Emerging Markets
Highlights Despite having the largest negative return of major markets during the global equity market correction, China's investable stock selloff appears to be normal after controlling for its risk characteristics. Taken together, the association between the global correction and volatility/valuation should be viewed as a sharp reduction in complacency in the market. Several factors make us cautious about China's outsized tech sector exposure in a world of reduced complacency. We recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. Feature Chart 1An Average Size, But Very Rapid, ##br##Global Selloff Global equities have sold off quite sharply since the end of January, having declined a total of 9% in US$ terms from their January 26 high to last Friday's close (Chart 1). BCA addressed the rout in a Special Report last week,1 and noted that strong economic growth and positive earnings surprises are likely to keep the global equity bull market intact, a view largely supported by this week's stock market behavior. Still, the report also highlighted that investors need to adjust to the fact that realized volatility is likely to sustainably rise, even if forward-looking volatility measures (such as the VIX in the U.S.) are currently too elevated. More generally, we equate the return of volatility with a reduction in complacency, and in this week's report we explore the implications of lower complacency for investors with an overweight allocation towards Chinese equities. Our judgement is that the complacency risk for China's ex-tech equity market is low, but that the same cannot be said for China's technology stocks. We conclude by recommending two trades that investors can employ to retain cyclical exposure to investable Chinese stocks, but with a neutralized exposure to the tech sector. Normal Underperformance For China Chart 2At First China Appears To Be Among ##br##The Worst Performers... At first blush, China's investable stock market fared quite poorly during the global stock market correction. Chart 2 lists 21 major country stock markets by the magnitude of their decline in US$ terms and highlights that China's selloff ranks at the very top of the list. But a simple comparison of stock market performance is misleading, as it fails to adjust for the different degrees of riskiness that are normally observed across global equity markets. For example, it is well known that emerging market equities have tended to be high beta relative to global stocks over the past decade, and we noted in a recent Special Report that Chinese investable stocks have become high beta even relative to emerging markets. In order to properly compare the performance of these markets during the global stock market selloff, we rely on the concept of "abnormal return" that is often employed in event study analysis. This approach involves calculating a counterfactual "normal" return for each market based on its rolling 1-year alpha and beta versus global stocks prior to the selloff, and then comparing it to the actual return. This difference, the "abnormal return" of each market, is shown in Chart 3, which highlights that China's performance during the selloff was perfectly normal after controlling for its risk characteristics. In fact, Chart 3 shows that many equity markets outperformed on a risk-adjusted basis, highlighting that the magnitude of the selloff in global stocks could actually have been worse. As for the underlying cause of the selloff, we showed in last week's Special Report that a crowded "short volatility" trade was undoubtedly a driving force: Chart 4 highlights that net long speculative positions on the VIX had fallen to a new low over the past six months, a circumstance that has now completely reversed. But Chart 5 shows that valuation also appears to have been a factor contributing to the selloff, by presenting the abnormal returns shown in Chart 3 as a function of the difference between the market's 12-month forward P/E and that of the global benchmark. While the fit is somewhat loose, the chart confirms that markets with higher (lower) forward P/E ratios were more likely to have negative (positive) abnormal returns over the two-week period. Chart 3...But Not After Adjusting##br## For Riskiness Chart 4The Low-Vol Trade Contributed ##br##To The Speed Of The Selloff... Taken together, the association between the selloff and volatility/valuation should be viewed as a sharp reduction in complacency in the market. While this does not necessarily bode poorly for global equities over the coming 6-12 months, there are some potential implications to explore for China's investable stock market. Chart 5...But Valuation Was Also A Factor Complacency Risk And Chinese Stocks The sharp reversal in global markets raises the question of whether Chinese equities are complacent about some looming risk. The obvious candidate for complacency risk in China would be focused on its economy, and the potential for a more substantial economic slowdown than is currently expected by market participants. However, we are unconvinced that Chinese ex-tech stocks are somehow neglecting the risks facing China's economy over the coming year. First, we have noted in previous reports that Chinese investable ex-tech stocks are extremely cheap versus global ex-tech stocks, highlighting that investors have priced in a degree of structural risk. Second, recent economic data releases from China do not suggest that the pace of the ongoing economic slowdown is accelerating, suggesting that there is no basis to expect a severe downturn over the coming year. But we acknowledge that the same cannot be said for China's tech sector. While Chinese tech stocks are not stretched on a technical basis (either versus the investable benchmark or versus global tech stocks), several observations make us cautious about China's outsized tech exposure in a world of reduced complacency: First, the growth rates of IBES 12-month trailing and forward earnings growth for global technology stocks are currently at the 80th and 85th percentiles, respectively (Chart 6). This suggests that a substantial amount of fundamental improvement has already been priced in to global tech stocks, raising the risk of earnings disappointment over the coming year. Given that China's tech sector weight (42%) is considerably above that of the global benchmark (18%), a global tech selloff would cause China's investable stock market to underperform even if Chinese tech performance is in line with that of the global tech sector. Second, relative to global technology stocks, the growth rates of China's 12-month trailing and forward earnings growth are also quite elevated, at the 80th and 70th percentiles, respectively (Chart 6 panel 2). This suggests that the tech earnings exuberance observed globally is even worse in China. Third, Chart 7 highlights that China's tech sector has been responsible for pushing our relative composite valuation indicator for China into overvalued territory over the past year. Relative to global ex-tech, China's ex-tech stocks are still significantly cheap; relative to global tech, China's tech stocks are significantly overvalued. Last, we have noted in past reports that China's tech sector appears to be a domestic consumer play, and thus unlikely to significantly underperform over the coming year. However, we also noted in last week's report on China's housing market that the optimism of the consumer sector may be somewhat unfounded if it is based on expectations of future gains in employment and/or income.2 While we do not expect a broad-based retracement in China's consumer sector, even a moderate decline in consumer confidence could spark a non-trivial selloff in Chinese tech stocks given the stretched fundamental picture highlighted above. Chart 6Tech Earnings Growth##br## Is Significantly Stretched Chart 7Tech Stocks Have Pushed China ##br##Into Overvalued Territory Investment Recommendations Given our observations about the complacency risk facing Chinese tech sector stocks, we are making the following changes to our investment recommendations: We are closing our overweight MSCI China Free versus the emerging markets benchmark trade for a 31% relative return. This has been a core trade for BCA's China Investment Strategy service and has provided investors with significant outperformance since its initiation in May 2012. We are opening two new trades as a replacement for the closed China / EM position: 1) long MSCI China investable ex-technology / short MSCI All Country World ex-technology, and 2) long MSCI China investable value / short All Country World value. These two new trades are a slight variation of a single theme, which is to retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector. While style indexes such as value and growth normally do not have such a stark sector orientation, Chart 8 highlights that the relative performance of China value vs global value looks very similar to our internally-calculated ex-technology indexes for both markets. This is because MSCI's China growth index is almost entirely made up of tech sector stocks, meaning that a relative value play effectively mimics an ex-tech position. As a final point, we noted above that it is difficult to see how Chinese ex-tech equities are complacent about the ongoing slowdown in China's economy. Chart 9 supports this view by presenting a model for China's investable ex-tech 12-month trailing earnings in US$ terms, based on the Li Keqiang index. The model fit has been tight over the past decade, and is currently forecasting roughly 10% earnings growth over the coming year. This would clearly represent a significant deceleration from current levels, but it is still a decent earnings result that signals Chinese ex-tech stocks are attractive on a risk/reward basis given the sizeable valuation discount that is levied on China relative to global stocks. Chart 8China Ex-Tech And Value:##br## Similar Performance Vs Global Chart 9Positive Ex-Tech Earnings Growth Likely, ##br##Even With A Slowing Economy We remain alert to the possibility of a further, more pronounced slowdown in China's economy, but barring that Chinese ex-tech stocks appear to be a solid buy over the coming 6-12 months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "The Return Of Vol", dated February 6, 2018, available at gis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Is China's Housing Market Stabilizing?", dated February 8, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The trajectory of EM bank profits and share prices will be critical to sustain the EM equity rally. Rising U.S. bond yields will push up EM local bond yields. This, along with poor quality of banks' earnings, will likely halt EM banks' stock rally. We reiterate our strategic equity position: short EM banks / long U.S. banks. The same strategy can be replicated in credit markets. In China, bank loan data are no longer indicative of aggregate lending to all segments of the economy. Banks' total claims, total assets, and money aggregates have all slowed. The Korean won is making a major top. Short it against an equal-weighted basket of the U.S. dollar and yen. Feature Chart I-1Rising U.S. Bond Yields = Higher EM Local ##br##Bond Yields And Lower Bank Stocks The key financial market variables with respect to the outlook for emerging markets (EM) are commodities prices, the U.S. dollar and EM bank share prices. We have written extensively on the former two, and today we elaborate on the third pillar: the importance of banks/financial stocks to the EM aggregate equity index. First, surging U.S. Treasurys yields point to higher EM local currency bond yields (Chart I-1, top panel). In turn, EM banks' share performance inversely correlates with EM local bond yields (Chart I-1, bottom panel). Altogether, this heralds lower EM bank share prices. Second, financials make up 24.4% of the MSCI EM equity market cap, with banks accounting for 18% out of the 24.4%. Hence, financials/banks' price fluctuations are critical to the EM equity benchmark. Importantly, financials' earnings accounts for 33.6% of EM listed companies earnings. By contrast, technology accounts for 27.6% of the EM market cap, but only 23.3% of EM total earnings (Table I-1). As to the EM technology sector, it is heavily skewed toward four large companies: Tencent, Alibaba, Samsung and TSMC. The latter two have already shown considerable weakness, with Samsung breaking down below its 200-day moving average (Chart I-2). Analyses on the former two companies are beyond the realm of macro research. What's more, these stocks are extremely overbought and probably expensive. If the rest of EM goes down, these two stocks are not likely to preclude it from happening. Third, banks in China, Turkey, Indonesia, Malaysia and Brazil have been boosting their reported EPS by reducing their provisions outright or the pace of provisioning. Table I-1EM Equity Sectors: Earnings & Market Cap Weights Chart I-2Is EM Tech Hardware Breaking Down? For various reasons, we believe these reductions in provisions are unjustified. In China, Turkey and Malaysia, NPLs are too low to begin with: the more accurate measures of NPLs are probably much higher in these banking systems given the magnitude and duration of the preceding credit boom (Chart I-3 and Chart I-4). Chart I-3China: Banks' Provisions Are Inadequate Chart I-4Turkey And Malaysia: ##br##Falling Provisions Are Untenable In Brazil and Indonesia, the recent weakness in nominal GDP growth - shown inverted on the chart - does not justify the outright reduction in the level of net new NPL provisions (Chart I-5). In short, some EM banks have inflated their EPS in recent quarters by reducing provisioning for bad loans. This suggests that their EPS quality is poor, and their profit recovery is unsustainable. Bottom Line: EM bank share prices have reached their previous high but are unlikely to break above that level, in our opinion (Chart I-6). Chart I-5Brazil And Indonesia: Declining ##br##Provisions Are Unsustainable Chart I-6EM Bank Share Prices ##br##Are Facing Resistance We reiterate our strategic call of being short EM banks and long U.S. bank stocks. The relative share price performance of EM versus U.S. banks has been inversely correlated with U.S. bond yields (Chart I-7). Chart I-7Rising U.S. Bond Yields = ##br##EM Banks Underperformance If our view on higher U.S. bond yields materializes, odds are that EM bank share prices will relapse considerably versus U.S. banks. Traders should consider implementing this trade. Credit investors can replicate the same strategy in credit markets. Strategy Considerations Investor sentiment remains bullish on risk assets in general and emerging markets in particular. The buy-on-dips mentality is well entrenched. Amid such investor consensus, it is important to consider alternative scenarios. Presently, the relative performance of Swiss versus global non-financial stocks is sitting on its long-term moving average (Chart I-8). Odds of a rebound in the relative performance of Swiss non-financial stocks from such oversold levels are fairly high. As and when the latter begin outperforming their global peers, it might entail a negative outlook for global bourses in general and cyclical equity sectors in particular. The basis is that Swiss non-financial stocks are defensive in nature, as pharmaceuticals and consumer staples account for a large portion of the total market cap. Not surprisingly, the previous bottoms in Swiss non-financials' relative performance versus global non-financials coincided with major tops in global equity bull markets. For now, the risk-reward for global stocks is unattractive, and the outlook for EM relative performance is extremely poor. Notably, relative manufacturing PMI trends favor DM over EM stocks (Chart I-9). Chart I-8Swiss Stocks Are At Critical Juncture: ##br##What Does It Mean For Global Equities? Chart I-9EM Relative To DM: PMIs And Share Prices Besides, as we discussed at great length in our recent report,1 EM equity valuations are on par with DM when adjusted for sector weights and sub-sectors with outlier valuation ratios. Our stance remains that EM risk assets will face a perfect storm this year for two reasons: Strong U.S. growth will cause U.S. inflation to rise, and the selloff in U.S. bonds has further to run. Higher U.S. interest rates should support the U.S. dollar and weigh on EM risk assets that have benefited disproportionally from the search for yield; While China's growth has slowed only moderately, our forward-looking leading indicators continue to point to further deceleration. A combination of these two tectonic shifts will amount to a perfect storm for EM risk assets in 2018. We explore these two issues in greater detail below. U.S. Inflation, The Fed And The U.S. Dollar We have the following observations on current U.S. economic dynamics: Fiscal stimulus is arriving at a time when growth is already robust, and the labor market is tight. This will likely produce higher inflation. Inflation does not need to surge to make a difference in financial markets. It would be fair to say investors have become complacent and financial markets are still pricing in a goldilocks scenario. Therefore, even a moderate rise in core inflation readings along with some anecdotal evidence that companies are able to raise prices will lead to further re-pricing in U.S. interest rate expectations. Higher U.S. interest rates pose a risk to EM, which have benefited considerably from the search for yield. EM currencies, domestic bonds and credit markets have so far held up well, despite the considerable rise in U.S. bond yields (see Chart I-1 on page 1). Based on this, it is tempting to argue that EM will be immune to rising U.S. interest rate expectations. Nevertheless, we believe this EM resilience has occurred because fund flows to EM remain very robust. These flows are often backward looking. Odds are that 10-year U.S. Treasury yields will move well north of 3%. Such a considerable rise in yields will weigh on EM risk assets. It is essential to realize that the positioning in EM stocks, local bonds and credit is more elevated today than it was before the 2015 downturn. Finally, Chart I-10 illustrates that U.S. banks' excess reserves at the Federal Reserve have started to drop. In recent years the periods of reserve declines have coincided with a strong U.S. dollar, yet the latest drop in banks' excess reserves has not yet produced a meaningful rally in the greenback (the dollar is shown inverted in Chart I-10). The Fed's ongoing tapering efforts and the U.S. Treasury's replenishment of its account at the Fed are bound to produce further reductions in banks' excess reserves. Based on the latter's correlation with the exchange rate, this should support the greenback. Notably, the U.S. dollar is fairly valued, according to our most favored valuation measure: the unit labor cost-based real effective exchange rate (Chart I-11). This takes into account both wages and productivity, and hence gauges competitiveness much better than real effective exchange rate measures that rely on consumer and producer prices. Chart I-10Shrinking U.S. Banks Excess ##br##Reserves = Stronger U.S. Dollar Chart I-11The U.S. Dollar Is Not Expensive Finally, tax cuts are supply side reforms, and they are typically bullish for the currency. Bottom Line: A combination of stronger growth, rising interest rate expectations, neutral valuations and oversold conditions should help the U.S. dollar to rebound. The rally in the U.S. exchange rate versus EM currencies will be pronounced if China's growth slows, as we expect it to. Making Sense Of Chinese Data China's slowdown has so far been moderate. However, in any economy a downturn almost always begins with a moderation in growth. That, however, is not sufficient reason to conclude that the growth slump will be benign or short-lived. Judgement on the duration and magnitude of a slowdown should be based on the existence of major macro imbalances, or lack thereof. Given that China has enormous money, credit and property market excesses/imbalances and policy has been tightening, we believe that growth disappointments will be non-trivial and more substantive than the market consensus currently expects. The following corroborate the case for a deepening growth slump ahead: The annual change in the manufacturing new orders-to-inventory ratio from the National Bureau of Statistics points to a relapse in Caixin's manufacturing PMI as well as steel, iron ore and coal prices (Chart I-12). This indicator also heralds a decline in analysts' EPS net revisions for all Chinese stocks (Chart I-13). Chart I-12China: An Impending Slowdown Chart I-13China: EPS Net Revisions Have Peaked While some economic data like imports for January were strong, it is important to realize that this January had a few more working days compared with January 2017 due to the Chinese New Year falling in February this year. Although the same seasonal adjustment should be applied to money and credit data, there are other critical dimensions specific to the credit data that investors should be aware of. Banks' loans to companies and households - widely watched by the investment community - was very strong in January relative to the previous month. However, loan and most of other data in China should be seasonally adjusted. The annual growth rate in RMB bank loans is still very robust at 13.2% (Chart I-14, top panel). However, the growth rates of banks' total assets, total claims and broad money have all dropped close to 10% or below (Chart I-14). The disparity between bank loans on the one hand and their claims and assets on the other is due to the following: In China's banking statistics, banks' loans to non-bank financial institutions - such as financial trusts, investment corporations, insurance, financial leasing companies and auto-financing companies, and loan companies - are not included in banks' loan data. Hence, bank loan data do not reveal the banks' full impact on the economy. By extending credit to non-bank financial institutions, banks have expanded their balance sheets without exceeding their loan quotas. In short, banks have funded shadow banking and by extension the real economy and speculative investment schemes but have done so via non-bank financial institutions. In addition, banks have also bought a lot of corporate and local government bonds that are not considered loans. Overall, bank loans have been understating the degree of the banking system's credit expansion. In the past year, regulators have been forcing banks to reduce their lending to non-bank financial institutions. With this channel of balance sheet expansion restricted (Chart I-15, top panel), banks are probably resorting to more traditional loans to expand their balance sheets and earn income. Chart I-14China: Bank Loans, ##br##Assets And Total Claims Chart I-15China: Bank Lending To Shadow ##br##Banking Is Being Curtailed In short, one needs to look at banks' aggregate claims on all entities - companies, households, non-bank financial institutions and governments - to assess whether their lending to the economy is slowing or accelerating. Chart I-16China: Structure Of Bank Assets Consistent with the ongoing regulatory clampdown, banks' claims on non-bank financial institutions - so called shadow banking - have plummeted in the past 12 months after expanding 50-70% annually for several years in a row (Chart I-15, top panel). The bottom three panels of Chart I-15 indicate that the annual growth rates of banks' claims on companies, household and the government have either already decelerated or are slowing now. Their respective shares in banks' total assets are displayed in Chart I-16. While banks' RMB loans remain the largest category of assets, the importance of other claims has risen. Bottom Line: Several leading indicators continue pointing to an impending slowdown in the mainland's economy. Bank loan data is no longer indicative of total bank assets expansion/aggregate lending to all segments in the economy. Broader measures - such as banks' total claims, assets and money aggregates - have decelerated considerably. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Korea: A Major Top In The Won The Korean won is vulnerable on several fronts: Its real effective exchange rate based on unit labor costs is well above its historical mean (Chart II-1, top panel). Importantly, based on this same measure, the won is very expensive versus the Japanese yen (Chart II-1, bottom panel). The manufacturing cycle has already weakened in Korea (Chart II-2). Chart II-1The Won Is Expensive Chart II-2Korea's Manufacturing Is Weakening Japanese exports in U.S. dollar terms are starting to outperform Korean ones (Chart II-3), suggesting that Korean exporters might be losing market share to their Japanese rivals. Furthermore, manufacturing inventories are rising sharply in Korea but not in Japan (Chart II-4). Relative manufacturing inventory trends also favor the yen versus the won (Chart II-4, bottom panel). Chart II-3Relative Exports: Korea Versus Japan Chart II-4Manufacturing Inventories: Korea And Japan The won's appreciation has depressed Korea's export prices in local-currency terms. In Japan, on the other hand, local-currency export prices are holding better. Interestingly, the relative export price trend in U.S. dollars points to the won's depreciation versus the yen (Chart II-5). Korean non-financial stocks have broken below their 200-day moving average, which corroborates that corporate profitability is deteriorating (Chart II-6). Korean equities have been among the world's worst-performing bourses year-to-date. Chart II-5Export Prices: Korea And Japan Chart II-6Korean Non-Financial Stocks Are Cracking In addition, the correction in Korean stocks commenced before the recent plunge in the S&P 500. This highlights that the relapse in Korean share prices was not only due to the contagion from the U.S. equity selloff. Finally, the technical profile of the won points to a major top. Chart II-7 shows that the won is facing multi-year technical resistance versus the U.S. dollar. Chart II-7KRW/USD Exchange Rate: ##br##A Long-Term Technical Profile Investment Conclusions We have been short the Korean won versus the Thai baht since October 19, 2016 and this trade has produced a 7.3% gain. We recommend closing this trade and shorting the won versus an equally-weighted basket of the U.S. dollar and yen. The rationale to short the KRW versus this basket is to hedge against a possible near-term U.S. dollar selloff if China is forced to revalue the RMB further, as we discussed in February 7, 2018 report.2 In regards to equities, we are closing our long KOSPI / short Nikkei trade with a 1% loss since April 26, 2017. Within the EM universe, we continue recommending a neutral allocation to Korean stocks excluding technology. Despite their recent underperformance, EM-dedicated managers should continue overweighting Korean tech stocks. The reasoning behind this is that the potential currency depreciation will help their corporate profitability as tech shipments are not exposed to Chinese capital spending. The latter will be the epicenter of negative growth surprises in our opinion. Finally, Korean local bond yields will soon top out as the deflationary pressures from a stronger currency become more evident in the economy. Korean bonds will outperform U.S. Treasurys on a currency-hedged basis. 1 Please refer to Emerging Markets Strategy Special Report, titled "EM Equity Valuations (Part I)," dated January 24, 2018, the link is available on page 19. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "A Regime Shift?," dated February 7, 2018, the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The recent house price weakness in Tier 1 markets likely reflects past economic "information", and does not suggest that a more pronounced slowdown is forthcoming. In fact, while it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored. These signs suggest that, at a minimum, the risk of a material housing downturn has somewhat eased. This is consistent with an overweight stance towards Chinese investable stocks within an emerging market or global equity portfolio. The enormous rise in Chinese investable real estate stocks over the past year reflects a significant improvement in fundamentals and a re-rating from deeply depressed levels. Our Sector Alpha Portfolio suggests that cutting exposure is not yet warranted, but investors should tighten their stops given now lofty earnings expectations over the coming year. Feature We presented our framework for tracking the end of China's mini-cycle in an October 2017 Weekly Report,1 and noted at that time that a weakening housing market was a trend that needed to be monitored. We argued that a moderation in house price appreciation was all but inevitable given the magnitude of the boom over the prior 2 years, and was not concerning in isolation. But we also highlighted that home sales and prices were a key bellwether of the efficacy of policymakers' reflationary efforts over the course of the recent mini-cycle, and that an eventual stabilization of the pace of decline would be an important signal confirming the benign nature of China's economic slowdown. Chart 1A Sharp Decline In Tier 1 House Prices The rate of appreciation in Chinese house prices has moderated further since we wrote our October report (Chart 1), with prices in Tier 1 markets (Beijing, Shanghai, Guangzhou, and Shenzhen) having recently decelerated to 0%. In this week's report we provide a brief update on China's housing market, and whether recent house price weakness is consistent with our benign slowdown view. We conclude that the softness in house prices, even in Tier 1 markets, has occurred due to the ongoing economic slowdown and does not likely reflect new information about the condition of the Chinese economy. In fact, while it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored. A Stylized View Of China's Housing Cycle Chart 2 presents a stylized description of the sequencing of China's housing market cycles since 2010, at the onset of China's "new normal" period of decelerating economic growth. Chart 3 presents these dynamics directly and illustrates the lag structure that has prevailed over the period. Chart 2A Stylized View Of China's Housing Market Dynamics: 2010 - Present Chart 3Residential Floor Space Sold And House Price Diffusion Indexes Lead ##br##Other Housing Market Data The charts highlight how residential floor space sold has tended to lead other major housing market data in China over the past several years, closely followed by house price diffusion indexes and the year-over-year house price index for Tier 1 markets. These series are, in turn, followed by residential floor space started, the growth rate of house prices in Tier 2 & 3 markets, and finally by land purchased for overall real estate development. Charts 2 & 3 present two noteworthy observations: While Tier 1 house prices have tended to lead prices in Tier 2 and Tier 3 markets, they themselves tend to be preceded by other important housing market series. The extent of the recent decline in Tier 1 house prices seems to simply be the mirror image of the enormous boom that occurred in late-2015 / early-2016, when prices rose over 30% year-over-year. Given the significant slowdown in floor space sold that has occurred since mid-2016, and the enormous rise in prices that preceded it, it seems reasonable to conclude that the recent price weakness in Tier 1 markets likely reflects past economic "information". The more salient question for investors is what developments are likely to occur in China's housing market over the coming year, and what investment strategy conclusions emerge from the outlook. The Cyclical Outlook For Chinese Housing While it is too soon to conclude that China's housing sector is about to enter a significant upturn, there are several signs of a potential pickup in activity that should be closely monitored: Charts 2 & 3 highlight that residential floor space sold has had the best leading properties of the overall housing market cycle in China over the past several years, and there has been a modest pickup in this series since October (Chart 4). Admittedly, there have been two false starts in this series since mid-2016, so it is too early to tell from this data alone that China's housing market activity is about to pick up significantly. However, there has also been a notable improvement in our BCA China 70-City House Price Diffusion Index (Chart 5), which measures the share of cities with accelerating year-over-year house prices. We flagged the previous sharp decline in this measure in our October report, but the recent rebound has resulted in a complete round-trip from last summer's levels. Official diffusion indexes, based on the number of cities with positive month-over-month price gains, are also well above the boom/bust line and have not deteriorated to the same extent as our index has over the past year. Chart 4A Modest Pickup##br## In Housing Sales Volume Chart 5A Notable Pickup##br## In Our House Price Diffusion Index The recent pickup in house prices may be linked to the rolling back of purchase restrictions in some cities, but the correlation is far from perfect. For example, Shijiazhuang, Xiamen, Changsha, Xi'an, and Lanzhou have all been cited in various news reports as having adjusted their housing policies, but none of these markets have experienced a pickup in house price appreciation. We will be watching for more compelling signs over the coming months that local housing market deregulation is the root cause of the recent pickup in our diffusion index. The easing in "for sale" floor space inventory to sales over the past two years has reduced some of the housing overhang, which may cause a moderate boost to new housing construction. Chart 6 highlights that the ratio of residential floor space started to sold has fallen significantly over the past few years, as inventories have been drawn down. Since most of the economic impact from housing comes through the construction process, a pickup in floor space started could shift the growth outlook for China in a positive direction. On the negative side, while survey data suggests that Chinese consumers are upbeat and are looking to buy a home (Chart 7), other indicators suggest that this pickup in interest may be occurring due to unfounded optimism about future employment and/or income. First, we have highlighted in several reports over the past months that the Li Keqiang index is falling (driven significantly by monetary tightening, including rising mortgage rates), which suggests that China's business cycle is shifting down, not up. This clearly raises the risk that income and employment growth with downshift with it. Second, Chart 8 highlights that the employment components of the official manufacturing and services PMIs have stagnated again, after having picked up in 2016 and early-2017. Third, Chart 9 illustrates that while per capita disposable income growth for urban households did pick up during the same period as the employment PMIs, it may be in the process of peaking (especially given the weak Q4 print). Chart 6An Easing In Inventories May Boost##br## New Housing Construction Chart 7Chinese Consumers ##br##Are Upbeat... Chart 8...But Employment Prospects Aren't Great... Chart 9...And Neither Is Recent Income Growth Investment Strategy Implications The first investment strategy implication is that our analysis is consistent with a benign view of the ongoing economic slowdown in China, which supports an overweight stance towards Chinese investable stocks within an emerging market or global equity portfolio. While it is too soon to conclude that housing is about to enter a significant upturn, the risk of a material housing downturn has somewhat eased. Second, a potential pickup in China's housing sector raises the question of whether construction-related sectors are poised to significantly outperform China's investable benchmark over the coming year. We recently closed our long investable building materials / short investable benchmark trade as part of a stringent trade review process, based on the view that a significant upturn in the housing market was far from guaranteed. Our analysis in this report supports that decision, as signs of a significant pickup are tentative at best. However, we will be actively looking to re-open the trade at some point over the coming months were we to observe compelling evidence that a significant acceleration in housing construction is imminent. Third, signs of a potential inflection point in China's housing market would normally be positive for the investable real estate stocks, but the outlook for this sector is clouded by its massive outperformance over the past year. We last wrote about real estate stocks in a September Weekly Report,2 and argued that a positive re-rating from extremely discounted levels had further to run. Indeed, our composite valuation indicator highlights that real estate stocks have merely become fairly valued over the past year (Chart 10), despite a 95% US$ price return in 2017. While this underscores that there has been a major fundamental improvement for Chinese investable real estate companies, Chart 11 highlights that these stocks are now priced for another year of 20-30% EPS growth, which may be a tall order unless a very substantial pickup in Chinese housing market activity materializes. Chart 10Chinese Real Estate Stocks ##br##Are Not Overvalued... Chart 11...But They Are At Risk Of ##br##An Earnings Disappointment For now, the BCA China Investable Sector Alpha Portfolio that we introduced in our January 11 Special Report continues to support an overweight stance towards the investable real estate sector (Table 1),3 and we are reluctant to recommend that investors cut their exposure to these stocks. Still, tight stops may be warranted, especially if the recent pickup in residential floor space sold proves to be fleeting. Table 1Our Investable Sector Alpha Portfolio Still Favors Real Estate Stocks Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Real Estate: Which Way Will The Wind Blow?", dated September 28, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Chart 1No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China Chart 9EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation
Highlights China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the dollar. Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to China's economy. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Feature Chart 1A Sharp Rise In CNY/USD The Chinese Renminbi (RMB) has risen over 4% versus the U.S. dollar since mid-December, and global investors have begun to take notice (Chart 1). The sharp acceleration in the RMB has raised several questions in the minds of market participants: What is the likely economic impact of the rise, and how does this fit into the view that China's ongoing growth slowdown is likely to be benign and controlled? How will policymakers respond to the strength in the exchange rate? Is there a risk of a 2015-style depreciation that would roil global financial markets? In this week's report we offer our perspective on these issues, and provide investors with forecasts for the RMB assuming a 5% appreciation or depreciation of the U.S. dollar versus major currencies over the coming 6-12 months. While it is true that the broad RMB trend has risen non-trivially over the past year, we conclude that is too early to view this rise as a threat to the export sector. This supports our view of a benign, controlled economic slowdown in China, as well as a cyclical overweight stance towards Chinese equities. Putting Recent Exchange Rate Movements In Context In order to answer the questions noted above, it is important to examine recent exchange rate movements in the context of China's ongoing efforts to internationalize the RMB, as they have had a substantial impact on the relationship between the RMB and the U.S. dollar over the past few years. Beijing has been taking steps for years to promote the global use of the RMB, but these efforts came into sharp focus on August 11-12, 2015, when the PBOC devalued the currency versus the U.S. dollar (Chart 2). In addition to the devaluation, the PBOC changed the way that the daily fixing rate would be set, in a fashion that increased the sensitivity of the rate to market forces. The PBOC made these changes at the time that they did for two specific reasons: The IMF was in the process of deciding whether to include the RMB in the SDR basket, after having stated that a more market-based RMB rate was a precondition for inclusion. The policy to link the RMB to the U.S. dollar was causing significant appreciation of the former during a period of enormous dollar strength. Given the decision to alter the fixing rate mechanism, the PBOC decided to devalue the exchange rate by a modest amount in one, bundled policy change. The important point for investors is that the market turmoil that followed the August 2015 changes to the exchange rate overshadowed a much more consequential announcement on December 11, 2015 that precipitated a shift in the link between the RMB and the US dollar (USD) towards multiple currencies.1 At first blush, the "decision" made by the PBOC in December was trivial: they announced that the China Foreign Exchange Trade System (CFETS) would publish an index for the RMB measured against a basket of foreign currencies. But the implication of the announcement was that the PBOC was shifting its focus from managing CNY/USD to managing the value of the RMB versus the currencies of many trading partners. Essentially, December 2015 marked the beginning of a new exchange rate policy in China. The effect of this new policy change can clearly be seen in the relationship between CNY/USD and the trade-weighted RMB versus the U.S. dollar (Chart 3). The chart highlights that the beta of J.P. Morgan's nominal trade-weighted RMB versus the Bloomberg U.S. Dollar Spot Index was strongly positive prior to 2016, whereas the beta of CNY/USD to the Dollar Index was weak. Following the PBOC's policy shift, these relationships traded places: the beta between CNY/USD and the dollar became much more negative, whereas the strength of the U.S. dollar / trade-weighted RMB link weakened considerably. Chart 2The August 2015 Deval Significantly##br## Impacted Global Markets Chart 3A New Exchange Rate Regime Began##br## In December 2015 Bottom Line: China's new exchange rate regime has significantly weakened the link between the U.S. dollar and the broad RMB trend, at the expense of a stronger (negative) relationship between CNY/USD and the broad dollar trend. The Economic Implications Of China's New Exchange Rate Policy Chart 4The Recent Rise In CNY/USD ##br##Has Been Dollar-Driven Given our discussion above, the recent strength of the CNY/USD exchange rate should not be surprising: Chart 4 highlights that its sharp rise is largely the mirror image of recent U.S. dollar weakness. Panel 2 illustrates another way of observing this effect; EUR/USD typically trades inversely to the broad dollar trend, and CNY/EUR has been little changed over the past six months. The key questions for investors are 1) how to assess what impact the broad RMB appreciation over the past year will have on Chinese export growth, and 2) what future dollar movements might imply for the broad RMB trend. We use two metrics to gauge the likely impact of broad exchange rate movements on export growth: a fair value assessment (Chart 5), and the rise of an export-weighted RMB index relative to its high and low points over the past few years, when the exchange rate was clearly negatively and positively contributing to monetary conditions (Chart 6). The charts highlight that the real effective RMB is currently cheap, and that a nominal export-weighted index is only marginally above the median value since 2015. Neither of these measures implies that the rise in the RMB has reached levels that would be restrictive for exports. Chart 7 shows that the annual growth rate of our export-weighted RMB index has been predicted quite well by that of the dollar index and the CNY/USD exchange rate over the past two years. Based on this regression, Chart 8 presents what is likely to occur to our export-weighted RMB index in a 5% appreciation & depreciation scenario. The chart shows that the impact of a 5% appreciation (which we expect) will be muted, whereas a 5% depreciation in the dollar would cause a meaningful further rise in the export-weighted RMB. Still, it would not be enough to push the index to a new high, nor would it cause the real effective RMB shown in Chart 5 to rise into expensive territory. Bottom Line: Our metrics to gauge the impact of broad RMB movements on exports suggest that the recent rise is not yet a threat to the export sector. A further 5% depreciation in the U.S. dollar would cause a meaningful further increase, but not one large enough for our metrics to flash a warning sign. Chart 5The RMB Is Cheap In REER Terms Chart 6Rising, But Not Yet Near Previous Highs Chart 7The Dollar and CNY/USD Explain ##br##The Broad RMB Trend Chart 8Further Dollar Depreciation Would Bite, ##br##But Not Disastrously So August 2015, Redux? Given that the PBOC's devaluation of the RMB in August 2015 roiled global financial markets, it seems natural to ask whether the Chinese central bank could cause another shock by again depreciating the CNY/USD exchange rate. In our view, the answer is no. First, there are several reasons why the PBOC is unlikely to intervene to limit a rise in CNY/USD barring material further strength: Trade frictions with the U.S. remain, and a stronger CNY/USD could reduce the likelihood that the Trump administration will levy across-the-board tariffs on Chinese imports The PBOC recently reduced the influence of the "counter-cyclical factor" that was included in the CNY/USD midpoint formula. Since the factor was introduced to lessen the impact of market forces on the yuan's reference rate, the PBOC would likely have refrained from making any changes to it if they were unduly worried about the upward impact of recent dollar declines on CNY/USD If the PBOC becomes uncomfortable with the extent of the RMB rise in trade or export-weighted terms, it could aim to lower the yuan versus other key trading partners, including the euro area. As noted above, CNY/EUR has recently remained flat during the euro's sharp recent upleg versus the dollar. We noted that the RMB is now cheap in real effective terms (Chart 5), unlike in August 2015 when the deviation from fair value was the highest that it had been since mid-2000. Chart 92015 Vs Today: A Completely Different ##br##Global Economic Backdrop Second, even if the PBOC were to depreciate the CNY/USD exchange rate over the coming months, we doubt that investors would react in the same way as they did to the initial devaluation. As we reviewed in a Weekly Report last October,2 the global economy was suffering from a synchronized slowdown, and the surprise decision caused global investors to speculate heavily that additional devaluations were likely. The current condition of the global economy is clearly quite different than that which prevailed in the summer of 2015. Global PMIs are the most synchronized that they have been since the earliest phase of the economic cycle (Chart 9), which suggests that a significant slowdown is not imminent. Even if the pace of growth becomes narrower or slows modestly, it is difficult to envision the same kind of panicked response absent a separate and highly impactful accompanying shock. Bottom Line: Several factors argue against the probability of an August 2015-style CNY/USD devaluation. Even if the PBOC were to do so, global investors would likely react very differently than they did in 2015, given the underlying strength of the global economy. Investment Strategy Implications Chart 10Export Impact Of The RMB Appreciation##br## Is Non-Trivial, But Manageable Over a 6-12 month time horizon, there are two investment strategy implications of our above discussion. First, our analysis suggests that investors should focus on the broad RMB trend rather than the CNY/USD exchange rate when determining the likely impact of currency fluctuations on China's growth picture. It is true that an export-weighted RMB index has risen by a greater amount over the past year than a typical trade-weighted RMB (or the CFETS RMB index) would suggest (Chart 10), but for now it is too early to conclude that this represents a threat to the export sector. This conclusion is consistent with our view that China's ongoing economic slowdown will be benign, and controlled in nature. Second, given the tight (negative) link between CNY/USD and the U.S. dollar, and our view that USD is more likely to appreciate than depreciate over the coming months, it is true that the US$ relative performance of Chinese equities may be somewhat negatively impacted by a retracement in CNY/USD. But as we noted when presenting our "decision tree" for Chinese stocks at the beginning of the year,3 the cyclical condition of China's business cycle is the dominant factor that investors should consider when judging the appropriate allocation to Chinese equities. As such, our focus on China's exchange rate remains on how it impacts the growth outlook, and our judgement on this question continues to support a favorable stance towards the equity market. Bottom Line: Stay overweight Chinese investable stocks over the cyclical investment horizon, despite a likely dollar-driven retracement in CNY/USD over the coming months. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 http://www.pbc.gov.cn/english/130721/2988680/index.html 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Decision Tree For Chinese Stocks", dated January 4, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The U.S.'s twin deficits do not explain the drop in the USD; Global growth is the biggest factor for the USD, and growth depends on China's economic reforms; The U.S. is turning more hawkish on China trade despite Beijing's reform-induced vulnerability; U.S. and Chinese political dynamics suggest upside risks in the former and downside in the latter; Go long DXY. Feature American policymakers scrambled to walk back Treasury Secretary Steven Mnuchin's "weak dollar" comments last week. Investors were left to wonder why Mnuchin broke with the long-held official position of favoring a strong dollar. Was it a "shot across the bow" of China, warning Beijing that the U.S. would engage in currency manipulation if it was not given concessions on trade? Or was it an admission that the U.S. would run large "twin deficits" - a budget deficit and a current account deficit - going forward? We don't have a good explanation for what Mnuchin said in Davos.1 But we can say with some conviction that the "twin deficit" explanation, which has been brought up in almost every client conversation so far this year, is wrong. Chart 1Twin Deficits: Why The Panic? Chart 2Because The Narrative Is Scary First, who says that the U.S. is about to widen its twin deficit (Chart 1)? The concern arises periodically in the marketplace but is often grossly off the mark in predicting the path of deficits or the dollar (Chart 2). We expect the budget deficit to hold steady in 2018, if not contract. Why? Because the fiscal deficit almost always contracts in the eight quarters before a recession, barring, in some cases, one or two quarters just before the recession hits (Chart 3). Unless investors have a high-conviction view that a recession is afoot in the next two quarters, they should ignore the dire predictions about the U.S. budget deficit. Chart 3The Deficit Is Not A Problem... Yet Chart 4Bond Market Not Sniffing Out Any Twin Deficit Crisis If the risk to the U.S. economy is to the upside, as we believe due to the tax cuts and unleashing of animal spirits, then deficits will come down regardless of additional tax or spending policy.2 In the long term, yes, the budget deficit will almost certainly expand due to entitlement spending, the impact of automatic stabilizers during a recession, and the loss of revenue from tax cuts. But long-term deficit concerns are the purview of the bond market, not currency traders. So what is the bond market telling us? Chart 4 shows that the yield curve tends to steepen as the twin deficit widens; both tend to occur during and after recessions. Today, however, the curve continues to flatten. Another fixed-income market indicator that tends to track budget deficits is the 30-year swap spread, which falls during recessions as budget deficits expand. But today the swap spread is not falling, it is increasing and doing so at the fastest pace since the 2008 recession (Chart 5). This may be a sign of resurgent animal spirits as banks throw caution - and concerns over Obama-era overregulation - to the wind. Credit demand is rising in the economy, which should increase both the velocity of money and growth. Concerns over the widening fiscal deficit are not being reflected in this indicator. Finally, our currency strategist, Mathieu Savary, has pointed out that a widening twin deficit only impacts developed economies' currencies about 50% of the time over 12 month periods. In other words, expansion of the twin deficit predicts currency moves about as well as flipping a coin. What really matters is how central banks respond to the causes and economic effects of the twin deficits. Protectionism, on the other hand, ought to be bullish for the dollar.3 As such, a potential trade war between China and the U.S. should not be the reason for the dollar's deepening doldrums. And while we are generally open to alarmism on trade protectionism - due to the fact that President Trump has few constitutional or political constraints holding him back on this issue - there is still not enough evidence to say whether the Trump administration will impose across-the-board tariffs on China. (See next section.) Could dollar weakness, conversely, be the result of a Plaza Accord 2.0 orchestrated between Chinese and American policymakers to depreciate the greenback in order to avert the need for protectionist policies? We doubt it. First, the U.S. and China economic dialogue has faltered. Second, the dollar would not have declined following the Plaza Accord had the Fed not aggressively cut rates from 1984 to 1985 by 423 basis points (Chart 6). And the Fed is obviously not cutting rates today, it is hiking them. Chart 5No Sign Of Deficit Here Chart 6The Fed Is More Important Than Politics... So, what matters for the U.S. dollar? Higher domestic inflation would matter as it would incentivize the Fed to tighten more than the market expects. Even here, however, recent history warrants caution on this view. Between 2004 and 2006, the Fed tightened 440 basis points and yet the dollar declined 11% from the start of the tightening cycle to its end (Chart 7). This is because the rest of the world's growth outpaced U.S. growth, particularly that of emerging markets, which grew at an annual 19%. We therefore come full circle to the single biggest issue on our forecasting horizon: Chinese policy. China is the most important variable for the U.S. dollar at the moment as it can single-handedly tip the global growth balance back towards the U.S., given its expected contribution to global growth (Chart 8). Chart 7...But Not More Important Than Global Growth Chart 8China Really Matters For Global Growth Our view is that Chinese policymakers are acting as an accelerant to BCA's House View that the Chinese economy will experience a benign slowdown. Risks are skewed towards the downside. We recently dedicated our monthly Crow's Nest Webcast solely to this issue and we highly encourage our clients to listen to it on replay.4 In today's weekly, we briefly assess where our Chinese view stands and then turn to U.S. politics. News Flash: Chimerica Has Been Dead Since 2012 Two critical aspects of our China view are coming together. The first is U.S. policy, which is becoming more aggressive after a year in which Trump showed restraint for the sake of North Korean negotiations.5 The second is China's renewed focus on domestic economic reforms.6 The "symbiotic" relationship between the U.S. and China is in decay, as we have argued since 2012.7 As China's economy grows, so grows its capacity for challenging the United States in the strategic sphere (Chart 9). Meanwhile the two economies have diverged markedly since U.S. households began to deleverage in 2008 (Chart 10). Chart 9China's Capabilities Are Growing Chart 10China No Longer Addicted To U.S. Demand The mainstream media is about to become more attuned to this reality now that the Trump administration has published a series of high-level reports declaring that U.S. strategy toward China is changing. Here are a few choice quotations: "China is a strategic competitor using predatory economics to intimidate its neighbors while militarizing features in the South China Sea." (Department of Defense, National Defense Strategy, 2018) "Long-term strategic competitions with China and Russia are the principal priorities for the Department." (Department of Defense, National Defense Strategy, 2018) "[High-level bilateral dialogues] largely have been unsuccessful - not because of failures by U.S. policymakers, but because Chinese policymakers were not interested in moving toward a true market economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States also will take all other steps necessary to rein in harmful state-led, mercantilist policies and practices pursued by China, even when they do not fall squarely within WTO disciplines." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "The United States ... is seeking fundamental changes to China's trade regime, including the overarching industrial policies that have continued to dominate China's state-led economy." (U.S. Trade Representative, 2017 Report to Congress On China's WTO Compliance, 2018) "China and Russia want to shape a world antithetical to U.S. values and interests. China seeks to displace the United States in the Indo-Pacific region, expand the reaches of its state-driven economic model, and reorder the region in its favor." (President Trump, National Security Strategy of the United States of America, 2017) We expect to find echoes of this tough rhetoric in Trump's State of the Union Address on January 30, which will air as we go to press. Already commentators have declared that the U.S. is entering a "post-engagement" phase in the U.S.-China relationship.8 The U.S. and China will continue to engage. What is important is the Trump administration's shift toward more aggressive economic statecraft. Trump's view, made amply clear on the campaign trail, and now officially U.S. policy, holds that China is a mercantilist as well as a revisionist power and that it has initiated a trade war against the U.S. Thus the real policy change lies not in naming China a "strategic competitor" antithetical to U.S. values, but in declaring that normal "WTO consistent" remedies are no longer sufficient and the U.S. will have to resort to "all other steps necessary." The question is whether the U.S., in adopting unilateral measures, will pursue trade remedies on an item-by-item basis, as it has done so far, or break out of the mold and levy broader tariffs to try to achieve "fundamental changes" as quoted above. Trump's recent tariffs on solar panels and washing machines adhered closely to U.S. institutional procedures and penalized U.S. ally South Korea as well as China: if this is the trajectory that the U.S. intends to take, then markets can breathe a sigh of relief.9 The basic trade data show that the U.S. has continued to expand imports from China despite past incidents of presidents slapping on tariffs (Chart 11). Chart 11China And U.S.: Ships Passing In The Night However, the U.S. is likely to draw a harder line than that. The same data also show that the U.S. is not gaining much access to the Chinese market over time, while China has greatly diminished its exposure both to exports and to U.S. trade as a whole. Furthermore, the Trump administration is accusing China of trying to gain superior technology from the U.S. in a way that jeopardizes its security and sovereignty in the pursuit of a better strategic position. This is said to include coercion and corruption of U.S. firms in China, favoring the manufacturing sector by squeezing out competition, preferring domestic-sourced goods over foreign goods, and jeopardizing U.S. companies' intellectual property and network security. The key grievances are forced technology transfer, the "Made in China 2025" industrial strategy, "indigenous innovation" rules, and the new Cyber-Security Law.10 A test case for the U.S.'s harder line will be the ongoing investigation into China's intellectual property theft, which is due by August but is expected to elicit action by Trump sooner. Trump has a range of actions he can take either within or without the WTO. Going outside the WTO would give him greater flexibility, for instance, to impose a "fine," as he called it, for the cumulative "big damages" of China's intellectual property theft - but it would also enable China to claim that the U.S. itself is violating WTO trade rules.11 How will China respond to this turn in U.S. policy? It will continue to focus on rebooting its economic reforms. Reform is both necessary for its own interests, as we have outlined in the past, and expedient in that it enables China to try to deflect and delay U.S. pressure.12 This is not to say that China will not retaliate to particular U.S. moves, but simply that it will prefer to minimize conflict unless and until the Trump administration demonstrates via broad and sweeping trade measures that Beijing has no choice but to engage in open trade war. China's recent declarations that it will accelerate economic reforms aimed at trade and investment openness - particularly in financial services but also more generally - are geared toward allaying Washington. Xi Jinping's right-hand economist, Liu He, who is a key figure, made this clear at the World Economic Forum in Davos, where he said that China's reform and opening up this year would "exceed international expectations." Politburo Standing Committee member Wang Yang made a similar point late last year, saying that the "Made in China 2025" program would not discriminate against foreign or private firms.13 Simultaneously, leading technocrats are calling attention to China's vulnerability as it attempts delicate financial reforms. Guo Shuqing of the China Banking Regulatory Commission has warned of "black swan" or "gray rhino" events as he continues with his financial regulatory crackdown, and he has been echoed by the vice-secretary general of the National Development and Reform Commission.14 These statements are prudent - as it is always risky for highly leveraged countries to tinker with financial tightening - and useful because Beijing wants to warn the U.S. against pushing too hard since it is both "making progress" and vulnerable to instability. We certainly expect the reforms to have a significant, adverse impact on China's economic growth this year. In the latest developments, the policy crackdown is spreading to local governments, where fiscal tightening could ensue (Chart 12). Local governments lack stable sources of revenue, have large hidden debts, face an intensifying debt repayment schedule over the next three years, and have recently begun to cancel infrastructure projects under central government scrutiny (in Inner Mongolia, Gansu, and other provinces, and reportedly even in Xi's favored province of Zhejiang). Furthermore, the reforms have involved a crackdown on shadow lending that has sent non-bank credit into a steep decline (Chart 13). While some market estimates suggest that bank loans could grow by 13%-15% in 2018, such estimates cut against the policy grain. Assuming that non-bank credit does not grow any faster in 2018 than it did in 2017 (9.7%), China can afford to let new bank loans grow at 9.7% and still keep its total social financing (TSF) at its five-year annual average growth rate of 14.5%. Policymakers will not be able to soften their line easily, as several key players are newly appointed and must establish their credibility from the outset. Chart 12Local Government Finances Under Scrutiny Chart 13Shadow Bank Crackdown To Weigh On Credit Growth Our view is that Trump will harden the line despite China's promises both of deeper internal reforms and greater opening up. But the timing is impossible to predict. The real fireworks may be reserved until closer to the U.S. midterm election, as campaigning heats up in the fall. That would be the time for Trump to try to rally his voters by means of a clash of economic nationalisms with China. Beyond the top U.S. grievances cited above, we would highlight the U.S. approach toward China's state-owned enterprises (SOEs). Preferential policies for SOEs are a structural issue that the U.S. is now criticizing. At the party congress in October, President Xi Jinping pledged not only to reform the SOEs but also to make them bigger and stronger. Hence there is a potential collision course. The precise implementation of China's reforms could determine whether the U.S. pursues the issue further. China's State-Owned Assets Supervision and Administration Commission has so far reaffirmed Xi's comments at the party congress but, in keeping with the subtlety of Xi's policies, has also suggested there may be room to intensify reforms. The combination of Trump's economic policies, and China's intensifying reforms, will result in the U.S. economy outperforming expectations relative to China while U.S. corporations will outperform their Chinese counterparts (Chart 14). China will experience higher volatility, both in general and in relation to the U.S., and Chinese companies that suffer from reforms will underperform U.S. companies that benefit most from tax cuts (Chart 15). This is ironic given the popular narrative that the U.S. is suffering from chaotic democratic politics while China's centralized authoritarian model reigns triumphant. Of course, we do think Xi has key capabilities to drive reforms further in his second term than in his first, so these U.S.-China divergences will continue for the next 6-to-12 months at least. China's slowdown and increase in equity volatility should create a policy response: more fiscal spending and credit expansion. The comparison of relative U.S. and Chinese credit impulses suggests that China extends more credit as relative volatility rises (Chart 16). Our view, however, is that China's credit impulse will continue disappointing this year as Beijing prioritizes reform over growth. The credit numbers in January are the next data set to watch, in addition to the aforementioned local government spending. Investors should brace for more uncertainty as the Lunar New Year approaches (Feb. 16). Chart 14U.S. Earnings Surprise Relative To China Chart 15Xi Adds Volatility Relative To Trump Bump Chart 16China's Credit Impulse Disappoints Bottom Line: The Trump administration has issued an ultimatum of sorts on trade. Yet China claims to be redoubling its efforts at reforming and opening up its economy - party to deflect the pressure. We are almost certain that Trump will take further punitive actions, but it is too soon to say when or if he will engage in sweeping measures that threaten to destabilize China and thus initiate a trade war. The political context heading into the U.S. midterm vote will be crucial. Is America Having A Macron Moment? It is unfortunate when one's forecast is challenged only weeks after it is conceived. But that appears to be happening to our view, articulated in late December, that investors should expect no significant legislation to come out of Congress following the passage of the tax cuts.15 Bad news for our forecast is perhaps good news for U.S. policy initiatives and the overall quality of U.S. governance. President Trump has softened his stance on immigration, stating that he would be willing to grant citizenship to roughly 1.8 million "Dreamers" - young adults who came to the U.S. as illegal immigrants.16 Clearing the immigration hurdle would mean that Congress can focus on passing a budget for FY2018 that would see both defense and discretionary spending levels significantly raised. It would also relegate the never-ending saga of the debt ceiling to the dustbin, at least for the duration of this political cycle. Trump also followed up his immigration proposal by sketching a $1.7 trillion infrastructure investment plan (albeit a vague one). Chart 17Bipartisanship = Steeper Bull Market? Could we be approaching a "Macron moment" in U.S. politics? A moment when the "silent majority" rises up and sends a message to politicians that it has had enough of polarizing extremes? Previous such moments have included President Reagan's collaboration with congressional Democrats and President Clinton's with Republicans, which underpinned that glorious stock market run between August 12, 1982 and March 24, 2000 (Chart 17). Both presidents passed significant economic and social reforms during that time. Chart 18Peak Partisanship? Chart 19Independents On The Rise Yes, polarization remains at extreme levels (Chart 18), but that could also mean that it is reaching its natural limits. Rather than dwell on the high levels of polarization, which are baked into the "expectations cake," we would point out that the percentage of Americans who identify as independents is now fast approaching the combined total who identify as either Republican or Democrat (Chart 19). Ominously for Republicans - who hold both the House and the Senate - midterm electoral sweeps have almost always occurred along with the share of independents crossing the 40% mark (Table 1). Table 1Sweep Elections Coincide With High Independent Affiliation Meanwhile, President Trump's conciliatory tone on immigration was met with howls of protest from conservative activists. This is despite the fact that his proposal essentially exchanges leniency for Dreamers for considerably tougher immigration laws in general, which would align the U.S. with its developed market peers.17 Conservative activists are, however, massively out of step with the rest of America. Polls show that immigration is not high on the list of priorities for most Americans, and that most Americans continue to believe both that immigration is a positive and that immigration intake should remain at current levels (Chart 20). Chart 20Americans Are Neither Anti-Immigrant Nor All That Concerned About Immigration Our gut call that President Trump was itching to move to the political middle appears to be correct.18 Whether this becomes investment relevant will ultimately depend on whether the Democrats reciprocate. If Democrats go by data, they will. The government shutdown imbroglio has cost them a double-digit lead in the generic congressional ballot (Chart 21). As a political strategy, the shutdown was a miserable failure. Furthermore, the 2016 election stands as clear evidence that "outrage" does not work. Clinton picked up almost a million more voters in California than President Obama yet failed to beat his performance where it mattered: the Midwest. If Democrats continue to run on a "resistance" platform in order to satisfy their activist base, they will fail to win the House. Chart 21Government Shutdown An 'Own Goal' For Dems Ironically, the best strategy for Democrats ahead of the midterm election is to cooperate with Trump. The swelling ranks of independent voters will reward them if they do so. That same strategy, however, will paradoxically boost Trump's chances in 2020. Bottom Line: The market is, of course, ideologically nihilist. But a move to the middle - which benefits everyone involved except House Republicans - would be positive for stocks and the economy. Key bellwethers going forward are how Democrats react to Trump's immigration proposal and whether Trump moves to the middle on trade deals, starting with NAFTA, whose sixth round of negotiations just ended inconclusively (although not negatively) in Montreal. Investment Implications From the perspective of global asset allocation, the most important issue today is Chinese economic and regulatory policy. Yes, U.S. inflation is important, but whether it moves the dollar - and therefore commodities and EM assets - will depend on the pace of the current Chinese slowdown. China is therefore the most "diagnostic variable" in 2018. If our House View that inflation is coming back in the U.S. is right and our Geopolitical Strategy view that risks to growth in China are to the downside is also right, then investors should go long the U.S. dollar and underweight EM and EM-leveraged assets. If, on the other hand, we are wrong, then investors should load up with EM risk assets to the hilt right now. It is that simple. For what it is worth, we are putting our moderate-conviction view to the test and opening a long DXY trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 But on a completely unrelated note we would like to remind our clients that, over the past 24 months, Mr. Mnuchin was the executive producer of How to Be Single, Midnight Special, Batman v. Superman: Dawn of Justice, Keanu, The Conjuring 2, Central Intelligence, The Legend of Tarzan, Lights Out, Suicide Squad, Sully, Storks, The Accountant, Rules Don't Apply, The Lego Batman Movie, Fist Fight, CHiPs, Going in Style, Unforgettable, King Arthur: Legend of the Sword, Wonder Woman, The House, Annabelle: Creation, The Lego Ninjago Movie, and The Disaster Artist. 2 Please see BCA Geopolitical Strategy Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 3 Please see BCA Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, and Weekly Reports, "Trump and Trade," December 9, 2016, and "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 4 Please see BCA Research Webcasts, Geopolitical Strategy Crow's Nest, "China: How Is Our View Working Out?" dated January 25, 2018. 5 Please see BCA Geopolitical Strategy Weekly Report, "BCA Geopolitical Strategy 2017 Report Card," dated December 20, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 8 Please see Daniel H. Rosen, "A Post-Engagement US-China Relationship," Rhodium Group, January 19, 2018, available at rhg.com. 9 In fact, in the case of washing machines, the U.S.-based GE Appliances stands to gain from the tariff and has been owned by China's Haier Electronics Group since 2016. 10 Several clients have asked us about China's Cyber-Security Law, which has been in the process of implementation since July 2017 and will go fully into effect by the end of 2018. The law is meant to give the Chinese government the option of exercising control over all networks in the country. State security agencies are deeply involved in its enforcement and oversight. Foreign business interests fear that the law's new obligations will be onerous and potentially damaging - including potential violations of corporate security over intellectual property, source code, supply chain details, and data storage and transmission. 11 Please see Stephen E. Becker, Nancy Fischer, and Sahar Hafeez, "Update on US Investigation of China's IP Practices," Lexology, January 8, 2018, available at www.lexology.com. 12 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 13 Wang has served as the top interlocutor with the U.S. in the U.S.-China Comprehensive Economic Dialogue. 14 Please see "China eyes black swans, gray rhinos as 2018 growth seen slowing to 6.5-6.8 percent: media," Reuters, January 28, 2018, available at www.reuters.com. "Gray rhinos," coined by author Michele Wucker, refer to high-probability, high-impact risks, whereas the proverbial "black swan" is a low-probability, high-impact risk. These terms have both been making the rounds more frequently in Chinese policymaking circles since last year. 15 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 16 What is fascinating about Trump's statement is that he cited the 1.8 million figure. There are actually only about 800,000 people who officially participated in President Obama's Deferred Action for Childhood Arrivals program. But estimates suggest that another 1,000,000 young adults are in the U.S. illegally, yet did not register. Trump has come under criticism from conservative, anti-immigration groups for essentially moving the goalposts beyond what even the Democrats had wanted. 17 Canada, for example, has a purely merit-based immigration system that is considerably tough on family reunification. (Reunification has even been suspended because of a large backlog.) In Europe, family reunification laws are extremely strict. Even spouses are not automatically allowed residency status in several major European countries unless they fulfill various conditions. 18 Please see footnote 2 above.
Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures Chart I-7China: Land Sales To Slump The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations