Trade / BOP
Highlights The latest round of tariffs on U.S. imports from China confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. Desynchronization between the U.S. and China/EM growth foreshadows dollar appreciation. The latter is the right medicine for the global economy for now. A stronger dollar is required to redistribute growth and inflation away from the U.S. and towards the rest of the world. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. For EM ex-China, the dollar rally is painful, but it is the right medicine in the long run. It will bring about the unraveling of excesses within their economies. Feature The global economy presently finds itself between two strong and opposing crosscurrents: robust growth and mounting inflationary pressures in the U.S. on the one hand, and weakening Chinese growth on the other. Desynchronization between China/EM and the U.S. has been our theme since April 2017.1 Although this theme has become evident and to a certain degree priced into the markets, we believe it is not yet time to abandon it. Before exploring this analysis in greater depth, we will address the issue of whether strong U.S. demand will reverse the slowdown in the global trade cycle, and update our thoughts on the trade wars. Global Trade And Trade Wars Our leading indicators for global trade do not herald a reversal in the global exports slowdown. Chart I-1 demonstrates that the ratio of risk-on versus safe-haven currencies2 leads global export volumes by several months, and it does not yet flag any improvement. Chart I-1Risk-On / Safe-Haven Currency Ratio As An Indicator Of Global Trade In addition, Taiwanese exports of electronic products lead the global trade cycles by a couple of months, and they are currently pointing to further deceleration in world exports (Chart I-2). It seems extremely robust U.S. domestic demand growth has not prevented a slowdown in global trade in general and EM exports in particular. The reason for this is that many developing countries' shipments to China are larger than their exports to the U.S., as illustrated in Table I-1. Chart I-2Taiwanese Electronics Exports##br## Slightly Lead Global Exports Table I-1Many Emerging Economies##br## Sell More To China Than To The U.S. The latest decision by the U.S. administration to impose a 10% tariff on $200 billion of imports from China and increase this rate to 25% starting January 1, 2019 confirms that the Trump administration's confrontation with China goes beyond the mid-term elections. The true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony. These episodes of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.3 In this vein, it is not clear to us why global growth-sensitive and China-leveraged plays in financial markets have rallied in recent days on the new tariff announcement. We can think of two reasons: (1) markets expect China to stimulate domestic demand aggressively to counter tariffs; and (2) gradually rising U.S. import tariffs will boost global trade in the near term, as companies front load their production and shipments before the 25% tariff rate takes hold. On the first point, there has so far been no major new fiscal stimulus announced in China. We detailed fiscal numbers in our August 23 report,4 and there have been no changes since. As to liquidity easing - which has been material - our assessment is that it is likely to be overwhelmed by ongoing regulatory tightening on banks and shadow banking. In short, lingering credit excesses and regulatory tightening will hamper the monetary transmission mechanism from lower interest rates to faster credit growth. So far, money growth in China remains very weak (Chart I-3). Chart I-3China's Narrow Money And EM Stocks On the second point, we cannot rule out a moderate and temporary improvement in global trade due to various technical factors. Yet, any rally rooted in this will prove to be short-lived and fleeting. Bottom Line: Escalating tariffs on U.S. imports from China will reinforce the tectonic macro shifts that have been in place since early this year: it will lift U.S. inflation slightly and weigh on Chinese growth. Rising U.S. Inflation U.S. core inflation is accelerating and moving above the Federal Reserve's soft target of 2%. This will substantially narrow the Fed's maneuvering room to respond to the turmoil in EM and weakening growth outside the U.S. Chart I-4 demonstrates that an equally weighted average of various core consumer inflation measures for the U.S. has been markedly accelerating. The components of this core inflation aggregate are presented in Chart I-5 and include: trimmed mean CPI, trimmed mean PCE, market-based core PCE and median CPI. Besides, the U.S. labor market is super tight, and employee compensation growth will continue to rise. This will put downward pressure on corporate profit margins and will push businesses to consider passing on their rising costs to consumers. Provided wage growth will continue accelerating and the job market and confidence both remain strong, odds are that companies will be able to raise their selling prices. Chart I-4U.S. Inflation Is Rising... Chart I-5...Based On Various Core Measures Weakening Chinese Growth Growth continues to weaken in China. In particular: The aggregate freight index (transport by railway, highway, waterway, and aviation) is sluggish and the measure of Air China's freight continues to downshift (Chart I-6). The strength in China's residential property market since 2015 has partially been due to the central bank providing very cheap financing directly to housing via its Pledged Supplementary Lending (PSL) scheme. We have argued in the past that this represents nothing less than monetization of excess housing inventories directly by the People's Bank of China.5 This has boosted property prices and sales, supporting the economy over the past two years. Having met the objective of reducing housing inventories, the PBoC has lately reduced the amount of PSL. Provided changes in PSL flows have led both housing prices and sales volumes, it is reasonable to expect a relapse in new sales in the next six months or so (Chart I-7). Chart I-6China: A Slowdown In Freight Indicators Chart I-7China: Housing Sales To Roll Over Soon Our main theme in China has been and remains shrinking construction activity - both infrastructure and property building. This is the primary rationale for our negative view on commodities prices as well as weakness in mainland aggregate imports. Chart I-8 illustrates property construction activity is already contracting. Headline fixed asset investment in real estate has been held up by booming land purchases, yet equipment purchases as well as construction and installation have been shrinking (Chart I-8). Capital expenditures for all industries, including construction and installation, purchase of equipment and instruments - but excluding land values - are also very weak (Chart I-9). Chart I-8China: Property Investment##br## Excluding Land Is Contracting Chart I-9China: Overall Capex##br## Is Very Weak Interestingly, our proxy for marginal propensity to spend6 by Chinese companies leads global industrial metals prices, and continues pointing to more downside (Chart I-10). With respect to oil, Chinese oil import growth has downshifted considerably (Chart I-11) implying that global oil prices have been mostly propped up by supply concerns. Chart I-10Chinese Companies' Propensity##br## To Spend And Metal Prices Chart I-11China: A Slowdown##br## In Oil Imports Currency Markets As A Rebalancing Mechanism Pressures from growth desynchronization between the U.S. and China and trade wars continue to build. Left unchecked, these imbalances will enlarge and culminate into a bust. A release valve is needed to diffuse these accumulating pressures. Currency and bond markets often act as such - they move to rebalance the global economy and amend economic excesses. Odds are that exchange rates will continue to act as a rebalancing conduit. A stronger dollar is the right medicine for the global economy at the moment. A stronger dollar is required to redistribute growth away from the U.S. and towards the rest of the world. In particular, dollar appreciation is needed to cap budding U.S. inflationary pressures. China needs a weaker currency to offset deflationary pressures stemming from domestic deleveraging and trade tariffs. In turn, a stronger greenback will cause capital outflows from EM and compel the unraveling of excesses within the developing economies. While the result will be painful growth retrenchment for EM in the medium term, cheapened currencies and deleveraging (an unwinding of credit excesses) will ultimately create a foundation for stronger and healthier growth in the years ahead. As to the question of why the dollar would rally in the face of widening twin deficits, we have the following remarks. In a world where growth and inflation are scarce (i.e., in a deflationary milieu), a wider current account deficit and higher inflation - signs of robust domestic demand - will attract capital, ultimately lifting a country's currency. By contrast, in a world of strong growth and intensifying inflationary pressures, twin deficits and higher inflation will cause a country's currency to depreciate. Our assessment is that the global economic backdrop is still more deflationary than inflationary, despite intensifying inflationary pressures in the U.S. Therefore, twin deficits and inflation in the U.S. will be at a premium. That and the fact that the Federal Reserve is willing to continue tightening are conducive for dollar appreciation. As we have argued in previous reports, the U.S. dollar is not cheap,7 but it is not particularly expensive either. In fact, odds are it will get much more expensive before topping out. Bottom Line: Beyond any possible short-term countertrend moves, the path of least resistance for the U.S. dollar is up, and for the RMB and EM currencies, down. As these adjustments within the currency markets endure, EM risk assets will stay under selling pressure and underperform their developed market counterparts. Indonesia: At The Whims Of Foreign Portfolio Flows 20 September 2018 The Indonesian currency has reached a two- decade low, and equities and bonds have sold off considerably. Is it time to turn positive on the nation's financial markets? Our bias remains that this selloff is not over and stocks, bonds as well as the currency have more downside. The basis is that Indonesia's balance of payments (BoP) will continue to deteriorate. Indonesia has been very reliant on volatile foreign portfolio flows to fund its current account deficit (Chart II-1). Not surprisingly, a reversal in foreign portfolio inflows to emerging markets (EM) has hurt this country's financial markets. We expect international capital flows to EM to be lackluster, which will continue to weigh on Indonesia's capital account. In the meantime, Indonesia's current account deficit is likely to widen in the months ahead. First, export revenues will begin rolling over on the back of lower copper and palm oil prices. Together, these commodities account for 13% of Indonesian exports. Second, the ongoing slowdown in China may eventually weigh on thermal coal prices. This commodity makes up another 12% of exports. Third, Indonesian imports remain very robust. Overall, a widening current account/trade deficit is typically negative for both share prices and the rupiah (Chart II-2). Chart II-1Indonesia: Foreign ##br##Portfolio Flows Are Key Chart II-2Deteriorating Trade Balance ##br##Is Bearish For Equities To prevent further currency depreciation, the government announced it will curb certain imports by raising tariffs.While this policy may succeed in limiting imports, it will also raise inflation by pushing prices of imported goods higher. This will allow inefficient domestic producers to stay in business. Higher inflation is fundamentally negative for the currency and local bonds. The above dynamics are making Indonesia's macro outlook increasingly toxic because Bank Indonesia (BI) will probably need to tighten monetary policy further in order to stabilize the rupiah and restrain inflation. Crucially, the BI's objective is to maintain rupiah stability in order to keep inflation tame. Further, Perry Warjiyo, the current governor of BI, has highlighted his preference for setting decisive and preemptive policies. Indonesia's central bank has already raised interest rates, and more hikes are likely if the currency continues depreciating - as we expect. On top of rate hikes, the BI will continue to deplete its foreign exchange reserves to defend the rupiah. Chart II-3 shows that foreign exchange reserve selling by the BI is shrinking local banking system liquidity (commercial bank reserves at the central bank) and lifting domestic interbank rates. In turn, higher local rates will cause bank loan growth to slow, hurting domestic demand. The latter will be very negative for profit growth and share prices because the Indonesian stock market is heavily dominated by banks and other domestic plays. The outlook for Indonesian banks is crucial for the performance of the Indonesian bourse, given they account for 42% of total MSCI market cap. Unfortunately, banks still rest on shaky foundations: Chart II-3Selling FX Reserves = Higher Interbank Rates Chart II-4Net Interest Margins Will Keep Compressing Not only will demand for loans slump as borrowing costs rise, but banks' net interest margins will also continue to compress (Chart II-4). Weaker growth and higher interest rates will also lead to a considerable rise in non-performing loans (NPLs), and cause banks' provisioning levels to spike. Higher provisions will hurt their earnings (Chart II-5). Notably, banks have boosted their profits substantially in the past two years by reducing their provisions. This process is set to reverse very soon. Finally, a word on overall equity valuations is warranted. Despite the correction that has taken place, this bourse is not yet trading at compelling valuation levels neither in absolute nor in relative terms (Chart II-6). Chart II-5Downside Ahead For Banks' Shares Chart II-6Indonesian Bourse Isn't Cheap Bottom Line: The rupiah will remain under selling pressure. This in turn will create a toxic macro mix of higher inflation, rising borrowing costs and weaker domestic demand. We recommend investors keep an underweight position in Indonesian stocks as well as local and sovereign bonds within their respective EM dedicated portfolios. We are also maintaining our short positions in the rupiah versus the U.S. dollar and on 5-year local currency bonds. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "Toward A Desynchonized World?" dated April 26, 2017, the link is available at ems.bcaresearch.com. 2 Relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc. 3 Please see Geopolitical Strategy Weekly Report, "We Are All Geopolitical Strategists Now," dated March 28, 2018, the link is available at gps.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "EM: Do Not Catch A Falling Knife," dated August 23, 2018, the link is available at ems.bcaresearch.com. 5 Please see Emerging Markets Strategy Special Report, "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, the link is available at ems.bcaresearch.com. 6 Calculated as a ratio of corporate demand deposits to time deposits. Rising demand deposits relative to time (savings) deposits entail that companies are gearing up to spend /invest money and vice versa. 7 Please see Emerging Markets Strategy Special Report, "The Dollar: Will The U.S. Invoke A "Nuclear" Option?" dated August 30, 2018, the link is available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. Feature How long and how deep will the selloff in emerging markets (EM) be? There are many factors that investors should be watching to gauge potential for further downside in the EM universe, and to exercise judgement about a bottom. These include the business cycle trajectory, policy actions and shifts, market technicals, liquidity, valuations and other fundamental variables. Not all of preconditions typically need to be satisfied before a major bottom emerges. What's more, not all bottoms are identical and contingent on the same factors. Hence, there is no magical formula for calling a bottom or top in any financial market. Today we revisit some of the variables that, in our opinion, are worth monitoring in terms of gauging a bottom. To begin, we address a currently popular narrative within the investment industry, which contends the following: EM woes are primarily being driven by Federal Reserve tightening. According to this view, when the Fed halts its tightening campaign, the skies will clear for EM risk assets. By and large, we disagree with this narrative. EM And The Fed: Let's Get Things Straight Fed policy and U.S. interest rates are not irrelevant to EM, but they are of secondary importance. The primary drivers of EM economies are domestic fundamentals and the overall global business cycle. Historically, the correlation between EM risk assets and the fed funds rate has been mixed (Chart 1). On this chart, we shaded the periods in which EM stocks rallied, despite a rising fed funds rate. Chart 1EM Equity Prices And Fed Funds Rate: Mixed Correlation There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin America debt crisis and the 1994 Mexican Tequila crisis. Yet, it is vital to emphasize that these crises occurred because of poor EM fundamentals: elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits, pegged exchange rates, and so on. Importantly, EM stocks and currencies did well during other periods of a rising fed funds rate: in 1983-1984, 1988-1989, 1999-2000 and 2017, as illustrated by the shaded periods in Chart 1. Hence, statistically there is no case that EMs plunge when the Fed is tightening policy. Why did the behavior of EM risk assets during various Fed tightening episodes differ? The key was EM fundamentals at the time: When fundamentals were healthy, EM managed to rally, despite Fed tightening; when fundamentals were flawed, EM markets relapsed regardless of the Fed's policy stance. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s EM crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Notably, U.S. and EU growth were booming and U.S. bond yields were dropping in 1997-'98. Specifically, U.S. and EU import volumes were growing at double-digit rates but this did not preclude EM crises, including in export-dependent Asian economies such as Korea, Malaysia and Thailand (Chart 2). It is critical to emphasize that China was not an economic superpower in the late 1990s. EM economic dependence on the U.S. and European economies was much greater than it is today. Yet neither booming demand in the U.S. and EU nor falling U.S. government bond yields prevented the Asian/EM crises from rolling across the globe in 1997-'98 (Chart 3A). Moreover, the S&P 500 was in a bull market in the second half of 1990s, as it is today (Chart 3B), but it did not help EM either. Chart 2Asian/EM Crises In 1997-98 Occurred Amid Booming Growth In U.S. And EU Chart 3AAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Chart 3BAsian/EM Crises In 1997-98 Took Place Amid Falling U.S. Bond Yields And Rising S&P 500 Hence, we can safely conclude that the EM fallout in 1997-'98 was due to EM domestic fundamentals - not developed market dynamics in general and Fed tightening in particular. An essential question is: Why are EM risk assets currently plunging while U.S. stocks and credit markets are holding up just fine? The U.S. economy is much more exposed to rising U.S. borrowing costs than EM. Despite this, the American economy, U.S. share prices and corporate bonds have been performing very well. In our view, this also stipulates that the core root for the current EM bear market is EM fundamentals. As we have repeatedly noted in various reports,1 EM fundamentals have been very frail, and the end of easy Fed monetary policy has not helped. The Fed's tightening can be regarded as the trigger - not the cause - of the EM bear market. The cause is weak EM fundamentals, such as credit excesses, low return on capital, weakening productivity growth and, in some cases, inflation and dependence on external funding. Importantly, the dependence of EM countries on the Chinese economy is presently greater than their dependence on the U.S. as shown in Table 1. Further, mainland growth is decelerating. Adding it all up, it is not surprising to us that EM financial markets are in turmoil. Table 1Many Emerging Economies Sell More##br## To China Than to The U.S. Our bearish view on EM has not been based on a negative view on U.S./EU growth. On the contrary, we have been bearish on EM/China and positive on domestic demand in the U.S. and the EU. Early this year, we promoted the theme of tectonic macro shifts,2 arguing that China/EM growth would slump and the U.S. economy would accelerate - and that such dynamics would propel the U.S. dollar higher. In turn, a firm dollar would inflict substantial pain on EM. Bottom Line: Rising U.S. interest rates, in and of itself, is neither a necessary nor a sufficient condition for EM to sell off. Consequently, the Fed adopting an easier policy stance or lower U.S. Treasury yields may not, in and of themselves, create sufficient conditions for a reversal in EM financial markets, unless they coincide with a turnaround in other variables that matter for EM. What Matters For EM? As of now, we do not think sufficient conditions exist for a bottom in EM financial markets because of several pertinent factors: The most important factor for EM assets in the medium term is the direction of the business cycle in EM in general, and in China in particular. The EM business cycle is still decelerating, as evidenced by falling manufacturing PMI indexes in EM ex-China and China (Chart 4). Consistently, corporate earnings growth is decelerating for EM non-financial companies and Chinese non-financial A-share corporates (Chart 5). The rationale for our focus on non-financial corporate earnings is that non-performing loans are usually not recognized and provisioned for by banks in a timely way to reflect their true profitability. Typically, banks' earnings cycle lags the real economy. When the real economy is slowing, banks' profits typically deteriorate with a time lag. Chart 4Manufacturing Is Slowing In China And EM Ex-China Chart 5EM/China Corporate Profit Growth Is Decelerating Corporate profits in China and in EM have not yet contracted, but our view is that there will be a meaningful profit contraction in this downturn. As and when corporate earnings shrink, share prices will sell off. In brief, we are not out of the woods yet. In China, the industrial part of the economy continues to weaken, as evidenced by the slump in the total freight index and electricity consumption by manufacturing and resource sectors (Chart 6). So far, the cumulative impact of policy easing in China has not been sufficient to reverse its business cycle. As we discussed in our prior report,3 money/credit impulses lead China's industrial sector by nine months or so. Even if the government's recent stimulus initiatives cause money/credit impulses to improve materially today (which we still doubt), the impact on growth will be felt only next year. While financial markets are forward-looking, they are unlikely to bottom a full six months before the bottom in the real economy. Hence, we are currently in the window where China plays in financial markets remain at risk. Global trade is also weakening, as evidenced by falling semiconductor prices (Chart 7) and industrial metals. Similarly, the container freight index at Chinese ports is sluggish, and broader Asian export volumes are slowing (Chart 8). Chart 6Signs Of Industrial Slowdown In China Chart 7Semiconductor Prices Are Plunging Chart 8Asian Export To Slow Further Regarding liquidity, there are various definitions and ways to measure liquidity. One measure of EM liquidity is EM local interest rates. Chart 9A and 9B shows that interbank rates in various EM countries are rising due to the ongoing currency weakness. EM benchmark local currency bond yields are also under upward pressure (Chart 10, top panel). These are all signs of tightening liquidity. The ramifications of higher interest rates will be a slowdown in money and credit, and consequently a slump in domestic demand. Chart 9AEM: Interbank Rates##br## Are Rising Chart 9BEM: Interbank Rates##br## Are Rising Chart 10EM: Local Currency Bonds Yields##br## And Narrow Money Growth Chart 10 illustrates that local bond yields negatively correlate with narrow money growth in EM ex-China, Korea, Taiwan and India. These four markets are not included in the EM GBI local bond index; to maintain consistency, we have removed them from the money supply aggregate. EM sovereign and corporate bond yields continue to rise. As we have shown numerous times in previous reports, EM share prices do not bottom until EM corporate and sovereign bond yields roll over on a sustainable basis. Finally, we discussed EM equity and currency valuations in our August 23 report. We maintain that aggregate EM equity and currency valuations are not yet cheap enough to warrant bottom-fishing. Bottom Line: The most vital factors that drive EM financial markets - the direction of global trade, domestic demand, corporate profits, and borrowing costs - do not currently indicate a sustainable bottom. Stay short/underweight EM risk assets. 6 September 2018 The list of our trades and country allocation is always presented at the end of each report (please see page 10-11). Specifically, we continue shorting BRL, CLP, ZAR, IDR and MYR versus the U.S. dollar. Within the equity space, our overweights are Taiwan, Korea, Thailand, Chile, India, Mexico and central Europe; and underweights are Brazil, Peru, Malaysia, Indonesia, and South Africa. Among local currency bonds we are overweight Russia, Korea, Mexico, Thailand, and central Europe and underweight Brazil, South Africa, Turkey, Malaysia, and Indonesia. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," July 19, 2018. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Two Tectonic Macro Shifts," January 31, 2018. 3 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Do Note Catch A Falling Knife," August 23, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Chart 5...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights China is turning moderately reflationary, but Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. Fiscal spending, rather than a sharp acceleration in credit growth, will dominate China's reflationary efforts, and even a strong fiscal response would involve more "soft infrastructure" than in the past. Consequently, expectations that Chinese reflation will dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy are not likely to be met. The goal of policymakers is merely to prevent a substantial, uncontrolled downturn in domestic demand. Convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy would cause us to advocate a more pro-cyclical investment stance. There is a small chance this may occur, but it is far from our base case view. For now, stay neutrally positioned towards Chinese stocks within a global equity portfolio, and favor low-beta sectors within the Chinese investable universe. Feature Today's Weekly Report is abridged, as we are sending you part 1 of a 2-part report written by my colleague Matt Gertken, Associate Vice President of BCA's Geopolitical Strategy (GPS) service. Last year our geopolitical team made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk. This view has played out quite well, and today's report presents an assessment of the likely impact of China's recent stimulus announcements along with the implications for investors. Matt's report concludes that China is turning moderately reflationary: a substantial boost to fiscal thrust, and possibly a smaller boost to credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. This will be discussed next week in the second-part of the two-part series. Today's GPS report is quite timely, as the intensity of China's reflationary efforts is at the forefront of investor attention. BCA's China Investment Strategy (CIS) argued in our July 26 Weekly Report that China is taking its foot off of the brake rather than pressing the accelerator,1 meaning that so far the stimulus announced has fallen short of a substantially reflationary response that would dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy. Chart 1 shows that market signals are so far consistent with this view, at least in terms of fiscal and/or infrastructure spending. The chart shows how domestic infrastructure stocks are outperforming the broad domestic market (in response to news two weeks ago of stepped up infrastructure spending), but that their performance remains anemic relative to global stocks. Presumably, "big bang" fiscal spending in China would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the global average. Matt notes in today's joint report that even a strong fiscal response would involve more "soft infrastructure" than in the past, and for now investors do not seem to be betting on an intense, "hard infrastructure" boom. Chart 1The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus Chart 2At First Blush, This Implies Maximum Reflationary Efforts However, one development that is not consistent with CIS' "foot off the brake" view is the extraordinary decline in interbank interest rates that has occurred over the past month. Chart 2 shows that the 3-month interbank repo rate (China's "de-facto" policy rate) has collapsed even further than it had when we published our July 26 report which, at first blush, suggests that the PBOC has turned the policy dial to maximum reflation. Chart 3 presents a stylized view of the possible PBOC reactions to the imposition of U.S. tariff imposition against China. In scenario 1, the PBOC eases policy in a way that is proportional to the tariff-induced deterioration in the growth outlook, which would stabilize the economy but not result in an acceleration in growth from conditions in place prior to the impact of tariffs on exports. In scenario 2, the PBOC stimulates disproportionately, giving investors license to expect that monetary easing will result in a growth outcome that is net positive. Chart 3A Proportional Monetary Response To A Deceleration In Growth Isn't A Net Positive For The World As Matt notes in his report, the decline in interbank interest rates may not feed through into significantly stronger credit growth if banks are afraid to lend, which could occur as long as the Xi administration remains even partially committed to its crackdown on the financial sector. The decline in the repo rate may not reflect the PBOC's intention to forcefully stimulate credit growth via lower borrowing rates, but rather is a necessary consequence of substantially increasing liquidity in the banking system to avoid any financial system instability stemming from a major shock to exports. We agree that the collapse in the 3-month repo rate is more consistent with scenario 2 than scenario 1, although there are two important counterpoints to consider: Chart 4Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth On the second point, the crackdown on shadow banking over the past 18 months has substantially (negatively) impacted small Chinese banks, and it is conceivable that the PBOC has acted to prevent a liquidity problem from become an outright solvency problem for some financial institutions. If true, this suggests that the extent of the decline in the repo rate may be temporary, or that policymakers will employ other tools to limit the feedthrough from lower interbank borrowing costs to lending rates in the real economy in order to limit the resulting pickup in credit growth. The latter option would, in effect, purposely engineer an expansion in bank net interest margins, a scenario that could explain the recent uptick in domestic bank relative performance without resorting to a forecast of surging credit growth (Chart 4). What does this all mean for investors? Were we to see convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy, we would recommend a more pro-cyclical investment stance. This could likely include the constituent assets of the China Play Index presented by my colleague Mathieu Savary, Vice President of BCA's Foreign Exchange Strategy service in his last Weekly Report,2 and we plan on employing the index as a gauge of investors' stimulus expectations. But for now, we are comfortable with our existing recommendations: investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. We will be monitoring the upcoming export shock as well as further policymaker responses continually over the coming weeks and months, and invite investors to come along for the ride. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China Is Easing Up On The Brake, Not Pressing The Accelerator," published July 26, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus," published August 3, 2018. Available at fes.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations