China
Highlights Two key issues will remain important drivers of global financial markets in the coming quarters: the direction of the dollar and Chinese policy stimulus. Policy and growth divergences will remain tailwinds for the dollar and there is little the Trump Administration can do to reverse the upward trend. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon. Expect more EM fireworks. EM market turmoil could pause the Fed's tightening campaign, but this would require evidence that the U.S. economy and/or financial markets are being negatively affected. Chinese stimulus is a risk to our base-case outlook. A growth impulse might keep the RMB from weakening further, boost commodity prices and support EM exports. However, we believe that Chinese stimulus will not be a 'game changer', and might even cause more problems if the authorities push the RMB lower. The U.S. economy and financial system are less exposed to emerging markets than in the Eurozone. An excellent profit backdrop also provides U.S. risk assets with a strong tailwind. Nonetheless, the U.S. is not immune to EM woes. Poor valuation implies a meaningful correction in U.S. risk assets on any flight-to-quality event. Stay cautious on asset allocation. Fed Chair Powell is willing to wait for the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Evidence of labor market overheating is accumulating. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. We believe that investors are underestimating the upside in U.S. inflation risks over the medium term. We recommend below-benchmark duration, although government bonds would temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Japanese corporate profits have been stellar, but that will soon change. EPS growth is likely to soften in the Eurozone too. Favor the U.S. market in unhedged terms. Feature There are numerous key issues on the investment landscape, but two stand out at the moment because they both have wide-ranging global implications: (1) Will the U.S. dollar continue to appreciate; and (2) Will Chinese policymakers place structural reform on the back burner and 'go for growth' in the near term? The latest U.S. economic and profit data provide a strong tailwind for American risk assets. Nonetheless, the mighty U.S. dollar is casting a dark shadow over the heavily-indebted emerging market economies, sparking comparisons with the late 1990s. Could Turkey be the start of a 'domino' effect, similar to Thailand's plunge into financial crisis in 1997 that eventually spread to Brazil and Russia, and finally contributed to the demise of Long-Term Capital Management in the fall of 1998? On the global growth front, the story has not changed much from our assessment last month. Growth is solid, but slowing, in part due to a deceleration in developed-economy capital spending. The global expansion has become less synchronized and relative growth dynamics are pointing to more upside for the greenback (Chart I-1). Chart I-1Cyclical Divergence Is Still Dollar Bullish As in the late 1990s, the Fed is likely to ignore turbulence in EM financial markets and will continue on its tightening path until it begins to affect the U.S. economy or asset prices. The path of least resistance for the dollar is up until something breaks. A major policy impulse from China could alter the feedback loop between the strengthening dollar and EM asset prices. A growth pickup would lift China's imports and commodity prices, both of which would support emerging market economies and asset prices. There is plenty of uncertainty regarding the size of the recently-announced Chinese stimulus measures, but our take is that they are likely to underwhelm because a major growth push would undermine the authorities' structural initiatives. The implication is that the global backdrop will remain unfriendly to emerging market assets at a time when they are more vulnerable than the consensus believes. The risk of a financial accident is escalating. The good news is that the U.S. earnings picture remains excellent, which precludes us from being underweight on risk assets. Nonetheless, investors should have no more than a benchmark allocation to equities and corporate bonds in the major advanced economies. We are upgrading government bonds to neutral at the expense of cash on a tactical basis, to reflect the rising possibility of a global flight-to-quality. The First Domino Turkey has had all the hallmarks of a crisis for a long while. Erdogan's slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. The central bank has been forced to provide large injections of liquidity into the banking system, despite double-digit inflation readings. The country suffers from a classic "twin deficit" problem. Turkish private sector external debt stands at 40% of GDP, of which 13% of GDP is short-term, the highest among EM countries. Erdogan wants economic growth at all costs, but has done little in terms of the structural reforms necessary to lift the country's growth potential. The Lira has lost almost 26% of its value versus the dollar since August 1 and Turkish spreads have blown out. It appears that a lot of bad news has been discounted, but our EM strategists do not see this as a buying opportunity. One risk is that Erdogan imposes capital controls next. Our emerging market team's long held caution on EM is rooted in concern for failing fundamentals.1 They emphasize that Turkey was the catalyst, not the main cause, for the broader financial stress observed across EM assets in August. BCA has highlighted for some time that EM debt is a ticking time bomb. Chart I-2 shows that EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports. Chart I-3 highlights the most vulnerable EM economies in terms of the foreign currency funding requirement, and the foreign debt-servicing obligation relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart I-2Debt Makes EM Vulnerable Chart I-3EM Debt Exposure In all previous major EM selloffs, any decoupling between different EM regions proved to be unsustainable. And it certainly does not help that the Fed remains on its tightening path; EM equities usually fall when U.S. financial conditions tighten (Chart I-4). The combination of a strong dollar and weak RMB is a deadly combination for highly-indebted emerging market economies. Chart I-4EM Highly Sensitive To U.S. Financial Conditions... Investors should expect contagion to intensify. China To The Rescue? Some investors are hoping that China will 'save the day' by providing a major dose of policy stimulus, as it did in 2015, the last time that EM was close to a tipping point. We doubt China will be able to play the same stabilizing role. The Chinese authorities are committed to their long-term structural goals. They have been trying to reorient the economy toward consumption and away from investment and exports, as well as undertake other reforms to reduce financial risk, pollution, poverty and corruption. China kept policy on the tight side until recently, which resulted in a gradual growth slowdown. The Li Keqiang index (LKI) is a good coincident indicator for economic growth (Chart I-5). This index has ticked up in recent months, along with imports, but this likely reflects industrial activity designed to fill foreign orders before the new U.S. tariffs take effect. Our LKI model, based on money and credit, points to further economic weakness ahead. Chart I-5China: Watch Credit And Fiscal Impulse The escalation of the trade war with the U.S. is forcing the Chinese authorities to provide some short-term policy stimulus in order to pre-empt any resulting economic damage. A flurry of policy announcements over the past month has given investors the impression that Beijing has cranked up the policy dial, including cuts to short-term interest rates, a decrease in reserve requirements, liquidity provision to the banking system, and promises of various forms of fiscal stimulus. Chinese stimulus has historically been positive for commodity prices and EM assets. However, we are less sanguine this time. First, the authorities are not abandoning structural reforms, which means that the associated growth headwinds will not disappear. Second, our China experts believe that Chinese policy is only turning moderately reflationary; this is not the 'big bang' that followed the Great Recession in the late 2000s, or the same level of stimulus provided following the 2015-16 global manufacturing downturn. There will no doubt be some fiscal stimulus, but we do not expect a major expansion in bank credit to the private sector because of the government's crackdown on shadow banking, excessive leverage and growing non-performing loans. The change in the policy stance amounts to 'taking the foot off the brake' rather than pressing firmly on the accelerator.2 Third, and perhaps most importantly, the authorities may rely even more on the currency lever to do the heavy lifting if the economy continues to slow and/or the tariff war escalates further. This would be negative for commodity demand because a weaker RMB will make commodities dearer for Chinese producers. Metals prices are particularly at risk. China's competitors will also feel the sting of a cheaper RMB. It will be critical to watch the Chinese money and credit data in the coming months to gauge whether our view on the policy stimulus is correct. We will also be watching the combined credit and fiscal impulse which, at the moment, points to continued weakening in import growth in the near term (Chart I-5, bottom panel). Slower EM growth and/or more financial market turbulence is likely to take a larger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks (Chart I-6). Notably, Spanish banks - BBVA in particular - has sizable exposure to Turkey. Meanwhile, Italian assets have come under pressure as the rift between the European Commission and the new populist government widens and Italian banks become increasingly wary of financing their government. Chart I-6DM Bank Exposure To EM European growth will therefore likely continue to trail that of the U.S. Our base case does not see euro area growth falling below a trend pace in the coming quarters, but relative growth momentum and the ongoing policy divergence will favor the dollar over the euro. FOMC: No Urgency The key message from the latest FOMC Minutes and Chairman Powell's Jackson Hole speech is that policymakers are sticking with the "gradual" approach to tightening, despite the late-cycle acceleration in economic growth. The blowout second-quarter GDP report supports the view that fiscal stimulus is stoking the economy at a time when there is little slack. Evidence that the labor market is overheating is not simply anecdotal anymore. In past cycles, an acceleration in growth at a time when inflation is already at target and unemployment is below estimates of full employment would have sparked aggressive Fed action. But the Minutes and Powell's speech revealed no sense of urgency. Powell made the case that the Fed must proceed carefully in an environment where there is much uncertainty about the level of the neutral policy rate, the natural rate of unemployment and the slope of the Phillips curve. Moreover, long-term inflation expectations are still hovering below a level that is consistent with meeting the 2% target over the medium term. Some FOMC policymakers believe that this fact justifies taking chances with an inflation overshoot in the coming quarters. Another reason for the FOMC to proceed cautiously is the wage picture, which is confusing even to economic experts because the official measures paint a mixed picture (Chart I-7). The Employment Cost Index for private sector workers continues to march higher. However, growth in compensation per hour, average hourly earnings (AHE) and unit labor costs have all eased a little this year. The Atlanta Fed Wage Tracker, one of the cleanest measures of wages, reveals an even more significant pullback. The softening in wage growth has been fairly widespread across age cohorts, educational attainment and regions, according to the Atlanta Fed data (Chart I-8). Part-time workers appear to be the only segment that has bucked the trend. It is not clear why workers in the 16-24 age group, as well as those with bachelor's degrees (of any age), have seen the most pronounced softening in wage growth this year. Chart I-7Mixed U.S. Wage Data Chart I-8U.S. Wage Slowdown Broadly-Based Which measure is telling the correct story: the ECI or the Atlanta Wage Tracker? Both are a relatively clean measure of wages and it is difficult to tell based on the relative merits of each index alone. Nonetheless, there is little doubt that the labor market is now very tight by historical standards. Small business owners' compensation plans remained near record levels in July, while concerns about the "quality of labor" have never been higher (Chart I-9). Chart I-10 shows that the ratio of the level of job openings to unemployed workers has surpassed the pre-recession level in all but one sector according to the Jolts survey. Indeed, in most cases this ratio is well above the previous peak. Unemployment is now below the estimated level of full-employment in more than 80% of U.S. states. Chart I-9U.S. Labor Shortage Is Growing Chart I-10JOLTS Signals Very Tight Jobs Market No Evidence Of U.S. Overheating? Labor shortages first appeared for skilled workers, helping to explain why highly-skilled workers have enjoyed the fastest wage gains in recent years. But this year's Fed Beige Books have noted that many businesses are now having trouble finding low- and middle-skilled workers, as listed in Table I-1. These industries roughly line up with the ones that reveal above-average growth in average hourly earnings, and with the ones where labor market tightness is the most acute according to the Jolts survey (second and third columns in the table). The shortages appear to be broadly based, ranging from truck transportation to financial services, manufacturing and construction. This makes it all the more curious that Chairman Powell finds that there is no evidence of overheating in the labor market. The evidence seems pretty conclusive to us and it even features in the Fed's own Beige Book. Keep in mind that inflation is not always the 'cost push' type, beginning in the labor market and traveling to consumer prices. Sometimes inflation can begin in the market for goods and services, and then affect wage demands. U.S. consumer price inflation appears to be headed higher based on the New York Fed's Underlying Inflation Gauge (Chart I-11). Our CPI diffusion index shows that inflation is accelerating in a majority of categories. Other measures of underlying inflation, such as the Sticky Price Index, the Trimmed Mean, and the Median inflation rate are all in a solid uptrend. Dollar strength this year will eventually put downward pressure on core goods inflation, but that will take some time; non-energy goods inflation is more likely to rise in the near term as it catches up to the previous acceleration in imported goods prices (Chart I-11, bottom panel). Table I-1Labor 'Shortages' Identified In The Beige Book Chart I-11U.S. Underlying Inflation Is Rising U.S. Inflation To Surprise On Upside We believe that the market is underestimating the risk of a meaningful inflation overshoot over the medium term. Investors still do not believe that the Fed will be able to consistently meet the 2% target over the long-term, based on CPI swaps and TIPS breakeven rates. BCA's Chief Global Strategist, Peter Berezin, penned a two-part Special Report in August on the potential for upside inflation surprises over the coming years.3 First, increasing political pressure on the major central banks is worrying. Second, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. This was a mistake last made in the inflationary 1970s. Finally, the pressure to keep monetary policy accommodative until the "whites of the eyes" of inflation are visible will remain strong. Bonds are in for some trouble if we are correct on the inflation outlook. We recommend that investors with a 6-12 month investor horizon remain short in duration and overweight TIPS versus conventional Treasurys. That said, we cannot rule out a flight-to-quality episode at some point, possibly reflecting trade tensions and/or EM turmoil, which would send Treasury yields temporarily lower. The Fed may be forced to place rate hikes on hold if financial conditions tighten too quickly. No Margin Peak Yet In The U.S.... The S&P 500 was unfazed by the turmoil in emerging markets and the re-widening in Italian bond spreads in August, likely because of continuing good news on the profit front. Corporate earnings remained in a sweet spot in the second quarter. Nominal GDP grew by a whopping 5.4% from a year ago, helping to boost the top line for the corporate sector. The lagged effect of previous dollar depreciation is still flattering earnings, although this only accounts for about two percentage points according to our model (Chart I-12). Meanwhile, equity buybacks have kicked into overdrive (Chart I-13). Chart I-12U.S. Dollar Impact On EPS Growth Chart I-13U.S. Equity Buyback In Overdrive Margins continued their impressive ascent in the second quarter to well above the pre-Lehman peak (Chart I-14). A lot of the increase is related to the tax cuts; EBITDA margins are still substantially below the 2007 peak according to the S&P data. It is disconcerting that all of the surge in S&P 500 margins is due to the Tech sector (Chart I-14, bottom panel). Excluding Tech, S&P after-tax margins have simply moved sideways since 2010. Looking ahead, the tailwind from previous dollar depreciation will shift to a headwind by mid-2019. Chart I-12 shows that the contribution from changes in the dollar to EPS growth will shift from a positive two percentage points to a drag of 1½ percentage points if the dollar is flat from today's level in broad trade-weighted terms. If the dollar rises by another 5% this year, then next year's drag on EPS growth will reach three percentage points. Moreover, the impact of the tax cuts on after-tax profits will fade next year. Wage pressures are building and this should eventually squeeze profit margins. That said, a margin peak does not appear to be imminent. Last month we introduced some macro indicators for profit margins (Chart I-15). Most appeared to be rolling over a month ago, but they have all since ticked up. Chart I-14Tech And Taxes Driving Profit Margins Chart I-15U.S. Margin Indicators Have Turned Up The bottom line is that we continue to expect a mean reversion in U.S. profit margins in the coming years, but this is not a risk for at least the rest of 2018. ...But Profit Outlook Darkening In Japan Second quarter earnings season was also a good one for Japanese companies. Twelve-month forward earnings estimates have been in a steep incline and margins have been rising (Chart I-16). Despite this, the Nikkei has only managed to move sideways this year in local currency terms. Concerns over trade and global growth have perhaps weighed on Japanese stock performance. Company profits have a high beta with respect to global growth. Things are looking shaky on the domestic front too. Domestic demand growth is decelerating, consistent with a weakening Economy Watcher's Survey. Some of the weakness may be related to poor weather, but the LEI suggests that this trend will continue in the coming quarters (Chart I-17, bottom panel). Chart I-16Japan: Trailing Earnings Are Solid... Chart I-17...But Profit Margins Will Narrow Chart I-17 presents some of the variables that have helped to explain historical trends in Japanese EPS. Industrial production growth, a good proxy for top line growth, is decelerating. Nominal GDP growth has fallen to just 1.1% year-over-year, at a time when total labor compensation has surged by more than 4%. The difference between these two, a proxy for profit margins, has therefore plunged. Previous shifts in the yen have not had a large impact on EPS growth over the past year and we do not expect that to change much in 2019. On a positive note, Japanese stocks are attractively valued now that the 12-month forward P/E ratio has fallen below 13 (Chart I-16, bottom panel). It is also constructive that the Bank of Japan is the only central bank that is not backing away from monetary stimulus. The recent widening of the trading band for the 10-year JGB yield was a technical change meant to give the central bank more flexibility, not a signal that policymakers are planning to change tack. Nonetheless, we believe that earnings growth and margins will disappoint market expectations over the next year. The story is much the same for the Eurozone. Both trailing and forward profit margins have been in a strong uptrend. Twelve-month forward EPS growth has been holding at a solid 9%. Nonetheless, the data that feed into our Eurozone profit model point to some softening ahead, including industrial production and the difference between nominal GDP and the aggregate wage bill (not shown). The Eurozone's credit impulse turned negative even before concerns about EM and Italian politics exploded onto the scene. Thus, home-grown profit generation is likely to moderate along with foreign-sourced earnings. For the moment, the BCA House View remains at benchmark on Japanese and Eurozone stocks in currency-hedged terms. In unhedged terms, we prefer the U.S. market to these other bourses because of our bullish dollar bias. Investment Conclusions: Two key issues will remain important drivers of global financial markets in the coming months and quarters: the direction of the dollar and Chinese policy stimulus. We believe that the U.S. dollar has additional upside potential due to growth and policy divergences. There is some speculation in the financial community that President Trump might resort to currency intervention. However, any intervention would be sterilized by the Fed. The only way to shift currencies on a sustained basis would be to organize a coordinated change in monetary or fiscal policies among the U.S. and its main trading partners. This is highly unlikely. Thus, the path of least resistance is up for the U.S. dollar. Dollar strength is exposing poor macro fundamentals in many emerging market economies. The problems facing EM economies run deep, and will not disappear anytime soon because high debt levels make these economies vulnerable to any weakness in global growth, commodity prices or global liquidity conditions. EM financial market turmoil could cause the Fed tightening campaign to go on hold, but this would require evidence that the former is negatively affecting the U.S. economy and/or financial markets. In other words, we need to see some pain before the Fed blinks. Chinese stimulus is a risk to our base-case EM outlook. Policy stimulus might keep the RMB from weakening further, boost commodity prices and support EM exports. This would not change the EM debt situation, but would at least give emerging economies a temporary reprieve. Careful analysis suggests that Chinese stimulus will not be a 'game changer', and might even cause problems if the authorities push the RMB lower. But it will be critical to monitor the next couple of money and credit reports. The U.S. economy and financial system are less exposed to further EM turmoil than in the Eurozone. But as the LTCM event demonstrated in 1998, the U.S. is not immune. Moreover, U.S. equity prices are more expensive than they were during previous EM selloffs that have occurred since the Great Recession. This could mean a larger equity re-rating on any flight-to-quality. This is not to say that we expect a bear market in DM risk assets to get underway in the near future. A U.S./global recession before 2020 is unlikely. Nonetheless, the risk of a meaningful correction is elevated enough that caution is warranted, especially at a time when all risk assets appear expensive. Chart I-18 updates our valuation measures for some major asset classes. All appear to be expensive, especially U.S. equities, raw materials and gold. EM sovereigns and equities are at the cheaper end of the spectrum, but are still not cheap in absolute terms even after the recent selloff. Chart I-18Major Asset Valuation Comparison Treasurys rallied briefly after Chairman Powell signaled that he is not willing to accelerate the pace of rate hikes in light of the U.S. economy's growth acceleration. He is willing to wait until he sees the "whites of the eyes" of inflation before becoming alarmed, almost ensuring that the FOMC will fall behind the inflation curve. Bond yields will rise as the FOMC tries to catch up and long-term inflation expectations bounce. Over the medium term, we believe that investors are underestimating the upside in U.S. inflation risks. We recommend below-benchmark duration, although bonds may temporarily rally if EM turbulence sparks a flight-to-quality. We still expect the supply/demand balance in the world oil market to tighten later this year. Stay positioned for higher oil prices. Finally, as we go to press, the U.S. is trying to force Canada to sign on to the U.S./Mexico 'agreement in principal' by August 31. A framework deal with Canada would likely leave many tough issues unresolved. There is also a chance that Canada misses the deadline and that the existing trilateral deal will not survive. It is technically possible that Canada's refusal to join the U.S.-Mexico bilateral deal will delay its ratification well into next year. In the meantime, Trump could raise the stakes for Canada by boosting tariffs on Canadian autos and/or by suspending NAFTA altogether. As a result, we decided to go ahead and publish our Special Report on U.S. equity sector implications if NAFTA is not ratified and tariffs rise to WTO levels. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst August 30, 2018 Next Report: September 27, 2018 1 Please see BCA Emerging Market Strategy Weekly Report "What's Really Driving The EM Selloff?"dated June 28, 2018, available on ems.bcaresearch.com 2 Please see BCA China Investment Strategy Weekly Report "China is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available on cis.bcaresearch.com 3 Please see BCA Global Investment Strategy Special Reports: "1970s-Style Inflation: Could It Happen Again? Parts I and II," dated August 10 and 24, 2018, available on gis.bcaresearch.com II. What If NAFTA Is Not A Done Deal? U.S. Equity Implications This Special Report examines the impact of a NAFTA cancelation on 21 level-three GICs industries. While the latest news on the NAFTA renegotiation with Mexico is positive as we go to press, there is still a non-negligible risk that the existing trilateral deal will not survive. The U.S.-Mexico bilateral deal is an "agreement in principle" and will take time to ratify. Meanwhile, a framework deal with Canada would leave many thorny issues to be resolved. President Trump can still revert to his tough tactics on Canada ahead of the U.S. mid-term elections. If the President does not gain major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base. The probability of Trump triggering Article 2205 and threatening to walk away from the suspended U.S.-Canada free trade agreement is still not trivial, despite the deal with Mexico. By itself, the cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved (especially Autos). We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and input cost exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. While the latest news on the renegotiation of the North American Free Trade Agreement (NAFTA) is positive as we go to press, there is still a non-negligible risk that President Trump could revert to his tough tactics ahead of the U.S. mid-term elections.1 Even if Canada signs on to a framework deal, a lot of thorny details will have to be worked out. A presidential proclamation triggering Article 2205 of the NAFTA agreement (as opposed to tweeting that the U.S. will withdraw) would initiate a six-month "exit" period. Trump could use this deadline, and the threat of canceling the underlying U.S.-Canada FTA, to put pressure on Canada (if not Mexico) to concede to U.S. demands, just as he could revoke his exit announcement anytime within the six-month period. While some market volatility would ensue upon any exit announcement, even a total withdrawal at the end of the six months would have a limited macro-economic impact as long as the U.S. continued to respect its WTO commitments and lifted tariffs only to Most Favored Nation (MFN) levels. Nonetheless, a modest tariff hike is not assured given the Administration's "America First" policy, its looming threat of Section 232 tariffs on auto imports, its warnings against the WTO itself, and the steep tariffs it has already imposed on Canada, including a 20% tariff on softwood lumber and the 300% tariff on Bombardier CSeries jets. Moreover, even a small rise in tariffs to MFN levels would have a significant negative impact on industries that are heavily integrated across borders. Our first report on the evolving U.S. trade situation analyzed the implications of the U.S.-China trade war for the 24 level two U.S. GICs equity sectors. This Special Report examines the impact of a NAFTA cancelation on 21 level three GICs industries (finer detail is required since NAFTA covers mostly goods industries). We find that there are no "winners" among the U.S. equity sectors because the negative impact would outweigh any positive effects. The hardest hit U.S. industries would be Autos, Metals & Mining, Food Products, Beverages, and Textiles and Apparel, but many others are heavily exposed to a failure of the free trade agreement. Out Of Time President Trump is seeking a new NAFTA deal ahead of the U.S. midterms in November. While this timing may yet prove too ambitious, the U.S. has made progress in recent bilateral negotiations with Mexico, raising the potential that Trump will be able to tout a new NAFTA framework deal by November 6. Yet, investors should be prepared for additional volatility. There are technical issues with the bilateral U.S.-Mexico deal that could delay ratification in Congress until mid-2019. The new Mexican Congress must ratify the deal by December 1 if outgoing President Enrique Peña Nieto is to sign off. Otherwise, the incoming Mexican President Andrés Manuel López Obrador may still want to revise any deal he signs, prolonging the process. Meanwhile, it would be surprising if the Canadians signed onto a U.S.-Mexico deal they had no part in negotiating without insisting on any adjustments.2 The important point is that President Trump's economic and legal constraints on withdrawing from NAFTA have fallen even further with the Mexican deal. If Trump does not get major concessions that can be presented as "victories" to voters, he is likely to take an aggressive stand in order to fire up his political base, as a gray area of "continuing talks" will not inspire voters. This could mean imposing the threatened auto tariffs or threatening to cancel the existing trade agreements with Canada. Thus, the risk of Trump triggering Article 2205 is still not trivial. A bilateral Mexican trade deal is not the same as NAFTA. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act. Some provisions of NAFTA under this act may continue, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. The potential saving grace for trade with Canada was that the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989, was incorporated into NAFTA. The U.S. and Canada agreed to suspend CUSFTA's operation when NAFTA was created, but the suspension only lasts as long as NAFTA is in effect. However, Trump may walk away from both CUSFTA and NAFTA in the same proclamation. In that event, WTO rules for preferential trade would require the U.S. and Canada to raise tariffs on trade with each other to Most Favored Nation (MFN) levels. These tariff levels are shown in Charts II-1A and II-1B. The Charts also show the maximum tariff that could potentially be applied under WTO rules. The latter are much higher than the MFN levels, underscoring that the situation could get really ugly if a full trade war scenario somehow still emerged among these three trading partners. Chart II-1AU.S.: MFN Tariff Rates By GICS Industry (2017) Chart II-1BMexico & Canada: MFN Tariff Rates By GICS Industry (2017) Current tariffs are set at zero for virtually all of these GICs industries, which means that the MFN levels also indicate how much tariffs will rise at a minimum if NAFTA is cancelled. Tariffs would rise the most for Automobiles, Textiles & Apparel, and Food Products (especially agricultural products), and Beverages. U.S. tariffs under the WTO are not significantly higher than NAFTA's rates; the average MFN tariff in 2016 was 3½%, which compares to 4.1% for the average Canadian MFN tariff. Would MFN Tariffs Be Painful? An increase in tariff rates of 3-4 percentage points may seem like small potatoes. Nonetheless, even this could have an outsized impact on some industries because tariffs are levied on trade flows, not on production. A substantial amount of trade today is in intermediate goods due to well-integrated supply chains. Charts II-2A and II-2B present a measure of integration. Exports and imports are quite large relative to total production in some industries. The most integrated U.S. GICs sectors include Automobiles & Components, Materials, Capital Goods and Electrical & Optical Equipment. Higher tariffs would slam those intermediate goods that cross the border multiple times at different stages of production. For example, studies of particular automobile models have found that "parts and components may cross the NAFTA countries' borders as many as eight times before being installed in a final assembly in one of the three partner countries."3 Tariffs would apply each time these parts cross the border if NAFTA fails. Chart II-2AU.S./Canada Supply Chain Integration Chart II-2BU.S./Mexico Supply Chain Integration Appendix Tables II-1 to II-4 show bilateral trade by product between the U.S. and Canada, and the U.S. and Mexico. In 2017, the U.S. imported almost $300b in goods from Canada, and exported $282b to that country, resulting in a small U.S. bilateral trade deficit. The bilateral deficit with Mexico is larger, with $314b in U.S. imports and $243b in exports. The largest trade categories include motor vehicles, machinery, and petroleum products. Telecom equipment and food products also rank highly. As mentioned above, the impact of rising tariffs is outsized to the extent that a substantial portion of trade in North America is in intermediate goods. Box II-1 reviews the five main channels through which rising tariffs can affect U.S. industry. Box II-1 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: (1) The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of import tariffs via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines). NAFTA also eliminated many non-tariff barriers, especially in service industries. Cancelling the agreement could thus see a return of these barriers to trade; (2) Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs. There would also be a loss of economies-of-scale and comparative advantage to the extent that firms are no longer able to use an "optimal" supply network that crosses borders, further raising the cost of doing business; (3) Foreign Direct Investment: Some U.S. imports emanate from U.S. multinationals' subsidiaries outside the U.S., or by foreign OEM suppliers for U.S. firms. NAFTA eliminated many national barriers to FDI, expanded basic protections for companies' FDI in other member nations, and established a dispute-settlement procedure. The Canadian and Mexican authorities could make life more difficult for those U.S. firms that have undertaken significant FDI in retaliation for NAFTA's cancellation; (4) Macro Effect: The end of NAFTA, especially if it were to lead to a trade war that results in tariffs in excess of the MFN levels, would take a toll on North American trade and reduce GDP growth across the three countries. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. The macro effect would probably not be large to the extent that tariffs only rise to MFN levels; (5) Currency Effect: To the extent that a trade war pushes up the dollar relative to the Canadian dollar and Mexican peso, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given that tariffs would rise for all three countries. Chart II-3 is a scatter chart of GICs industries that compares the average MFN tariff on U.S. imports to the average MFN tariff on Canadian and Mexican imports from the U.S. A U.S. industry may benefit if it garners significant import protection but does not face a higher tariff on its exports to the other two countries. Unfortunately, there are no industries that fall into the north-west portion of the chart. The opposite corner, signifying low import protection but high tariffs on exports, includes Beverages, Household Durables, Household Products, Personal Products and Machinery. Chart II-3Import And Export Tariffs Faced By U.S. GICS Industries Model-Based Approach The C.D. Howe Institute has employed a general equilibrium model to estimate the impact of a NAFTA failure at the industrial level.4 The model is able to capture the impact on trade conducted through foreign affiliates. The study captures the direct implications of higher tariffs, but also includes a negative shock to business investment that would stem from heightened uncertainty about the future of market access for cross-border trade. It also takes into consideration non-tariff barriers affecting services. Table II-1Impact Of NAFTA Cancellation By Industry As with most studies of this type, the Howe report finds that the level of GDP falls by a relatively small amount relative to the baseline in all three countries - i.e. there are no winners if NAFTA goes down. Moreover, the U.S. is not even able to reduce its external deficit. While the trade barriers trim U.S. imports from NAFTA parties by $60b, exports to Canada and Mexico fall by $62b. At the industry level, the model sums the impacts of the NAFTA shock on imports, exports and domestic market share to arrive at the estimated change in total shipments (Table II-1). It is possible that an industry will enjoy a boost to total shipments if a larger domestic market share outweighs the damage to exports. However, the vast majority of U.S. industries would suffer a decline in total shipments according to this study, because the estimated gain in domestic market share is simply not large enough. Beef, Pork & Poultry and Dairy would see a 1-2% drop in total shipments relative to the baseline forecast. Next on the list are textiles & apparel, food products and automotive products. Even some service industries suffer a small decline in business, due to indirect income effects. Foreign-Sourced Revenue And Input Cost Approach Another way to approach this issue is to identify the U.S. industries that garner the largest proportion of total revenues from Mexico and Canada. Unfortunately, few companies provide much country detail on where their foreign revenues are derived. Many simply split U.S. and non-U.S. revenues, or North American and non-North American revenues. Table II-2 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the industry by market cap (in some cases the proportion that is generated outside of North America was used as a proxy for foreign- sourced revenues). While this approach is not perfect, it does provide a good indication of how exposed a U.S. industry is to Canada and Mexico. This is because any company that has "gone global" will very likely be doing substantial business in these two countries. Table II-2Foreign Revenue Exposure At the top of the list are the Metals & Mining, Personal Products, and Auto Component industries. Between 62% and 81% of revenues in these three industries is derived from foreign sources. Following that is Household Durables, Leisure Products, Chemicals and Tobacco. Indeed, all of the level three GICs industries we are analyzing are moderately-to-highly globally-oriented, with the sole exception of Construction Materials. Table II-3Import Tariff Exposure U.S. companies are also exposed to U.S. tariffs that boost the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A then sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that would be affected by a rise in tariffs to MFN levels. We then allocated the industries contained in the input/output tables to the 21 GICs level 3 industries we are considering, in order to obtain an import exposure ranking in S&P industry space (Table II-3). All 21 industries are significantly vulnerable to rising input costs, which is not surprising given that we are focusing on the manufacturing-based GICs industries and NAFTA focused on trade in goods. The vast majority of the industries could face a cost increase on 50% or more of their intermediate inputs to the production process. The Automobile industry is at the top of the list, with 72% of its intermediate inputs potentially affected by the shift up in tariffs (Automobile Components is down the list, at 56%). Containers & Packaging, Oil & Gas, Aerospace & Defense, Textiles and Food Products are also highly exposed to tariff increases. The automobile industry is a special case because of the safeguards built into NAFTA regarding rules-of-origin and the associated tracing list. The U.S. is seeking significant changes in both in order to tilt the playing field toward U.S. production, but this could severely undermine the intricate supply chain linking the three countries. Box II-2 provides more details. Box II-2 Automotive Production In NAFTA; Update Required We are focused on two key aspects to the renegotiation of the NAFTA rules that could have far reaching implications for automakers and the auto component maker supply base: the tracing list and country of origin rules. Regarding the first of these, the Trump administration has a legitimate gripe when it comes to automotive production. A tracing list was written in the early-1990's to define automotive components such that the rules of origin (ROO) could be easily met; anything not on the list is deemed originating in North America. As anyone who has driven a vehicle of early-1990's vintage and one of late-2010's vintage can attest, high tech components (largely not included on the tracing list) have grown exponentially as a percentage of the cost of the vehicle and, at least with respect to electronic and display components, are sourced mostly from overseas. Updating the tracing list would force auto makers to source a significantly greater amount of components domestically, almost certainly raising the cost of the vehicle and either hurting margins or hurting competitiveness through higher prices. The current NAFTA ROO require that 62.5% of the content of a vehicle must be sourced in North America, with no distinction between any of the member nations. The result of this legislation has been the creation of a highly integrated supply base that sees components move back and forth across borders through each stage of the manufacturing process. Early proposals from the Trump administration for a NAFTA rework included a country of origin provision for as much as 50% U.S. content. Such a provision would certainly cause a massive disruption in the automotive supply chain with components manufacturers forced to relocate or automakers electing to source overseas and pay the 2.5% MFN tariff on exports within North America. Either scenario presents a headwind to the tightly woven auto components base, underscoring BCA's U.S. Equity Strategy's underweight recommendation on the sector. The recently announced bilateral trade deal with Mexico raises the ROO content requirements to 75% from the 62.5% contemplated under NAFTA but, importantly, no country of origin provisions appear in the new deal. Still, given how quickly this is evolving, a final NAFTA deal could be significantly different. Chart II-4 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries in the north-east corner of the diagram are the most exposed to NAFTA failure. The problem is that there are so many in this region that it is difficult to choose the top two or three, although Metals & Mining stands out from the rest. It is easier to identify the industries that face less risk in relative terms: Pharmaceuticals, Construction Materials, Health Care & Supplies, Leisure Products and, perhaps, Machinery. The rest rank highly in terms of both foreign revenue exposure and import tariff exposure. Chart II-4Foreign Revenue And Import Tariff Exposure Conclusions: By itself, a total cancelation of NAFTA would not be devastating for any particular U.S. industry because the size of the tariff increases would be fairly small as long as all parties stick with MFN tariff levels. That said, the impact would not be trivial, especially for those industries that have extensive supply lines that run between the three countries involved. The negative impact on GDP growth would likely be worse for Canada (and Mexico if its bilateral somehow fell through), but U.S. exporters would see some loss of business. We approached the issue from four different perspectives; international supply chains, a model-based approach, and an analysis of foreign revenue exposure and import tariff exposure. The broad conclusion is that there are no winners from a NAFTA cancelation for the U.S. manufacturing GICs industries. Pharmaceuticals, Health Care Equipment & Supplies, Personal Products and Construction Materials are lower on the risk scale, but cannot be considered beneficiaries of a NAFTA collapse. The remaining industries are all moderately-to-highly exposed. Considering the four perspectives as a group, the most vulnerable industries are Automobiles, Automobile Components, Metals & Mining, Food Products, Beverages, and Textiles & Apparel. Our U.S. equity sector specialists recommend overweight positions in Defense and Financials; while neither stands to benefit from a NAFTA abrogation, they should at least be relative outperformers. They recommend underweight positions on Auto Components, Steel and Electrical Components & Equipment as relative (and probably absolute) underperformers should NAFTA disappear. As we go to press, rapid developments are taking place in the NAFTA negotiations. The U.S. and Mexico have completed a bilateral agreement in principle and a Canadian team is looking into whether to sign onto the agreement by a U.S.-imposed August 31 deadline. This deadline would enable the current U.S. Congress to proceed to ratification before turning over its seats in January, though it is not a hard deadline. It is possible that the negotiations will conclude this week and the crisis will be averted. But the lack of constraints on President Trump's trade authority gives reason for pause. If Canada demurs, Trump could move to raise the cost through auto tariffs or announcements that he intends to withdraw from existing U.S.-Canada agreements in advance of November 6. While Mexico has now tentatively secured bilaterals with both countries through the new U.S. deal and the Trans-Pacific Partnership (which includes Canada), it still stands to suffer if a trilateral agreement is not in place. Moreover it is technically possible that Canada's refusal to join the U.S.-Mexico bilateral could delay the latter's ratification well into next year. Therefore, we treat Mexico the same as Canada in our analysis, despite the fact that Mexican assets stand to benefit in relative terms from having a floor put under them by the Trump Administration's more constructive posture and this week's framework deal. If Trump does not pursue a hard line with Canada, then it will be an important sign that he is adjusting his trade policy to contain the degree of confrontation with the developed nations and allies and instead focus squarely on China, where we expect trade risks to increase in the coming months. Mark McClellan Senior Vice President The Bank Credit Analyst Matt Gertken Associate Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy APPENDIX TABLE II-1 U.S. Imports From Canada (2017) APPENDIX TABLE II-2 U.S. Exports To Canada (2017) APPENDIX TABLE II-3 U.S. Imports From Mexico (2017) APPENDIX TABLE II-4 U.S. Exports To Mexico (2017) 1 Please see BCA Geopolitical Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28, 2018, and Weekly Report, "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com 2 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com 3 Working Together: Economic Ties Between the United States and Mexico. Christopher E. Wilson, November 2011. 4 The NAFTA Renegotiation: What if the U.S. Walks Away? The C.D. Howe Institute Working Paper. November 2017. III. Indicators And Reference Charts Our equity indicators continue to signal that caution is warranted, but U.S. profits have been so strong recently as to dominate any negative market forces. Our Monetary Indicator is hovering at a low level by historical standards, suggesting that liquidity conditions have tightened. It is constructive that our Composite Technical Indicator has hooked up, narrowly avoiding a technical break below the zero line. It is also positive that our Composite Sentiment Indicator is rising, but not yet to a level that would signal trouble for stocks from a contrary perspective. However, our U.S. Willingness-to-Pay (WTP) indicator continues to erode, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Moreover, our Revealed Preference Indicator (RPI) for stocks remained on a 'sell' signal in August. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. Our indicators thus suggest that the underlying health of the U.S. equity bull market is fraying at the edges. Nonetheless, robust U.S. profits figures have sparked a euphoric late-cycle blow-off phase. The net revisions ratio is still in positive territory, and the net earnings surprises index has surged to an all-time high. Not much has changed on the U.S. Treasury front. The 10-year bond is slightly on the cheap side according to our model, and oversold conditions have not yet been worked off. This month's Overview section discusses the potential for upside inflation surprises in the U.S. that will place the FOMC "behind the curve". The term premium and long-term inflation expectations are still too low. This year's dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but economic and policy divergences vis-à-vis the U.S. and the other major economies suggests that the dollar is likely to continue moving higher in the near term. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst
Highlights The indicators that led the EM selloff continue to point to more downside. Meanwhile, broader EM valuation and positioning indicators have not yet bombed out to warrant bottom fishing. In China, policymakers are not yet embracing stimulus of the same magnitude as in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Feature Calling market bottoms and tops is an art -not a science - as there is no formula that works at all times, in all markets. The fundamental case for EM/China remains negative, as credit excesses of previous years have not been unwound, and commodities prices remain at risk. However, to avoid being part of a herd and to maintain investment discipline, it is vital to re-visit market indicators from time to time. In this week's report, we explore directional market indicators and valuations, and offer some thoughts on investor sentiment and positioning in EM. Putting all of these together with our fundamental analysis, we still see meaningful downside in EM risk assets, and continue recommending a defensive strategy. A Review Of Indicators The indicators that led this EM selloff continue to point to additional downside. Meanwhile, valuation and positioning indicators have not yet bombed out. Chart I-1 illustrates that EM corporate U.S. dollar bond yields continue to rise (shown inverted on the chart), entailing lower EM share prices. The message is the same whether we consider EM high-yield or investment-grade corporate or EM sovereign U.S. dollar bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise We have repeatedly highlighted1 that EM share prices correlate with EM borrowing costs rather than risk-free rates. So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under selling pressure. Chart I-2 illustrates that a similar relationship exists between China's onshore AA- corporate bond yields and A share prices. AA- corporate bond yields have not yet dropped, and, thereby, they still point to lower share prices ahead. Even though risk-free and interbank rates have plummeted on the mainland, corporate borrowing costs have not. If the Chinese authorities do indeed eradicate the perception of implicit government guarantees for the majority of corporate borrowers - one of the most important items on the government's structural reforms agenda - the odds are that corporate bond yields will rise further to price in higher risk of defaults. This would be a bad omen for corporate borrowing costs, capital spending and share prices. Our risky to safe-haven currency ratio is making new lows. Given it has historically been highly correlated with EM stocks, odds are that EM share prices will continue to drop (Chart I-3). Chart I-2China: On-Shore Corporate Bond (AA-) ##br##Yields And A-Share Market Chart I-3Risky To Safe-Haven Currencies ##br##Ratio And EM Stocks Notably, this ratio is also agnostic to the dollar's direction - it swings between risk-on versus risk-off regimes in financial markets, regardless of the greenback's general trend. Hence, it addresses the question of the direction of EM equity prices, irrespective of the dollar's trajectory. Industrial metals prices correlate with EM corporate earnings growth as demonstrated in Chart I-4. The basis is that both are affected by global growth. Presently, falling metals prices are signaling further deceleration in EM non-financials corporate EBITDA growth. We want to emphasize again that the EM selloff this year has primarily been due to the growth slowdown in EM/China rather than higher U.S. bond yields. If anything, the opposite has been occurring: the EM turmoil and growth slowdown have capped U.S. bond yields since April. Moreover, the currency selloff in EM ex-China has led to rising local currency interest rates in many developing economies. Looking forward, higher local rates entail a capital spending slump, which will weigh on EM and global growth. EM risk assets are highly sensitive to global trade growth. The poor performance of global cyclical equity sectors corroborates weakening world trade. In particular, global mining, steel, chemicals, industrials and semiconductor stocks have all broken below their 200-day moving averages (Chart I-5). Chart I-4More Deceleration In EM Corporate Profits Chart I-5Global Equities: Cyclical Sectors Have Broken Down EM equity valuations are currently roughly neutral, down from being one standard deviation above fair value in January (Chart I-6). Hence, EM stocks are not expensive, but they are not cheap either. When equity valuations are neutral rather than at extremes, the market can either rally or sell off. In brief, when equity valuations are not at extremes, the direction of share prices is contingent on the profit cycle. The outlook for EM corporate earnings at the moment is downbeat (as shown in Chart I-4 on page 3), presaging a market selloff. With respect to high-yielding EM currencies, Chart I-7 demonstrates that the aggregate real effective exchange rate for EM ex-China, Korea and Taiwan has dropped quite a bit, but still stands above its historical lows. Chart I-6EM Stocks Are Not Cheap Chart I-7EM Currencies Are Only Moderately Cheap Regarding credit market valuations, EM corporate credit spreads are still below their post-2009 mean (Chart I-8, top panels). EM sovereign spreads are above their post-2009 mean, but this is due to crisis-stricken outliers. Some pockets of EM, such as Argentina or Turkey,2 might be undervalued for a reason. However, sovereign spreads for EM ex-Venezuela, Argentina and Turkey are still at their post-2009 mean (Chart I-8, bottom panel). On the whole, EM market valuations have improved, but EM assets are not yet cheap to warrant bottom-fishing. Finally, investor sentiment towards EM is no longer wildly bullish as it was last year, but our sense is that the average investor believes this EM selloff will not develop into an extended major bear market. Consistent with this, investors may have hedged some of their bets, or are reducing their exposure, but they have not capitulated or gone bearish/underweight on EM assets. For example, Chart I-9 illustrates that leveraged investors - who have little tolerance for volatility - have substantially reduced their net long positions in EM ETF equity futures, yet asset managers are still very long. Chart I-8EM Credit Spreads Do Not Yet Offer Value Chart I-9EM Stock Futures: Leveraged Funds Have Sold, ##br##But Asset Managers Have Not Besides, investor sentiment on copper - a proxy for EM - is not yet depressed (Chart I-10). As can be seen on this chart, EM share prices bottom when the net bullish sentiment on copper typically drops close to 25%. That is not the case at the moment. Chart I-10Bullish Sentiment On Copper And EM Share Prices Bottom Line: Investors should stay put on EM and underweight EM assets relative to their DM counterparts in general, and the U.S. in particular. China: Juggling Contradictory Objectives China's central bank has substantially eased liquidity in the banking system, as evidenced by the 200-basis-point plunge in interbank rates. In addition, the authorities have instructed local governments to accelerate issuance of the remaining quota of their bonds. What's more, the banking regulator has urged banks to lend more to infrastructure development and to the export sector. We offer several comments and observations regarding China's current round of policy stimulus: First, there has so far been no additional fiscal stimulus announced. General government spending growth for 2018 is planned at 3%, and managed funds spending at 24.1%. Altogether public (fiscal and quasi-fiscal) spending in 2018 is projected to be 8% compared to 8.6% in 2017 and 8.1% in 2016 (Table I-1). Table I-1China: Fiscal And Quasi-Fiscal Spending (Annual Nominal Growth Rates) With no new announced public spending, front-loading previously planned spending could alter the near-term growth trajectory, but it will not affect the economy's cyclical outlook. Second, the key risk to our downbeat view is an acceleration in credit origination.3 Our baseline scenario is that regulatory tightening for banks and shadow banking as well as the ongoing anti-corruption campaign in the financial sector - both components of the broader structural reforms agenda - will continue, and will curb credit growth despite more liquidity provision by the People's Bank of China and lower interbank rates. Importantly, so far there has been little deleveraging. If the authorities allow a credit acceleration, it would negate their adherence to structural reforms in general, and deleveraging in particular. In such a case, China's growth will revive and the negative view on China-leveraged markets will prove to be wrong. Furthermore, a revival in credit growth would go against the policy priority of containing financial risks - code for not allowing bubbles to inflate further. In fact, property sales and starts have recently accelerated (Chart I-11). Stimulating money and credit now would mean inflating the real estate bubble further. Third, broad money (official M2 and our measure of M3) impulses have ticked up, but the credit impulse has not (Chart I-12, top panel). Chart I-11China: Housing Is Proving Resilient Chart I-12China: Money/Credit Impulses Importantly, the broad money impulses rolled over in the second half of 2016, yet EM/China markets and commodities prices remained resilient until early 2018 (Chart I-12, bottom panel). There was roughly an 12-month plus time lag between the rollover in the money/credit impulses and the peak in China-related financial markets. Hence, there will likely be an interval of at least six months before financial markets react to the recent improvement in the money impulses. As such, it is probably too early to bottom-fish EM/China plays. There could be considerable downside in financial markets in the next six months or so, notwithstanding short-term rebounds. Finally, the PBoC's ability to keep money market rates down will be constrained by its appetite for further weakness in the RMB exchange rate. Chart I-13 illustrates that the drop in the interest rate differential between China and the U.S. has coincided with the latest down-leg in the RMB's value. Chart I-13China: Lower Interest Rate Differential = Weaker RMB The interest rate differential between China and the U.S. is now only 100 basis points. Given that U.S. short interest rates are bound to rise further, we expect one of the following scenarios to unfold: If the PBoC opts to lower rates further or keep them at current levels, the yuan will continue to depreciate versus the U.S. dollar. This will be negative for China/EM financial markets; If the PBoC prefers to stabilize the RMB exchange rate versus the dollar, it will need to push up money market rates, thereby undoing its liquidity easing of the past several months. If this takes place, the odds of a credit revival will drop considerably and chances of an economic growth recovery will diminish. Given the above and the fact that EM financial markets have reacted poorly to the RMB's recent depreciation, staying negative on EM risk assets appears to be the more prudent course. We are not sure which option the PBoC will choose in the near term, but in the long run China will have to drop interest rates to soften the deleveraging process. Bottom Line: Chinese policymakers are attempting to simultaneously achieve contradictory objectives: On one hand, they want to deleverage the system and contain the property and credit bubbles. On the other hand, they are not ready to tolerate weaker growth, and have lately opted for stimulus as soon as growth has downshifted. It will be very hard to achieve these contradictory objectives at the same time. For now, policymakers are not yet embracing stimulus of the magnitude that was implemented in 2015-2016. Consequently, the odds for now favor staying put on China-leveraged plays. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "On EM Blues, Brazil And Malaysia," dated May 17, 2018, a link available on page 13. 2 Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, a link available on page 13. 3 Underestimating the recovery in credit growth was the reason why we misjudged the magnitude and duration of 2016-17 recovery in China. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. CNYUSD may have some upside from current levels if the Trump administration applies only 10% rate to the second round of planned tariffs, but on balance is likely to come under further market pressure. This explains the PBOC's decision to try to support the currency. Interestingly, July brought some hopeful (albeit early) macro signals from China among the data that we track, some of which appear to have been overlooked by investors. Still, a neutral stance towards Chinese investable stocks versus the global benchmark continues to be warranted, at least until some clarity emerges about the magnitude and disposition of the export shock. Feature Economic and financial market conditions in China have not meaningfully improved since the publication of our last weekly report. Chart 1 highlights that China's economic surprise index remains in negative territory, and Chart 2 shows that Chinese investable and domestic stocks remain 22% and 29%, respectively, below their rolling 1-year high in local currency terms. In US$ terms, domestic Chinese stocks are 34% below their January peak, owing to the significant decline in CNYUSD. The BCA China Play Index and the relative performance of domestic infrastructure stocks versus global equities are two additional market indicators that we are watching closely as proxies for reflation, and neither is signaling a significant improvement (Chart 3). Chart 1Persistently Negative Economic Surprises... Chart 2...And Still In A Bear Market Chart 3Reflation Proxies Are Not Signaling A Major Economic Upturn The RMB Factor The persistent weakness of the RMB appears to be one important factor weighing on Chinese stocks, particularly the domestic market. While a weaker currency will actually help offset some of the export shock, Chart 4 shows that domestic stocks have not responded positively to the decline: the rolling 3-month correlation between the two has soared even further into positive territory over the past month, which may explain recent actions from the PBOC to help stabilize the currency. In short, the RMB appears to be acting as the "panic barometer" for domestic equity investors. Chart 4The RMB Is Acting As A "Panic Barometer" For Domestic Stocks Chart 5Some Evidence Of PBOC-Driven Depreciation The PBOC continues to maintain that it is not actively manipulating the RMB, arguing that both last year's appreciation and Q2's depreciation have occurred due to market supply and demand. Chart 5 casts some doubt on this claim, suggesting that at least some of the recent decline has been purposeful. The chart shows the standardized 1-month percent change in official reserves, measured in SDRs to help remove the impact of currency fluctuations. It highlights that the change in currency-neutral reserves has been quite elevated over the past three months relative to recent history, which is what would be expected (absent major capital outflow) if the PBOC was buying foreign currency assets to push down the exchange rate. But we agree that the extent of the decline is now probably more than what policymakers are comfortable with, which raises the question of how much more market-based pressure the RMB is likely to come under. In attempting to answer this question, it is interesting to note that the magnitude of the decline in CNYUSD over the past two months seems to have been closely aligned with the share of proposed tariffs as a share of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Chart 6 illustrates the magnitude of the decline in CNYUSD that would be implied by this framework in a variety of tariff scenarios. The chart shows that the RMB has some upside from current levels if the rate on the second round of tariffs is limited to 10% (instead of the 25% that has been threatened), and no additional tariffs are levied. But it also shows that further market pressure on the exchange rate is likely if the Trump administration simply follows through with their stated plans, and especially if the U.S. moves to tariff all imports from China. Notably, in the scenarios showing a further RMB decline, all of them fall below the psychologically important level of 7 yuan to the dollar. Chart 6More Pressure On RMB To Come If Trump Merely Follows Through With His Threats Given this, it is easy to see why investors feel that they are in limbo regarding the outlook for Chinese stock prices. They can observe the reflationary outlook of Chinese policymakers, but they are also factoring in: A looming export shock of still uncertain magnitude A strong signal from authorities that the campaign to control leverage and crackdown on shadow banking will not be abandoned Persistent RMB volatility An ongoing "old economy" slowdown that was already underway prior to the imposition of tariffs Domestic Economy Crosscurrents Chart 7Closely Watched Data Releases Negatively Surprised In July Concerning the last of these factors, we have written about a slowdown in China's old economy for the better part of the past year, a view that is now sharply in the market's focus given the negative external outlook. Last week's disappointing release of the July retail sales, industrial production, and fixed asset investment data certainly did not help improve investor sentiment towards China's economy (Chart 7). Interestingly, however, July did bring some hopeful (albeit early) macro signals from China, some of which appear to have been overlooked by investors. Table 1 presents the dashboard of select macro series that we have showed in several reports over the past few months. It highlights the evolution of the key six components of our BCA Li Keqiang index Leading Indicator, four housing market series that we have found to have strongly leading properties, as well as the NBS and Caixin manufacturing PMIs. Credit growth and the PMIs are currently providing the most negative signals, in that they declined in July and are below their 12-month moving average. In the case of credit growth, this is a continuation of an almost 2-year downtrend, but the PMI weakness has been much more recent (in response to the worsening export outlook). But several indicators that we track ticked up in July, including 4 out of 6 components of our leading indicator for the Li Keqiang index (LKI). The fact that monetary conditions indexes have risen should not be surprising given the recent weakness in the currency, but growth in the money supply also ticked up non-trivially last month (possibly due to the PBOC's apparent manipulation of the RMB). In the case of M2, the tick up technically pushed the YoY growth rate (modestly) above its trend for the first time in 2 years. Table 1Some Hopeful Signs, But Credit Remains Weak There are two other points from Table 1 worth highlighting, the first of which is negative. While the LKI itself has looked reasonably strong over the past few months (in contrast to our slowing domestic demand view), it ticked down in July for the second time. In addition, the LKI has recently been propped up by two, presumably unsustainable, factors: a spurt of rail cargo volume growth that appears to be strongly linked to trade front-running in advance of the U.S. import tariffs, and a surge in electricity consumption from the services industry (which is not investment-intensive). Chart 8 controls for the second factor by presenting an alternative measure of the LKI that replaces overall electricity production with consumption in primary and secondary industries; the difference in the recent trend between the two measures is clear. Chart 8The LKI Is Being Held Up By Trade Front Running And Services The second important point from Table 1 is positive: both housing starts and sales accelerated very significantly in July, with sales being particularly notable. BCA's China Investment Strategy service has highlighted that the housing sector represented the best candidate for meaningful acceleration in Chinese economic activity, and the July data was particularly impressive. It remains unclear whether the authorities will continue to follow through with a crackdown on the property sector, despite recent statements suggesting they will: household leverage is not enormously elevated relative to GDP, but it has accelerated very significantly over the past couple of years. But if the recent strength in sales volume continues and policymakers do not respond aggressively with macroprudential measures, our conviction in a sustained residential construction boom in China would rise materially. This will be important for investors to monitor, as it could provide a critical source of investment-driven domestic demand over the coming 6-12 months. Investment Conclusions Despite the crosscurrents buffeting China's economic outlook, we can draw three conclusions that lead us to firm near-term investment strategy recommendations: Market proxies are not signaling that Chinese policymakers will end up overstimulating the economy For now, credit growth, and the domestic "old economy" more generally, continues to decelerate Further RMB weakness may be in the cards To us, these conclusions clearly argue for a neutral stance towards Chinese investable stocks versus the global benchmark, at least until some clarity emerges about the magnitude and disposition of the export shock. We also continue to recommend that investors favor low market beta sectors within the investable universe, such as classical defensives as well as industrials.1 In early-July, we opened a "shadow" trade of being long the MSCI China A Onshore index / short MSCI China index, which we said we would consider implementing in response to a 5% rally in relative dollar performance. Chart 9 highlights that this threshold has not yet been reached, and we continue to warn against trying to catch a falling knife. But Chart 10 underscores how stretched (to the downside) domestic stocks have become: versus the global benchmark, relative stock prices in US$ have fallen to an 11-year low. Panel 2 illustrates that this stretched performance is at least in part driven by the performance of U.S. equities, but domestic stocks prices are still at the very low end of their post-GFC range when compared with global ex-U.S. stocks. Chart 9Still Too Early To Buy A-Shares... Chart 10...But The Selloff Seems Extremely Late In short, the potential for a substantial bounce in relative domestic equity performance is considerable were the economic outlook to stabilize, and we will be watching closely for an opportunity to time a reversal. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Investable industrial stocks in China have become relatively low-beta, owing to the fact that they had already materially underperformed the investable benchmark prior to the emergence of trade frictions with the U.S. Cyclical Investment Stance Equity Sector Recommendations
Highlights The Turkish economy is in disarray, ... : The lira's plunge has reminded some investors of the Thai baht's in 1997, but we do not foresee a replay of the Asian Crisis. ... highlighting emerging markets' vulnerability to external factors: EM economies may be on firmer footing than they were 20 years ago, but the vicissitudes of dollar-denominated debt remain their Achilles' heel. Fraught times around the world justify paring back portfolio risk, ... : Increased caution is appropriate in the face of potential EM distress. Multiples are elevated and spreads are tight, leaving stocks and bonds susceptible to a pickup in risk aversion. ... even if domestic data indicate that the U.S. expansion is alive and well: Global concerns did nothing to dim small businesses' rosy outlook, but the dirty little secret within the July NFIB survey is that rising cost pressures will keep the Fed from backing off of its tightening plans. Feature Dear Client, This is our final report for the month of August. We will resume our regular publication schedule the first week of September. We wish everyone an enjoyable rest of the summer. Best regards, Doug Peta, Chief U.S. Investment Strategist What a difference a year makes. If 2017 was all about synchronized global growth, 2018 has been a study in desynchronization. While the list of sputtering international economies grows longer with every passing month, the U.S. economy continues to gather steam. The fact that it is leaving the laggards choking on its exhaust as it speeds by, trampling the conventions of the postwar international order the U.S. itself established, and tightening the screws on dollar borrowers, is bruising feelings from Ankara and Beijing to Ottawa and Brussels. There is nothing on the horizon to indicate that the desynchronization trend is about to end. Surreal as it may be for baby boomers and other pre-millennials, trade barriers are an essential plank in the Republicans' midterm election platform. Our geopolitical strategists caution that there is little reason to expect the anti-trade rhetoric out of Washington to die down before November. The associated headwinds for multinational corporations and economies more reliant on global trade are likely to persist for at least a few more months. The other global policy irritant comes from the Fed. Although it is not blind to the impact of its policies on other economies, its America First mandate is firmly entrenched. Confronted with a domestic economy that is being force-fed stimulus when it is already showing signs of bumping up against supply constraints, the Fed has very little room to relax its vigilance. Investors counting on an "EM put" to alter the course of rate hikes should recognize that that put is way out of the money: it will take a great deal of EM pain for the Fed to back away from its projected course. Turkey's Tenuous Model Before the Asian Crisis, the growth of the Asian Tiger economies was the envy of the world. The formula was simple and effective: take ample supplies of cheap labor, mix with developed-world capital to finance a buildup of manufacturing capacity, and watch eye-popping growth ensue. All was well until too much excitement led to hard-currency-debt-financed investment in overcapacity. When exchange-rate pegs fell, domestic borrowers became unable to meet their obligations and the Asian Miracle imploded. The Turkish lira's plunge has put many investors in mind of the Thai baht's 1997 collapse that set the Asian Crisis in motion. The EM contagion eventually found its way to Russia in the summer of 1998, felling hedge fund titan Long-Term Capital Management (LTCM) and thoroughly rattling several of its Wall Street enablers. Investors would be foolish to ignore the problems in Turkey, which could well ripple out into other EM economies and the developed world. However, our current base-case scenario does not call for anything on the order of the Asian Crisis. Chart of the WeekTurkey Is A Clear Outlier Today ... Chart 2... But It Would Have Been In The Thick Of Things In 1997 Turkey's dependency on external capital flows is reminiscent of the Asian Tigers', but it is an outlier in today's more conservative context (Chart of the Week). On the eve of the Asian Crisis, Turkey's external financing profile, on both a flow (current-account balance as a share of GDP) and a stock (external private debt as a share of GDP) basis, would have placed it squarely within the smart set (Chart 2). In retrospect, the Asian Miracle template of the early and mid '90s was an accident waiting to happen. Currency pegs are seen as a naïve relic, and exporters assiduously build up reserve war chests to prevent currency panics from taking root. Chart 3U.S. Banks Have Modest EM Exposure The key issue for U.S. investors is the potential for contagion to the U.S. banking system and its markets. It is almost impossible to identify an LTCM in advance, but the fact that the banking system is on a much tighter leash following the crisis means that it is far less vulnerable than it was in the late '90s. As our f/x strategists point out,1 European banks (especially Spain's BBVA) have considerably more exposure to Turkey and other fragile EM economies (Chart 3). Sentiment is the most likely transmission mechanism, and U.S. assets would seem to be last in line for multiple de-rating and spread widening, given the strength of the U.S. economy and its comparative remove from the rest of the world. Bottom Line: The magnitude of Turkey's financing excesses is not representative of the entire EM complex. U.S. investors should operate with a heightened sense of caution, but they should not panic. Emerging Markets' Achilles' Heel The magnitude of Turkey's reliance on external financing is unusual, but the direction is common. The vast bulk of the world's wealth is held in developed economies, and EM projects necessarily source capital from DM investors. Over 90% of all EM corporate debt is denominated in hard currency, of which the vast majority is denominated in U.S. dollars. For EM corporates with mainly domestic revenues, moves in the dollar exchange rate exert disproportionate influence over how comfortably they can service their debt. Exchange rates are determined by many factors, but real interest rate differentials are among the most prominent drivers. When the Fed hikes the fed funds rate while other central banks are easing policy or standing pat, the dollar tends to appreciate. A rising dollar pressures EM corporate borrowers, and hasn't been good for EM stock prices, either (Chart 4). If the Fed were to lift the fed funds rate all the way to 3.5% by the end of 2019, as we expect, several EM borrowers could find themselves in the crosshairs. Chart 4Tighter Fed Policy Squeezes EM Equities, Too Meaningful Chinese stimulus could go a long way to offsetting Fed tightening pressures. A more robust Chinese economy would trade more and consume more natural resources. Increased export volumes and higher commodity prices would boost EM exports and commodity prices, helping to support exchange rates. Unfortunately for Asian and Latin American EMs, the jury is still out as to whether or not the Chinese cavalry will ride to the rescue. Our China strategists have observed that a sizable stimulus injection would run counter to policy makers' commitment to reining in shadow banking excesses and cooling off the property market. If the trade war with the U.S. really starts to bite, however, reform may become a lesser priority. The powers that be have been circumspect with stimulus so far (Chart 5), weakening the currency to defend exports (Chart 6) rather than attempting to boost domestic activity via government spending. We will keep a close eye on Chinese policy developments as they unfold. Chart 5Instead Of Helping The EM Bloc With Reflation,... Chart 6...China Has Been Exporting Deflation Bottom Line: Chinese stimulus could help cushion the blow from a stronger dollar, but policy makers have yet to show their hand. Stay tuned. The View From Main Street Despite the global challenges, the July NFIB survey underlined the point that the U.S. economy is flying high. The headline Optimism Index is a single tick below its all-time high (Chart 7, top panel), the Hiring Plans (Chart 7, second panel) and Job Openings components (Chart 7, third panel) are at or near all-time highs, and the Good Time to Expand component is just off the high it set in May (Chart 7, bottom panel). All in all, the view from Main Street is the best it's ever been over the survey's 44-year history. All of the readings in Chart 7 are so good (two-plus standard deviations above the mean), that there is little scope for improvement. Mean reversion may well begin to assert itself, but it is likely to be a slow process. Overall optimism peaks well ahead of downturns, and tends to take its time deteriorating. It lends support to the message from our recession indicator2 that the expansion has at least another year to run. All good things come to an end, however, and the downside to the gangbusters survey results is that they foreshadow the expansion's eventual demise. Respondents' reports of price changes and future intentions to raise them correlate closely with PCE inflation (Chart 8). Record strength in job openings and hiring intentions indicates the labor market is tight enough to squeak, suggesting that firms will soon have to bid up wages to attract new employees. Taken together, the inflation-related measures imply that the Fed will not be able to let up, supporting the house view that the fed funds rate will surprise to the upside. Chart 7A Roaring Economy... Chart 8...Carries The Seeds Of Its Own Demise Bottom Line: The end of the expansion is not at hand, but its strength will eventually compel the Fed to step in to cut it off. Investment Implications Fiscal stimulus and monetary policy still support the expansion and the bull markets in equities and corporate debt, but they will not do so indefinitely. Stimulus is not sustainable from a budgetary standpoint, and gathering inflationary pressures will eventually inspire the Fed to wield its policy tools to bring the curtain down on the business cycle. The shift to restrictive policy will mark an inflection point in risk-asset performance, and investors should pursue more defensive portfolio positioning when it arrives. Although the cyclical inflection point is not yet upon us, the uncertain outcome of trade tensions and emerging market vulnerabilities merit dialing back portfolio risk in the near term. In line with the BCA house view, we recommend overweighting cash and underweighting bonds, while maintaining benchmark positioning in equities. Treasuries will likely outperform if the EM rumblings turn into something more serious, but we would view any decline in yields as a temporary respite from a Treasury bear market that has already been in place for two years. Depending on when, or if, the current global pressures abate, the equity bull market may still have some juice, and we are keeping an open mind about moving stocks back to overweight for the final push. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 17, 2018 Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers," available at fes.bcaresearch.com. 2 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.
Dear Client, We had intended to send you the second part of our two-part special report on long-term inflation risks this week, but given the sharp moves in the dollar and emerging market assets, we decided to write this bulletin instead. Barring any further major market turbulence, we will send you the sequel to the inflation report next week. Best regards, Peter Berezin, Chief Global Strategist Highlights The dollar rally and EM selloff have further to go. The U.S. economy is firing on all cylinders, while the rest of the world is sputtering. Turkey is not an isolated case. Emerging markets as a whole have feasted on debt over the past decade, and now will be held to account. We remain neutral on global equities, while underweighting EM relative to DM and overweighting defensives relative to deep cyclicals. Brewing EM stresses could cause the 10-year Treasury yield to temporarily fall to 2.5%, leading to a further flattening of the yield curve. However, the long-term path for yields is up. Feature King Dollar Reigns Supreme Our expectation going into this year was that the dollar would strengthen, triggering turmoil in emerging markets. This thesis has panned out, raising the question of whether it is time to declare victory and move on. We don't think so. While market positioning has clearly shifted closer towards our own views, we still think that the stronger dollar/weaker EM story has further to run. To understand why, it is useful to review the reasoning behind our thesis. Our bullish dollar view was based on a simple observation, which is that the U.S. had finally reached a point where aggregate demand was starting to outstrip supply. This implied that the dollar would need to strengthen in order to shift demand away from the United States. It is amazing how many commentators still think that the U.S. can divert spending towards imported goods without any change in the value of the dollar. Americans do not care what the CBO's or IMF's estimate of the domestic output gap is when they are deciding whether to buy U.S. or foreign-made goods. They care about relative quality-adjusted prices. Since the U.S. is a fairly closed economy - imports are only 15% of GDP - we reckoned that the dollar would need to strengthen considerably in order to displace a significant amount of domestic production with foreign-made goods. This is exactly what happened. Still More Upside For U.S. Rates Currency values tend to track interest rate differentials (Chart 1). As such, our prediction of a stronger dollar entailed the expectation that investors would increasingly price in a more hawkish path for the fed funds rate. This has indeed occurred. Since the start of the year, the expected fed funds rate has risen by 34 basis points for end-2018 and by 65 basis points for end-2019 (Chart 2). Chart 1Historically, The Dollar Has Moved In Line With Interest Rate Differentials Chart 2Rate Expectations Have Increased, ##br##But There Is Still A Long Way To Go Our sense is that U.S. interest rate expectations can rise further. Faster wage growth will boost consumption. The household savings rate can also fall from its current elevated level, which will give consumer spending an additional boost (Chart 3). Business investment should remain firm. Chart 4 shows that capex intentions are strong, while bank lending standards for commercial and industrial loans, which tend to lead loan growth, continue to ease. Fiscal stimulus will also goose the economy. Chart 3Consumption Could Accelerate As The Savings Rate Drops Chart 4U.S. Capex Investment Going Strong Could interest rate expectations move up more in the rest of the world than in the U.S., causing the dollar to tumble? It is possible, but unlikely. In contrast to most other central banks, the Fed wants to tighten financial conditions in order to keep the economy from overheating. A weaker dollar would entail an easing of financial conditions, and hence would require an even more hawkish response from the Fed. Currency Intervention Is Unlikely To Succeed Some have speculated that the Trump administration will intervene in the foreign exchange market in order to drive down the value of the dollar. We doubt this will happen, but even if such interventions were to take place, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck out those dollars from the financial system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs This brings us to emerging markets. EM equities almost always fall when U.S. financial conditions are tightening (Chart 5). One can believe that emerging market stocks will go up; one can also believe, as we do, that the Fed will do its job and tighten financial conditions. But one cannot believe that both of these things will happen at the same time. Some pundits think that the plunge in the Turkish lira is not emblematic of the problems facing emerging markets. We are skeptical of this sanguine conclusion. Chart 6 shows that as a share of both GDP and exports, EM dollar-denominated debt is now as high as it was in the late 1990s. Turkey may be the worst of the lot, but it is hardly an isolated case. Chart 5Tightening U.S. Financial Conditions Do Not Bode Well For EM Stocks Chart 6EM Dollar Debt Is High Chart 7 presents a vulnerability heat map for a number of key emerging markets.1 We consider fourteen variables (expressed as a share of GDP, unless otherwise noted): 1) Current account balance; 2) Net international investment position; 3) External debt; 4) Change in external debt during the past five years; 5) External debt-servicing obligations coming due over the next 12 months as a share of exports; 6) External funding requirements over the next 12 months as a share of foreign exchange reserves; 7) Private sector savings-investment balance; 8) Private-sector debt; 9) Change in private-sector debt over the past five years; 10) Government budget balance; 11) Government debt; 12) Change in government debt over the past five years; 13) Share of domestic debt held by overseas investors; and 14) Inflation. Our analysis suggests that Turkey, Argentina, Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia are all vulnerable to balance of payments stresses. Chart 7Vulnerability Heat Map For Key EM Markets Of course, asset markets in some of these economies have already moved quite a bit over the past few months, so it is useful to benchmark their stock markets and currencies to the underlying macro risks they face. For stock markets, we do this by comparing the heat map score with a composite valuation measure that incorporates price-to-book, price-to-sales, price-to-forward earnings, price-to-cash flow, and the dividend yield. Our analysis suggests that stocks in Russia and Korea are rather cheap, while equities in Indonesia, Mexico, South Africa, and Argentina are still quite expensive (Chart 8, top panel). Chart 8Some EM Stock Markets And Currencies Have Not Fully Priced In Macro Risks For currencies, we compare the heat map score with the level of the real effective exchange rate relative to its ten-year average. The Mexican peso, Brazilian real, Chilean peso, Indonesian rupiah, and South African rand still look pricey on this basis (Chart 8, bottom panel). In contrast, the Turkish lira and the Argentine peso are starting to look fairly cheap, although they could still get quite a bit cheaper before finding a floor. The China Wildcard The last time emerging markets seemed at risk of melting down was in 2015. Fortunately for them, China came to the rescue, delivering a massive double dose of fiscal and credit easing. Things may not be so straightforward this time around. China does not want to let its economy falter, but high debt levels and an overvalued housing market have made the usual policy prescriptions less appealing. As such, we would not necessarily conclude that the recent decline in the Chinese three-month interbank rate is a signal that the authorities want to see much faster credit growth (Chart 9). They may simply want to see a weaker currency. This is an important distinction because while faster credit growth would boost demand for EM exports, a weaker yuan would hurt other emerging markets by giving China a leg up in competitiveness. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. It is too soon to know what policy mix the Chinese authorities will choose to pursue. Investors should pay close attention to the monthly data on the growth rates of social financing and local government bond issuance. So far, the combined credit and fiscal impulse has continued to weaken, suggesting that the authorities are in no hurry to open the stimulus floodgate (Chart 10). Chart 9Is China Trying To Stimulate Credit ##br##Growth Or Weaken The Yuan? Chart 10China Has Been Slow To Open The Credit And Fiscal Spigots Worries About The Euro Area Slower EM growth is likely to take a bigger toll on the euro area than the United States. Exports to emerging markets account for only 3.6% of GDP for the U.S., compared to 9.7% of GDP for the euro area. Euro area banks also have more exposure to emerging markets than U.S. banks. Notably, Spanish banks have sizeable exposure to Turkey and other vulnerable emerging markets (Chart 11). Meanwhile, worries about Italy have resurfaced. The 10-year Italian bond yield has moved back above 3%, not far from its May highs. The gap in fiscal policy between what Italy's new populist government has promised voters and what the European Commission is willing to accept remains a mile wide. Italian banks have become increasingly wary of financing their spendthrift government. With the ECB stepping back from asset purchases, two critical buyers of Italian debt are moving to the sidelines. The credit impulse in the euro area turned negative even before concerns about emerging markets and Italian politics came to the fore. As Chart 12 shows, the credit impulse has reliably tracked euro area growth. Right now, there is little reason to think that European banks will open the credit spigots, suggesting that euro area growth will be lackluster. Chart 11Who Has More Exposure To EM? Chart 12Euro Area Credit Impulse Suggests Growth Will Remain Lackluster Investment Conclusions If last year was the year of global growth resynchronization, this year is turning into one of desynchronization. The U.S. economy is outperforming the rest of the world, and the dollar is benefiting in the process. As we go to press, the broad trade-weighted dollar is up 6.1% year-to-date and stands only 2.2% below its December 28, 2016 high (Chart 13). From a long-term perspective, the greenback has become expensive, so we are inclined to close our strategic long DXY trade for a potential carry-adjusted profit of 15.7% if it reaches our target of 98 (as of the time of writing, the DXY is at 96.5). However, even if we were to close this trade, our tactical bias would be to remain long the dollar until clearer evidence emerges that the brewing EM crisis is about to abate. We moved from overweight to neutral on global equities on June 19. The MSCI All-Country World index has fluctuated a lot since then, but is currently up only 0.7% in dollar terms. Developed markets have gained 1.4%, while emerging markets have lost 3.8% (Chart 14). We have yet to reach a capitulation point for EM equities. The number of shares in the iShares MSCI Turkey ETF has almost doubled since August 3rd, as a stampede of bottom fishers have plowed into the fund (Chart 15). Equity investors should maintain our recommendation to underweight emerging markets relative to DM and to favor defensive sectors over deep cyclicals. We expect euro area stocks to perform in line with their U.S. peers in local-currency terms, but to underperform in dollar terms over the remainder of the year. Chart 13The Dollar Is Back Near Its Highs Chart 14Stock Market Performance: Roller Coaster Ride Chart 15Foreign Investors And Turkish Stocks: ##br##Trying To Catch A Falling Knife In the fixed-income realm, the long-term trend in global bond yields remains to the upside, but near-term EM stresses could cause the 10-year Treasury yield to temporarily fall back towards 2.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 We collaborated with our colleague Mathieu Savary and his team at BCA’s Foreign Exchange Strategy to build this heat map. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades