Emerging Markets
Domestic demand growth is either sluggish, decelerating or contracting in the overwhelming majority of countries. This is in addition to the export contraction currently taking place in many EMs. Consistently, EM overall EPS and small-cap EPS growth rates…
Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest. This reveals that the…
The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control…
Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon. Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S. A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin. The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply. Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle. Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14). Chart 14Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17). Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall. Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 15...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5 Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Geopolitical Calendar
Chart Of The WeekEM Profits Contraction Today we are publishing a review of domestic demand conditions in each of the 22 emerging economies we cover. Domestic demand growth is either sluggish, decelerating or contracting in the overwhelming majority of countries. This is in addition to the export contraction currently taking place in many EMs. Consistently, EM overall EPS and small-cap EPS growth rates have fallen to zero in local currency terms (Chart Of The Week). In U.S. dollar terms, overall EM EPS are contracting. The recent dollar weakness versus EM currencies has allowed some EM central banks to cut rates. However, we expect the greenback to strengthen, as we elaborated in last week's report, and that will prevent central banks in high-yielding EMs from easing monetary policy further. Hence, a domestic demand revival in EM is not imminent. We reiterate our negative stance on EM currencies and risk assets. China: Consumer Is Mixed; Capex Is Weak Chart I-1 Chart I-2 India: Domestic Demand Is Decelerating Chart I-3 Chart I-4 Indonesia: Domestic Demand Is Very Weak Chart I-5 Chart I-6 Malaysia: Is The Downturn Late? Chart I-7 Chart I-8 Singapore: Domestic Demand Is Contracting Chart I-9 Chart I-10 Thailand: Stable Domestic Demand Growth Chart I-11 Chart I-12 Philippines: From Boom To Bust? Chart I-13 Chart I-14 Korea: Exports Recession Will Dampen Domestic Demand Chart I-15 Chart I-16 Taiwan: Moderate Domestic Demand Growth Chart I-17 Chart I-18 Vietnam: Robust Domestic Demand Chart I-19 Chart I-20 Brazil: The Economy Needs Stimulus Chart II-1 Chart II-2 Chart II-3 Chart II-4 Mexico: Heading Into A Mild Recession? Chart II-5 Chart II-6 Chile: Heading Into A Recession? Chart II-7 Chart II-8 Chart II-9 Argentina: As Bad As It Gets? Chart II-10 Chart II-11 Chart II-12 Chart II-13 Colombia: Entering Another Downtrend Chart II-14 Chart II-15 Chart II-16 Peru: External Sector Drives Credit Cycle Chart II-17 Chart II-18 South Africa: More Downside Ahead? Chart III-1 Chart III-3 Chart III-2 Turkey: As Bad As It Gets? Chart III-4 Chart III-5 Chart III-6 Chart III-7 Russia: Sluggish Economy Chart III-8 Chart III-9 Chart III-10 Central Europe: Strong Demand/Weak Manufacturing Chart III-11 Chart III-12 Equity Recommendations Fixed-Income, Credit And Currency Recommendations
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