Emerging Markets
Highlights The rise in the yen sparked by the verbal confrontation between the U.S. and North Korea is creating an opportunity to buy USD/JPY. The DXY is set to stabilize and may even rebound, removing a key support for the yen. The U.S. economy is showing signs of strength, and the bond market is expensive, a backup in yields is likely. Rising U.S. bond yields should be poisonous for the yen Until higher bond yields cause an acute selloff in risks assets, an opportunity to buy USD/JPY is in place for investors. Feature After benefiting from the U.S. dollar's generalized weakness, the yen has received a renewed fillip thanks to the rising tensions between North Korea and the U.S. If the U.S. were indeed to unleash "fire and fury" on North Korea, safe-haven currencies like the yen or Swiss franc would obviously shine. While the verbal saber-rattling will inevitably continue, our colleagues Marko Papic and Matt Gertken - head and Asia specialist respectively of our Geopolitical Strategy service - expect neither the U.S. nor North Korea to go to war. Historically, North Korea has behaved rationally, and it only wants to use the nuclear deterrent as a bargaining chip. Meanwhile, the U.S does not want to invest the time, energy, and money required to enact a regime change in that country. Additionally, China is already imposing sanctions on Pyongyang, and Moon Jae-in, South Korea's new president, wants to appease its northern neighbor. With cooler heads ultimately likely to prevail, will the yen rally peter off, or should investors position themselves for additional USD/JPY weakness? We are inclined to buy USD/JPY at current levels. DXY: Little Downside, Potential Upside Most of the weakness in USD/JPY since July 10 has been a reflection of the 3.7% decline in the DXY between that time and August 2nd. However, the dollar downside is now quite limited and could even reverse, at least temporarily. The dollar is currently trading at its deepest discount since 2010 to our augmented interest rate parity model, based on real interest rate differentials - both at the long and short-end of the curve - as well as global credit spreads and commodity prices (Chart I-1). Crucially, the euro, which accounts for 58% of the dollar index, is its mirror image, being now overvalued by two sigma, the most since 2010 (Chart I-2). Confirming these valuations, investors have now fully purged their long bets on the USD, and are most net-long the euro since 2013. Chart I-1DXY Is Cheap... Chart I-2...But The Euro Is Not Valuations are only an indication of relative upside and downside; the macro economy dictates the directionality. While U.S. financial conditions have eased this year, they have tightened in Europe, resulting in the biggest brake on euro area growth relative to the U.S. in more than two years (Chart I-3). This is why euro area stocks have eradicated their 2017 outperformance against the S&P 500, why PMIs across Europe have begun disappointing, and why the euro area economic surprise index has rolled over - especially when compared to that of the U.S. The improvement in U.S. economic activity generated by easing financial conditions also has implications for the dollar. As Chart I-4 illustrates, the gap between the U.S. ISM manufacturing index and global PMIs has historically led the DXY by six months or so. This gap currently points to a sharp appreciation in the dollar. Chart I-3Easing Versus Tightening FCI Chart I-4PMIs Point To USD Rally If the dollar were indeed to stop falling, let alone appreciate, this would represent a hurdle for the yen to overcome, especially as the outlook for U.S. bond yields is pointing up. Bottom Line: Before North Korea grabbed the headlines, the USD/JPY selloff was powered by a weakening dollar. However, the dollar has limited downside from here. It is trading at a discount to intermediate-term models, while macroeconomic momentum is moving away from the euro area and toward the U.S. - a key consequence of the tightening in European financial conditions vis-à-vis the U.S. Additionally, the strong outperformance of the U.S. ISM relative to the rest of the world highlights that the dollar may even be on the cusp of experiencing significant upside. The Key To A Falling Yen: Treasury Yields Upside An end to the fall in the USD is important to end the downside in USD/JPY. However, rising Treasury yields are the necessary ingredient to actually see a rally in this pair. We are optimistic that U.S. bond yields can rise from current levels. The U.S. job market remains very strong. The JOLTS data this week was unequivocal on that subject. Not only are there now 6.2 million job openings in the U.S., but the ratio of unemployed to openings has hit its lowest level since the BLS began publishing the data, suggesting there is now a limited supply of labor relative to demand. Additionally, the number of unfilled jobs is nearly 30% greater than it was at its 2007 peak, pointing to an increasingly tighter labor market. We could therefore see an acceleration in wage growth going into the remainder of this business cycle, even if structural factors like the "gig-economy", the increasing role of robotics, or even the now-maligned "Amazon" effect limit how high wage growth ultimately rises. The Philips curve, when estimated using the employment cost index and the level of non-employment among prime-age workers, still holds (Chart I-5). Thus, a tight labor market in conjunction with continued job-creation north of 100,000 a month should put upward pressure on wages. Even when it comes to average hourly earnings, glimmers of hope are emerging. Our diffusion index of hourly wages based on the industries covered by the BLS cratered when wage growth slowed over the past year. However, it has hit historical lows and is beginning to rebound - a sign that average hourly earnings should also reaccelerate (Chart I-6). Chart I-5The Philips Curve Still Works Chart I-6Even AHE Are Set To Re-Accelerate The job market is not the only source of optimism, as U.S. capex should continue to be accretive to growth. Despite vanishing hopes of aggressive deregulation, the NFIB small business survey picked up this month. Even more importantly, various capex intention surveys as well as the CEO confidence index point to continued expansion of corporate investment (Chart I-7). Healthy profit growth is providing both the necessary signal and the source of funds to engage in this capex. This will continue to lift the economy. This is essential to our bond and our yen views, as it points to higher U.S. inflation. In itself, economic activity is not enough to generate higher prices. However, when this happens as aggregate capacity utilization in the economy is becoming tight, inflation emerges. As Chart I-8 shows, today, our composite capacity utilization indicator - based on both labor market conditions and the traditional capacity utilization measure published by the Federal Reserve - is in "no-slack" territory, a condition historically marked by bouts of inflation. Chart I-7U.S. Capex To Boost Growth Further Chart I-8No Slack Plus Growth Equals Inflation The recent increase to a three-year high in the "Reported Price Changes" component of the NFIB survey corroborates this picture, also pointing to an acceleration in core inflation (Chart I-9). But to us, the most telling sign that inflation will soon re-emerge is the behavior of the U.S. velocity of money. For the past 20 years, changes in velocity - as measured by the ratio of nominal GDP to the money of zero maturity - have lead gyrations in core inflation, reflecting increasing transaction demand for money. Today, the increase in velocity over the past nine months points to a rebound in core inflation by year-end (Chart I-10). Chart I-9The Pricing Behavior Of Small Businesses ##br##Points To An Inflation Pick Up Chart I-10Reaching Escape ##br##Velocity Expecting higher inflation is not the same thing as expecting higher interest rates and bond yields. However, we believe this time, higher inflation will result in higher yields. First, the Fed wants to push interest rates higher. Fed Chairwoman Janet Yellen and her acolytes have been very clear about this, with the "dot plot" anticipating rates to rise to 2.9% by the end of 2019. While the Fed's preference and reality can be at odds, this is currently not the case. Our Fed monitor continues to be in the "tighter-policy-needed" zone. While it is undeniable that it is doing so by only a small margin, higher inflation - as we expect - would only push this indicator higher. Moreover, the diffusion index of the components of the Fed monitor is already pointing toward an improvement in this policy gauge (Chart I-11). Chart I-11The Fed Monitor Will Pick Up Second, the Fed may have increased rates, and the spread between U.S. policy rates and the rest of the world may have widened, but the dollar has weakened this year. This counterintuitive result highlights that the Fed's effort has had little impact in tightening liquidity conditions. In fact, as we have mentioned, because of the lower dollar and higher asset prices, financial conditions have eased, suggesting liquidity remains plentiful. As such, like in 1987 or 1994, this is only likely to re-invigorate the Fed in its confidence that it can hike rates further, as liquidity conditions remain massively accommodative. Third, beyond the Fed's reaction function, what also matters are investors' expectations. At the time of writing, investors only expect 45 basis points of rate hikes over the upcoming 24 months, which is a reasonable expectation only if inflation does not move back toward the Fed's 2% target. However, our work clearly points toward higher inflation by year end. In a fight between the Fed's "dot plot" and the OIS curve, right now, we would take the side of the Fed. Fourth, it is not just 2-year interest rate expectations that seems mispriced, based on our view on U.S. growth, inflation, and the Fed. U.S. Treasury yields are also trading at a 36 basis points discount to the fair-value model developed by our U.S. Bond Strategy sister service (Chart I-12). Continued good news on the job front and an uptick in inflation would likely do great harm to Treasury holders. Finally, the oversold extreme experienced by the U.S. bond market in the wake of the Trump victory has been purged. While we are not at an oversold extreme, our Composite Technical Indicator never punched much into overbought territory during the Fed tightening cycle from 2004 to 2006 (Chart I-13). Moreover, with no more stale shorts, an upswing in U.S. economic and inflation surprises should help put upward pressure on U.S. bond yields. Confirming the intuition laid out above, the copper-to-gold ratio, a measure of growth expectations relative to reflation, has now broken out - despite the North Korean risks. In the past, such a development signaled higher yields (Chart I-14). With this in mind, let's turn to the yen itself. Chart I-12U.S. Bonds Are##br## Too Expensive Chart I-13Stale Shorts Have Been Purged, ##br##But Overbought Conditions Are Unlikely Chart I-14Where The Copper-To-Gold Ratio Goes, ##br## So Do Bond Yields Bottom Line: The U.S. economy looks healthy. The labor market is strong, and capex continues to offer upside. Because capacity utilization is tight and money velocity is accelerating, inflation should begin surprising to the upside through the remainder of 2017. With the market pricing barely two more hikes over the course of the next 24 months and U.S. bonds trading richly, such an economic backdrop should result in higher U.S. bond yields. Yen At Risk, Even If Volatility Rises JGB yields have historically displayed a low beta to global bond yields. As a result, when global bond yields rise, the yen tends to weaken. USD/JPY is particularly sensitive to yield upswings driven by actions in the Treasury market. This contention is even truer now than it has been. The Bank of Japan is targeting a fixed yield curve slope and does not want to see JGB yields rise much above 10 basis points. With the paucity of inflation experienced by Japan - core-core inflation is in a downtrend, ticking in at zero, courtesy of tightening financial conditions on the back of a stronger yen - this policy remains firmly in place. Emerging signs of weakness in Japan highlight that the BoJ is likely to remain wedded to this policy, even as Shinzo Abe's popularity hits a low for his current premiership. The recent fall in the leading indicator diffusion index suggests that industrial production - which has been a bright spot - is likely to roll over in the coming months (Chart I-15). This means the improvement in capacity utilization will end, entrenching already strong deflationary pressures in Japan. This only reinforces the easing bias of the BoJ, and truncates any downside for Japanese bond prices. Chart I-15The Coming Japanese IP Slowdown In short, while JGB yields might still experience some downside when global yields fall, they will continue to capture none of the potential upside. This makes the yen even more vulnerable to higher Treasury yields than it was before. Hence, based on our view on U.S. inflation and yields, USD/JPY is an attractive buy at current levels. But what if the rise in U.S. bond yields causes a correction in risk assets, especially EM ones? Again, monetary policy differences and the trend in yields will dominate. As Chart I-16 illustrates, USD/JPY has a much stronger correlation with dynamics in the bond markets than it has with EM equity prices. Chart I-16Yen: More Like Bonds Than Anything Else Chart I-17USD/JPY Falls Only When EM Selloffs Are So Acute That They Cause Bond Rallies Moreover, as the experience of the past three years illustrates, only once EM selloffs become particularly acute does USD/JPY weaken (Chart I-17). Essentially, the EM selloff has to be so severe that it threatens the Fed's ability to tighten policy, and therefore causes U.S. bond yields to fall. It is very possible that a rise in Treasury yields will ultimately generate this outcome, but in the meantime the rise in U.S. bond yields should create a tradeable opportunity to buy USD/JPY. Bottom Line: With Japan still in the thralls of deflation and the BoJ committed to fight it, JGB yields have minimal upside. Therefore, higher Treasury yields are likely to do what they do best: cause USD/JPY to rally. This might ultimately lead to a selloff in EM stocks, but in the meanwhile, a playable USD/JPY rally is likely to emerge. Thus, we are opening a long USD/JPY trade this week. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The U.S. labor market continues to strengthen, with the JOLTS Survey's Job Openings and Hires both ticking up. The NFIB Survey also shows signs of strength as the Business Optimism Index steadied at lofty levels, coming in at 105.2. Unit labor costs disappointed, but this supports U.S. equities. Nonfarm productivity also outperformed, pointing to improving living standards. U.S. data has turned around, with data surprises improving relative to the euro area. These dynamics are likely to prompt a resumption of the greenback's bull market. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data has been mixed: German current account underperformed, with both exports and imports contracting on a monthly rate, and underperforming expectations. The trade balance, however, outperformed; German industrial production failed to meet expectations, even contracting on a monthly basis; Italian industrial production outperformed both on a monthly and yearly rate, but remains well below capacity European data has begun to show the pain inflicted by tightening financial conditions. Relative to the U.S., the economic surprise index has rolled over. If this trend continues, EUR/USD will struggle to appreciate more this year, and may even weaken if U.S. inflation can improve. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been negative in Japan: Labor cash earnings yearly growth went from 0.6% in May to a contraction of 0.4% in June, underperforming expectations. Machinery orders yearly growth fell down sharply, contracting at a 5.2% rate and underperforming expectations. The Japanese economy continues to show signs of weakness, which means that the Bank of Japan will not let 10-year JGB yields rise above 10 basis points. In an environment of rising U.S. bond yields this will cause the yen to fall. However the question remains: Could a selloff in EM prompted by a rising dollar help the yen? This should not be the case, at least for now, as the yen is much more correlated with U.S. bond yields than it is with EM stock prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: BRC like-for-like retail sales yearly growth came in at 0.9%, outperforming expectations. However, the RICS Hosing Price Balance - a crucial bellweather for the British economy - came in at 1%, dramatically underperforming expectations. Also, the trade balance underperformed expectations, falling to a 12 billion pounds deficit for the month of June as exports sagged. As we mentioned on our previous report, we expect the pound to suffer in the short term, as the high inflation produced by the fall in the pound following the Brexit vote is starting to weigh on consumers. Furthermore, house prices are also suffering, and could soon dip into negative territory. All of these factors will keep the BoE off its hawkish rhetoric for longer than priced by the markets. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 AUD gains are reversing as the U.S. dollar rebounds from a crucial support level. This has also occurred due to mixed Chinese and Australian data: Chinese trade balance beat expectations, however, both exports and imports underperformed; Chinese inflation underperformed expectations; Australian Westpac Consumer Confidence fell to -1.2% from 0.4% in August; This is largely in line with our view that the rally in AUD was would only create a better shorting opportunity. Underlying structural and fundamental issues will remain a headwind for the AUD for the remainder of the year. Iron ore inventories in China are also at an all-time high, which paints a dim picture for Australian mining and exports going forward. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Wednesday, the RBNZ left their Official Cash Rate unchanged at 1.75%. Overall, the bank signaled that it will continue its accommodative monetary policy for "a considerable period of time". Furthermore the RBNZ's outlook for inflation, specifically tradables inflation, remains weak. Finally, the bank also showed concern for the rise in the kiwi, stating that "A lower New Zealand Dollar is needed to increase tradables inflation and help deliver more balanced growth". Overall, we continue to be positive on the kiwi against the AUD. While the outlook for tradable-goods inflation might be poor, this is a variable determined by the global industrial cycle.. Being a metal producer, Australia is much more exposed to these dynamics than New Zealand, a food producer. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Data continues to look positive for Canada: Housing Starts increased by 222,300, beating expectations; Building permits also increased at a monthly pace of 2.5%, also beating expectations. CAD has experienced some downside as the stretched long positioning that emerged in the wake of the BoC's newfound hawkishness are being corrected. While we expect the CAD to outperform other commodity currencies, based on rate differentials and oil outperformance, USD/CAD should is likely to trend higher as U.S. inflation bottoms. EUR/CAD should trend lower by the end of this year as euro positioning reverts. As a mirror image, CAD/SEK may appreciate based on the same dynamics. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Last week we highlighted the possibility of a correction in EUR/CHF, given that it had reached highly overbought levels. This prediction turned out to be accurate, as EUR/CHF fell by almost 2% this week, as tensions between North Korea and the United States continue to escalate. Meanwhile on the economic front, Switzerland continues to show a tepid recovery: Headline inflation went from 0.2% in June to 0.3% in July, just in line with expectations. The unemployment rate continues to be very low at 3.2%, also coming in according to expectations. Inflation, house prices and various economic indicators are all ticking up, however, the economic recovery is still too weak to cause a major shift in monetary policy. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone has fallen this week against the U.S. dollar, even as oil prices have remained relatively flat. This highlights a key theme we have mentioned before: USD/NOK is more sensitive to rate differentials than it is to oil prices. We expect these rate differentials to continue to widen, as the Norwegian economy remains weak, and inflation will likely remain below the Norges Bank target in the coming years. On the other hand, U.S. yields are set to rise, as a tight labor market will eventually lift wages higher and thus increase rate expectations. Meanwhile EUR/NOK, which is much more sensitive to oil prices than USD/NOK, will keep going down, as inventory drawdowns caused by the OPEC cuts should continue pushing up Brent prices. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data in Sweden was mixed: New Orders Manufacturing yearly growth fell from 7.3% to 4.4%. Industrial production yearly growth increased from 7.5% in May to 8.5% in June, outperforming expectations. The Swedish economy continues to exhibit signs of strong inflationary pressures. Overall we continue to be bullish on the krona, particularly against the euro, as the exit of Stefan Ingves at the end of this year should give way for a more hawkish governor, who would respond to the strength in the economy with a more hawkish stance. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017Xx Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights Strong corporate earnings growth will drown out worries about North Korea. Stay cyclically overweight global equities. Underlying wage growth in the U.S. is stronger than the official data suggest. Surveys point to a further acceleration in U.S. wages, as do pay gains at the lower end of the income distribution. Labor's share of income will resume its cyclical recovery. This will lead to more consumer spending, and ultimately, higher price inflation. Wage growth elsewhere in the world will also pick up as labor slack declines. Global fixed-income investors should underweight duration and increase exposure to inflation-linked securities. Feature Focus On Corporate Earnings, Not Korea Chart 1EPS Estimates Have Remained ##br##Resilient This Year Global equities dropped over the past few days on the back of rising risks of conflict in the Korean peninsula. Our geopolitical strategists believe that neither the U.S. nor North Korea will launch a preemptive strike.1 Despite its bluster, North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty. The U.S. has forsworn regime change as a policy goal. China has recommitted to new sanctions and the South is pro-engagement. This raises the likelihood that a diplomatic solution will be found. Unfortunately, getting from here (open hostilities) to there (negotiated solution) will take time, which leaves the door open to increased market volatility. Nevertheless, we expect any selloff to be short-lived, owing to the positive earnings picture. More than anything else, strong profit growth has underpinned the cyclical bull market in stocks, and we expect this to remain the case over the coming months. More than 80% of S&P 500 companies have reported Q2 results. Based on these preliminary numbers, EPS appears to have increased by 11% over the previous year, marking the fourth consecutive quarter of margin expansion. The strength has been broad based, with all eleven sectors reporting positive growth. U.S. earnings estimates for both 2017 and 2018 have remained steady since January, bucking the historic pattern of downward revisions throughout the course of the year (Chart 1). The picture is even more impressive outside the U.S., where earnings estimates continue to move higher. The Euro STOXX 600 is now expected to deliver EPS growth of 12.6% this year. EPS of stocks listed on the Japanese Topix is expected to rise 14.8% this year and 7.3% next year, giving them an attractive 2018E P/E of 13.6. We recommend overweighting euro area and Japanese stocks over their U.S. counterparts in currency-hedged terms. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. The U.S. Labor Market Gets A JOLT, But Where's The Wage Growth? The Job Openings and Labor Turnover Survey (JOLTS) released on Tuesday provided more good news about the state of the U.S. labor market (Chart 2). The number of job openings rose to 6.2 million in June. There are now 28% more unfilled jobs in the U.S. than at the prior peak in April 2007. The number of unemployed workers per job opening fell to 1.1, the lowest level in the history of the series. One might think that with numbers like these, wage growth would be skyrocketing. Yet, it is not. While monthly average hourly wages did surprise to the upside in the June payrolls report, the year-over-year change remained stuck at 2.5%. This week's productivity report showed that compensation per hour increased by only 1% in Q2 relative to the same period in 2016. Other measures of wage growth generally point to some softening this year (Chart 3). Chart 2More Good News For The U.S. Labor Market Chart 3U.S. Wage Growth Remains Soft Many commentators regard the lackluster pace of wage inflation - coming at a time when the unemployment rate has fallen below its 2007 lows - as a "mystery" that needs to be solved. As we argue in this report, there is less to this mystery than meets the eye. Properly measured, underlying wage growth in the U.S. has been rising for some time, and may actually be stronger than the "fundamentals" warrant. Wage inflation elsewhere in the world is more subdued. However, this is largely because progress towards restoring full employment has been slower outside the U.S. Is Wage Growth Being Mismeasured? How can U.S. wage growth be characterized as "strong" when it is still so weak by historic standards? Part of the answer has to do with that old bugbear: measurement error. Low-skilled workers have been re-entering the labor force en masse over the past few years, after having deserted it during the Great Recession. This has put downward pressure on average wages, arithmetically leading to slower wage growth. Most of the official wage series, including the Employment Cost Index, do not adjust for this statistical bias.2 In a recent research report, economists at the San Francisco Fed concluded that "correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment."3 In addition to cyclical factors, demographic shifts have depressed official measures of wage inflation. Historically, population aging has pushed up average wages because older workers tend to earn more than younger ones. The retirement of millions of well-paid baby boomers over the past few years has reversed this trend, at least temporarily. Chart 4 shows that the median age of employed workers has fallen for the past three years, the first time this has happened since the 1970s. Weak Productivity Growth Dragging Down Wages Unfortunately, there is more to the story than measurement error. Today's young workers are not better skilled or educated than those of previous generations. This, along with other factors that we have discussed extensively in past reports, has dragged down productivity growth.4 Nonfarm productivity has increased at an average annualized pace of less than 1% over the past few years, down from 3% in the early 2000s (Chart 5). Slower productivity growth gives firms less scope to raise wages. In fact, for all the talk about how wages are stagnant, real wages have risen by more than productivity since 2014. This has pushed labor's share of income off its post-recession lows. Chart 4Median Age Of Workers No Longer Rising Chart 5Real Wages Have Increased Faster ##br##Than Productivity Over The Past Few Years It remains to be seen whether the structural downtrend in the share of income going to labor will be reversed. One can make compelling arguments for both sides of the issue.5 But over a cyclical horizon of one-to-two years, it is highly likely that labor's share will rise. Labor's share of income is fairly procyclical. It increased significantly in the late 1990s and rose again in the years leading up to the Great Recession. Considering how low unemployment is today, it is not unreasonable to assume that it will maintain its cyclical uptrend. If so, this will lead to more consumer spending, and ultimately, higher inflation. Surveys Point To Faster Wage Growth... Surveys such as those conducted by the National Federation of Independent Business, Duke University/CFO Institute, National Association for Business Economics, and various regional Federal Reserve banks suggest that employers are becoming increasingly willing to raise compensation in order to fill vacancies (Chart 6). Workers, in turn, are becoming more choosy. This can be seen in an improving assessment of job availability and a rising quits rate. Both of these measures lead wage growth (Chart 7). Chart 6ASurveys Show Employers More Willing To Raise Compensation Chart 6BSurveys Show Employers More Willing To Raise Compensation Chart 7Workers Are Feeling More Confident ...As Do Wage Gains Among Low-Income Workers Median weekly earnings of low-income workers have accelerated this year, even as wage gains among higher-income workers have hit an air pocket (Chart 8). For example, restaurant workers have seen pay hikes of nearly 5% this year, up from 1% in 2014. Wage growth among lower-income workers tends to be less noisy than for higher-income workers. The incomes of better-paid workers are often influenced by bonuses and other variables that may be driven more by industry-specific or economy-wide profit trends rather than labor slack per se. Less-skilled workers are usually the first to get fired and the last to get hired. Thus, wage pressures at the lower end of the skill distribution often coincide with an overheated labor market. This makes the trend in lower-income wages a more reliable gauge of underlying labor market slack. Wage Inflation Will Slowly Pick Up As Global Slack Diminishes We expect U.S. wage growth to rise over the next few quarters by enough to allow the Fed to raise rates in line with the dots. However, a more rapid acceleration - one that forces the Fed to raise rates aggressively - is improbable, at least over the next 12 months. This is mainly because the relationship between domestic labor market slack and wage growth is not as tight as it once was. Trade unions have less clout these days, which means it takes longer for a tight labor market to produce larger negotiated pay hikes. The labor market has also become less fluid, as evidenced by the structural decline in both the rate of job creation and job destruction (Chart 9). Wages tend to adjust more slowly when there is less hiring and firing going on. Chart 8Better Pay For Low-Wage Earners: ##br##A Sign Of A Tighter Labor Market Chart 9Structural Declines In Job Creation##br## And Destruction Perhaps most importantly, an increasingly globalized workforce has given firms the ability to move production abroad in response to rising wages at home. This suggests that wage growth in the U.S. is unlikely to increase significantly until falling unemployment begins to push up wages abroad. Wage Growth Around The World For now, wage growth in America's trading partners remains subdued. Euro area wage inflation is stuck between 1% and 1.5%, although with important regional variations (Chart 10). Wage inflation has accelerated to over 2% in Germany, but is still close to zero in Italy and Spain. Considering that unemployment in both countries remains well above pre-recession levels, it will be difficult for the ECB to tighten monetary policy to any great degree over the next few years. Japanese wage growth has picked up since 2010, but is still below the level consistent with the BoJ's 2% inflation target (Chart 11). Wage inflation is likely to ratchet higher over the next few years, now that the ratio of job openings-to-applicants has risen to the highest level since 1974 (Chart 12). In a sign of the times, Yamato Transport, Japan's largest parcel delivery company, recently told Amazon that it would not be able to make same-day deliveries due to a shortage of available drivers. Chart 10Euro Area Wage Growth Remains ##br##Weak Outside Of Germany Chart 11Modest Pickup In Japanese Wages Wage growth in Canada has actually declined since 2014. However, that is likely to change given that the unemployment rate has fallen close to nine-year lows. Falling unemployment rates should also boost wage inflation in the U.K., Australia, and New Zealand. Chinese wage growth also remains brisk. Chart 13 shows that urban household future income confidence has picked up notably of late, as growth has improved and the labor market has tightened. Chart 12Job Openings Ratio Will Push Wages Higher Chart 13Optimism Over The Labor Market In China Faster Wage Growth Will Ultimately Lead To Higher Inflation Chart 14The Decline In Inflation Expectations ##br##Have Weighed On Wage Growth Going forward, the combination of falling labor slack abroad and an overheated labor market at home will cause U.S. wage inflation to increase more rapidly starting in the second half of 2018. This will be a break from the past. Lower longer-term inflation expectations have tempered nominal wage growth over the past eight years (Chart 14). Both market-based inflation expectations and inflation expectations 5-to-10 years out in the University of Michigan's survey have fallen by about half a point since the financial crisis. The recent decline in headline CPI inflation from 2.7% in February to 1.6% in June may also explain why wage growth has dipped this year even as payroll gains have rebounded. Rising wage growth could begin to feed on itself. As we have discussed before, the Phillips curve tends to steepen once an economy reaches full employment (Chart 15). If the unemployment rate falls from 7% to 6%, this is unlikely to have a huge effect on wages. But if it falls from 4.5% to 3.5%, the effect could be substantial. A recent Fed paper concluded that "evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point."6 The implication is that once inflation does start rising, it could rise more quickly than investors (or the Fed) expect. Concluding Thoughts The past three U.S. recessions were all caused by the unravelling of financial sector and asset market excesses: The housing bust lay the groundwork for the Great Recession; the collapse of dotcom stocks ushered in the 2001 recession; and the failure of hundreds of banks during the Savings and Loan crisis paved the way for the 1990-91 recession. Unlike the last few recessions, the next one may end up being more akin to those of 1960s, 70s, and 80s. Those earlier recessions were generally triggered by aggressive Fed rate hikes in the face of an overheated economy and rising inflation (Chart 16). Chart 15The Phillips Curve Appears To Be Non-Linear Chart 16Are We Heading Towards A "Retro-Recession"? The good news is that neither wage nor price inflation is likely to soar over the next 12 months. This means that the bull market in global equities can continue for a while longer. The bad news is that complacency about inflation risk is liable to cause central bankers to fall increasingly behind the curve. Rising inflation will force the Fed to pick up the pace of rate hikes in the second half of 2018. This is likely to lead to a stronger dollar and higher Treasury yields. The resulting tightening in U.S. financial conditions could trigger a recession in 2019 or 2020. Investors should remain overweight risk assets for now, but prepare to scale back exposure next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report titled "North Korea: Beyond Satire," dated April 19, 2017. 2 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. However it, too, is subject to a number of methodological problems. 3 Mary C. Daly, Bart Hobijn, and Benjamin Pyle, "What's Up with Wage Growth?" FRBSF Economic Letter 2016-07 (March 7, 2016). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 5 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and The Bank Credit Analyst Special Report, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June, 2014. 6 Jeremy Nalewaik, "Non-Linear Phillips Curves With Inflation Regime-Switching," Federal Reserve Board, Finance and Economics Discussion Series 2016-078 (August 2016). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The Kingdom of Saudi Arabia (KSA) is taking a well-timed tactical decision to make room for increased Libyan and Nigerian output, by reducing allocations to refiners by more than 500k b/d in September. The bulk of these reductions will be directed at U.S. refiners, which are running their units at close to record output, while reducing their crude imports and boosting product exports. This will keep the year-on-year (yoy) reductions in OECD commercial oil stocks now showing up in the data on track, driven by continued sharp draws in U.S. inventories. Most importantly, these reductions will occur in the highly visible, high-frequency data produced by the U.S. every week. Energy: Overweight. Reports of foreign workers being pulled from Venezuelan oil fields will keep markets on edge. We remain long Dec/17 $50/bbl calls and short $55/bbl calls in Brent and WTI, which are up 127% and 74% since inception on June 22 and June 15, respectively. Base Metals: Neutral. Aluminum rallied on the back of news reports China's Shandong province ordered more than 3.2mm MT/yr of capacity shuttered by end-July. While surprising, such actions are not inconsistent with the stricter enforcement of environmental regulations in China we expect going forward. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge. Recent geopolitical tensions between the U.S. and North Korea are supporting this position, which is up 2.1% since inception on May 4, 2017. Ags/Softs: Underweight. Grains were treading water ahead of today's WASDE. We remain bearish, but continue to avoid shorting the complex. Feature Chart of the WeekU.S. Refiners Running At Close To Record Rates KSA's decision to reduce crude oil allocations to refiners in September, particularly in the U.S., is a well-timed tactical move.1 U.S. refinery net crude inputs hit record levels in early June at 17.3mm b/d, and remain close to that level (Chart of the Week). U.S. product exports continue at near-record levels, while imports have been trending lower (Chart 2). Crude oil exports from the U.S. are running close to record levels, and imports are trending lower (Chart 3). U.S. exports of crude and products hit a record in January at 5.9mm b/d - 5.24mm b/d of products, and just under 650k b/d for crude exports. At the end of July, total exports of crude and products stood at 5.44mm b/d, or 7.4% below the record set in January. U.S. product exports fell to 4.6mm b/d, while crude exports stood at 845k b/d. It is worthwhile pointing out that, in terms of total oil and products exports, the U.S. ranks among the top exporters in the world: KSA exports ~ 7mm b/d of crude, while Russia exports ~ 5mm b/d of crude. Chart 2U.S. Product Export Remain Strong,##BR##While Imports Continue Trending Lower ... Chart 3... While U.S. Crude Exports Remain High,##BR##And Imports Are Moderating With net U.S. crude and product imports declining (Chart 4), we expect U.S. commercial oil inventories - crude and products - to continue to draw sharply, which, since they account for close to 45% of OECD inventories, will draw down total DM stock levels as well (Chart 5). Indeed, U.S. commercial inventories drew close to 4% yoy in July, based on EIA historical data, the second month in a row the yoy comparisons came in negative in America. For the OECD as a whole, July marked the first month this year that the yoy percent change in stock levels was negative (-1.8%). Thus, as the summer driving season - and peak refiner crude demand - reaches its denouement next month, KSA's well-timed move to reduce shipments to U.S. refiners will push inventories lower and advance OPEC 2.0's agenda to clear out surplus OECD commercial oil inventories over the short term (Chart 6). Chart 4U.S. Net Crude And##BR##Product Imports Are Falling ... Chart 5... Which Will Support Continued Draws In##BR##Commercial Oil Stocks (Crude And Products) Chart 6KSA Will Continue Reducing##BR##Shipments To U.S. Refiners The OPEC 2.0 Agreement Is Holding ... On Average ... KSA is following through on Energy Minister Khalid al-Falih's "whatever it takes" assertion and making room for Libya and Nigeria, which together have added some 750k b/d of production to the market vs. April's level - 470k b/d for Libya and 280k b/d for Nigeria. April happens to be the month during which OPEC's producers recorded their largest production cuts vs. October's levels (1.12mm b/d), based on the EIA's historical tallies. OPEC 2.0 benchmarks to October 2016 production levels. Among OPEC members, neither Libya nor Nigeria were bound by the historic OPEC 2.0 Production Agreement. However, for those states that did obligate themselves to the agreement, compliance has been fairly high on average. OPEC member states that are party to the 2.0 deal have overproduced relative to their agreed production volumes by some 20k b/d over the January - July period on average.2 So, relative to the deal the OPEC members agreed, they've managed to cut 800k b/d of crude production on average versus their October 2016 production levels.3 During this period, Iraq stands out for its overproduction, having pumped 100k b/d on average over its agreed OPEC 2.0 volume of 4.35mm b/d (Chart 7). Among the non-OPEC members of the OPEC 2.0 coalition, Russia's compliance appears to be holding up, at close to 300k b/d below its October levels of crude and liquids production in 2Q17 and July (Chart 8). Oman produced ~ 980k b/d, over the first seven months of the deal vs. 1.02mm b/d in October, while Kazakhstan has faltered, with production averaging 1.88mm b/d in Jan - July, versus 1.79mm b/d in October. Chart 7Iraq Stands Out For Overproduction;##BR##Libya, Nigeria Not Covered In OPEC 2.0 Deal Chart 8Russia And KSA##BR##Continue To Lead OPEC 2.0 ... But Markets Await Articulated Strategy We continue to expect compliance with the OPEC 2.0 deal to remain relatively high to March 2018, which will draw OECD storage down to five-year average levels. We also are maintaining our expectation Brent prices will trade to $60/bbl by year end, with WTI trading ~ $58/bbl. Nonetheless, when we update our balances this month, we will continue to model for "compliance fatigue" among the OPEC 2.0 coalition. The fact that KSA and Russia are able to keep their rapport strong and compliance levels among OPEC and non-OPEC states relatively high, is a necessary condition for keeping OPEC 2.0 a viable coalition. However, the sufficient condition remains articulating a position on managing production via OPEC 2.0 that all these states can buy into, and support with concrete action. If, once the deal expires, the parties to the OPEC 2.0 coalition are left to go their own way and resume a production free-for-all, prices almost surely will fall, as the battle for market share is resumed. The ironic outcome of all this likely would be further destruction of capex budgets, which will set up another violent price surge that kills demand. We have no doubt the principal negotiators in OPEC 2.0 continue to discuss this, and that they are working on guidance. Bottom Line: KSA's tactical move to reduce exports to the U.S. likely will accelerate the commercial oil storage drawdown now apparent in OECD inventories, if current U.S. trends hold up - i.e., refinery runs remain high, exports of crude and products remain strong, and imports continue to fall yoy. Strategically, OPEC 2.0 still needs to convince markets there is a longer-term game plan for managing its output, short of a production free-for-all. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 This tactical move was reported by Reuters earlier this week. Please see "Saudi Arabia cuts crude oil allocations in September by more than its OPEC pledge," which was published by reuters.com August 8, 2017. 2 We are using the production levels specified by the Cartel in its "OPEC Bulletin 11 - 12/16" on p. 35. 3 This likely overstates the actual production available for export by KSA, since the Kingdom typically consumes some 500 - 600k b/d of crude domestically over the June - September period as direct-burn fuel to power generation producing electricity for air conditioners. So the reported data likely are noisy at this time of year. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Chart I-4BWidening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The Mueller investigation is part of the "Trump Put;" General White House disarray and congressional incompetence combine to produce Goldilocks conditions for U.S. equities; Mexico's frontrunner in the upcoming elections, Andres Manuel Lopez Obrador, is no Chavez; Malaysian political risks are overstated, the ruling Barisan Nasional has pushed through painful reforms; With economic growth stabilizing, cheap valuations, and overstated political risks, Malaysia could be an intriguing investment opportunity. Feature This week, we turn to two emerging markets: Mexico and Malaysia. Our approach to EMs is to look for opportunities where politics may emerge as the alpha amidst appealing valuations. We rely on our sister strategy, BCA's Emerging Market Strategy, for fundamental analysis, to which we then add our political research. We find it striking that these two EMs are the very two that stood to suffer the most should U.S. Congress have passed a border adjustment tax (Chart 1). Not only have the Republicans forsworn the border tax, but these countries will benefit from other trends, as we explain below. Before we dive into Malaysia and Mexico, however, a short note on the latest developments in the White House is in order. Clients from St. Louis, Missouri to Auckland, New Zealand are asking us the same question this summer: when does the Mueller investigation become a headwind for the SPX? Chart 1Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes The "Trump Put" Continues Our answer is that Special Counsel Robert Mueller's investigation may already be a tailwind to the U.S. equity market. The investigation, along with general White House disarray and congressional incompetence, makes up the ongoing "Trump Put."1 The American political imbroglio has combined with decent earnings and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. The political fulcrum upon which all these assets turn is the failure of the Trump administration to deliver its promised fiscal stimulus (Chart 2). Tax reform, which was supposed to be the main vehicle of such stimulus, is increasingly looking like it will fail to live up to its hype. We still think it will pass, for three broad reasons: Chart 2Handcuffed Trump The Most Likely Scenario Trump's low popularity remains an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results. Our simple "line-of-best-fit" model between a Republican president's approval rating and the GOP's midterm performance produces a 38-seat loss in the upcoming election (Chart 3). Republicans need a legislative win and need it fast. The House has laid the groundwork for tax reform, passing the FY2018 budget resolution with reconciliation instructions focused on tax legislation. This means that the Obamacare replace and repeal effort has until October 1 to be resolved.2 Investors are conflating replacing and repealing Obamacare with tax reform. The former is an entitlement program, the latter a more popular measure that Republicans have always tried to move through Congress. It is very rare for U.S. policymakers to successfully reduce or remove an entitlement program. Cutting, even reforming, taxes is easier to justify politically. Chart 3The Clock Is Ticking For The GOP On Tax Reform Although we still maintain that tax reform, or mere tax cuts, will happen, they are unlikely to be as stimulative as originally advertised. Corporate and household tax rates are unlikely to be lowered by as much as originally touted. That is because Republicans in the House will demand "revenue offsets" to accomplish rate reduction, yet they have already lost key offsets like Obamacare repeal and the border adjustment tax.3#fn_3 The White House could change all that by using its considerable political capital among conservative grassroots voters and the bully pulpit to get fiscally conservative Republicans in the House to move a stimulative tax reform through Congress. But, as we noted two weeks ago, factional fighting in the White House and an ineffective chief of staff are considerable hurdles.4 A few days after we published that report, President Trump replaced Reince Priebus with retired General and Homeland Security Secretary John Kelly. While Kelly is likely to introduce some discipline into the White House, we doubt he will make the executive more effective in cajoling House Representatives to toe the administration's line on tax reform. This is because Kelly adds no legislative experience to a White House that is already quite low on it by recent historical standards (Chart 4). Chart 4Trump Administration Is On The Low End Of Congressional Experience Additionally, the Trump Administration continues to drag its feet on presidential appointments, hurting the effectiveness of the executive. Only 220 appointments had been sent to the Senate by July 19, compared to the average 309 during the same time period by the previous four presidents (Chart 5). The Senate is very slow in confirming the candidates, perhaps because of their unorthodox backgrounds and resumes. The average time to confirm a Trump nominee is 45 days, which is astonishing given that the Senate is controlled by Republicans. Chart 5The Trump Administration Is Dragging Its Feet On Appointments In addition to the ineffectiveness of the White House, investors fret that the ongoing Mueller investigation, which has just impaneled a grand jury, could undercut the rally in risk assets. By summoning a grand jury Mueller can subpoena documents and obtain testimony of witnesses under oath. Doing so will accelerate the investigation and perhaps take it down new avenues. For example, the Kenneth Starr investigation initially focused on the suicide of deputy White House counsel Vince Foster and the Whitewater real estate investments by Bill Clinton. But the trail led elsewhere. Ultimately, the "Starr Report" alleged that Clinton lied under oath regarding his extramarital affair with Monica Lewinsky. Impeachment proceedings ensued. That said, we are sticking with our conclusion from May that investors should look through any risk of impeachment or indictment for President Trump, at least as long as Republicans hold the House of Representatives (i.e., at least until the midterms in 2018).5 In particular, there are three main reasons to fade any near-term equity market volatility: President Mike Pence - Under both impeachment rules and the 25th amendment, the U.S. president would be replaced by the vice president. Vice President Pence's approval rating largely tracks that of President Trump and is in the 40% area, but investors should note that he once stood at nearly 60% during the campaign (Chart 6). As such, the worst-case scenario for investors in the event of a post-midterm impeachment is that Trump is replaced by Pence, an orthodox Republican, and that Pence has to deal with a split Congress. And that is not bad! It would grind reforms to a halt, but at least tax reform would be out of the way by then. Midterm Election - If the Trump White House becomes engulfed in scandal, Republicans in the House will fear losing their majority. Yes, the partisan drawing of electoral districts - "gerrymandering" - has reduced the number of competitive U.S. House districts from 164 in 1998 to 72 in 2016 (Chart 7). But the Democrats managed to win the House in 2006 and the Republicans managed to take it back in 2010, so there is no reason the roles cannot be reversed yet again. However, this is not a risk, it is an opportunity. It will motivate the GOP in Congress to lock in tax and health care reform well ahead of the midterm elections. Counter-Revolution - With Trump embattled and facing impeachment, the market may let out a sigh of relief because it would mark a clear defeat of populist politics in the U.S. Much as with electoral outcomes in Europe, investors may want to cheer the defeat of an unorthodox, anti-establishment movement in the U.S. As such, we would push against any "Russia scandal"-induced volatility in the U.S. markets, at least until the midterm election. We think the market would digest the volatility and realize that Trump's impeachment, were it to occur after midterm elections, would not arrest the Republican agenda before the midterms. After all, the GOP has waited over 15 years to make Bush-era tax cuts permanent and the opportunity to do so may evaporate within the next 12 months. In addition, given the performance of high tax-rate S&P 500 equities (Chart 8), investors appear to have already discounted the failure of meaningful tax reform in the market. This means that the "Trump Put" is in full effect: investors are bidding up risk assets not because they expect something to happen (tax reform, fiscal stimulus, financial deregulation, etc.), but because they expect nothing to happen (no fiscal stimulus, no fast Fed rate hikes, no onerous regulation for businesses, etc.). Chart 6Could Be Worse ##br##Than Pence Chart 7Gerrymandering Reduces##br## Competitive House Seats Chart 8Investors No Longer##br## Expect Tax Reform What about the long term? A scandal-ridden White House, escalating leaks against the administration, and a mounting bureaucratic revolt against the executive cannot be good for the U.S., can they? The news flow out of Washington increasingly looks like news from Ankara, Brasilia, or Pretoria. There are two diametrically opposed directions the U.S. can take. The first is deepening polarization and policy gridlock that leads to President Trump being replaced by an even greater bout of populism in 2020 or 2024. We described this scenario recently in a pessimistic note about the coming social unrest in America.6 The alternative is that Democrats and Republicans in Congress (particularly the Senate), representing the country's elites, decide to work together on legislation. Both parties recently united to pass veto-proof sanctions on Russia with a 98-2 vote that has bound the executive to future review by Congress. And some green shoots of bipartisanship appeared over the past two weeks on tax reform and even on health care. It is too soon to say which path American policymakers will take. Investors may have to wait until after the midterm election for genuine cooperation. But it would be very positive for the U.S. economy and prospects of reform if genuine bipartisanship emerged as a reaction to the incompetence, scandal, nationalism, and populism of the White House. Bottom Line: The intensifying Mueller investigation and ongoing White House incompetence will only further fuel the "Trump Put." This is positive for U.S. equities, neutral for bonds, and bad for the dollar, ceteris paribus. A significant pickup in inflation could overwhelm the "Trump Put" and cause the dollar to rally. As such, investors should focus on inflation prospects more than politics in the White House. What If Mexico Builds A Wall First? For every action, there is an equal and opposite reaction. The election of President Donald Trump, an unabashed nationalist who campaigned on an anti-immigrant platform, is spurring the campaign of Andres Manuel Lopez Obrador, also known as AMLO, in the upcoming July 1, 2018 elections in Mexico. Obrador has been a left-wing firebrand of Mexican politics for years. He was the Head of Government of Mexico City (essentially the city's mayor) from 2000 to 2005 and contested a close election against Felipe Calderon in 2006, which he narrowly lost. He lost the 2012 election by a much wider margin, but still came second to current president Enrique Pena Nieto of the Institutional Revolutionary Party (PRI). Obrador's election campaign calls for a confrontational attitude towards President Trump, the renegotiation of NAFTA, an increase to farm subsidies, and limitations on foreign investment in Mexico. He has said that he would reverse the opening of the energy sector to foreign investment through a referendum, but that he is in favor of public-private partnerships in the sector. That said, his left-wing firebrand persona is more PR than substance. In 2012, for example, he also campaigned on cutting government expenditure and ending monopolies - not exactly Chavista credentials. Nonetheless, he quit the left-leaning Party of the Democratic Revolution (PRD) to form a more left-wing movement. Obrador's new party, the National Regeneration Movement (MORENA), did well in the 2015 midterms and is currently leading in the polls ahead of the 2018 election (Chart 9). MORENA also did well in the State of Mexico, a PRI stronghold and Nieto's home state, in the June 4 election. The ruling PRI held the state for 90 years and is accused of election-rigging in order to, only narrowly, defeat an unknown MORENA candidate this year. Chart 9MORENA Has Lead In The Polls Given that the election is a year away, it is too soon to make a forecast. Nonetheless, it is clear that Obrador is the frontrunner for the presidency. There are three reasons why his election may be an over-hyped risk: The Congress: For much of Mexico's twentieth century history, the president was essentially a dictator due to the one-party rule of PRI. In the twenty-first century, however, Congress has become plural, forcing the president to cooperate with the body or see his reforms stalled. Given recent elections (Chart 10), it is highly unlikely that Obrador would have a congressional majority behind him, thus forcing him to temper his policies. Chart 10Mexico's Rising Political Plurality The PAN-PRD Alliance: An unlikely alliance of the conservative National Action Party (PAN) and the center-left PRD has emerged as a reaction to the rise of MORENA in the polls. (These two parties have a history of cooperating against PRI presidents.) The two parties come from completely opposite ideological spectrums, but successfully joined forces in several state elections in 2016. It is unlikely that the two parties will unify sufficiently to field a single candidate - they failed to do so in the June 4 State of Mexico elections - but they may get enough votes to form a plurality in Congress. Mexicans do not lean left: Unlike most of Latin America, Mexico is a conservative country. Most Mexicans either think of themselves as centrist or lean right (Chart 11). While our data stops in 2015, the historical trend is clear: Mexico is a right-leaning country. As such, it is highly unlikely that AMLO will be able to manipulate the country's democratic institutions - which have been strengthened over the past twenty years - to turn Mexico into Venezuela. Chart 11Mexicans Lean Right We would therefore fade any politically induced volatility in Mexican assets. Next year, investors should prepare to "sell the rumor and buy the news" (you read that right), as Mexican election fever grips the markets. Given current macroeconomic fundamentals, an entry point in Mexican assets may develop if they sell off ahead of the election - but they are not a buy at the moment. BCA's Emerging Market Strategy has pointed out in a recent report that:7 Inflation is well above the central bank's target and is broad based (Chart 12). Notably, wage growth is elevated (Chart 13). Given meager productivity growth, unit labor costs - calculated as wage-per-hour divided by productivity (output-per-hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will, in turn, prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Chart 12Inflation is Above Target Chart 13Wage Inflation Is High Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail a further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart 14). This will weigh on corporate profits and share prices. Even though non-oil exports and manufacturing output are accelerating (Chart 15), non-oil exports - which make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. That said, the positive for Mexico is that the Mexican peso remains cheap (Chart 16) and may rally against other EM currencies. Our EM strategists suggest that investors should overweight MXN versus ZAR and BRL. Chart 14Domestic Demand to Buckle Chart 15Exports are Robust Chart 16Peso is Cheap If EM currencies depreciate or oil prices drop, it would be difficult to see MXN rally against the USD. However, MXN should outperform other currencies, especially given that political risks in Mexico are far lower than they are in Brazil and South Africa. Bottom Line: The Mexican markets may get AMLO-fever in 2018. Obrador is a clear frontrunner in the election to be held a year from now. However, AMLO will face off against constitutional, political, and societal constraints. As such, we would fade any politically induced risks in Mexican markets. Go strategically long MXN versus BRL and ZAR and look for an entry point into Mexican risk assets over the next 12 months. Malaysia: Hold Your Nose And Buy We have been broadly bearish on Malaysia since August 2015, but the upcoming elections - due by August 2018, but we expect to occur sooner rather than later - are likely to cause the markets to re-price Malaysian assets (Chart 17). The country's fundamentals are not rosy, and it remains vulnerable to a slowdown in China, a drop in commodities prices, and bad loans. Nevertheless, its underperformance is late, and this fact, combined with the political outlook, suggests that it will outperform for a while. Malaysia is in the midst of a long saga of party polarization that began amid the Asian Financial Crisis, when Prime Minister Mahathir Mohamad ousted his ambitious deputy, Anwar Ibrahim. Both men hailed from the dominant party of the country's ethnic Malay majority: the United Malay National Organization (UMNO), which is the center of Barisan Nasional (BN). The BN is a multi-ethnic coalition that has held power in one form or another since independence in 1957. Anwar went on to lead the reformasi (reform) movement, creating an opposition coalition of strange bedfellows: his own urban Malay People's Justice Party (PKR), the ethnic Chinese DAP, and the Islamist PAS. In the 2008 general elections, the opposition shocked the BN, depriving it of a two-thirds super-majority for the first time since 1969. In the 2013 general elections, the opposition won the popular vote, though BN retained control of parliament due to inherent advantages in the electoral system (Chart 18). Hence the past two elections, particularly the last one in 2013, have shaken the political system to the core. Since the 2013 shock, the opposition has had its sights set on the 2018 election, and a series of blows to the Najib government have given cause for hope. First, exports and commodity prices plunged from 2014 to 2016, damaging the economy and giving the opposition a grand opportunity to attack the administration (Chart 19). Second, Najib was personally implicated in a massive scandal involving 1MDB, a sovereign wealth fund that Najib helped create and from which he allegedly embezzled $700 million (!). Street protests emerged in 2015 and suddenly Najib faced a revolt from the old guard within his own party (including Mahathir himself). Chart 17Malaysian Underperformance Is Late Chart 18Opposition Threatens UMNO's Dominance Chart 19Commodities Should Help Malaysian Exports The problem for the opposition, however, is timing. The 2008 election occurred before the worst of the global financial crisis had been felt; the 2013 election occurred before the full impact of the commodity bust; and now the ruling coalition's fortunes are recovering in time for the upcoming election - which, of course, the prime minister schedules to his advantage. Thus, the opposition once again faces an uphill battle in this election cycle: The Malaysian economy has beaten expectations, growing by 5.6% in the first quarter of 2017, the fastest rate in two years. This was driven mainly by exports and the manufacturing sector (Chart 20). Money supply growth is strong while the credit impulse has bottomed and is approaching positive territory (Chart 21). The 1MDB scandal has mostly dissipated. Najib publicly confessed that the $700 million found in his personal account was a donation from a foreign government, and Saudi Arabian authorities confirmed this, prompting Najib to return the money. Malaysia's attorney general, anti-corruption commission, and central bank have all cleared Najib of wrongdoing, and his popular support has recovered from the fever pitch of the scandal in 2015-16, as demonstrated by the net-gain for BN in by-elections since 2013, and the fact that the BN saw its share of seats rise from 27% to 37% in the 2016 Sarawak State Assembly elections. This state's local elections have tended to foreshadow national elections, and it has the largest representation of any state in the national parliament (31/222). The opposition is split. Najib has courted the Islamist opposition party, PAS, peeling it away from the opposition coalition. Without PAS, the opposition falls from 89 seats in parliament to 71 seats, which is 41 shy of a majority. Even in the best case scenario for the opposition in the upcoming election, in which the opposition holds all seats from 2013 and Bersatu gains all of UMNO's seats in Kedah and Johor, the opposition would still fall 16 seats shy of a majority. Chart 20Growth Is Strong Chart 21Credit Cycle Is Picking Up Bottom Line: Our baseline case holds that Najib and BN will retain control of the government in the upcoming election on the back of the fading scandal, economic recovery, and a shrewd practice of dividing political enemies. What Does A Najib Win Mean? Is a Najib/BN victory positive for Malaysian risk assets? We think so, at least relative to other EMs. While Malaysia would benefit in the long run from breaking the BN's monopoly over parliament, the immediate consequence of an opposition victory would be confusion as the various opposition parties have widely divergent interests ... and zero governing experience. On the other hand, Najib's government has undertaken some significant reforms, expanded infrastructure, and improved government finances, making his corrupt and pseudo-authoritarian government not as market unfriendly as one might expect: As a result of weak commodities, cuts in subsidies, and the introduction of a goods and services tax (GST) and a tourism tax, Malaysia's fiscal deficit has improved from 5.5% in 2013, when Najib took office, to 3.1% today (Chart 22). The government is on a path to close the deficit by the end of the decade. The GST has allowed the government to reduce its dependency on oil revenues. Non-tax revenues, which include oil royalties, have decreased from 35% in 2010 to only 20% of total revenue, while indirect taxes (which include GST) have increased from 17% to 28% of revenue (Chart 23, top three panels). There are plans to increase the goods covered by the GST in the near future. The government has cut subsidies in fuel and cooking gas, taking advantage of low oil prices. The government had also eliminated subsidies in cooking oil and sugar. Subsidies as a percent of total expenditures have declined from almost 20% in 2014 to only 9% today (Chart 23, bottom panel). The government has expanded infrastructure, completing a mass rail transit extension in Kuala Lumpur, connecting the two East Malaysian states of Sabah and Sarawak via a 2,000 km highway, and attracting Chinese investment from the One Belt One Road program. The latter entails China building an East Coast Rail Link to connect the west and east coasts. Upon completion, this link will enable shippers to circumvent the port of Singapore and reach the South China Sea in a shorter time period. Chart 22Austerity Works Chart 23Tax Reforms Paid Off One perceived drawback of Najib's government is that in order to stay in power, he has had to court the Islamist PAS party, as mentioned above, specifically by allowing it to promote aspects of shariah law in the country's parliament. However, Malaysia is not at risk of being swept away by an imaginary rising tide of Islamic extremism. The country is very diverse, and Malay Muslims make up only a little more than half of the population. Malaysians are highly religious, but they are also highly tolerant, as they have lived among other races and religions since independence (Chart 24). Moreover, Islam is regulated and bureaucratized in Malaysia, which discourages the emergence of charismatic, anti-establishment religious leaders and the development of extremist movements. Finally, the government has an absolute need to win votes both in the Borneo states of Sabah and Sarawak, which have sizable Christian and non-Malay populations (adding up to more than half), and in the population centers of Kuala Lumpur and Penang. This means that it is not likely to allow PAS (or other Islamist movements) to go too far. Chart 24Malaysians Are Tolerant Bottom Line: Najib's government is corrupt and has authoritarian leanings, but has improved its management of the economy and public finances, and is not getting out of control with Islamism or populism. We would not expect a sustained market sell off in the face of a BN victory in upcoming polls. By contrast, if the opposition coalition wins a majority, it offers the long-term promise of a more inclusive and competitive political system that would be good for Malaysia, but would bring greater policy uncertainty in the short term. The opposition would likely have a low probability of achieving major reforms, as the BN party-state conglomerate would fight tooth and nail against it. A positive knee-jerk market response to an opposition win - on the expectation that "regime change" raises the probability of pro-market reforms - would likely be ephemeral. Investment Conclusion A key internal risk to the Malaysian economy stems from the country's fairly sizable debt, which may eventually become unsustainable. Yet at the moment, household and government debt are both rolling over even as growth is improving (Chart 25). A key external risk stems from China. Chinese politics are likely to shift from a tailwind for Chinese growth - fiscal stimulus and the need for stability ahead of the National Party Congress - to a headwind, as stimulus subsides and reforms are rebooted in 2018.8 We do not expect China's investment in Malaysia to fall sharply, since it is tied to a broad, long-term, strategic plan; nor do we see Malaysia as overexposed to Chinese imports or tourism. Nevertheless, Malaysia would suffer to some extent, and it is indirectly vulnerable as Malaysian exports to ASEAN and tourists from ASEAN are significant, and ASEAN would suffer from a Chinese slowdown. In short, China is a risk, albeit not as direct or major as one might think. The Malaysian ringgit has already become the best-performing currency this year. Yet this recent appreciation has not come near to reversing the currency's roughly 20% depreciation since 2014. A cheap currency, combined with robust external demand, should be a tailwind for Malaysian exports and the broader economy (Chart 26). Moreover, the rising price of key Malaysian exports like energy and palm oil should be positive for Malaysian equities (Chart 27). Chart 25Debt Is High, But Is Rolling Over Chart 26Cheap Currency Is A Tailwind For Exports Chart 27Commodities Support Equity Prices At the same time, valuations are attractive. Malaysian equities have underperformed the EM universe and its ASEAN peers since 2013 (see Chart 17 above). Malaysian equities have lost considerable value relative to their EM peers, and are trading at a discount relative to ASEAN peers. Compared to historical valuations, Malaysian equities are also trading at a discount (Chart 28 A and B). Chart 28aMalaysia Is Cheap Compared To Peers... Chart 28b...And Its Historical Valuation Bottom Line: The likely start of a new credit cycle, improving government finances, a persistently cheap currency, and the likelihood of an acceptable policy status quo should put a tailwind behind Malaysian risk assets. We recommend going long Malaysian equities relative to their EM peers. Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst Emerging Markets Strategy stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?," dated February 8, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 7 Please see BCA Emerging Market Strategy Weekly Report, "The Case For A Major Top In EM," dated July 12, 2017, available at ems.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com.
Highlights Investors are becoming less concerned about China's growth outlook, but there is no sign of euphoria. Monitor three risk factors that could disrupt the positive growth outlook and the bull market in Chinese stocks. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. Remain positive and stay invested. Feature The latest purchasing managers surveys released early this week confirm that the Chinese economy remains buoyant. The manufacturing and service PMIs from both official and private sources remain comfortably in expansionary territory, and there are no signs of a material deterioration from the readings of the sub-indices. Improving growth also appears to be reflected in the stock market. Chinese investable equities have rallied by over 30% so far this year, beating the major global and EM benchmarks (Chart 1). Despite the improvement in the growth numbers and the rally in stock prices, there is no sign of euphoria among investors with respect to China. On the contrary, Chinese stocks' multiples are still among the lowest of the major global bourses (Chart 2). Importantly, ETFs investing in Chinese assets are still witnessing net redemptions: China-focused ETFs listed in the U.S. and Hong Kong have been witnessing constant net capital outflows since 2013 (Chart 3). Even in the first half of this year, these ETFs have continued to lose capital despite rising stock prices - which means retail investors have not participated in the rally. Attractive valuations and lack of "irrational exuberance" suggest the rally in Chinese investable stocks should have further to run. Chart 1Chinese Equities Have Outperformed... Chart 2...But Still With Much Lower Multiples Chart 3... And Net ETF Redemptions Overall, we remain positive on both Chinese equities and the economy's cyclical outlook, and see limited downside risks in the near term, as discussed in detail in recent weeks.1 However, as growth and stock market performance have been largely in line with our expectations, it is always useful to reflect on risk factors. We see three potential risks that could upset the economy and the ongoing rally in Chinese stocks that need to be closely monitored. Will The Trump Wildcard Strike Again? There are increasing signs that tensions between the U.S. and China are on the rise again after a period of relative tranquility. The first round of U.S.-China Comprehensive Economic Dialogue (CED) resulted in no material progress or concrete plans to improve bilateral trade imbalances. U.S. President Donald Trump has continued to pull "China hawks" into his trade policy team, naming Dennis Shea, well known for being highly critical of China's trade practices, as deputy U.S. Trade Representative. Furthermore, the U.S. State Department recently approved a major weapon package to Taiwan, the first arms sales to the Island since 2015. More recently, President Trump has openly accused China of not helping deal with the North Korea nuclear issue after the country tested an intercontinental ballistic missile (ICBM) that it claims can reach continental America. In addition, the Trump administration is reportedly planning trade measures to force Beijing to crack down on intellectual-property theft and ease requirements that American companies share advanced technologies to gain entry to the Chinese market. Overall, it is widely viewed that the brief "honeymoon" in U.S.-China relations following the April Summit between the leaders of the two countries has decisively ended, and the odds for protectionism tactics against Chinese products have increased. The "Trump wildcard" has always been a key risk with respect to our outlook for China2 - the latest developments suggest this risk remains firmly in place. President Trump and his inner circle appear genuinely convinced that punitive tactics could solve the country's chronic trade deficit. Moreover, President Trump has been increasingly bogged down by domestic policy, and he may lash out on the international front in an effort to boost his popularity. Furthermore, the U.S. President has few legal constitutional constraints to using tariffs against trade partners, giving him maneuvering room. From a big-picture perspective, the conflict between the U.S. and China has deep ideological and geopolitical roots, which are even harder to deal with than trade issues. Chart 4Steel Is No Longer Relevant For ##br##U.S.-China Trade Nonetheless, we maintain our guarded optimism that unilateral protectionism measures will not materially undermine Chinese exports, at least in the near term. On the U.S. side, even though President Trump has toughened his rhetoric on China and trade issues of late, it is still far less extreme compared to the promises he made on the campaign trail, in which he pledged to slap a 45% tariff on all imports from China and to label the country a currency manipulator on "day one." So far, the U.S. administration has mainly been focusing on specific industries, particularly steel, rather than broad-based tariffs, the impact of which should be marginal. For example, China accounts for only 3% of American steel imports. Sales to the U.S. account for less than 1% of China's massive steel output (Chart 4). In other words, steel appears to be a highly symbolic sector in Trump's trade policy, but the real impact on China-U.S. trade is negligible. On the Chinese side, the authorities have hard-drawn redlines on political and sovereign issues, but have much greater flexibility on trade-related issues. Chinese officials understand that the country's large surplus with the U.S. puts it at a near-term disadvantage in a trade war, and therefore will likely cave to pressure from the U.S. Moreover, the sectors that President Trump has been complaining about, namely steel and some other base metals, are the same sectors the Chinese government wants to restrict. Therefore, China will not fight for its own "out of favor" industries to disrupt the broader picture in exports. Taken together, President Trump's trade policy has once again become unpredictable, and some punitive measures on specific products appear likely in the near term. However, we still assign low odds of a drastic escalation in trade frictions, and we expect the Chinese authorities to refrain from tit-for-tat retaliation that could lead to a trade war. Protectionism risks, however, will remain a long-term structural issue that complicates the global trade and growth outlook. Deflationary Pressures And The Risk Of Policy Overkill? Chart 5Headline CPI Is Set To Drop Further A key feature of the Chinese economy is strong disinflationary/deflationary pressures, despite robust growth and job creation. Headline inflation to be released next week will likely once again surprise to the downside, mainly due to food prices (Chart 5). Wholesale prices of agricultural products have weakened substantially in recent months, pointing to sharply lower food CPI. Core CPI remains around 1%, underscoring incredibly low inflationary pressures. The key challenge for the Chinese authorities is figuring out how to manage economic policies to achieve the delicate balance between growth and disinflation/deflation. We have long viewed that one of the critical reasons behind China's sharp growth deterioration between 2012 and 2015 was a policy mistake, in which the authorities allowed monetary conditions to tighten dramatically. We are hopeful that the authorities have realized the cost of policy overkill, and will avoid similar mistakes down the road, but the risk certainly cannot be dismissed entirely. For now, we see low odds of policy overkill that could lead to price deflation and negative growth surprises. First, as growth has improved, some policy tightening is warranted. The authorities recently reported that the economy added 7.35 million new jobs in the first half of the year, far exceeding the government's target, pushing the registered urban unemployment rate to 3.95%, the lowest in recent years. In fact, the People's Bank of China may still be behind the curve, meaning that further tightening is simply a "catch-up" and is not immediately restrictive. Chart 6Another Sharp Rally ##br##In The Trade Weighted RMB is Unlikely Second, a major factor behind China's drastic tightening in monetary conditions in previous years was the sharp rally in the trade-weighted RMB, which appreciated by almost 30% between mid-2011 and early/late 2015 - a massive deflationary shock to Chinese exporters (Chart 6). Looking forward, it is extremely unlikely that the PBoC will allow the RMB to rise by a similar magnitude anytime soon. Finally, from investors' perspective, producer output prices are more important to watch for pricing power and profitability. On this front, PPI inflation has also rolled over and will likely continue to downshift, but will not turn to outright deflation in our view. It is important to note that the sharp decline in producer prices in previous years was due to a multi-year deterioration in Chinese growth, which has historically been an anomaly. The only other period in China's post-reform history with falling PPI happened in the late 1990s in the aftermath of the Asian crisis (Chart 7). In other words, falling PPI only occurs under rather extreme growth difficulties. Our model suggests that PPI inflation may decelerate to 3% by year end. Our PPI diffusion index, which measures the percentage of industrial sectors experiencing rising prices, suggests the majority of sectors are still witnessing higher prices both compared with previous months and a year ago (Chart 8). We are monitoring the PPI diffusion index closely to heed a leading signal on corporate pricing power and overall deflationary pressures in the corporate sector. Chart 7Producer Prices: A Historical Perspective Chart 8PPI Watch Bottom Line: A policy mistake of overtightening by the Chinese authorities remains a key threat to the near-term growth outlook, but is not our base case scenario. The Resumption Of The Dollar Bull Market? The U.S. dollar has rapidly dropped out of favor among global investors. The dollar index has fallen by 10% so far this year, the weakest among the major currencies. The weak U.S. dollar has provided a Goldilocks scenario for both the Chinese economy and financial markets: a weaker dollar depreciates the RMB in trade-weighted terms, which is reflationary for the Chinese economy. For investors, the broad dollar weakness also alleviates downward pressure on the CNY/USD, and a stable CNY/USD in turn reduces investors' anxiety on China's macro conditions, pushing up stock prices. This Goldilocks scenario could once again be disrupted if the dollar bull market resumes, and the positive feedback loop goes into reverse. A stronger dollar tends to strengthen the trade-weighted RMB, which is bad news for exporters. Meanwhile, it could rekindle downward pressure on the CNY/USD, re-intensifying domestic capital outflows, which could be viewed as a sign of China's macro troubles. Fears of an economic hard landing would quickly resurface. In our view, Chinese stocks are more vulnerable if the dollar's strength resumes, but the real damage on the broader economy should not be material. It is highly unlikely that Chinese policymakers would allow the trade-weighted RMB to rise alongside the dollar, and will tighten capital account controls to stop domestic capital flight. Chinese equities will suffer in this scenario, as investors' risk aversion increases. However, so long as the Chinese economy and corporate profits do not suffer a major relapse, the rally in stocks should eventually resume. All in all, the three risk factors should be closely monitored in the coming months, especially if investors become increasingly comfortable with the Chinese growth outlook. For now, the risks appear reasonably contained, and the lack of a complacency in the marketplace means it is too early to bet against the herd. We remain positive on Chinese growth, and favor Chinese equites both in absolute terms and against global/EM benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Reports, "China Outlook: A Mid-Year Revisit", dated July 13, 2017, "Rising Odds Of PBoC Rate Hikes", dated July 20, 2017, and Special Report, "Focusing On Chinese Money Supply", dated July 27, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard", dated January 12, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart I-1The Economy Has Stabilized##br## But Has Not Recovered Brazil desperately needs to boost nominal growth to avoid public debt spiraling out of control1. We do not think it is possible without resorting to meaningful currency depreciation and much lower interest rates. The Brazilian economy has stabilized, but it has not yet recovered (Chart I-1). To stage a sustainable recovery, much easier monetary conditions and fiscal stance are required. However, monetary conditions remain tight and fiscal policy is tightening: Feature Real interest rates are about 5.5-6% - as high as they were before the current rate-cut cycle commenced (Chart I-2). The Brazilian central bank's aggressive rate cuts have largely matched the drop in the inflation rate, keeping real borrowing costs elevated. Besides, household debt servicing costs (interest payments and principal) are high, above 20% of disposable income (Chart I-3) and employment conditions remain extremely poor. In this environment, households will not be inclined to expand leverage considerably. The Brazilian real is not cheap. In fact, the real effective exchange rate is slightly above its fair value (Chart I-4). Nominal GDP growth is currently running close to 4%, while the government's budget assumption for nominal GDP growth in 2017 is 5-5.5%. Not surprisingly, government revenues are disappointing and the budget deficit is above its target (Chart I-5). Furthermore, the improvement in government revenues in the past 12 months has been due to one-off measures such as non-recurring privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL and tax amnesty/capital repatriation programs that will not be repeated. In brief, more tax hikes are needed to achieve revenue targets but higher taxes will in turn jeopardize the economic revival. Taxes on fuel have been raised in recent weeks. Chart I-2Interest Rates Are##br## Still Very High Chart I-3Household Debt Servicing##br## Ratio Has Not Yet Declined Chart I-4The Real Is Not Cheap Chart I-5Brazil: No Improvement In Fiscal Accounts Given that fiscal policy is straightjacketed by high and rapidly rising public debt levels, the onus of boosting nominal growth is squarely on the central bank. Not only have the monetary authorities cut interest rates, they have also been monetizing government debt. Chart I-6 shows that the central bank's holdings of government securities have skyrocketed, i.e., the central bank has bought BRL531 billion of government paper since January 2015. While it has partially sterilized its debt monetization by using these securities as reverse repos with banks, the amount of high-powered money/liquidity withdrawal via repos has been much smaller than the central bank's liquidity injections. Chart I-6aBrazil: Central Bank Has##br## Been Monetizing Public Debt... Chart I-6b...And Sterilizing It ##br##Only Partially This has helped liquidity in the banking system considerably, and smoothed the banking system adjustment at a time of surging non-performing loans. However, it has not generated enough purchasing power in the economy to boost nominal growth. Notably, broad money growth is slowing (Chart I-7). Even though bank loan growth may have troughed (Chart I-7, bottom panel), it is unlikely to recover strongly due to high real rates. Broad money captures the stance of credit and fiscal policies because broad money reflects purchasing power created by commercial banks and central bank when lending to and buying government bonds from non-banks. Remarkably, the broad money impulse - which is the second derivative of outstanding broad money - points to weakness in nominal GDP growth (Chart I-8). Chart I-7Brazil: Broad Money##br## And Bank Loans Chart I-8Broad Money And Terms Of Trade Point ##br## To Weaker Nominal Growth In addition, nominal GDP growth correlates with terms of trade, and the latter has also relapsed (Chart I-8, bottom panel). Furthermore, high-frequency data reveal that manufacturing PMI and consumer confidence have also rolled over lately, pointing to stalling improvement in both the manufacturing sector and consumer spending (Chart I-9). All in all, policymakers are behind the curve. The central bank could continue cutting interest rates, increase its purchases of government bonds, and also use other measures to inject more money – both high-powered money and broad money – into circulation. If they do so, it will eventually help the economy recover and boost inflation, yet it is bearish for the exchange rate. However, if the exchange rate relapses on its own (due to other factors), that will limit the authorities' ability to reduce interest rates further. This is on top of heightened political uncertainty that does not bode well for Brazilian financial markets. In a nutshell, Brazil needs to engineer currency depreciation to boost nominal growth and make public debt sustainable. This is true especially as Argentina is opting to keep its currency competitive, and it will be even more critical if commodities prices relapse, as we expect (Chart I-10). Provided the share of foreign currency public debt is low, reflating via currency depreciation is the least painful way out for Brazil. Bottom Line: Policymakers are desperate to boost nominal growth to stabilize public debt. Yet, in our opinion, nominal growth will not improve without further sizable rate cuts and meaningful currency depreciation. Eventually, policymakers will allow the BRL to depreciate 20%-plus, which will hurt foreign investments in local asset markets. We remain negative on/underweight Brazil equities, currency and sovereign debt. That said, we recommend fixed-income investors to bet on the 3/1-year yield curve flattening: receive 3-year / pay 1-year swap rate (Chart I-11). Chart I-9High-Frequency Indicators:##br## Improvement Has Stalled Chart I-10Other Headwinds##br## For BRL Chart I-11A New Trade: ##br## Bet On 3/1-Year Yield Curve Flattening Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 11 - we argued that Brazil's public debt dynamics is unsustainable without strong nominal growth and/or social security reforms. Equity Recommendations Fixed-Income, Credit And Currency Recommendations