Emerging Markets
How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)
Highlights U.S. Treasuries - Fair Value: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. U.S. Treasuries - Technicals: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market and possibly sets the stage for another leg higher in yields. China: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Feature Bonds rallied strongly late last week without any obvious economic catalyst. Now that the dust has settled we find the 10-year U.S. Treasury yield trading at 2.34%, 7 bps below our estimate of fair value (Chart 1). Chart 12-Factor U.S. Treasury Model Updating Our U.S. Treasury Model That fair value estimate comes from our 2-factor U.S. Treasury model, based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar. In our view, these two factors capture the most important macro drivers of U.S. bond yields. Stronger global growth, as proxied by the Global Manufacturing PMI, tends to push yields higher. However, to the extent that stronger global growth coincides with an appreciating U.S. dollar, the amount of monetary tightening that needs to be achieved through higher interest rates is limited. This caps the upside in long-dated U.S. bond yields. Put differently, it is not just the magnitude of the global growth impulse that matters for U.S. bond yields, but also the breadth of the recovery. The more broad-based the recovery, the less upward pressure on the U.S. dollar and the higher U.S. Treasury yields can rise. Last week we received Flash PMI estimates for the U.S., Eurozone and Japan that we can use to estimate the Global PMI for February. According to the Flash estimates, the U.S. PMI declined slightly in February, but this was more than offset by accelerations in both the Eurozone and Japan. Altogether, these three regions account for 48% of the Global PMI and, assuming PMIs in all other countries remain flat, we can calculate that the global PMI will nudge higher from 52.7 in January to 52.9 in February. Of course one month of data is much less important than the longer run trend. Taking a step back, we see that manufacturing PMIs are trending higher in every major economic bloc (Chart 2). Our diffusion index also shows that the global manufacturing recovery is more broadly based than at any time during the past three years (Chart 2, top panel). The synchronized nature of the recovery is also reflected in the behavior of the U.S. dollar, which has not appreciated during the past month even though Fed rate hike expectations have shifted up (Chart 3). The message from the survey of bullish dollar sentiment - the series that is included in our Treasury model - is more mixed. Bullish dollar sentiment plunged from elevated levels in January but has recovered somewhat during the past few weeks (Chart 3, panel 2). Meantime, U.S. Treasury spreads over German bunds and JGBs are also sending mixed signals. Short-maturity spreads have widened alongside increased U.S. rate hike expectations, while long-maturity spreads have been well contained (Chart 3, bottom 2 panels). Chart 2Synchronized Global Recovery Chart 3Keep Watching The Dollar Global bond investors should closely monitor trends in the U.S. dollar, bullish sentiment toward the dollar, and U.S. Treasury spreads over bunds and JGBs. Each of these indicators provides information about the breadth of the economic recovery. If Fed rate hike expectations remain firm, or even move higher, and that trend is not matched by a stronger dollar or wider Treasury spreads, then that would signal that the global recovery is becoming more synchronized, suggesting additional upside for bond yields. Bottom Line: The 10-year U.S. Treasury yield now appears 7 bps expensive on our model. Investors should maintain below-benchmark duration and continue to monitor bullish sentiment toward the U.S. dollar for signals about the breadth of the global economic recovery. Chart 4Positioning Becoming More Balanced Treasury Technicals Less Stretched This brings us back to last Friday's bond rally. Puzzlingly, the 2-year U.S. Treasury yield declined 6 bps and the 10-year yield fell 7 bps on a day without any significant economic or political news. In fact, Treasury yields managed to decline even though rate hike expectations embedded in the overnight index swap curve were unchanged and the probability of a March rate hike priced into fed funds futures actually increased from 31% to 33%! The unusual disconnect between Treasury yields and rate hike expectations is probably related to the expiry of the March bond futures contracts. Last week, traders had to decide whether to let their March contracts expire or roll them over into June. Positioning data show that speculators carried large net short positions into last week (Chart 4), so it is possible that it was the capitulation of these large short positions that drove yields lower on Friday. More timely data from the skew between payer and receiver swaptions show that swaption investors are no longer betting on rising rates (Chart 4, panel 4). Net speculative positions in Treasury futures could follow suit when the data are released later this week. In addition, our composite sentiment indicator has just recently ticked back above the zero line (Chart 4, panel 2). Bottom Line: Large net short bond positions are in the process of being unwound. A more balanced technical picture removes one of the key impediments to the bond bear market, and possibly sets the stage for another leg higher in yields. China's Bond Market Balancing Act Chart 5Easy Money Spurs Chinese Growth In the context of the 2-factor U.S. Treasury model presented above, there are two reasons why developments in China matter for U.S. bond markets. The first is that China accounts for the single largest weighting in the Global Manufacturing PMI, so stronger growth in the Chinese manufacturing sector will pressure bond yields higher, all else equal. But the Chinese economy can also influence U.S. bond yields if changes in the RMB exert meaningful influence on the trade-weighted U.S. dollar. For example, faster Chinese growth pressures U.S. bond yields higher, but some of that upward pressure could be mitigated if that strong growth is engineered through a rapid depreciation of the RMB relative to the U.S. dollar. On the first point, China's manufacturing PMI is in a clear uptrend although the recent contraction in the government's fiscal expenditures is a potential warning sign (Chart 5). Our China Investment Strategy service views the fiscal contraction as a risk but still expects the Chinese economy to remain buoyant this year.1 This is because Chinese monetary conditions remain supportive of further gains in the manufacturing sector, and the rebound in China's PMI that began early last year is more tied to easing monetary conditions - a weaker exchange rate and falling real interest rates - than to increased fiscal spending. On the second point, while a weaker trade-weighted RMB has helped spur the recovery in Chinese manufacturing, the impulse from a weaker RMB has so far not been potent enough to move the needle on the trade-weighted U.S. dollar (Chart 6). From the perspective of U.S. fixed income markets a continuation of this trend would be the most bond-bearish outcome. Chinese monetary policy remains easy enough to spur economic growth but not so easy that it causes the U.S. dollar to spike. For the time being at least, China has been actively selling Treasuries in order to mitigate the extent of its currency depreciation (Chart 7). If China were to suddenly stop selling Treasuries, then the RMB would likely depreciate sharply. This would actually have an ambiguous impact on U.S. Treasury yields since it would probably lead to both a stronger U.S. dollar and faster global growth. Chart 6USD So Far Not Impacted By RMB Chart 7China Is A Treasury Seller More likely, however, is that China will continue to manage the gradual depreciation of its currency unless it is forced to take more dramatic action in the face of a negative growth shock. Our China Investment Strategy team notes that the annual People's Congress in early March should offer some important clues about the Chinese government's growth priorities and policy direction going forward. Bottom Line: Chinese monetary policy that is sufficiently accommodative to spur economic growth, but not so accommodative that it causes undue strength in the trade-weighted U.S. dollar, is the most bearish outcome for U.S. bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening", dated February 16, 2017, available at cis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights There is little evidence of a major "credit bubble" in China. Rising debt is largely the consequence of the country's high saving rate. This has mixed implications for global bonds: On the one hand, an exaggerated fear of a hard landing in China has kept global bond yields below where they would otherwise be; on the other hand, high levels of Chinese savings will continue to weigh on real long-term yields. The real trade-weighted RMB will depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. Chinese shares are still attractive at current valuation levels. Go long the H-share market versus the MSCI EM index. We are booking a loss of 10% on our NASDAQ hedge. Feature Indefatigable The global economy remains in recovery mode. As we discussed last week, leading indicators point to strong global growth and accelerating earnings over the next six months.1 This justifies a cyclically overweight tilt towards global equities. Still, we worry that equity markets have gotten ahead of themselves. We thought that the backup in yields late last year, along with Trump's protectionist rhetoric, would cause stocks to correct to the downside, at least temporarily. Instead, they ripped higher, causing our short NASDAQ hedge trade to briefly go through its 10% stop loss on Wednesday. Our technical indicators continue to point to heightened risks of a correction. Whether such a correction proves to be the proverbial "buying opportunity" - our baseline view - or morphs into something more ominous will depend on the durability of the economic backdrop. We discussed some of the risks around Europe and the U.S. last week. This week we turn to China. The China Question Recent Chinese economic data have been fairly solid and our China analysts expect that growth momentum will be sustained over the coming months.2 Nevertheless, there are plenty of clouds on the horizon. Direct fiscal spending has slowed sharply over the past 12 months. In addition, a crackdown on property speculation last year has led to a deceleration in home price inflation, which could adversely affect household spending and construction later this year. Then, of course, there is all that debt. There is no shortage of commentators who argue that China is experiencing a full-blown credit bubble. Others contend that rising debt in China is largely a manifestation of a chronic excess of domestic savings. Knowing which side is correct is critical for investors. If China is in the midst of a massive credit bubble, then it is natural to fear that this bubble will burst fairly soon. This could prove to be devastating to global financial markets. In contrast, if rising debt in China mainly reflects an overabundance of savings, then it is possible that debt will continue rising until those savings dissipate - something that may not happen for many years. We won't beat around the bush. Our view is that rising debt in China has largely been the result of excess savings. This implies that a financial crisis in China is unlikely anytime soon. That does not mean that China will cease being a source of occasional investor angst. But if another major global recession is coming, it will not be because of China. The Debt-Savings Tango Endless ink has been spilled on the question of whether savings create bank credit or bank credit creates savings. In reality, the answer is "both": Just like income can create spending and spending can create income, savings can create debt and vice versa. If an economy is operating at less than full employment, the decision by banks to extend new credit is likely to boost aggregate demand, leading to more hiring. This will raise household disposable income and potentially lift aggregate savings.3 On the flipside, if households decide to save a bit more, this will push down real interest rates. That, in turn, could entice firms to increase how much they borrow and invest. Debt creates savings, and savings create debt; it's a two-way street. Admittedly, thinking through the specific forces underlying the relationship between debt and savings is one of those things that can make your head spin. Thus, it is worthwhile to go through a few simple examples in order to elucidate the principles at work. With this knowledge in hand, we will be able to debunk many of the fallacies that investors routinely succumb to. Cuckoo For Coconuts: How To Think About Debt And Savings Imagine a small island economy consisting of 100 people, each of whom toils away producing 100 coconuts every year, resulting in annual GDP of 10,000 coconuts. Consider the following five examples, summarized in Table 1: Table 1Cuckoo For Coconuts: Debt Creates Savings, Savings Create Debt Example #1: Each person consumes 100 coconuts. As a result, a total of 10,000 coconuts are consumed. Total savings is zero, as is total investment. No debt is created. Example #2: Each person consumes only 75 coconuts, selling the other 25 coconuts to a nearby plantation. The plantation buys these coconuts with the help of a bank loan and plants them, resulting in 2,500 new coconut trees. Total consumption falls to 7,500. Savings and investment equals 2,500 coconuts. 2,500 coconuts worth of bank loans are created. Notice that higher savings have led to more debt. Example #3: Same as Example 2, but now instead of selling the excess coconuts to a nearby plantation, they are exported abroad. Savings equal 2,500 coconuts, investment is zero, and the current account surplus is 2,500. The island accumulates 2,500 coconuts worth of foreign assets. The lesson here is that if a country can export some of its excess savings abroad, debt may not need to rise by as much as if the savings had to be intermediated by the domestic financial system. Note also that this example reveals the famous economic identity: S-I=CA. Example #4: Each person consumes 125 coconuts, made possible by importing 25 coconuts per person. Consumption now equals 12,500 coconuts. Savings equal -2,500 coconuts, investment is zero, and the current account deficit is 2,500. The island takes on 2,500 coconuts worth of external debt. Example #5: Half the island's residents consume 75 coconuts each, while the other half consumes 125 coconuts each. Those who consume 75 coconuts sell their surplus nuts on the open market, placing the proceeds in a bank. The bank lends out these savings to the other half of the population. Net savings and investment is zero. However, 1,250 coconuts worth of new bank loans are created. Debt Puzzles The key idea stemming from these examples is that debt is often formed when there is a persistent divergence between spending and income.4 This is true for the economy as a whole, as well as for its individual constituents (households, firms, and the government). Understanding this point helps resolve a number of seeming puzzles. For instance, it is sometimes alleged that China's debt buildup cannot be the result of the country's high saving rate because U.S. debt also rose rapidly in the years leading up to the financial crisis, an era during which the U.S. national saving rate was very low. Our simple examples demonstrate why this is a misleading argument. Examples 2, 4, and 5 show that debt levels will rise regardless of whether income exceeds spending or spending exceeds income. It is the absolute difference between the two that matters, not whether the residual is positive or negative. In Example 2, which is applicable to China today, households spend less than they earn. The resulting savings are intermediated by the financial system and transformed into investment, creating new debt along the way. In Example 4, which is applicable to the U.S. before the financial crisis, households spend more than they earn, leading them to take on new debt in order to finance imports. The increase in debt may get amplified, as in Example 5, if some households save while others dissave. As discussed in Box 1, Example 5 also helps explain why inequality and debt levels tend to rise and fall together over time. The Future Of Chinese Household Savings Chinese household savings now stand at nearly 40% of disposable income, notably higher than in other major developed and emerging economies. The increase in China's household savings, along with a widening gap between rich and poor, have been important drivers of faster debt growth (Chart 1). As time goes by, China's household saving rate will begin to decline due to the aging of its population, the expansion of household credit, and the emergence of a stronger "consumer culture." Yet, that shift is likely to be a gradual one. Progress in building out a social safety net has been painfully slow. This has forced households to maintain high levels of precautionary savings. The share of China's population in its 'prime savings years' (between the ages of 30-and-59) will also continue to increase over the next 15 years, which should support an elevated saving rate (Chart 2). Chart 1China: Higher Saving Rate And ##br##Inequality Went Hand In Hand With Debt Growth Chart 2China: Share Of Population In Its High ##br##Saving Years Has Not Yet Peaked In addition, sky-high property prices have forced young people to save a large fraction of their incomes in order to have any hope of owning a home. This is particularly true for men. Brides are in short supply in China. The saving rate among single-child households with one son is about four percentage points higher in rural areas and two percentage points higher in urban areas, compared to single-child households with one daughter. One academic study concluded that about half of the increase in China's household saving rate since the late-1970s could be attributed to this factor.5 Unfortunately, this problem is not going to go away anytime soon. The ratio of men between the ages of 25-and-39 and women between the ages of 20-and-34 - a proxy for gender imbalances in the marriage market - will surge from 1.06 at present to 1.35 by the middle of the next decade (Chart 3). What do countries with surplus savings and surplus men tend to do? Historically, the answer is that they have sent them off to fight. China's military spending has grown by leaps and bounds over the past decade (Chart 4). This trend is bound to continue, making East Asia an increasingly likely setting for future military conflicts.6 Chart 3A Shortage Of Chinese Brides Chart 4China: A Lot Of Dry Powder Understanding Chinese Corporate Debt Dynamics Chart 5China: State-Owned Companies Are ##br##Not The Only Ones With Access To Cheap Financing Many companies around the world rely heavily on retained earnings and equity sales to finance new investment projects. When this happens, investment can take place without the need for the creation of new debt. China has its fair share of consistently profitable companies that fund capital expenditures using internally generated funds, while tapping the equity markets as necessary to finance larger projects. However, the country is also awash with companies that are in constant need of debt financing. Perhaps not surprisingly, the former tend to be private firms while the latter are often state-owned enterprises (SOEs). Pundits like to assert that the secret to boosting growth in China is to wean these money-losing public companies off cheap credit, forcing them to cut back on production and capital spending. This will allow scarce economic resources to migrate to better-managed firms that will use them more wisely. But is this really a sensible assumption? What exactly is the evidence that China's well-run private companies have been starved of credit because most of it is flowing to money-losing companies? The data does not fit this "crowding out" story at all (Chart 5). The Japan Analogy A more sensible narrative is that the Chinese government has been prodding state-owned banks into lending money to state-owned companies and local governments in order to support aggregate demand and keep unemployment from rising. The experience of Japan is instructive here. Starting in the early 1990s, Japan entered an extended era where the private sector was trying to spend less than it earned (Chart 6). In order to keep unemployment from rising, the Japanese government was forced to try to export these excess savings abroad via a current account surplus or, failing that, absorb them with dissavings from the public sector. While Japan was able to lift its current account surplus from 1.4% of GDP in 1990 to 3% of GDP in 1998, this was not enough to fully offset the surge in desired private-sector savings. This necessitated the government to run large budget deficits. The same sort of fiscal trap now stalks China. Up until the Great Recession, China was able to export much of its excess savings. The current account surplus hit a record high of nearly 10% of GDP in 2007. In effect, China was doing what the islanders in Example 3 were able to do. The subsequent appreciation of the RMB undermined this strategy, forcing the government to take steps to boost domestic demand. It is no surprise that China's debt stock began to grow rapidly just as its current account surplus started to dwindle (Chart 7). Chart 6Japan Relied On Fiscal Largess And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 7China: Debt Increased When Current ##br##Account Surplus Began Its Descent Keep in mind that fiscal policy in China entails much more than adjustments to government spending and taxes. Central government spending accounts for a fairly small share of GDP. The vast majority of fiscal stimulus is done via the banking system. This makes Chinese fiscal policy nearly indistinguishable from credit policy. Chart 8Chinese Private Firms: Liabilities-To-Assets Trending##br## Lower For A Decade From this perspective, China's so-called "debt mountain" is not much different from Japan's debt mountain once we acknowledge that the bulk of China's corporate debt in China is, in fact, quasi-fiscal debt. As evidence, note that in sharp contrast to the SOE sector, the ratio of liabilities-to-assets among private Chinese companies has actually been trending lower over the past decade (Chart 8). Yes, many of the investment projects undertaken by SOEs and local governments are of questionable economic merit. But that's beside the point. China's money-losing SOEs are the equivalent of Japan's fabled "bridges to nowhere." From the Chinese government's point of view, an SOE that is producing something is still preferable to one that is producing nothing. The ever-rising debt burden that these state-owned firms must carry to cover operating losses and finance new investment is just the price the government must pay to keep the economy afloat. Little Evidence Of A Genuine Credit Bubble Genuine credit bubbles tend to happen during periods of euphoria. U.S., Spanish, and Irish banks all traded at lofty multiples to book value on the eve of the financial crisis, having massively outperformed their respective indices in the preceding years. That's obviously not the case for Chinese banks today, which remain one of the most loathed sectors of the global equity market (Chart 9). The U.S., Spanish, and Irish housing booms also occurred alongside ballooning current account deficits, something that doesn't apply to China (Chart 10). One can debate whether China is in the midst of a property bubble, but even if it is, it looks a lot more like the one Hong Kong experienced in the late 1990s. When that bubble burst, property prices plummeted by 70%. Yet, Hong Kong banks were barely affected (Chart 11). Chart 9Chinese Banks: Unloved And Unwanted Chart 10Recent Credit Bubbles Developed ##br##Amid Widening Current Account Deficits Chart 11Hong Kong Is The Correct Analogy There is a lot of debt in China. However, most of it has not been centered on the property market (Chart 12). Rather, just as in Japan, debt has served a fiscal purpose - it has been used to absorb the excess savings of the private sector, so as to keep unemployment from rising. Chart 13 shows that national saving rates and debt-to-GDP ratios are positively correlated across emerging economies. China sits close to the trend line, suggesting that its debt stock is roughly what you would expect it to be. Chart 12Chinese Debt: Not Predominately ##br##Tied To The Property Market Chart 13Positive Correlation Between National Savings And Indebtedness Investment Conclusions Where does this leave investors? For global bonds, the implications of our analysis are somewhat mixed. On the one hand, the high probability that the Chinese government can maintain the status quo of continued credit expansion for the foreseeable future means that a hard landing for the economy - and the associated drop in safe-haven developed economy government bond yields that this would trigger - is unlikely to occur. On the other hand, high levels of Chinese savings will continue to fuel the global savings glut, keeping real long-term bond yields lower than they would otherwise be. On balance, investors should maintain a modest underweight allocation toward global bonds. Our analysis does not warrant either a very bearish or very bullish stance towards the RMB. Granted, a banking crisis could prompt Chinese savers to look for ways to move more of their money overseas, leading to further capital flight and a tumbling currency. As noted, however, such an outcome is not in the cards. On the flipside, a chronic shortfall of domestic demand will keep the pressure on the government to try to export excess production abroad by running a larger current account surplus. As we foretold in our March 2015 report "A Weaker RMB Ahead," this will push the authorities to weaken the currency.7 We expect the real trade-weighted RMB to depreciate by a further 3%-to-5% over the next 12 months, with the bulk of the decline coming against the U.S. dollar. If China averts a debt crisis, that's good news for global equities. In the developed market universe, Europe and Japan stand to benefit the most, given the cyclical bent of their stock markets. We are overweight both regions (currency hedged). Despite a weak start to the year, both markets have outperformed the U.S. in local-currency terms since bottoming last summer, a trend we expect will resume over the coming months (Chart 14). What about Chinese shares specifically? Clearly, there are many risks facing the Chinese economy that transcend debt worries, a possible trade war with the U.S. being the prominent example. Yet, considering that Chinese stocks trade at fairly cheap valuation levels, our sense is that these risks have been more than fully priced in by investors. With this in mind, we are going long Chinese H-shares relative to the overall EM basket.8 Chart 15 shows that H-shares now trade at a substantial discount to the EM index. Chart 14Euro Area And Japan: Rebound Will Continue Chart 15Chinese Investable Stocks Are Cheap Finally, one housekeeping note: Since we already have exposure to the H-share market via our strategic recommendation to be long China/Europe/Japan versus the U.S., we are closing that trade and opening a new one that is simply long Europe and Japan versus the U.S. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com Box 1: Debt And Inequality Chart 16U.S.: Positive Correlation Between ##br##Income Inequality And Debt-To-GDP Income inequality and the ratio of private debt-to-GDP have been positively correlated in the U.S. over the past century (Chart 16). The existence of this relationship is not merely due to a third factor: economic growth. Growth was strong in the 1920 and 1980s/90s - two periods of rapidly increasingly inequality - but it was also strong during the 1960s, a decade when inequality was falling. Our analysis helps shed light on this relationship. Return to Example 5, but this time assume that each resident consumes 100 coconuts, with half the population producing 75 coconuts and the other half producing 125 coconuts. 10,000 coconuts are still produced and consumed in aggregate, resulting in no net savings. But because half the population is borrowing money to acquire coconuts from the other half, debt levels still rise. Higher inequality leads to more debt. To be sure, the correlation between inequality and debt runs in both directions. Rising debt has historically led to an expansion of the financial sector. This has helped enrich Wall Street elites. In this way, rising debt can exacerbate inequality. On the flipside, rising income inequality entails a shift of income from poorer households - with high marginal propensities to consume - to richer ones - who generally save a large fraction of their income. This tends to reduce aggregate demand. Lower aggregate demand, in turn, leads to lower real rates, making it easier for poorer households to load up on debt and live beyond their means. 1 Please see Global Investment Strategy Weekly Report, "The Reflation Trade Rumbles On," dated February 17, 2017, available at gis.bcaresearch.com. 2 Please see China Investment Strategy, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 3 A few technical caveats are in order. Think of a simple closed-economy "Keynesian" model where aggregate demand determines income and where savings (S), by definition, are equal to investment (I). In this model, investment is usually treated as exogenous. Thus, if increased bank credit is used to finance new investment projects, this will also translate into higher savings (i.e., if "I" goes up, "S" must also rise). In contrast, if the credit ends up flowing into consumption, savings will remain unchanged. More plausibly, one can imagine that investment is subject to an "accelerator effect," so that increased aggregate demand prompts firms to increase capital spending. In that case, even if the credit flows into consumption, investment will still rise - and since savings is equal to investment, this means that savings will also go up. Intuitively, this happens because the increase in income derived from higher employment more than offsets the increase in consumption. This leads to higher aggregate savings. 4 The word "persistent" is important here. To see why, suppose that in Example 5, the people who consumed 125 coconuts each had previously been thrifty, which had allowed them to build up large bank deposits. Then they could finance their additional spending by running down their accumulated savings, rather than taking on new debt. Likewise, if those who consumed 75 coconuts had previously lived beyond their means, then instead of adding to their deposits, they would be paying back existing debt. The net result would be less debt, not more. 5 Shang-Jin Wei and Xiao Zhang, "The Competitive Saving Motive: Evidence From Rising Sex Ratios And Savings Rates In China," Journal of Political Economy, Vol. 119, No. 3, 2011. 6 Please see Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 6, 2015, available at gis.bcaresearch.com. 8 The exact trade is to be long China H-Shares versus the MSCI Emerging Market index, currency unhedged. The corresponding ETFs for this trade are the Hang Seng Investment Index Funds Series: H-Share Index ETF (2828 HK), and the iShares MSCI Emerging Markets ETF (EEM US). The Hang Seng China Enterprise index comprises of China H-Shares (Chinese stocks available to international investors) currently trading on the Hong Kong Stock Exchange. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Chinese fiscal stimulus, both direct fiscal spending and infrastructure investment, has slowed significantly since late last year. This raises a red flag on the sustainability of the cyclical upturn. The Chinese economy should remain buoyant in the near term, despite fiscal retrenchment. Policy initiatives should be closely monitored. Tactically upgrade H shares back to "overweight." Stay cyclically positive, and favor Chinese equities in global and EM portfolios. There are early signs that deflation is re-emerging in Hong Kong. Feature The Chinese economy has maintained strong momentum since the beginning of the year. Some sectors are showing remarkable strength, an extraordinary development considering that January is historically a lackluster month for industrial activity due to seasonality factors. The recent strength is all the more noteworthy as policymakers have apparently rolled back fiscal support significantly since late last year, and have more recently also tightened on the monetary front.1 The divergence between strengthening growth momentum and waning policy support raises hopes that the economy has finally found its footing with self-sustainable dynamics, but at the same time raises the risk that growth may relapse anew without policy tailwinds - especially if struck by an exogenous shock. For now we maintain our benign view on China's cyclical growth outlook, but the risk is tilted to the downside, and policy initiatives should be closely monitored going forward. Meanwhile, we remain positive on Chinese equities on a cyclical basis. This week we are also upgrading our tactical "bullishness rating" on H shares back to "overweight." Strengthening Growth Versus Waning Fiscal Support Despite seasonal noise in the macro data in the first two months of the year, most macro numbers coming out of China of late have surprised significantly to the upside. Producer prices have continued to accelerate, heavy-machine sales have been booming, and even exports have rebounded sharply (Chart 1). The regained strength in the economy is partly attributable to early last year's low base, which has supercharged year-over-year growth rates. However, there is little doubt at this stage that China's growth recovery since early last year has developed into a mini boom. Beneath the robust growth numbers, there are some disconcerting undercurrents on the policy front (Chart 2). Fiscal spending growth has decelerated sharply since early 2016, and actually contracted towards year end. More importantly, capital spending on infrastructure construction, which can be viewed as an indicator for broader policy-driven spending in the economy, also slowed sharply in the last quarter. Fixed asset investment in transportation networks and utility concerns have also abruptly slowed. Investment in railway construction contracted by almost 30% in the final months of last year from a year earlier. All of this underscores a synchronized reduction in the public sector's involvement in the economy of late. Chart 1Growth Recovery... Chart 2... Meets Waning Fiscal Stimulus It is not immediately clear why the government has significantly scaled back fiscal support. Combined with the latest interest rate adjustments by the People's Bank of China, it is likely that the authorities have become content with the economy's performance to a degree that any direct policy pump-priming in their view is no longer necessary or justified. If China's ongoing cyclical growth improvement was due to the authorities' reflationary efforts, then the abrupt change in policy course certainly raises a red flag on how long the recovery may last. Can The Growth Recovery Continue Without Fiscal Support? Chart 3Monetary Conditions Matter More Than Fiscal We expect the Chinese economy to remain buoyant in the next two quarters, even without major acceleration in fiscal spending, for the following reasons: First, China's growth recovery since last year has been driven primarily by easing monetary conditions through a weakening exchange rate and falling real interest rates, rather than strong fiscal boost. Chart 3 shows that industrial sector growth deterioration worsened dramatically in 2014, which in hindsight was due to a combination of aggressive fiscal retrenchment and tighter monetary conditions index (MCI). Even though fiscal expenditures began to accelerate strongly starting in early 2015, the economy only began to improve a year later when the MCI started to ease. In fact, the industrial sector continued to improve throughout 2016 along with a rising MCI when fiscal expenditures decelerated. In other words, the industrial sector's performance is much more tightly correlated with the country's monetary conditions than the cyclical swings in fiscal spending. On one hand, the RMB exchange rate matters fundamentally for the manufacturing sector, which is heavily exposed to overseas markets. On the other hand, lower real interest rates, either through easing deflation or falling nominal rates, has been a primary driver of corporate profitability and overall business conditions, given the country's debt-centric financial intermediation system (Chart 4). As PPI is still rising rapidly and the trade-weighted RMB has once again rolled over, monetary conditions will likely continue to ease, which will further boost the industrial sector despite the fiscal cuts. Second, the slowdown in infrastructure spending will likely be compensated by accelerating investment in other sectors, manufacturing and mining in particular. Easing monetary conditions and ensuing growth improvement have significantly boosted corporate profitability, which should in turn boost manufacturing capital spending (Chart 5). It is likely that the multi-year slowdown in manufacturing sector capital spending has run its course and will accelerate going forward, albeit gradually.2 Investment in the mining sector is still contracting sharply. However, there has also been a dramatic improvement in profits among mining related industries, particularly coal and base metals (Chart 5, bottom panel). If historical correlations hold, the dramatic contraction in mining sector investment has likely already become very advanced, if not already bottomed. At minimum, it is highly unlikely that mining-related capex will continue to contract at an accelerating pace. Chart 4Interest Rates Versus Corporate Profits Chart 5Profits Versus Capital Spending A potential revival in manufacturing and mining capex will reverse a major growth headwind the Chinese economy has faced in recent years, which will continue to buoy growth despite slowing infrastructure construction. Manufacturing and mining account for over 33% of China's total fixed asset investment, higher than the 25% share of infrastructure alone (Chart 6). Indeed, there are signs that the corporate sector's intentions to expand capital investment may already be improving. In recent months medium- to long-term new loans to the corporate sector have accelerated strongly, which could be a sign that the corporate sector is beefing up on investment capital (Chart 7). Chart 6Manufacturing And Mining Capex ##br##Versus Infrastructure Construction Chart 7Longer Term Loans##br## Have Accelerated Sharply Finally, we maintain the view that overall inventory levels in the economy are unsustainably low, and improving growth and easing deflation should push producers to re-stock (Chart 8). This should also ease any near-term pressure on production, even if new orders are hit by slowing public sector demand. In other words, the economy has a built-in buffer for a period of weaker demand which could allow policymakers to re-orient demand-side policies in light of the new growth situation. Chart 8The Case For Inventory Restocking In short, we expect that waning fiscal support in the economy will not derail the cyclical recovery. Macro numbers may look toppy in the coming months, as the favorable base effect from last year's low levels wears out, but business activity should remain buoyant at least in the coming two quarters. Nonetheless, in a global environment that is still facing enormous challenges and mounting uncertainties, domestic policy tightening obviously raises downside risks. The annual People's Congress in early March should offer some important clues on the Chinese government's growth priorities and policy directions, and should be closely monitored. Tactically Upgrade H Shares In terms of Chinese stocks, our attempt to time a market correction in H shares ahead of the U.S. presidential elections in October did not bear fruit as expected.3 This week we are upgrading our tactical "bullishness rating" on H shares back to "overweight". Even though H shares did correct, they found support at key technical levels and have broken out of late, underscoring a strong technical pattern (Chart 9). We are still concerned that some global markets, especially U.S. stocks, appear frothy and are vulnerable to some sort of shakeout, but the market appears to be in a melt-up phase in the near term. The risk of being left out in a rising market is higher than otherwise. More importantly, Chinese H shares are not nearly as frothy, if not outright cheap, which should further limit downside risks. The Trump administration has notably toned down the anti-China rhetoric, and the near term risk of escalating trade tension between the U.S. and China has abated.4 This should also soothe investors' concerns on Chinese stocks. Bottom Line: Tactically upgrade H shares back to "overweight." A shares will likely remain largely trendless. Meanwhile, stay cyclically positive, and favor Chinese equities in global and EM portfolios. Hong Kong: Is Deflation Coming Back? Hong Kong's GDP numbers to be released next week are likely to show the economy accelerated in the final quarter of the year, according to our model (Chart 10). However, the improvement was likely almost entirely driven by exports rather than domestic factors. In fact, retail sales contracted by 3% in December from a year ago. More importantly, with the exception of essential items such as food, alcohol and tobacco, the growth rates of all other major consumer goods are in deeply negative territory. Durable goods, an important barometer for consumer confidence and spending power, dropped by a whopping 20% in value, or 15.8% in real terms from a year ago, underscoring very weak domestic demand. Therefore, Hong Kong's growth outlook will remain heavily dependent on external demand. Chart 9H Shares: A Technical Breakout Chart 10Hong Kong's Growth Recovery Weak domestic demand also weighs heavy on inflation. Hong Kong's headline inflation is falling rapidly, primarily driven by declining rental prices, and odds are high that inflation may dip below zero in the coming months. This means that deflation may re-emerge for the first time since 2005. These developing deflationary pressures underscore the frothy housing market, and also suggest the Hong Kong dollar may have become expensive again. The currency board system prevents nominal exchange rate adjustments, and therefore any adjustment has to be through changes in domestic prices. There is little systemic risk in Hong Kong's financial system, but the re-emergence of deflationary pressures further weakens domestic demand, augments growth difficulties and bodes poorly for asset prices, especially real estate. We will follow up on these issues in the coming weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "On Chinese Tightening," dated February 9, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Growth Watch," dated January 19, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Chart I-1No Recovery In Domestic Demand Feature Today we are publishing charts on cyclical economic conditions within developing economies. The aim of this report is to aid investors in gauging the business cycle profiles of these individual emerging economies. Global trade and manufacturing have recovered, driven by an acceleration in U.S. and euro area demand. Chinese imports have also recovered, supporting global trade amelioration. Although there has been improvement in EM manufacturing PMIs (diffusion indexes), "hard" EM economic data have not recovered (Chart I-1). This is especially true for EM domestic demand measures such as consumer spending and real gross fixed capital formation. Given the still-lingering credit excesses in many EM countries, credit growth is likely to decelerate further, leaving little chance of domestic demand recovering. Bottom Line: Continue underweighting EM equities and credit markets versus their DM peers. China Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 Chart I-2C2 Chart I-3C3 Chart I-4C4 Chart I-5C5 Chart I-6C6 Chart I-7C7 Korea Chart I-8, Chart I-9, Chart I-10, Chart I-11 Chart I-8C8 Chart I-9C9 Chart I-10C10 Chart I-11C11 Taiwan Chart I-12, Chart I-13 Chart I-12C12 Chart I-13C13 India Chart I-14, Chart I-15, Chart I-16, Chart I-17 Chart I-14C14 Chart I-15C15 Chart I-16C16 Chart I-17C17 Indonesia Chart I-18, Chart I-19 Chart I-18C18 Chart I-19C19 Malaysia Chart I-20, Chart I-21 Chart I-20C20 Chart I-21C21 Thailand Chart I-22, Chart I-23, Chart I-24 Chart I-22C22Chart I-24C24 Chart I-23C23 Philippines Chart I-25, Chart I-26 Chart I-25C25 Chart I-26C26 Brazil Chart I-27, Chart I-28, Chart I-29, Chart I-30, Chart I-31, Chart I-32 Chart I-27C27 Chart I-28C28 Chart I-29C29 Chart I-30C30 Chart I-31C31 Chart I-32C32 Mexico Chart I-33, Chart I-34, Chart I-35, Chart I-36, Chart I-37 Chart I-33C33 Chart I-34C34 Chart I-35C35 Chart I-36C36 Chart I-37C37 Colombia Chart I-38, Chart I-39, Chart I-40, Chart I-41 Chart I-38C38 Chart I-39C39 Chart I-40C40 Chart I-41C41 Peru Chart I-42, Chart I-43, Chart I-44 Chart I-42C42Chart I-43C43 Chart I-44C44 Chile Chart I-45, Chart I-46, Chart I-47, Chart I-48 Chart I-45C45 Chart I-46C46Chart I-47C47Chart I-48C48 Argentina Chart I-49, Chart I-50, Chart I-51, Chart I-52, Chart I-53 Chart I-49C49 Chart I-50C50 Chart I-51C51 Chart I-52C52 Chart I-53C53 Russia Chart I-54, Chart I-55 Chart I-54C54 Chart I-55C55 Turkey Chart I-56, Chart I-57, Chart I-58, Chart I-59 Chart I-56C56 Chart I-57C57 Chart I-58C58 Chart I-59C59 South Africa Chart I-60, Chart I-61, Chart I-62, Chart I-63 Chart I-60C60 Chart I-61C61 Chart I-62C62 Chart I-63C63 Central Europe Chart I-64, Chart I-65 Chart I-64C64 Chart I-65C65 Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The latest adjustment of the interest rates of some PBoC lending facilities reflects China's ongoing moves toward market-driven interest rate reforms. Domestic growth improvement calls for higher interest rates, but it is too soon to conclude whether the latest interest rate adjustment is the beginning of a new tightening cycle or a temporary pause in a broad reflation process. The PBoC will remain data dependent and policy will remain accommodative. The interest rate increases in the PBoC lending facilities will likely lead to higher cost of funding for the corporate sector as well as mortgage borrowers The economic impact of the rising cost of funding should not be significant. Feature In the past three weeks, the People's Bank of China (PBoC) has raised the interest rates it charges financial institutions through various lending facilities. Questions abound over how the PBoC's latest maneuvers differ from their traditional monetary policy tools, and more importantly how these changes impact the economy and financial markets. What? In a slew of actions since late January, the PBoC has increased interest rates on several liquidity management facilities. On January 25th interest rates on the Medium-Term Lending facility (MLF) were raised, the first increase since the MLF debuted in 2014. Last week interest rates on reverse repurchase agreements (repos) were also hiked by 10 basis points. Meanwhile, interest rates on the Standing Lending Facility (SLF) were also lifted. Overall, these actions have increased financial institutions' funding costs on borrowing from the central bank. Table 1The PBoC's Tool Box There have been important changes in how the PBoC conducts monetary policy in recent years. While conventional measures such as the benchmark lending rate and reserve requirement ratio (RRR) have not been abandoned, the PBoC has been increasingly focusing on utilizing various new tools (Table 1).1 The RRR has been left unchanged, while the central bank has been actively dealing with financial institutions directly to manage interbank liquidity. The latest move shows a further departure from conventional monetary operations: instead of directly adjusting benchmark policy rates on lending and deposits of commercial banks, the PBoC has targeted interest rates on its claims to financial institutions. These changes reflect China's ongoing moves toward market-driven interest rate reforms, which at this stage have become quite advanced. Commercial banks are no longer under the administrative constraints on interest rates they pay to depositors and charge borrowers, and therefore their marginal cost of funding has become increasingly important for setting their own loan rates. Meanwhile, targeting interest rates of these lending facilities rather than benchmark interest rates or the RRR provides some important advantages from the PBoC's point of view. The newly created alphabet soup of various lending facilities gives the PBoC much more flexibility to "fine-tune" interbank liquidity in terms of both magnitude and timing, and can be quickly reversed if necessary. The RRR adjustment, on the other hand, is inherently much more blunt and harder to turn. These lending facilities can aid the central bank's macro-prudential policy. For example, banks that fail to meet certain conditions of the macro-prudential assessment (MPA) will have to pay punitive interest rates to borrow from the PBoC. Similarly, the PBoC can offer subsidized loans to policy lenders for certain prioritized projects. Direct adjustment on commercial banks' loan and deposit rates is not only against the broad trend of the country's interest rate reform, but also requires coordination of various government departments under the State Council. The PBoC has much higher discretion in changing its own interest rates that it charges commercial banks. Chart 1Policy Rates Catch Up To The Market Why? The PBoC's latest adjustments on interest rates of various lending facilities and open market operations should not be surprising, given the significant increase in interbank interest rates and domestic bond yields since late last year. For example, both the seven-day interbank rate and one-year government bond yields have increased from about 2.3% to 2.6% (Chart 1). If the PBoC left its short-term lending rates unchanged, it would potentially create arbitrage opportunities in which commercial banks could borrow from the central bank and lend out to other institutions. In other words, the PBoC has already begun to tighten by allowing market interest rates to inch higher since late last year, and the recent policy rate adjustment is in fact a "catch-up." A few reasons may be behind the central bank's tightening bias. The economy has recovered considerably, with both quickening activity and easing deflation. Nominal GDP growth accelerated to 9.6% in the last quarter, up from a bottom of 6.5% in late 2015 when benchmark interest rates were cut to current levels2 (Chart 2). The January macro numbers are likely distorted by the Chinese New Year effect, but holiday sales have been quite strong compared with a year ago, and the latest PMI numbers suggest continued acceleration in both the industrial and service sectors. All of this naturally calls for higher interest rates. It is possible that the January credit numbers are uncomfortably high for the PBoC, which may have pushed the authorities to send a signal to lenders to cool things off to prevent overheating and damp further property price gains. The central bank has been concerned about leverage and overtrading in the interbank market as well as local bond markets by financial institutions, and the latest tightening moves have also been designed to reduce financial excess (Chart 3). Repo transactions in the interbank market have already dropped sharply since late year when the PBoC began to push interest rates higher. This, together with regulators' latest administrative overhaul on commercial banks' wealth management products and off-balance-sheet items, all underscore the determination to rein in excesses in the banking sector. Chart 2Growth Rebound Generates Upward Pressure ##br##On Interest Rates Chart 3The PBoC Aims To Tame##br## Financial Excess So What? Whatever the reason, the PBoC will likely continue to shift away from "conventional" tools and increasingly focus on the new framework that has emerged in recent years in conducting monetary policy. Benchmark loan and deposits rates are already on the way out, and the RRR will also be gradually faded. The problem is that the RRR is still at 17% for large banks and 15% for smaller lenders - both of which are still elevated compared with historical norms. As a result, commercial banks have been putting ever rising reserve deposits with the central bank, while at the same time their borrowings from the PBoC have also skyrocketed - leading to an ever-expanding balance sheet at the PBoC (Chart 4). Technically, it is likely that the RRR will be lowered to a more reasonable level, cutting the central bank's liability, while at the same time the PBoC can reduce its claims to commercial banks on the asset side. This operation will shrink the PBoC's balance sheet, but does not necessarily change the liquidity situation in the banking system. It is too soon to conclude whether the latest interest rate adjustment is the beginning of a new tightening cycle or a temporary pause in a broad reflation process. We expect the PBoC will remain data dependent, and that the Federal Reserve's actions will also be taken into consideration. In the near term, a few observations can be made. First, the interest rate increases in the PBoC lending facilities, together with the increase in market-driven interest rates, will likely lead to higher cost of funding for the corporate sector as well as mortgage borrowers (Chart 5). Already, discount rates of bank acceptance bills, a proxy for short-term funding costs of the corporate sector tightly linked with interbank rates, have surged in recent months. The expected returns of Wealth Management Products (WMPs), an alternative to conventional bank deposits that set banks' marginal funding costs, have also picked up notably since October. This means the average interest rate on commercial banks' loans likely have already been rising. Chart 4The PBoC's Liquidity Operation Chart 5Corporate Cost Of Borrowing Will Likely Rise The economic impact of the rising cost of funding should not be meaningful, in our view, as it is accompanied by a strengthening economy and easing deflation. The overall monetary conditions index, which takes into consideration both real interest rates and the exchange rate, has continued to ease, thanks largely to the rapid increase in producer prices. Furthermore, there is still massive scope for the Chinese authorities to reform the financial sector and reduce the funding costs of the country's dynamic smaller private enterprises - although falling sharply in recent years, the Wenzhou private loan rate, a proxy for private enterprises' borrowing costs, still stands at 16% (Chart 6). This will likely continue to drift lower as the country's financial reforms continue to deepen. In short, the latest policy tightening does not change our cyclical assessment on the broader economy. In this vein, higher interest rates may introduce some near-term turbulence in stocks, but will not change the cyclical profile. The marginal increase in interest rates will not derail the growth improvement, profit growth should continue to recover and policymakers are unlikely to overkill. Meanwhile, strategically we continue to favor Chinese equities in global and EM portfolios. Finally, rising interest rates in China should lend some support to the RMB, due to the close link between China-U.S. interest rate differentials and the USD/CNY exchange rate (Chart 7). The interest rate gap between Chinese government bonds and U.S. Treasurys has widened notably since late last year, which should marginally make RMB assets more attractive in the near term. Nonetheless, the broad trend of the dollar against other majors will remain the dominant force setting the USD/CNY cross rate. The PBoC still faces challenges to contain capital outflows and maintain exchange rate stability. Chart 6Private Loan Rate Needs ##br##To Drop Further Chart 7China - U.S. Interest Rate Gap And##br## USD/CNY Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "A Closer Look At The PBoC's Balance Sheet," dated September 23, 2015, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Growth Watch," dated January 19, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations