in financial markets. Chart I-10The Dollar Is Poised To Break Out Or Break Down We would be much more comfortable upgrading the EM outlook if the broad trade-weighted U.S. dollar broke down, corroborating the improvement in global/EM growth. So far, the greenback has been moving sideways along its 200-day moving average (Chart I-10, bottom panel). If the dollar breaks out, it would confirm the negative outlook for EM. Investors should closely watch foreign exchange markets and adjust their investment strategy accordingly. “Helicopter” Money Forever = A Socialist Put China’s forthcoming recovery is good news for financial markets. Nonetheless, the long-term outlook for the Chinese economy is deteriorating because the credit and money, as well as property bubbles, will keep expanding. First, China holds the world record with respect to corporate sector leverage (Chart I-11). Second, households in China are more leveraged than those in the U.S. (Chart I-12). Given that borrowing costs for households are higher in China than in the U.S., interest payments take up a larger share of Chinese households’ disposable income. Chart I-11Corporate Sector Leverage: China Holds The World Record Chart I-12Chinese Households Are More Leveraged Than Americans   Third, contrary to popular belief, banks do not channel savings/deposits into credit. They create deposits/money supply when they lend to or buy assets from non-banks. Money supply is the sum of deposits and cash in circulation. Financial markets’ aggregate volatility is extremely low. This is especially true for the currency markets. In a nutshell, credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. We have elaborated on this point in a series of reports we have written on credit, money and savings.1 When commercial banks originate a loan, they create new money and new purchasing power “out of thin air.” Nobody needs to save for a bank to make a loan or buy assets. Consequently, new purchasing power for goods and services boosts demand in the real economy and inflates asset prices. Chinese banks have literally been dropping “helicopter” money over the past 10 years. Since January 2009 – the onset of the country’s massive credit binge – banks have created 165 trillion yuan ($25 trillion) of new broad money, based on our measure of M3 broad money. This is triple of the $8.3 trillion broad money supply created in the U.S., the euro area and Japan combined during the same period (Chart I-13, top panel). Chart I-13Helicopter Money In China China’s broad (M3) money supply now stands at 220 trillion yuan, equivalent to $32.5 trillion. What’s astonishing is that Chinese broad money is larger than the sum of broad money in both the U.S. and the euro area (i.e. all outstanding U.S. dollars and euros in the world combined) (Chart I-13, bottom panel). Yet China’s nominal GDP is only 38% of U.S. and euro area’s GDP combined. Credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. In a market-based economy, the constraints on banks doing “helicopter” money are bank shareholders, regulators and central banks. Bank shareholders are the primary and largest losers from credit booms because they are highly exposed to non-performing loans. That is why they should be the first to cut credit flows to the economy when they sense non-payments on loans could rise. In China, neither bank shareholders nor bank regulators or the People’s Bank of China have prevented banks from expanding credit/money. Moreover, the authorities have not forced banks to acknowledge non-performing loans. This scenario – whereby banks expand credit without taking responsibility for collecting the loans – only occurs in a socialist system. This is the ultimate socialist put. China’s Potential Growth Roadmaps We have been arguing for several years that China is facing a historic choice between: (1) Moving toward a more market-based economic system that entails making creditors and borrowers take responsibility for their lending/borrowing and investment decisions. If lenders and borrowers are made explicitly accountable for their business/financial decisions, then credit flows will decelerate considerably, bankruptcies will mushroom and a period of deleveraging will be inevitable. However, the quality of capital allocation will improve, enhancing the country’s productivity and potential growth in the long run (Chart I-14). This is a scenario of medium-term pain, long-term gain. The recent ramp-up in credit growth does not suggest the authorities are willing to embrace this option. Chart I-15China: Structural Growth Tailwinds Have Dissipated (2) “Helicopter money” and a socialist put scenario entails lower potential GDP growth and rising inflation. If China continues opting to keep the socialist put in place, its potential growth rate – which is equivalent to the sum of growth rates in productivity and the labor force – will drop significantly. In the long run, this socialist put discourages innovation and breeds capital misallocation, reducing productivity growth. In fact, the industrialization ratio is 85% – not 60% as many contend(Chart I-15, top panel). Further, China’s labor force growth has stalled and will be mildly negative in the years to come (Chart I-15, bottom panel). Together, these circumstances point to a slower potential growth rate. Meanwhile, recurring stimulus via “helicopter” money will create mini-cycles around a falling potential growth rate (Chart I-16). Below we discuss the investment strategy this scenario entails. Implications Of The Socialist Put For The Currency… Slowing productivity and rampant money/purchasing power creation ultimately lead to rising inflation. Higher inflation and low interest rates - required to sustain an ever-rising debt burden - are a recipe for currency depreciation. Chinese households and businesses are eager to diversify their copious and mushrooming renminbi deposits into foreign currencies and assets. The PBoC’s foreign exchange reserves of $3 trillion are equal to only 10% of the amount of yuan deposits and cash in circulation. Foreign exchange reserves’ coverage of local currency money supply is much higher in many other EM countries, including Brazil and Russia (Chart I-17). Chart I-17China's FX Reserves Cover Less Local Currency Deposits Than Peers The enormous amount of money supply/deposits in China is “the sword of Damocles” on the yuan’s exchange rate in the long run. It is therefore inconceivable that China can fully open its capital account in the foreseeable future. On the contrary, capital account restrictions will be further tightened. Plus, the current account will become much more regulated so that there is no leakage of capital via trade transactions – such as over-invoicing of imports or under-invoicing of exports. The inability to repatriate capital when needed and structural RMB depreciation are the key risks to long-term investors in China’s onshore capital markets. …And Chinese Stocks In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks: Investors should attempt to play the resultant mini-cycles (Chart I-16). In reality, however, economic and especially financial market mini-cycles are not symmetric, and investors can make money only if they time them properly. In fact, this decade Chinese share prices – both in absolute terms and relative to global stocks – have experience wild swings (Chart I-18). Chart I-18Chinese Stocks Are Following Mini-Cycles Concerning the current outlook for Chinese investable stocks, our take is as follows: On absolute performance, we will turn positive on Chinese share prices if our stop-buy on EM equities is triggered, as per our discussion above. As for their relative performance within EM and global equity portfolios, simply because the stimulus originates in China does not warrant an overweight position in Chinese stocks. The primary losers from credit bubbles are banks and other financial companies. The basis is that they will carry the burden of potential rising non-performing loans unless the government bails them out by purchasing bad assets at par. The latter has not been the case so far this decade. Hence, an underweight position in Chinese banks/financials is currently warranted. Furthermore, the large debtors in the non-financial corporate sector should also be underweighted. When a company increases its debt but its new investments produce little net new cash flow, its equity value declines. It is difficult to find so many high-return investment projects, especially in a slowing economy. Therefore, another round of considerable capital misallocation is currently underway, and shareholders of the companies that are undertaking these investments will end up losing. In a socialist system, shareholders typically do not make money. They lose money. This is the rationale to underweight Chinese stocks within both EM and global equity portfolios. Yet, there is a caveat: This framework may not be pertinent to the two largest companies in the Chinese investable equity index Ali-Baba and Tencent - each of which accounts for 13% of the index. These two companies score well on the above issues but face different non-macro hazards including regulatory, business model and other risks. Weighing the pros and cons, we recommend maintaining a market weight allocation in Chinese equities within an EM equity portfolio. This is the view of BCA’s Emerging Markets Strategy team, which differs from the recommendations of other BCA services that are currently advocating an overweight position in Chinese stocks within a global equity portfolio. A New Trade: Short Chinese Bank / Long U.S. Bank Stocks Chinese banks’ equity value will erode as they once again expand their balance sheets aggressively, as per our discussion above. Chinese banks’ EPS have been and will continue to be diluted by the need to raise more capital. U.S. banks are better capitalized, and their asset quality is much better. Since the 2007-08 credit crisis, they have been much more prudent in expanding their balance sheets. U.S. bank stocks have underperformed the S&P 500 index since August 2018 because of falling U.S. interest rate expectations. The odds are high that U.S. bond yields are bottoming and will rise considerably – because the drag from China’s slowdown on the global economy is diminishing. This will help U.S. bank stocks. Although Chinese bank stocks optically appear undervalued, they are “cheap” for a reason. The fact that they have been “cheap” since 2011 and have failed to re-rate confirms that they suffer from chronic problems that have not been addressed yet (Chart I-19). Finally, their relative performance is facing a major resistance level, and will likely relapse (Chart I-20). Chart I-19Chinese Banks Are Cheap##br## For A Reason Chart I-20A New Trade: Short Chinese Banks / Long U.S. Banks   Take Profits On Short Chinese Property Developers / Long U.S. Homebuilders Position “Helicopter” money might be temporary positive for mainland property developers. In the meantime, share prices of U.S. homebuilders will be hurt due to rising U.S. bond yields. We are closing this position to protect profits. This recommendation has produced a 90% gain since its initiation on March 6, 2012. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "Misconceptions About China's Credit Excesses," dated October 26, 2016 and Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations