Trade / BOP
Highlights The U.S. dollar still has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. Fixed-income investors should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Argentine financial markets are rioting. We elaborate on our investment strategy below. Downgrade Indonesian stocks from neutral to underweight within an EM equity portfolio. Feature The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought. Rüdiger Dornbusch Emerging markets (EM) currencies have come under substantial selling pressure. Various indexes of EM currencies versus the U.S. dollar have broken below their 200-day moving averages (Chart I-1). EM sovereign spreads are widening, and local bonds yields are moving higher from very low levels. Chart I-1EM Currencies: A Breakdown? Our view is that we are witnessing the beginning of a major down leg in EM currencies and a major up leg in the U.S. dollar. This constitutes a negative environment for all EM risk assets. As the above quote from professor Rüdiger Dornbusch eloquently states, a meltdown in financial markets could take much longer to develop, but once it commences it is likely to play out much faster than investors expect. This does not mean we are certain that a full-blown EM crisis is bound to happen. Neither can we predict the speed of financial market moves. Nevertheless, based on our macro themes, we maintain that this down leg in EM currencies and EM risk assets will likely be large enough to qualify as a bear market rather than a correction. Consistently, we continue to recommend that investors adopt defensive strategies or play EM risk assets on the short side. This bear market in EM could be comparable to the EM selloff episodes of 2013 (Taper Tantrum) or 2015 (China's slowdown). In this report, we first discuss the outlook for the broad U.S. dollar, then examine the factors that typically drive EM currencies, and those that do not. The Dollar: A Major Bottom In Place The U.S. dollar has recently rebounded sharply, and we believe this marks the beginning of a major rally. The following factors will support the greenback in the months ahead: The U.S. dollar does well in periods of a slowdown in global trade (Chart I-2). The average manufacturing PMI index of export-oriented Asia economies such as Korea, Taiwan and Singapore points to a peak in global export volumes (Chart I-3). Further, China's Container Freight index signifies an impending deceleration in Asian export shipments (Chart I-4, top panel). Chart I-2U.S. Dollar Rallies When Global Trade Slows Chart I-3A Peak In Global Export Growth Chart I-4A Leading Indicator For Asian Exports ##br##And Asian Currencies Notably, this freight index - the price to ship containers - also correlates with emerging Asia currencies, and suggests that the latter stands to depreciate (Chart I-4, bottom panel). Chart I-5U.S. Dollar Liquidity And Exchange Rate The dollar should do particularly well if the epicenter of the global growth slowdown is centred in China - and if U.S. domestic demand remains robust due to fiscal stimulus, as we expect. Within advanced economies, the U.S. is the least vulnerable to a China and EM slowdown. Delta of relative growth will be shifting in favor of the U.S. versus the rest of the world. This will propel the dollar higher. Amid weakness in the world trade, growth will be priced at a premium. This will favor financial markets with stronger growth. The greenback will be the winner in the coming months. The U.S. twin deficits - the current account and budget deficits - would have acted as a drag on the dollar if global growth was robust/recovering. However, amid weakening global growth, the U.S. twin deficits are not a malignant phenomenon for the dollar; they will in fact support it as they instigate and reflect strong U.S. growth. As the Federal Reserve continues to reduce its balance sheet, the banking system's excess reserves will decline. Our U.S. dollar liquidity measure has petered out, which has historically been consistent with a bottom in the dollar; the latter is shown inverted on Chart I-5. As we have argued for some time, and to the contrary of widespread investor consensus, the U.S. dollar is not expensive. According to the real effective exchange rate based on unit labor costs, the greenback is fairly valued, as is the euro (Chart I-6). The yen is cheap but the Korean won is expensive (Chart I-6, bottom two panels). In our opinion, a real effective exchange rate based on unit labor costs is the most pertinent measure of exchange rate valuation. The basis is that it takes into account both wages and productivity. Labor costs are the largest cost component in many companies and unit labor costs are critical to competitiveness. Chart I-7 demonstrates that commodities-related currencies including those of Australia, New Zealand and Norway are on the expensive side, while the Canadian dollar is fairly valued. Chart I-6The U.S. Dollar Is Not Expensive Chart I-7Commodities Currencies Are Not Cheap There are no measures of real effective exchange rate based on unit labor costs for many EM currencies. If DM commodities currencies are not cheap, then it is fair to assume that EM commodities currencies are not cheap either. We are not suggesting that exchange rates of commodity producing EM nations are expensive, but we do believe their valuations are probably closer to neutral. When valuations are neutral, they are not a constraint for the underlying asset price. The latter can go either up or down. In short, the dollar is not expensive, and valuations will not deter its appreciation in the coming months. Finally, from the perspective of market technicals, the dollar's exchange rates versus many currencies appear to have encountered resistance at their long-term moving averages, as illustrated in Chart I-8A and Chart I-8B. Usually, when a market finds support (or resistance) at its long-term moving average, it often makes new highs (or lows). Chart I-8ATechnicals Are Positive For Dollar, ##br##Negative For EM Currencies Chart I-8BTechnicals Are Positive For Dollar, ##br##Negative For EM Currencies We are not certain if the broad trade-weighted U.S. dollar will make a new high. However, some EM currencies will drop close to or retest their early 2016 lows. Such potential downside is substantial enough to short the most vulnerable EM currencies. Bottom Line: The U.S. dollar has meaningful upside versus the majority of currencies. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: TRY, ZAR, BRL, IDR, MYR and KRW. What Really Drives EM Currencies A common narrative is that EM balance of payments and fiscal balances have already improved, making many EMs less vulnerable than they were during the 2013 Taper Tantrum. What's more, the interest rate differential between EM and the U.S. is still positive, heralding upward pressure on EM currencies. We do not subscribe to this analysis. First, current account balances do not always drive EM exchange rates. Chart I-9A and Chart I-9B illustrates that there is no meaningful positive correlation between EM currencies and both the level and changes in their current account balances. The same holds for the correlation between fiscal balances and exchange rates. Chart I-9ACurrent Account Balances ##br##And Currencies: No Correlation Chart I-9BCurrent Account Balances ##br##And Currencies: No Correlation Second, neither nominal nor real interest rate differentials over U.S. rates explain the trend in EM currencies, as shown in Chart I-10. Further, neither the level nor changes in interest rate differentials explain trends in EM exchange rates. On the contrary, it is the trend in EM currencies that drives local interest rates in EM. That is why getting the currencies right is of paramount importance to investors in various EM asset classes. So which factors do drive EM exchange rates? The key variables that define trends in EM currencies are U.S. bond yields, global trade cycles and commodities prices. The changes in U.S. bond yields and TIPS (inflation-adjusted) yields - not their difference with EM yields - have explained EM currency moves in recent years (Chart I-11). Chart I-10Interest Rate Differential Does Not ##br##Explain EM Exchange Rates Moves Chart I-11EM Currencies And U.S. Bond Yields Chart I-4 on page 3 demonstrates that China's Container Freight index leads regional exports and strongly correlates with emerging Asian currencies. Non-Asian EM currencies are mostly leveraged to commodities prices, as these countries (all nations in Latin America, Russia and South Africa) produce commodities. Not surprisingly, the EM exchange rate composed primarily of EM non-Asian currencies correlates well with commodities prices (Chart I-12). Finally, EM currencies are substantially more exposed to China than to DM economies. Chart I-13 shows that when Chinese imports are underperforming DM imports, EM currencies tend to depreciate. Chart I-12EM Currencies And Commodities Prices Chart I-13EM Currencies Are Exposed To China Not DM As such, what has caused EM currencies to riot in recent weeks? In short, it is the combination of the rise in U.S. bond yields and budding signs of slowdown in global trade. Chart I-14EM Currencies' Vol Is Still Low Commodities prices have so far been firm with oil prices skyrocketing. We expect the combination of China's slowdown and a stronger U.S. dollar to eventually suppress commodities prices in the months ahead. That will produce another down leg in EM currencies. Finally, the volatility measure for EM currencies is still very low, albeit rising (Chart I-14). This suggests that investors remain somewhat complacent on EM exchange rates. Bottom Line: Our negative view on EM currencies has been anchored on two pillars: the U.S. dollar rally driven by higher U.S. interest rate expectations and weaker Chinese growth/lower commodities prices. We are now witnessing the first down leg in EM currency bear market propelled by the first pillar. It is not over yet. The second down leg will come when China's growth slows and commodities prices relapse in the coming months. All in all, there is still material downside in EM exchange rates. EM Local Bond And Credit Markets EM local bond yields typically rise when EM currencies drop meaningfully (Chart I-15). Foreign investors hold a large share of EM local currency bonds (Table I-1). Chart I-15EM Local Bond Yields And EM Currencies Table I-1Foreign Ownership Of EM Local Bonds As EM currency depreciation erodes foreign investors' returns on EM local currency bonds, there could be a rush to exit their positions. Chart I-16 portrays that the total return on J.P. Morgan GBI EM local currency bonds in U.S. dollar terms has broken below its 200-day moving average. Fluctuations in total return on local bonds is primary driven by currency moves. If our negative EM currency view is correct, there will be more downside in this EM domestic bonds total return index. EM sovereign and corporate credit spreads often widen when EM currencies depreciate (Chart I-17). As EM currencies lose value, U.S. dollar debt becomes more expensive to service, and credit spreads should widen to reflect higher credit risks. Chart I-16EM Local Bonds Total ##br##Return Index In U.S. Dollars Chart I-17EM Credit Spreads And EM Currencies Finally, the ratios of U.S. dollar debt-to-exports and U.S. dollar debt-to-international reserves for EM ex-China are very elevated (Chart I-18). If these nations' exports stumble in the months ahead, the inflows of foreign currency will diminish, and credit spreads could widen to price this in. Chart I-18EM Ex-China: U.S. Dollar Debt ##br##Burden In Perspective To be sure, this does not mean there will be widespread defaults. Simply, credit spreads are too low and investor sentiment is too upbeat. As EM growth deteriorates, asset prices will have to re-price. Bottom Line: Asset allocators should continue to adopt a defensive allocation with respect EM local bonds. Asset allocators should underweight EM sovereign and corporate credit within a global credit portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Argentina Is Under Fire 10 May 2018 Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Chart II-1Argentina's Achilles Heal: Twin Deficits Chart II-2Argentina: Credit Growth Has To Be Reined In Chart II-3Argentina: Inflation Is Still A Problem Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Chart II-4Argentina: Are Interest ##br##Rates High Enough? Chart II-5Argentina: Highest Real Interest ##br##Rates In Over 13 Years! The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Chart II-6Argentina: High Borrowing Costs ##br##Will Crash Domestic Demand Chart II-7Argentina: Real Wage Growth Is Moderate Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Indonesia: Facing Major Headwinds 10 May 2018 Indonesian stocks appear to be in freefall in absolute terms and relative to the EM benchmark (Chart III-1). Meanwhile, the currency has been selling off and local currency as well as sovereign (U.S. dollar) bonds spreads are widening versus U.S. Treasurys from low levels (Chart III-2). Chart III-1Indonesian Equities: Absolute ##br##And Relative Performance Chart III-2Indonesian Local Bonds ##br##And Sovereign Spreads These developments have been occurring due to vulnerabilities relating to Indonesia's balance of payments (BoP) dynamics. We believe Indonesia's BoP dynamics will deteriorate further and as such there is more downside for both the rupiah and its financial markets from here: Stronger U.S. growth and higher inflation prints will likely lead to higher interest rate expectations in the U.S. and lift the U.S. dollar further. This will likely lead to Indonesia's underperformance. Chart III-3 shows that Indonesia's relative equity performance versus the EM benchmark has been extremely sensitive to moves in U.S. Treasury yields. Hence, the cost of funding has been a critical variable for Indonesia. Indonesia is also a large commodities exporting nation and the latter account for around 30% of its exports. Specifically, coal, palm oil and copper make up about 9%, 8% and 2% of its exports, respectively. Coal exports are facing major headwinds. The Chinese government has moved to restrict coal imports in several Chinese ports in order to protect its domestic coal producers as we argued in our Special Report titled Revisiting China's De-Capacity Reforms.1 This development will be devastating for Indonesia's coal industry. Chart III-4 shows that the Adaro Energy's stock price - a large Indonesian coal mining company - is falling sharply. This stock price has already fallen by 40% in U.S. dollar terms since its peak on January 30. Chart III-3Indonesia Is Very Sensitive ##br##To U.S. Bond Yields Chart III-4Trouble In Indonesia's Coal Sector Further, palm oil prices have been weak while copper prices might be on edge of breaking down. Meanwhile, there are others negatives related to shipments of these commodities. Palm oil exports are at risk because India has imposed import duties on palm oil, while the European Parliament voted in favor of a ban on the use of palm oil in bio fuel by 2021. Offsetting these, however, China has just agreed to purchase more palm oil from Indonesia. In regard to copper, the ongoing dispute on environmental regulation between Freeport-McMoRan - a U.S. mining company that operates a large copper mine in Indonesia - and the Indonesian government, risks disrupting Freeport's copper production in Indonesia, hurting the country's export revenues. On the whole, export revenues are at risk of plummeting at a time when Indonesian imports are already too strong. This will worsen BoP dynamics further. Chart III-5 shows that a deteriorating trade balance in Indonesia is usually bearish for its equity market. It seems that the current account deficit will be widening when foreign funding is drying up. This requires either a major depreciation in the currency or much higher interest rates. As such, Bank Indonesia (BI) - Indonesia's central bank - might be forced to raise interest rates to cool down domestic demand and attract foreign funding to stabilize the rupiah. Even if the BI does not raise rates, it might opt to defend the rupiah by selling its international reserves. This would still bid up local interbank rates as defending the currency entails drawing down banking system liquidity, i.e., banks' reserves at the central bank. Chart III-6 shows that Indonesian interbank rates are starting to rise in response to falling international reserves. Chart III-5Indonesia: Swings In Trade ##br##Balance And Share Prices Chart III-6Indonesia: Currency Defense By Selling ##br##FX Reserves Leads To Higher Interbank Rates Higher rates will weaken domestic demand and are bearish for share prices. Importantly, foreign ownership of local bonds is still high at 39% and a weaker rupiah could cause selling by foreign investors, pushing yields even higher. Chart III-7Indonesia: Banks Profits Are At Risk Finally, a word on Indonesian banks is warranted. Financials account for 42% of Indonesia's MSCI market cap and 47% of its total earnings. Thus their performance is also very crucial for the outlook of the overall stock market. In our March 1st Weekly Report,2 we argued that Indonesian banks have been lowering their provisions to artificially boost earnings. This is not sustainable as these provisions are insufficient and will have to rise. As they ultimately rise, bank profits and share prices will hurt (Chart III-7). Bottom Line: We recommend investors to downgrade Indonesia's stocks from neutral to underweight within an EM equity portfolio. We also reiterate our short IDR / long USD trade and the short position in local bonds. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "Revisiting China's De-Capacity Reforms," dated April 26, 2018, the link available on page 23. 2 Please see Emerging Markets Strategy Weekly Report "EM Equity Valuations (Part II)," dated March 1, 2018, the link available on page 23. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The greenback normally weakens when the U.S. business cycle matures; 2018 may prove an exception to this rule. Rising U.S. inflation could clash with deteriorating global growth, bringing the monetary divergence narrative back in vogue. This would help the dollar. EM assets are especially at risk from a rising dollar. Tightening EM financial conditions would ensue, creating additional support for the dollar. The yen is caught between bearish and bullish crosscurrents. Continue to favor short EUR/JPY and short AUD/JPY over bets on USD/JPY. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Feature Late in the business cycle, U.S. growth begins to slow relative to the rest of the world, and normally the U.S. dollar weakens in the process. The general trajectory of the dollar this business cycle is likely to end up following this historical pattern, and last year's decline for the greenback was fully in line with past experience. However, 2018 could be an odd year, where the dollar manages to rally thanks to a combination of softening global growth and rising inflationary pressures in the U.S., which forces the Federal Reserve to be less sensitive to the trajectory of global economic conditions than it has been since the recession ended in 2009. Normally, The USD Sags Late Cycle We have already showed that EUR/USD tends to rally once the U.S. business cycle matures enough that the Fed pushes interest rates closer to their neutral level. Essentially, because the eurozone business cycle tends to lag that of the U.S., the European Central Bank also lags the Fed, which also implies that European policy rates remain accommodative longer than those in the U.S. Paradoxically, this means that late in the cycle, European growth can outperform that of the U.S., and markets can price in more upcoming interest rate increases in Europe than in the U.S., lifting the euro in the process (Chart I-1). Chart I-1The Euro Rallies Late In The Business Cycle Not too surprisingly, these dynamics can be recreated for the entire dollar index. As Chart I-2 illustrates, when we move into the later innings of the business cycle, global growth begins to outperform U.S. growth, and in the process, the DXY weakens. There has been an exception to these dynamics - the late 1990s - when the dollar managed to rally despite the lateness of the U.S. business cycle. Back then, the dollar was in a bubble, and the strong sensitivity of the dollar to momentum (Chart I-3) helped foment self-fulfilling dollar strength.1 Moreover, EM growth was generally weak. This begs the question, could 2018 evoke the late 1990s? Chart I-2What Works For The Euro Mirrors What Works For The Dollar Chart I-3Momentum Winners: USD And JPY Crosses Bottom Line: Normally, the U.S. dollar tends to weaken in the later innings of the U.S. business cycle, as non-U.S. growth overtakes U.S. growth. However, in 1999 and in 2000, the dollar managed to rally despite the U.S. business cycle moving toward its last hurrah. Not A Normal Cycle This cycle has been anything but normal. Growth in the entire G-10 has been rather tepid. While it is true that potential growth, or the supply side of the economy, is lower than it once was, courtesy of anemic productivity growth and an ageing population, demand growth has also suffered thanks to a protracted period of deleveraging. But the U.S. has been quicker than most other major economies in dealing with the ills that ailed her, executing a quicker private sector deleveraging than the rest of the G-10 (Chart I-4). As a result, today the U.S. output and unemployment gaps are more closed than is the case in the rest of the G-10. As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Chart I-4The U.S. Delevered, It Is Now Reaping The Benefits Chart I-5The Fed Is Now Less Sensitive To Foreign Shocks As Chart I-5 illustrates, aggregate U.S. capacity utilization - which incorporates both industrial capacity utilization and labor market conditions - is at its highest level since 2006. With growth staying above trend, the inevitable is finally materializing and inflation is picking up. Core PCE is now at 1.9%, and thus the 2% target is finally within reach. Just as importantly, 10-year and 5-year/5-year forward inflation breakevens have rebounded to 2.17% and 2.24% respectively, close to the 2.3% to 2.5% range - consistent with the Fed achieving its inflation target (Chart I-6). This implies that inflation expectations are getting re-anchored at comfortable levels for the Fed. As the threat of deflation and deflationary expectation passes, the Fed is escaping the fate of the Bank of Japan in the late 1990s. It also means that the Fed is now less likely to respond as vigorously to a deflationary shock emanating from outside the U.S. than was the case in 2016, when the U.S. economy still had plentiful slack, and realized and expected inflation was wobblier. The rest of the DM economies have not deleveraged, have more slack, and are more opened to global trade than the U.S. This exposure to the global economic cycle was a blessing in 2017, when global trade and global industrial activity were accelerating. But this is not the case anymore. As Chart I-7 illustrates, the Global Zew Economic Expectations survey is exhibiting negative momentum, which historically has preceded periods of deceleration in the momentum of global PMIs as well. Chart I-6Stage 1 Almost Complete The Fed Finally Enjoys ##br##Compliant Inflationary Conditions Chart I-7Downdraft In##br## Global Growth While this phenomenon is a global one, Asia stands at its epicenter. China's industrial activity is slowing sharply, as both the Li-Keqiang index2 and its leading index, developed by Jonathan LaBerge who runs BCA's China Investment Strategy service, are falling (Chart I-8, top panel). China is not alone: Korean exports and manufacturing production are now contracting on an annual basis; Singapore too is suffering from a clearly visible malaise (Chart I-8, middle and bottom panels). Advanced economies are also catching the Asian cold. Australia and Sweden, two small open economies, have seen key leading economic gauges slow (Chart I-9, top panel). Even Canadian export volumes have rolled over (Chart I-9, middle panel). Finally, the more closed European economy is showing worrying signs, with exports slowing sharply and PMIs rolling over. As we highlighted two weeks ago, even the European locomotive - Germany - is being affected, with domestic manufacturing orders now contracting on an annual basis.3 Chart I-8Asia Is The Source Of The Malaise Chart I-9The Cold Might Be Spreading This dichotomy between U.S. inflation and weakening global activity is resurrecting a theme that was all the rage in 2015 and 2016: monetary divergences. Fed officials sound as hawkish as ever and will likely push up the fed funds rate five times over the next 18 months even if global growth softens a bit. However, the ECB, the Riksbank, the Bank of England, the Reserve Bank of Australia, the Bank of Canada and even the BoJ are all backpedaling on their removal of monetary accommodation. They worry that growth is not yet robust enough, or that capacity utilization is not as high as may seem. The theme of monetary divergence will therefore likely be the result of non-U.S. central banks softening their rhetoric, not the Fed tightening hers. The end result is likely to cause a period of strength in the U.S. dollar, one that may have already begun. In fact, that strength is likely to have further to go for the following five reasons: First, as we showed in Chart I-3, the dollar is a momentum currency, and as Chart I-10 illustrates, the dollar's momentum is improving after having formed a positive divergence with prices. Chart I-10USD Momentum Is Picking Up Second, speculators and levered investors currently hold near-record amounts of long bets on various currencies, implying they are massively short the dollar (Chart I-11). This raises the probability of a short squeeze if the dollar's autocorrelation of returns stays in place. Chart I-11 Third, the dollar is prodigiously cheap relative to interest rate differentials (Chart I-12). While divergences from interest rate parity are common in the FX market, they never last forever. Thus, if monetary divergences become once again a dominant narrative among FX market participants, a move toward UIP equilibria will grow more likely. Fourth, rising Libor-OIS spreads have been pointing to a growing shortage of dollars in the offshore market. The decline in excess reserves in the U.S. banking system corroborates the view that liquidity is slowing drying up. Historically, these occurrences point to a strong dollar (Chart I-13). Chart I-12A Return To Interest-Rate##br## Parity? Chart I-13Falling Excess Bank Reserves Equals Strong Greenback Liquidity Factors Point To A Dollar Rebound Fifth, a strong dollar tightens EM financial conditions (Chart I-14). This could deepen the malaise already visible in Asia that seems to be slowly spreading to the global economy. This last point is essential, as it lies at the crux of the reason why the USD is the epitome of "momentum currencies." Essentially, this reflects the importance of the dollar as a source of funding for emerging market governments and businesses. The amount of EM dollar debt has been rising. In fact, excluding China, dollar-denominated debt today represents 16% of EM GDP, 65% of EM exports and 75% of EM reserves - the highest levels since the turn of the millennium (Chart I-15). Practically, this means that the price of EM currencies versus the USD is a key component to the cost of capital in EM. Chart I-14The Dollar Is The Enemy ##br##Of EM Financial Conditions Chart I-15EM Have A Lot ##br##Of Dollar Debt Additionally, EM local currency debt instruments are exhibiting their highest duration since we have data, making them more vulnerable to higher global interest rates (Chart I-16). Hence, the capital losses resulting from a given move higher in interest rates have grown, sharpening the risk that EM bond markets could experience a violent liquidation event. Moreover according to the IIF, the average sovereign rating of EM debt is at its lowest level since 2009. Normally, the allocation of global institutional investors into EM debt is positively correlated with the quality of EM issuers, but today this allocation has risen to more than 12%, the highest share in over five years. This suggests that DM investors are overly exposed to EM risk, creating another source of potential selling of EM assets. Ultimately, these risk factors can create a powerful feedback loop that support the sensitivity of the dollar to momentum. A strong U.S. dollar hurts EM assets, which prompts overexposed global investors to sell EM currencies further. This can be seen in the negative correlation of the broad trade-weighted dollar and high-yield EM bond prices (Chart I-17, top panel). Additionally, because rising EM bond yields as well as falling EM equities and currencies tighten EM financial conditions, this hurts EM growth. However, the U.S. economy is not as sensitive to EM growth as the rest of the world is.4 As a result, weakness in EM assets also translates into dollar strength against the majors (Chart I-17, middle panel). Additionally, commodity currencies tend to suffer more in this environment than European ones, as shown by the rallies in EUR/AUD concurrent with EM bond price weakness (Chart I-17, bottom panel). These risky dynamics in EM markets therefore are a key reason why we expect the U.S. dollar to be able to rally, bucking the normal weakness associated with the late stages of a U.S. business cycle expansion. Specifically, EUR/USD is set to suffer this year as the euro's technical picture has deteriorated significantly (Chart I-18), and, as we argued two weeks ago, the euro area still has plenty of slack. Chart I-16Heightened EM Duration Risk Chart I-17EM Risks Help The Greenback Chart I-18EUR/USD Technicals Are Flimsy Bottom Line: For the remainder of 2018, the dollar is likely to buck the weakness it normally experiences in the late innings of a .S. business cycle expansion. The U.S. is significantly ahead of the rest of the world when it comes to inflation, giving more room for the Fed to hike rates. This difference is now put in sharper focus than last year as the global economy is weakening, which could prompt a period of dovish rhetoric in the rest of the world that will not be matched by an equivalent backtracking in the U.S. Moreover, while positioning and technical considerations also favor a dollar rebound, the vulnerability of EM assets increases this risk by creating an additional drag on foreign growth. What To Do With The Yen? The yen currently sits at a tricky spot. Historically, the yen tends to depreciate against the USD when we are at the tail end of a U.S. business cycle expansion (Chart I-19). Toward the end of the business cycle, U.S. bond yields experience some upside - upside that is not mimicked by Japanese interest rates. The resultant widening in interest rate differentials favors the dollar. Chart I-19The Yen Doesn't Enjoy Late Cycle Dynamics On the other hand, a period of weakness in EM assets, even if prompted by a dollar rebound, could help the yen. The yen is a crucial funding currency in global carry trades, and a reversal of these carry trades will spur some large yen buying. Moreover, Japan has a net international investment position of US$3.1 trillion. This means that Japanese investors, who are heavily exposed to EM assets, are likely to repatriate some funds back home. So what to do? We have to listen to economic conditions in Japan. So far, despite an unemployment rate at 25-year lows and a job-opening-to-applicant ratio at a 44-year highs, Japan has not been able to generate much inflationary pressures. In fact, while the national CPI data has remained robust, the Tokyo CPI, which provides one additional month of data, has begun to roll over (Chart I-20). The Japanese current account is deteriorating sharply. This mostly reflects the downshift in EM economic activity as 44% of Japanese exports are destined to those markets. Interestingly, in response to the deterioration in export growth, import growth is also decelerating sharply, pointing toward a domestic impact from the foreign weakness (Chart I-21). It is looking increasingly clear that overall economic momentum in Japan is slowing. Both the shipment-to-inventory ratio as well as the Cabinet Office leading diffusion index are exhibiting sharp drops - signs that normally foretell a slowdown in industrial production and therefore a deterioration in capacity utilization, which still stands well below pre-2008 levels (Chart I-22). Chart I-20Weakening Japanese Inflation Chart I-21The Asian Malaise Is Hitting Japan Chart I-22Japanese Outlook Deteriorating In response to these developments, BoJ Governor Haruhiko Kuroda has been sounding more dovish. Moreover, after its latest policy meeting, the BoJ is acknowledging that it will take more time than anticipated for inflation to move toward its 2% target. In this environment, the yen has begun to weaken against the USD, especially as the greenback has been strong across the board. Moreover, USD/JPY was already trading at a discount to interest rate differentials. The downshift in Japanese economic data as well as the shift in tone by the BoJ are catalyzing the closure of this gap. Practically talking, USD/JPY is currently a very dangerous cross to play, as it is caught between various cross currents: a broad-based dollar rebound and a BoJ responding to a slowing economy can help USD/JPY; however, rising EM risks could boost it. On balance, we now expect the bullish USD forces to prevail on the yen, but we are not strongly committed to this view. Instead, have long maintained that the higher probability vehicle to play the yen is to short EUR/JPY.5 We remain committed to this strategy for the yen. Based on interest rate differentials, the price of commodities and global risk aversion, the euro can decline further against the yen, as previous overshoots are followed with significant undershoots (Chart 23, left panels). Moreover, speculators remains too long the euro versus the yen (Chart I-23, right panels). Additionally, EUR/JPY remains expensive on a long-term basis, trading 13% above its PPP-implied fair value. Finally, in contrast to Japan's large positive net international investment position, Europe's stands at -4.5% of GDP. Japanese investors have proportionally more funds held abroad than European investors do, and therefore more scope to repatriate funds in the event of rising EM asset volatility. We have also highlighted that selling AUD/JPY, while a more volatile bet than being short EUR/JPY, is another attractive way to play the risk to EM markets. Not only is AUD/JPY still very overvalued (Chart I-24), but Australia remains highly exposed to EM growth. This remains an attractive bet, despite a good selloff so far this year. Chart I-23AShort EUR/JPY Is A Cleaner Story (I) Chart I-23BShort EUR/JPY Is A Cleaner Story (II) Chart I-24AUD/JPY Is At Risk Bottom Line: The yen tends to depreciate against the USD in the later innings of a U.S. business cycle expansion, a response to rising U.S. bond yields. However, the yen also benefits when EM asset prices fall, a growing risk at the current economic juncture. Moreover, Japanese economic data are deteriorating and the BoJ is shifting toward a more dovish slant. The balance of these forces suggests that the yen rally against the dollar is done for now. However, the yen has further scope to rise against the EUR and the AUD. Two Charts On EUR/GBP Since we are anticipating EUR/USD to fall further toward 1.15, this also begs questions for the pound. Historically, a weak EUR/USD is accompanied by a depreciating EUR/GBP (Chart I-25). Essentially, the pound acts as a low-beta euro against the USD, and therefore when EUR/USD weakens, GBP/USD weakens less, resulting in a falling EUR/GBP. This time around, British economic developments further confirm this assessment. The spread between the British CBI retail sales survey actual and expected component has collapsed, pointing to a depreciating EUR/GBP (Chart I-26). Essentially, the brunt of the negative impact of Brexit on the British economy is currently being felt, which is affecting investor sentiment on the pound relative to the euro. Why could consumption, which represents nearly 70% of the U.K. economy, rebound from current poor readings? Once inflation weakens - a direct consequence of the previous rebound in cable - real incomes of British households will recover from their currently depressed levels, boosting consumption in the process. Chart I-25Where EUR/USD Goes,##br## EUR/GBP Follows Chart I-26Economic Conditions Also Point ##br##To A Weakening EUR/GBP Finally, today only 42% of the British electorate is pleased with having voted for Brexit, the lowest share of the population since that fateful June 2016 night. Moreover, this week, the House of Lords voted that Westminster can adjust the final deal with the EU before turning it into law. This implies that the probability of a soft Brexit, or even no Brexit at all, is increasing. However, the challenge to Theresa May's post-Brexit customs plan by MP Rees-Mogg, is creating yet another short-term hurdle that makes the path toward this outcome rather torturous. Additionally, it also raises the probability of a Corbyn-led government if the current one collapses. As a result, while the economic developments continue to favor being short EUR/GBP, the political environment is still filled with landmines, creating ample volatility in the pound crosses. We will use any rebound to EUR/GBP 0.895 to sell this pair. Bottom Line: If the euro weakens further, GBP/USD is likely to follow and depreciate as well. However, the pound will likely rally against the euro. Historically, GBP/USD behaves as a low-beta version of EUR/USD. Moreover, the maximum post-Brexit economic pain is potentially being felt right now, implying a less cloudy economic outlook for the U.K. Additionally, the probability of a soft Brexit or no Brexit at all is growing even if partial volatility remains. Set a stop sell on EUR/GBP at 0.895, with a target at 0.8300 and a stop loss at 0.917. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 The Li-Keqiang index is based on railway cargo volume, electricity consumption, and loan growth. 3 Please see Foreign Exchange Strategy Weekly Report, titled "The ECB's Dilemma", dated April 20, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YYC!", dated January 12, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues... For Now", dated February 16, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was marginally positive this week. As headline PCE climbed to the targeted 2% level, the underlying core PCE also edged up to 1.9%, highlighting growing inflationary forces. However, countering these positive releases were disappointing PMIs and a slowing ISM, as well as pending home sales, which contracted on a 4.4% annual basis. Regardless, the Fed acknowledged the strength of the U.S. economy. The FOMC referred to the inflation target as "symmetric", signaling that for now, inflation above target will not be used as an excuse to lift rates faster than currently forecasted in the dots. Nevertheless, the much-awaited breakout in the dollar materialized two weeks ago. As global growth wains, key central banks such as the ECB, BoJ, and BoE are likely to retreat to a more dovish tilt, as growth forecasts are revised down. This should give the greenback a substantial boost this year. Report Links: Is King Dollar Facing Regicide? - April 27, 2018 U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was weak: M3 and M1 money supply growth both weakened to 3.7% and 7.6%; Annual GDP growth slowed down to 2.5%, as expected; Both the headline and core measures of inflation disappointed, coming in at 1.2% and 0.7%, respectively. The euro broke down below a crucial upward-slopping trendline, which was defining the euro's rally last year. Additionally, EUR/USD has also broken the 200-day moving average technical barrier, highlighting the impact on the euro of weakening global growth and faltering European data. This decline in activity, along with the presence of hidden-labor market slack have been picked up by President Mario Draghi and other key ECB officials. Therefore, weakness in the euro is likely to continue for now. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Nikkei manufacturing PMI surprised to the upside, coming in at 53.8. However, Tokyo inflation ex-fresh food underperformed expectations, coming in at 0.6%. Moreover, consumer confidence also surprised negatively, coming in at 43.6. Finally, housing starts yearly growth underperformed expectations, coming in at -8.3%. The Bank of Japan decided to keep its key policy rate at -0.1% last Friday. Overall, the BoJ sounded slightly more dovish, acknowledging that it might take more time for inflation to move to their 2% target. Taking this into account, it might be dangerous to short USD/JPY as the BoJ could adjust policy to depreciate the currency. However investors could short EUR/JPY to take advantage of increased risk aversion. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 1.2%. Moreover, manufacturing PMI also surprised to the downside, coming in at 53.9. Additionally, both consumer credit and mortgage approvals underperformed expectations, coming in at 0.254 billion pounds, and 62.014 thousand approvals respectively. The pound has depreciated by nearly 5.5% in the past 2 weeks. Poor inflation and economic data as well as generalized dollar strength. Overall, we continue to be bearish on the pound, as the uncertainty surrounding Brexit will continue to scare away international capital. Moreover, the strength of the pound last year should weigh significantly on inflation, limiting the ability of the BoE to raise rates significantly. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was generally good: Building permits picked up, growing at a 14.5% annual rate, and a 2.6% monthly rate, beating expectations; The trade balance outperformed expectations comfortably, coming in at AUD 1.527 million; However, the AIG Performance of Manufacturing Index went down to 58.3 from 63.1; The AUD capitulated as a result of the growing global growth weakness, trading at just above 0.75. The RBA is reluctant to hike rates as Governor Lowe sited both stress in the money market and stretched household-debt levels as key reasons for his reluctance to hike. In other news, growing tension between Australia and its largest investor, China, are emerging in response to rumors that Chinese agents have been lobbying Australian officials in order to influence Australian politics. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The unemployment rate surprised positively, coming in at 4.4%. Moreover, employment quarter-on-quarter growth outperformed expectations, coming in at 0.6%. However, the Labour cost index yearly growth surprised to the downside, coming in at 1.9%. Finally, the participation rate also surprised negatively, coming in at 70.8%. NZD/USD has depreciated by nearly 5%. Overall we continue to be negative on the kiwi, given that an environment of risk aversion will hurt high carry currencies like the New Zealand dollar. Moreover, a slowdown in global growth should also start to hurt the kiwi economy, given that this economy is very levered to China and emerging markets. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was mixed: Raw material price index increased by 2.1% in March, more than the expected 0.6%; GDP grew at a 0.4% monthly rate, beating expectations of 0.3%; However, the Markit manufacturing PMI disappointed slightly at 55.5. The CAD only suffered lightly despite the greenback's rally. Governor Poloz argued that the expensive Canadian housing market and the elevated household debt load have made the economy more sensitive to higher interest rates than in the past. He also pointed out that interest rates "will naturally move higher" to the neutral rate level, ultimately giving mixed signals. Despite these mixed comments by Poloz, the CAD managed to rise against most currencies expect the USD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales yearly growth underperformed expectations, coming in at -1.8%. Moreover, the KOF leading indicator also surprised negatively, coming in at 105.3 However, the SVME Purchasing Manager's Index came in at 63.9. EUR/CHF has been flat these last 2 weeks. Overall, we continue to bullish on this cross on a cyclical basis, given that the SNB will keep intervening in currency markets, as the economy is still too weak, and inflationary pressures are still to tepid for Switzerland to sustain a strong franc. However, EUR/CHF could see some downside tactically in an environment of rising risk aversion. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Registered unemployment surprised positively, coming in at 2.4%. Moreover, the Norges Bank credit indicator also outperformed expectations, coming in at 6.3%. USD/NOK has risen by more than 4% these past 2 weeks. This has occurred even though oil has been flat during this same time period. Overall we are positive on USD/NOK, as this cross is more influenced by relative rate differentials between the U.S. and Norway than it is by oil prices. However, the krone could outperform other commodity currencies, as oil should outperform base metals, as the latter is more sensitive to the Chinese industrial cycle than the latter. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The krona's collapse seem never ending. While the krona never responds well to an environment where global growth is weakening and where asset prices are becoming more volatile, Riksbank governor Stefan Ingves is not backing away from his dovish bias. In fact, the Swedish central bank is perfectly pleased with the krona's dismal performance. Thus, the Riksbank is creating a stealth devaluation of its currency, one that is falling under President Donald Trump's radar. Swedish core inflation currently stands at 1.5%, but it is set to increase. The Riksbank's resource utilization gauge is trending up and the Swedish housing bubble is supporting domestic consumption. As a result, the Swedish output gap is well above zero, and wage and inflationary pressures are growing. The Riksbank will ultimately be forced to hike rates much faster than it currently forecasts. Thus, we would anticipate than when the global soft patch passes, the SEK could begin to rally with great alacrity. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Feature Chart of the WeekAg Vol Will Rise Over the coming three months markets will be zeroing in on spring planting in the U.S., looking for deviations from the USDA's March intentions report. This will occur against the cyclical backdrop of increased volatility, as markets attempt to price the real impact of Chinese tariffs (Chart of the Week). Putting aside fundamentals, U.S. financial conditions will be a headwind to ag prices this year. Longer term, despite the more favorable USD outlook, a slowdown in China, which accounts for ~ 20% of global food demand, could be bearish for ag prices. Highlights Energy: Overweight. U.S. crude oil output rose to a record 10.3mm b/d in February according to the U.S. EIA. U.S. crude production exceeded Saudi Arabia's in 1Q18; we expect it to exceed Russia's output of 11.2mm b/d by December, 2018. Base Metals: Neutral. Permanent waivers on steel and aluminum tariffs were granted to Australian, Argentine, and Brazilian imports by U.S. firms, while exemptions on imports from the EU, Canada and Mexico were extended to June 1. Precious Metals: Neutral. USD strength is weighing on gold and silver: Our long positions on both metals are down 3.0% and 6.2%, respectively, over the past two weeks. Ags/Softs: Underweight. Ag market volatility will increase, as markets assess U.S. spring planting progress against a backdrop of a possible trade war in ags between the U.S. and China (see below). Feature All Eyes On U.S. Planting Progress It is a busy time of year for U.S. farmers as spring planting is underway. Based on the USDA's annual Prospective Planting Report, released end-March, corn and soybean plantings will fall 2% y/y and 1% y/y, respectively. If realized, corn planted area in the 2018/19 crop year will be the lowest since 2015, and, for only the second time in the history of the series, will fall behind soybean acreage (Chart 2). The USDA's survey also indicates U.S. corn and soybeans will lose ground to wheat, where farmers intend to expand acreage by 3%. Even so, wheat planting intentions are the second lowest on record since the beginning of the series in 1919, surpassed only by last year's all-time low. Mother Nature is not co-operating either: unseasonably cold and wet weather is hindering planting this spring (Table 1). Planting of corn and spring wheat are significantly behind average for this time of the year. Similarly, heading of winter wheat - which accounts for ~ 70% of total wheat intentions - is also behind schedule. Furthermore, harsh winter weather reduced the condition of almost 40% of the crop to poor or very poor, with only 33% qualifying as good or excellent, compared to last year's assessment of 13% and 54%, respectively. Chart 2U.S. Soybean Acreage To Surpass Corn In 2018/19 Table 1U.S. Farmers Are Behind Schedule Weather-related delays are less of a risk for soybean plantings, which begin and end later in the summer. Progress is currently in line with historical averages, and, since farmers have an additional month of planting compared to corn and wheat, it is possible they will opt to switch their unplanted corn and wheat acreage to beans. This is a downside risk to the soybean market: When all is said and done, June soybean acreage may exceed targets indicated in the USDA's March intentions report. Although farmers' current lack of headway on the fields is cause for concern, it is still possible that farmers will be able to catch up, attaining their targeted acreage. A Backdrop Of Falling Inventories The termination of China's corn stockpiling scheme, which, prior to 2016 led to the rapid buildup of domestic inventories, was accompanied by policies designed to incentivize soybean plantings over corn. In the case of corn, these policies have paid off. By the end of the current crop year we expect the drawdown in Chinese inventories - along with U.S. stockpiles - to drag world corn reserves lower for the first time since 2010/11 (Chart 3).1 China's pro-soybean production policy is expected to yield a 1.1% expansion in the oilseed's planting area, leading to a 12.8% increase in output this crop year. Regardless, domestic inventories expressed in stocks-to-use (STU) terms are projected to fall (Chart 4). Similarly, world soybean reserves will contract on the back of a decline in Argentine output, which will lead to the largest - and one of only three on record - soybean deficits in the domestic market. In the case of wheat, although U.S. output is forecast to come down this year, weighing on domestic inventories, global markets remain well supplied (Chart 5). In fact, even though USDA's monthly revisions to U.S. production have been downward, forecasts of total use also were revised down. This means the net impact on the balance will be a wider-than-expected surplus. In the case of global markets, world wheat STU ratio will increase to levels last seen in 1986. Net, despite unfavorable weather weighing on the quality and quantity of U.S. wheat crops, there is no shortage of wheat in the world, unlike corn and soybeans. Chart 3Corn Deficit Eating##BR##Away At Stockpiles Chart 4China STU Falls Despite##BR##Pro-Soybean Policies Chart 5Global Wheat Markets Well Supplied##BR##Amid U.S. Supply Concerns Bottom Line: Given the slower-than-average planting progress this year, near term prices will likely reflect developments in the U.S., as farmers rush to get the crops in the ground. While winter wheat appears to be of poor quality this year, corn and spring wheat plantings are significantly behind schedule. This raises the risk that their acreages will be abandoned in favor of soybeans, which has a later planting window. All in all, if the June acreage report aligns with farmers' planting intentions, we expect to see an increase in wheat acreage at the expense of corn and soybean, which will provide some supply relief to domestic wheat markets. U.S. Farmers Less Competitive, Especially In Soybean Markets In theory, China's announced plans to levy duties on U.S. ag imports puts U.S. farmers - part of President Trump's base - at a disadvantage. But, reality may not be as bearish. The outcome hinges on whether the U.S. will be able to ramp up its exports to other markets amid declining imports from the top bean consumer. Given the impact of weather on soybean output in Argentina - where drought cut soybean output by 30% y/y - there will be a void in global supply. Since soybeans are fungible, we expect ex-China demand to remain supported on the back of limited global supply. This will provide an opportunity for the U.S. to export its surplus, at least in this crop year. To date, there appears to be some evidence of this. Domestic supply will be insufficient to cover Argentinian consumption this year (Chart 6). In an unusual move, USDA export sales data shows Argentina booked a 240k MT purchase of U.S. soybeans for delivery in the next marketing year. Argentina traditionally is a net exporter of soybeans. While we expect tariffs to reshuffle trade flows as China attempts to ensure supplies while avoiding U.S. soybeans, the net effect in terms of global demand for U.S. soybeans may not be as bearish as is feared. China simply does not have the domestic supply to satisfy its demands for beans. While opting for Brazilian or Argentinian beans may be way around importing U.S. supplies, this will open up other export opportunities for the U.S. variety, leading to a simple restructuring of trade flows.2 Recent declines in Chinese imports of U.S. soybeans amid growing imports from Brazil have been cited as evidence of a gloomy future for U.S. soybean farmers. However, this phenomenon is part of the Chinese import cycle: Brazilian soybeans flood Chinese markets in the second and third quarters, while American supplies flow in during the last and first quarters of any given year (Chart 7). Furthermore, U.S. soybean imports have been on the downtrend since the middle of last year. Thus, this observation alone does not signal a change in trend. Chart 6Weak Argentine Output##BR##Restrict Global Supplies Chart 7Chinese Preference For Brazilian Beans##BR##Typical For This Time Of Year In fact, the premium paid for Brazilian beans over those traded in Chicago spiked earlier last month. Although it has since come down slightly, it suggests Chinese consumers will have to bear the brunt of more expensive imports. Furthermore, this makes U.S. beans relatively cheaper - and more attractive - in the global market. All the same, higher costs may entice Chinese consumers to look at adjusting the feed formula by diversifying the source of feed. Although our baseline scenario is that these tariffs will remain in place, U.S. Treasury Secretary Steven Mnuchin and U.S. Trade Representative Robert E. Lightizer's trip to Beijing may be the opening salvo to less hostile trade developments. If this is the case, we would expect these trade-related risks to ease. Bottom Line: Tariffs on U.S. soybean imports to China are, in theory, bearish for U.S. markets. However, China's reliance on these beans, along with a tight market this year, makes the outlook less gloomy. Courses of action that may be pursued by China are (1) diversifying the source of the bean, (2) reducing demand for the bean by adjusting feed formula, and (3) continuing to raise domestic soybean acreage. Given the cyclical nature of China's soybean imports, we are entering a period of naturally low demand for U.S. soybeans. Thus, we will not likely see the real impact of current trade disputes until China's demand for American beans kicks in again in 4Q18. In the meantime, a global deficit will open up alternative opportunities for U.S. exports. U.S. And Foreign Financial Conditions Drive Long Run Outlook As weather and the on-going trade tensions between the U.S. and China evolve, the U.S. financial backdrop - particularly real interest rates and the broad USD trade-weighted index (TWIB) - will remain crucial to ag markets. In line with BCA Research's House View, we expect Fed rate hikes to exceed those of other central banks, providing support to a stronger USD over the next 12 months. This will weigh on ag prices.3 Chinese economic growth also could figure prominently, based on recent research from the CME Group, which operates the world's benchmark grain futures markets.4 The relationship between China's unofficial economic gauge - the Li Keqiang Index (LKI) - and ag prices appear to operate through the currency channel. A weaker Chinese economy - reflected in the LKI - suppresses industrial commodity demand, which ends up weighing on the currencies of major commodity exporters. This means the local costs of production for these exporters fall, which, with a 1- to 2-year lag, incentivizes crop plantings in these regions. The increased supply at the margin is bearish for ag prices, all else equal. Given the current environment of a slowing Chinese economy, this relationship is relevant to the longer-term outlook. The significance of the LKI in our grains models provides some evidence of this relationship (Chart 8). When applying the analysis to Brazilian and Russian ag markets, we find the LKI to be positively correlated with the Brazilian Real and the Russian Ruble. This, in turn, explains the inverse correlation we find between the LKI and future ag production in these two markets (Chart 9). A weaker domestic currency does appear to entice farmers to increase plantings of ag commodities, allowing them to take advantage of greater local currency profits from USD-denominated ag exports. Chart 8China Slowdown May Weigh Down On Ags... Chart 9...By Incentivizing Production Bottom Line: This preliminary analysis uncovers a supply side channel through which China may impact global ag supplies. It implies that a slowing Chinese economy may in effect spur greater global ag supplies, eventually weighing down on ag prices. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst HugoB@bcaresearch.com 1 Despite the increase in domestic supply amid greater offerings of state reserves, much of the state corn stocks are reportedly in poor condition, only suitable as a source for ethanol production - cited as the justification for upward revisions to corn consumption this year. As such, imports will likely remain indispensable. Overall it appears that China intends to raise its industrial consumption of corn in order to digest its stockpiles, with limited impact on prices. Late last year, China announced its target of nationwide use of bioethanol gasoline by 2020. It estimates that corn stockpiles are sufficient to meet near term demand for the grain used as the ingredient in E10, and hopes to achieve a physical corn market balance within five years. 2 Please see the Ags/Softs back section titled "Can China Retaliate With Agriculture," in BCA Research Commodity & Energy Strategy Weekly Report titled "Oil Price Forecast Steady, But Risks Expand," dated March 22, 2018, available at ces.bcaresearch.com. 3 For a more detailed discussion of the impact of U.S. financial variables on ag markets, please see BCA Research Commodity & Energy Strategy Weekly Report titled "Global Financial Conditions Will Drive Grain Prices In 2018," dated November 30, 2017, available at ces.bcaresearch.com. 4 Please see "Will A Sino-U.S. Trade War Impact Grain, Meat Markets?" dated March 28, 2018, available at cmegroup.com. 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 Our constraints-based methodology does not rely on human intelligence or the "rumor mill" to analyze political risks; Yet insights from our travels across the U.S., including inside the Beltway, offer interesting background information and a sense of the general pulse; Anecdotal information suggests that Trump is not "normalizing" in office; that U.S.-China relations will get worse before they get better; and that Trump will walk away from the 2015 Iranian nuclear deal. Stick to our current trades: energy over industrial metals; South Korean bull steepener; long DXY; long DM equities versus EM; long JPY/EUR; short Chinese tech stocks and U.S. S&P500 China-exposed stocks. Feature With the third inter-Korean summit demonstrating our view that "diplomacy is on track,"1 we remind investors of the key geopolitical risks we have been emphasizing - souring U.S.-China relations and rising geopolitical risks over Iran's role in the Middle East.2 We at BCA's Geopolitical Strategy do not base our analysis on information from human "intelligence" sources. No private enterprise can obtain the volume of intelligence that would make the sample statistically significant. Private political analysts relying on such intelligence are at best using flawed reasoning devoid of an analytical framework, and at worst are hucksters. Government intelligence agencies obviously collect a wide swath of not only human but also electronic and signals intelligence. Their sample can be statistically significant. However, the cost of such an effort is prohibitive to the private sector. Nonetheless, we may use human intelligence for background information, insight into how to improve our framework, and to take the subjective pulse of any particular situation. The latter is sometimes the most useful. It is not what a policymaker says that matters so much as how they say it, or the fact that they mention the subject at all. Given that we live in an era of political paradigm shifts, and that "charismatic leadership" is rising in influence relative to more predictable, established institutions and systems,3 we have decided to do something we have not done in the past: share some insights from our recent trips to Washington, DC and elsewhere in the U.S. Caveat emptor: the rumor mill is often wildly misleading, which is why we do not base our research on it. Exhibit A: Donald Trump's tax cuts, which our constraints-based methodology enabled us to predict in spite of the prognostications of in-the-know people throughout the year.4 Trump Is Not Normalizing U.S. domestic politics is the top concern of investors, policymakers, and policy wonks almost everywhere we go. It routinely ranks above concerns about Russia, China, the Middle East, or emerging markets (EM). We frequently heard that the U.S. is entering a period of political turmoil worse than anything since President Richard Nixon and the Watergate scandal. Some old Washington hands even claim that the Trump era will cause even greater uncertainty than the Nixon era did because Congress is allegedly less willing to keep the president in check. Economic policy uncertainty, based on newspaper word count, is at least comparable today to the tumultuous 1973-74 period, which culminated with Nixon's resignation in August 1974, and is trending upward (Chart 1). Chart 1Trump Uncertainty Approaching Nixon Levels? Of course, there is a big difference between Trump's and Nixon's context: today the economy is not going through a recession but rip-roaring ahead, charged with Trump's tax cuts and a bipartisan spending splurge. And the nation is not in the midst of a large-scale and deeply divisive war (not yet, anyway). There is little chance of major new legislation this year, yet deregulation, particularly financial deregulation, will continue to pad corporate earnings and grease the wheels of the economy. The booming economy is lifting Trump's approval ratings, which are trying to converge to the average of previous presidents at this stage in their terms (Chart 2). This development poses the single biggest risk to the unanimous opinion in DC that Republicans face a "Blue Wave" (Democratic Party sweep) in the midterm elections on November 6. However, a key support of the "Blue Wave" theory is that Republicans are split among themselves - and no one in the Washington swamp will deny it. Pro-business, establishment Republicans have never trusted Trump. They are retiring in droves rather than face up to either populist challengers in the Republican primary elections this summer or enthusiastic "anti-Trump" Democrats and independents in the general election (Chart 3).5 Chart 2Is Trump's Stimulus Bump Over? Chart 3GOP Retirements Are Unprecedented Trump is expected to ignite a constitutional crisis by firing Special Counsel Robert Mueller, the man leading the investigation into the Trump campaign's alleged collusion with Russia. Republicans are widely against firing Mueller, but they are not united in legislating against it, leaving Trump unconstrained. Senate Majority Leader Mitch McConnell (R, KY) says he will not allow consideration on the Senate floor of a bill approved by the Senate Judiciary Committee that would protect Mueller from firing.6 If Trump fires Mueller, Democrats expect a political earthquake. Some think that mass protests, and mass counter-protests encouraged by Trump himself, will culminate in violence. (We would expect protests to be mostly limited to activists, but obviously violent incidents are probable at mass rallies with opposing sides.) The Democrats are widely expected to take the House of Representatives; most observers are on the fence about the Senate. The House is enough to impeach Trump, which is widely expected to occur, by hook or by crook. But the impact on the country's political polarization will be much worse if there is impeachment without "smoking gun" evidence against Trump's person. Nixon, recall, refused to hand over evidence (the Watergate tapes) under a court order. When he handed some tapes over, they emitted a suspicious buzzing sound at critical points in the recording. Public opinion turned against him, prompting his party to abandon ship. He resigned because the loss of party support made him unlikely to survive impeachment. By contrast, there is not yet any comparable missing or doctored evidence in Trump's case, nor any sinkhole in Republican opinion that would presage a 67-vote conviction in the Senate (Chart 4). Chart 4Trump Not Yet In Nixon's Shoes Still, clouds are on the horizon. When people raise concerns about geopolitical issues - the U.S.-Russia confrontation, or the potential for a trade war with China - their starting point is uncertainty about President Donald Trump and his administration's policies. The United States is seen as the chief source of political risk in the world. Bottom Line: People in the Beltway who were once willing to believe that Trump would learn on the job and become "normalized" in office now seem to be shifting to the view that he is truly an unorthodox, and potentially reckless, president. The New (Aggressive) Consensus On China China is in the air like never before in D.C. In policy circles, the striking thing is the near unanimity of the disenchantment with China. Republicans are angry with China over trade and national security. Democrats are not to be outdone, having long been angry with China over trade, and also labor issues and human rights violations. It seems that everyone in the government and bureaucracy, liberal or conservative, is either demanding a tougher policy on China or resigned to its inevitability. American officials flatly reject the view that the Trump administration is instigating a conflict with China that destabilizes the world economy. Rather they insist that China has already instigated the conflict and caused destabilizing global imbalances through its mercantilist policies. They firmly believe that the U.S. can and should disrupt the status quo in order to change China's behavior, but that no one wants a trade war. They believe that the U.S. can be aggressive without causing things to spiral out of control. This could be a problem, as we detect a similar hardening of sentiment in China. On our travels there, the attitude was one of defiance toward Trump and Washington. We have received assurances that Beijing will not simply fold, no matter how much pain is incurred from trade measures. Of course, it is in China's interest to bluster in order to deter the U.S. from tariffs. But Chinese policymakers may be ready to sustain greater damage than Washington or the investment community expects. Tech companies are particularly out of the loop with Washington. They are said to have been unprepared for the president's actions upon receiving the Section 301 investigation results. They may also be underestimating the product list that the U.S. Trade Representative has drawn up pursuant to Section 301.7 Even products on that list that are not imported directly from China could have their trade disrupted. While China is demanding that the U.S. ease restrictions on high-tech exports, to reduce the trade imbalance (Chart 5), the U.S. believes that export controls allow for plenty of waivers and exceptions. They do not see export controls as a major risk. Chart 5U.S. Deficit Due To Security Concerns Rather, they see rising U.S. restrictions on Chinese investment in the U.S. as the real risk. The U.S. wants reciprocity in investment as well as trade. The emphasis lies on fair and equal access, which will require massive compromises from China, given its practice of walling off "strategic" sectors (including aviation, energy, electricity, shipping, and communications) from foreign interests. China's recent pledges to allow foreigners majority stakes in financial companies may not be enough to pacify the U.S. negotiators, especially if the promises hinge on long-term implementation. Treasury Secretary Steve Mnuchin will cause a stir when he releases his guidelines for investment restrictions, as expected by May 21 under the president's declaration on the Section 301 probe (Table 1).8 Both the House of Representatives and Senate are expected, within a couple of months, to pass the Foreign Investment Risk Review Modernization Act, proposed by Senator John Cornyn (R, TX) and Representative Robert Pittenger (R, NC). This bill would grant greater powers to the secretive Committee on Foreign Investment in the United States (CFIUS) in conducting investigations into foreign investment deals with national security ramifications. Under the new law CFIUS will be able to review proposed investment deals on grounds that go beyond a strict reading of national security. They will now include economic security, and potential sectoral impacts as well as individual corporate impacts, and previously neglected issues like intellectual property.9 Trump is unlikely to veto the bill, as previous presidents have done when laws cracking down on China have passed Congress, given his desire to shake up the China relationship. Table 1Protectionism: Upcoming Dates To Watch Will CFIUS enforcement truly intensify? Treasury's actions may preempt the bill, and CFIUS has already been subjecting China to greater scrutiny for years (Chart 6). Moreover, American presidents have always canceled investment deals if CFIUS advised against them.10 Presumably broadening CFIUS's powers will result in a wider range of deals struck down. The government already stopped Broadcom, a Singaporean company, from taking over the U.S. firm Qualcomm, in March, for reasons that have more to do with R&D and competitiveness (economic security) than with any military applications of its technologies (national security). Separately, U.S. policy elites are starting to turn their sights toward China's global propaganda and psychological operations. The scandal over the Communist Party's subversive institutional and political influence in Australia has heightened concerns in other Western, especially Anglo-Saxon, countries.11 This is a new trend that will have bigger implications going forward in Western civil society and the business community, with state efforts to create firewalls against Chinese state intrusion exacerbating political and trade tensions. Australians have the most favorable view of China in the West, and on the whole they continue to see China in a positive light. However, this view will likely sour this year. The recent attempt by Prime Minister Malcolm Turnbull to pass legislation guarding against Communist Party interference in Australian politics has already led to a series of diplomatic incidents, including tensions over the South China Sea and Pacific Islands. These can get worse in the near future. Consistently, over 40% of Australians view China as "likely" to become a military threat over the next 20 years (Chart 7), and this number will worsen if attempts to safeguard democratic institutions from state-backed influence operations cause China to retaliate with punitive measures toward Australia. China is offering some concessions to counteract the new, aggressive consensus in Washington. Enforcing UN sanctions against North Korea was the big turn. But it is also allowing the RMB to appreciate against the USD (Chart 8), which is an issue close to Trump's heart. The change in temperature in Washington can be measured by the fact that these concessions seem to be taken for granted while the discussion moves onto other demands like trade and investment reciprocity. Chart 6U.S. To Restrict Chinese Investment Chart 7Australian Fears About China To Rise Chart 8Is This Enough To Stay Trump's Hand On Tariffs? Simultaneously, China is courting Europe. European policymakers say that they share U.S. concerns about China's trade practices but wish to resolve disputes through the World Trade Organization and reject unilateral American actions or aggressive punitive measures that could harm global stability. Meanwhile China hopes that American policy toward Iran and the Middle East will alienate the Europeans while distracting Washington from formulating a coherent pivot to Asia. Bottom Line: Investors are underestimating the potential for a full-blown trade war. Policymakers - in China as well as the U.S. - have greater appetite for confrontation. Iran: Reversing Obama's Legacy The financial news media continue to underrate the importance of geopolitical risk tied to Iran this year (Chart 9). Our sense is that the Trump administration, when in doubt, is still biased towards reversing Obama-era policy on any given issue. Iranian nuclear deal of 2015 appears to be no exception. Chart 9Iranian Geopolitical Risk About to Shoot Up Signs have emerged for months that Trump is likely to refuse to waive Iranian sanctions (Table 2) when the renewal comes due on May 12. He has fired his national security adviser and secretary of state, as well as lesser officials, in preference for Iran hawks.12 French President Emmanuel Macron, having tried to convince Trump to retain the deal on his recent state visit to Washington, is apparently convinced Trump will scrap it.13 Table 2U.S. Sanctions Have Global Reach Moreover, discussions of Iran mark the one exception to the hardening consensus on China. A number of people we spoke with were not convinced that the Trump administration will truly devote the main thrust of its foreign policy to countering China. Some believed U.S. voters did not have the stomach for a trade fight that would affect their pocketbooks. Others believed that the Trump administration would simply revert to a more traditional Republican foreign policy, accepting a "quick win" on China trade while pursuing a confrontational military posture in the Persian Gulf. Still others believed that Trump has unique reasons, such as political weakness at home and the desire to be respected abroad, for wanting to be in lock-step with Israeli Prime Minister Benjamin Netanyahu and Crown Prince Mohammad bin Salman against Iran. All agreed that while a shift to China makes strategic sense, it may not overrule Republican policy preferences or inertia. The stakes are high. Allowing sanctions to snap back into place would affect a substantial portion of the one million barrels per day of oil that Iran has brought onto global markets since sanctions were eased in January 2016 (Chart 10). Chart 10Re-Imposing Iranian Sanctions Threatens Oil Supply And Middle East Stability As BCA's Commodity & Energy Strategy notes, global oil supply is tight and the critical driver - emerging market demand - remains strong. Meanwhile the "OPEC 2.0" cartel plans to extend production cuts throughout 2018 and likely into 2019, further draining global inventories. Inventories are now on track to fall beneath their 2010-14 average level by next year. In this context, the geopolitical risk premium will add to upside oil price risks this year. Our commodity strategists still expect oil prices to average $70-$74 per barrel this year (WTI and Brent respectively), but they can see it shooting above $80 per barrel on occasion, and warn that even small supply disruptions (whether from Iran, Venezuela, Libya, or elsewhere) could send prices even higher (Chart 11).14 Chart 11Oil Prices Can Make Runs Into /Barrel Range If the U.S. re-imposes sanctions on Iran, we doubt that the full one million barrels per day of post-sanctions Iranian production will be taken offline. Global compliance with sanctions will be ineffective this time around. The Trump administration's sanctions will not have the legitimacy or buy-in that the Obama administration's sanctions did. Trump may even intend to impose the sanctions for domestic political consumption while giving Europe, Japan, and others a free pass. Still, the geopolitical and production impact will be significant. As for oil, price overshoots are even more likely when one considers Venezuela, where our oil analysts estimate that state collapse will remove around 500,000 barrel per day from last year's average by the end of this year.15 Bottom Line: We continue to expect energy commodities to outperform metals in an environment where energy prices benefit from a rising geopolitical risk premium, while metals could suffer from ongoing risks to Chinese growth. Investment Conclusions Independently of the above anecdotes, Geopolitical Strategy has laid out a case urging clients to sell in May and go away.16 Last year we were confident recommending that clients forget this old adage because we had clarity on the geopolitical risks and their constraints. This year, with both China and Iran, we lack that clarity. The U.S.'s European allies could perhaps convince Trump to maintain the 2015 Iranian nuclear agreement, and Trump could perhaps accept China's concessions (such as they are) to get a "quick win" on the trade front before the midterm elections. But we have no basis for assessing that he will do either with any degree of conviction. How long will it take to resolve the raft of outstanding U.S.-Iran and U.S.-China tensions? Our uncertainty here gives us a high conviction view that this summer will be turbulent. Geopolitical tensions will likely get worse before they get better. We would reiterate our recommendation that clients be long DXY and hold a "geopolitical protector portfolio" of Swiss bonds and gold. We remain long developed market equities relative to emerging markets and long JPY/EUR. We are also maintaining our shorts on Chinese tech stocks and U.S. stocks exposed to China. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 6 Please see Jordain Carney, "McConnell: Senate won't take up Mueller protection bill," April 17, 2018, available at thehill.com. 7 Please see U.S. Trade Representative, "Under Section 301 Action, USTR Releases Proposed Tariff List on Chinese Products," and "USTR Robert Lighthizer Statement on the President's Additional Section 301 Action," dated April 3 and April 5, 2018, available at ustr.gov. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 9 Please see Senator Jon Cornyn, "S.2098 - Foreign Investment Risk Review Modernization Act of 2017," dated Nov. 8, 2017, available at www.congress.gov. For the argument behind the bill, see Cornyn and Dianne Feinstein, "FIRRMA Act will give Committee on Foreign Investment a needed update," The Hill, dated March 21, 2018, available at thehill.com. 10 Please see Wilson Sonsini Goodrich & Rosati, "CFIUS In 2017: A Momentous Year," 2018, available at www.wsgr.com. 11 Australian Senator Sam Dastyari (Labor Party) resigned on December 11, 2017 after it was exposed that he accepted cash donations from a Chinese property developer that he used to repay his own debts. He had also supported China's position in the South China Sea. The scandal prompted revelations of a range of Chinese state-linked political donations. Prime Minister Malcolm Turnbull has introduced legislation banning foreign political donations and forcing lobbyists for foreign countries to register. 12 Mike Pompeo replaced Rex Tillerson as Secretary of State, John Bolton replaced H.R. McMaster as National Security Adviser, and Chief of Staff John Kelly has been sidelined; Bolton has appointed Mira Ricardel as his deputy, who has been said to clash with Secretary of Defense James Mattis in trying to staff the Pentagon with Trump loyalists. Please see Niall Stanage, "The Memo: Nationalists gain upper hand in Trump's White House," The Hill, April 25, 2018, available at thehill.com. 13 Macron has presented a framework that German Chancellor Angela Merkel and U.K. Prime Minister Theresa May have accepted that would call for improvements to outstanding issues with Iran while keeping the 2015 deal intact. Macron has also spoken with Iranian President Hassan Rouhani about retaining the deal while addressing the Trump administration's grievances. 14 Please see BCA Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely," dated April 19, 2018, available at ces.bcaresearch.com. 15 Please see footnote 14, and BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. Geopolitical Calendar
Highlights The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Chart 11...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth (ceteris paribus). Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat, but with a short leash. Feature Trade frictions between China and the U.S. continue to dominate the headlines of the financial press. The most significant potential escalation in the conflict came two weeks ago, when President Trump instructed the U.S. Trade Representative to consider an additional $100 billion in tariffs on imports from China (on top of the initially proposed $50 billion). For investors, the possibility of a full-blown trade war between China and the U.S. and its implications for financial markets remains the "question that won't go away". Given that negotiations between trade representatives of both countries are highly active, the President's public suggestion that an additional heavy salvo of tariffs may be levied appears to be a clear case of economic saber-rattling. Still, investors cannot neglect the odds that such a scenario does indeed materialize, and in this week's report we revisit some of our previous work on the impact of proposed U.S. tariffs on Chinese economic growth. We also outline the (difficult) policy options available to Chinese policymakers, update investors on the state of China's business cycle, and reiterate our recommended investment strategy of staying overweight Chinese ex-tech stocks (with a short leash). The Impact Of Proposed Tariffs On Growth, Part II Chart 1150$ Billion In Import Tariffs Would Seriously ##br##Harm Chinese Export Growth We presented our framework for modeling the impact of U.S. import tariffs on overall Chinese export growth in our March 28 Weekly Report.1 Our approach suggested that the original $50 billion in proposed tariffs would cause China's total export growth to decelerate about 2%, which would work to counteract the acceleration in underlying export growth that we would normally expect over the coming months given the pace of the global demand. Chart 1 updates this framework assuming a total of $150 billion in tariffs. While overall nominal export growth would not contract outright as a result of the tariff imposition, it would decelerate materially from our estimate of its underlying rate (currently 10%). There are good odds that Trump's suggestion of an additional $100 billion in tariffs against China was merely a negotiating tactic, and it is clear that China has a strong incentive to agree to a trade deal with the U.S. that will prevent the scenario depicted in Chart 1 from taking place. But were it to, it would represent a significant threat to China's cyclical economic momentum, in a manner that would surpass the direct contribution to Chinese growth from the external sector. Charts 2 and 3 explain why. Chart 2 first presents an annual time series of the net export (NX) contribution to Chinese real GDP growth, relative to final consumption expenditure and gross capital formation. Investors might initially react to this chart by concluding that a significant deceleration in export growth would have a minimal impact on the Chinese economy, since the net contribution to growth from the external sector has typically been small relative to the other expenditure categories. Chart 2Net Exports Are Not A Huge##br## Direct Contributor To Growth... Chart 3...But The Export Sector Is Highly ##br## Investment-Intensive However, this perspective misses two important elements of the Chinese economy that are crucial to understand: China's import demand is strongly tied to the export channel, given that roughly half of Chinese imports are commodity-oriented. This means that Chinese import growth would also suffer from a sudden hit to U.S. exports, which would reverberate the shock to China's trading partners (and back again to China). In short, the imposition of major U.S. tariffs on imports from China would cause a negative feedback loop for China and its key trading partners. Abstracting from the global financial crisis, Chart 3 highlights that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent investment. This underscores that an important portion of China's gross capital formation, which is a significant contributor to the Chinese economy, is driven by the export sector. Based on the relationship shown in Chart 3, and the historical relationship between nominal exports and the real contribution from net exports, the scenario depicted in Chart 1 could cause the contribution to growth from Chinese investment to fall 0.5-0.6 percentage points, which could push real GDP growth to or below 6% if consumption remained constant. While we have not focused on real GDP growth as an accurate measure of Chinese economic activity, a deceleration of that magnitude would be on par with what occurred in 2011-2012, when Chinese stocks and related financial assets fared quite poorly. Bottom Line: An additional heavy salvo of U.S. import tariffs, were they to occur, would cause a material deceleration in Chinese economic growth. Trade negotiations are likely to produce a relatively benign outcome, but Chinese stocks and related financial assets may suffer meaningfully if not. China's Policy Options Our analysis above did not incorporate a stimulative response from Chinese policymakers, which we would certainly expect if China experienced a large shock to its export sector. Table 1 presents a brief list of policy actions that the Chinese government could employ in response; some are narrowly focused on the export channel, and some would impact the economy more broadly. Table 1No Easy Cure-Alls To Ease The Impact Of Tariffs Our assumption is that policymakers will initially choose more focused policies and will refrain from broad-based stimulus unless the impact of the export sector shock is expected to much more significant than is currently the case. This is particularly true given that Table 1 highlights the difficulty facing Chinese policymakers, in that there are significant drawbacks associated with any of the policies described. Given that the proposed import tariffs will primarily affect firms manufacturing goods for export to the U.S., the most focused policies would be to provide some offsetting form of stimulus to the manufacturing sector and to depreciate the RMB versus the U.S. dollar. In our view, manufacturing sector-specific stimulus is the most likely to occur of any policies described in Table 1: the drawbacks are primarily structural in nature, and China has already announced a slight reduction in the tax rate for manufacturing industries as part of a series of changes to the VAT regime. We expect to see more announcements in this vein over the coming months. Materially depreciating the RMB vs the U.S. dollar, however, is quite unlikely to occur as a stimulative response, as it would very likely inflame trade tension with the U.S. Chinese authorities may use threats of backtracking on the non-trivial appreciation in CNYUSD over the past year during talks with the U.S., but we doubt that authorities would actually go ahead with this barring a complete breakdown in negotiations. Depreciating versus the euro is similarly problematic. Chart 4 highlights that the RMB has barely risen at all versus the euro over the past year, implying that a meaningful depreciation would likely anger euro area policymakers, especially given that the trade-weighted euro has already risen nearly 10% over the past year. Instead, Chart 5 highlights the most likely route if China chooses to use the RMB as a relief valve: a depreciation against Japan, Korea, Vietnam, and India. China's combined export weight to these countries is meaningful, and the chart shows that there is depreciation potential: a weighted RMB index versus these currencies has risen about 8% in the past 12 months. Chart 4The RMB Has Not Appreciated ##br##Against The Euro Chart 5Room To Depreciate Against A ##br##Basket Of Asian Currencies We will revisit the remaining policies listed in Table 1 if the U.S. does indeed follow through with a second round of significant tariffs against Chinese imports, or if the economic effect of the first round proves to be more significant than we expect. From a bigger picture perspective, the potential for broader stimulus from Chinese authorities (in response to a more impactful shock) raises the interesting possibility of another economic mini cycle in China. While the need to stimulate broadly, were it to occur, would clearly imply that the economy would first be weakening, investors should remember that China's economy ultimately accelerated meaningfully in response to the last episode of material fiscal & monetary easing. We presented our framework for tracking the end of China's current mini-cycle in our October 12 Weekly Report,2 and argued that a benign, controlled deceleration was the most likely outcome (Chart 6). In our view the economic data has validated this call over the past six months, and we do not see any reason yet to deviate from it (see next section below). But a severe export shock followed by a burst of economic stimulus would clearly alter our expectations for China's business cycle dynamics, and would also create some exciting investment opportunities for investors (both on the downside and the upside). While the odds of this scenario are not currently probable, we raise the possibility because of the significance that another cycle would have for global investor sentiment and the returns from Chinese financial assets. Chart 6A Stylized View Of China's Recent "Mini-Cycle" Bottom Line: Chinese policymakers have several policy options at their disposal to ease the impact of a major export sector shock, but many drawbacks make the choice a difficult one. For now, manufacturing sector-specific stimulus is the most likely policy response. Abstracting From Trade, China Continues To Slow As noted above, we have been flagging a deceleration in China's industrial sector since early-October. Table 2 is an updated version of a table that we presented in our March 7 Weekly Report,3 which shows recent data points for several series that we have identified as having leading properties for the Chinese business cycle, as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, and how long this has been the case. While we do not yet have all of the March components of our BCA Li Keqiang leading indicator, the four that are available all declined in March from February, suggesting that the ongoing economic slowdown continues. Table 2Key Chinese Data Do Not Signal A Broad Acceleration The table does highlight, however, two relatively positive developments: the Bloomberg Li Keqiang index was materially higher on average in January and February than it was in the two months prior, and now both the official and Caixin manufacturing PMIs are above their 12-month moving average, with the latter having been so for 4 months in a row. An average of the two measures, along with its 12-month moving average, in shown in Chart 7. Are these budding signs of a durable upturn in China's industrial sector? We do not take a dogmatic approach to forecasting China's cyclical trajectory, and will be monitoring this possibility over the coming months. But in our current judgement, the answer is no. The January pop in Bloomberg Li Keqiang index reflects two separate factors: a jump in the annual growth of rail cargo volume in January (which subsequently unwound in February), as well as strong growth in electricity production on average in January and February (Chart 8). Normally this would be an encouraging sign for China's economy, but when connected with the countertrend move in the manufacturing PMIs and the sharp, unsustainable rise in February's export growth, a pattern begins to emerge. Chart 7A Modest Tick Up In China's ##br##Manufacturing PMIs Chart 8The Li Keqiang Index: ##br##A Brief, Countertrend Move While far from conclusive, it would appear that China experienced a very sudden burst of goods production for the purposes of export. Given that this is occurring in the context of considerable trade frictions and the eventual imposition of import tariffs, and against the backdrop of strong but steady (and possibly peaking) global demand, it is conceivable that China's exporters are attempting to front-load shipments for the year before these tariffs take effect. Although a February surge is visible in Chinese export growth to several countries (not just the U.S.), and undoubtedly some of the effect is due to the timing of the Chinese new year, it is possible that Chinese exporters are acting in anticipation of possible additional tariffs on other countries or global industries that China acts as a supplier to. We noted above that the imposition of the first round of U.S. tariffs will likely be enough to arrest any acceleration in overall Chinese export growth, with a second round likely to cause a downward change in trend. Thus, to us, it is difficult to see an export-driven catalyst for China's industrial sector continuing over the coming months. On the import side, the data has also been more positive than we would have expected, given the close link between import growth and the Li Keqiang index (Chart 9). Part of this deviation may be accounted for by unsustainable export growth, given the typically strong link between import and export growth in highly trade-oriented economies. Interestingly, Chart 10 highlights that the flat trend in import growth appears to be supported by an uptrend in manufactured products, whereas the trend of primary products imports is much more consistent with what our indicators would suggest. For now, we are sticking with the signal given by the latter, since it has historically been a more reliable predictor of whether overall future import growth will be growing at an above-trend pace. But as we stated above, our view of a benign slowdown in China is empirically-based, and we will continue to monitor the data for signs that the external sector of China's economy warrants a change in our slowdown view. Chart 9Import Growth Has Held Up##br## Better Than We Expected... Chart 10...But Commodity Imports Suggest##br## Broad Import Growth Will Weaken Bottom Line: A broad reading of key leading indicators for China's business cycle suggest that the industrial sector continues to slow. Recent bright spots in the data appear to be linked to unsustainably strong export demand, which is likely to wane in the months ahead. Investment Implications We noted in our March 28 Weekly Report that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks.1 We recommended in that report that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. This recommendation stands, although it is notable that the relative performance of Chinese ex-tech shares (versus global) remains comfortably above its 200-day moving average (Chart 11). Chinese tech stocks, on the other hand, have sold off meaningfully over the past month (Chart 11 panel 2) due in part to the tech oriented nature of the U.S.' trade action. We advised investors to reduce their exposure to the tech sector in our February 15 Weekly Report,4 based on elevated earnings momentum and very rich valuation. Conversely, pricing also appears to be at the root of resilient ex-tech relative performance: Chart 12 shows that the 12-month forward earnings yield versus U.S. 10-year Treasurys is considerably higher for Chinese ex-tech companies than in developed or other emerging equity markets. This reinforces an argument that we have made in previous reports, which is that investors should have a high threshold for reducing exposure to China. Chart 11Chinese Ex-Tech Stocks ##br##Are Doing Fine, For Now... Chart 12...Supported By A Sizeable ##br##Risk Premium The key question is therefore whether the probable shock to Chinese export growth coupled with the ongoing slowdown in the industrial sector is significant enough to pre-emptively downgrade Chinese stocks. Our answer to this question remains "no", since investors still do not have the requisite visibility on the magnitude of the hit to exports and the likely policy response. Until this information emerges, we continue to recommend that investors stay overweight Chinese ex-tech stocks unless a technical breakdown emerges, and to watch for additional updates on this issue from BCA's China Investment Strategy service over the coming weeks and months. Bottom Line: Stay overweight Chinese ex-tech stocks versus their global peers despite the looming trade threat. Our downgrade watch remains in effect, and we are likely to advise a reduction in exposure in response to a technical breakdown. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "After The Selloff: A View From China", dated February 15, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations