Emerging Markets

Special Report

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart 14 (PETER)The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1      To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4      Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5      France is a good proxy for the euro area. 6      Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.

Oil price volatility will remain elevated, as markets transition from a pronounced demand slowdown in 1H19, which is apparent in actual consumption data, to stronger growth. We expect global fiscal and monetary accommodation will arrest and reverse this slowdown in 2H19, and spur oil demand growth in 2020. Consistent with BCA’s Geopolitical Strategy, we are not expecting a resolution to the Sino – U.S. trade war that boosts demand; however, we could see a limited deal by 2H20 that partially addresses tariff barriers and boosts trade in the short run.1 In line with the EIA’s and IEA’s weaker 1H19 oil-consumption assessments, we now expect global demand to grow 1.25mm b/d this year, and 1.50mm b/d next year. These expectations are down 100k b/d and 50k b/d, respectively, from our June estimates. Chart of the WeekOPEC 2.0’s Storage Strategy Continues To Drive Production Supply – demand factors combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. On the supply side, we continue to expect OPEC 2.0’s production strategy to be driven by its primary goal – reducing global oil inventories – which means it will maintain production discipline this year and possibly into 1Q20 (Chart of the Week). We also expect capital discipline in the U.S. to restrain shale-oil production. Lastly, news flows around U.S. – Iran tensions continue to oscillate between hopeful resolution and a hardening of positions, which fuels price volatility. At the end of the day, we expect any increase in Iranian exports resulting from an easing of U.S.-GCC-Iran tensions to be accommodated by OPEC 2.0, as it was prior to the re-imposition of U.S. export sanctions.2 These supply – demand factors combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. We continue to expect WTI to trade $7/bbl below Brent this year, and $5/bbl lower next year (Chart 2). Chart 2Demand Slowdown In 1H19 Pushes Brent Forecast Lower Highlights Energy: Overweight. Given our expectation for tighter markets, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close, expecting steeper backwardation in the benchmark forward curve as global inventories draw in 2H19. Base Metals: Neutral. At $52.50/MT, Fastmarkets MB’s spot copper TC/RC Asia – Pacific index remains depressed, suggesting smelters will have to continue to discount their services due to tight physical supplies. Expecting tighter markets, we are getting long Dec19 $3.00/lb COMEX call spreads, vs. short Dec19 $3.30/lb COMEX calls at tonight’s close. Precious Metals: Neutral. Gold prices are largely being driven by U.S. real interest rates and the broad trade weighted USD, which we will explore in detail next week in a Special Report written with our colleagues in BCA’s Foreign Exchange Strategy. Given our expectation for Fed accommodation this year, we remain long gold. Ags/Softs: Underweight. The USDA lifted expected ending stocks for corn in its latest WASDE released last week. The department expects supply growth to outstrip use, which will raise stocks 335mm bushels to 2.0 billion. Feature Last week, we had the good fortune to visit U.S. clients in “The Great State,” otherwise known as Texas. It was a fortuitous swing through the Promised Land, because we had the opportunity to gain insight on a wide range of topics impacting commodity markets, particularly oil and gold, which are responding to many of the same factors driving markets for risky assets generally. Demand for industrial commodities in particular should pick up this year and next. More than a few of our discussions centered on global aggregate demand for real and financial assets. Prior to the Osaka G20 meeting last month, it looked like the odds of a global recession were increasing. Markets were contending with tightening financial conditions in the wake of the Fed’s December 2018 rate hike, the fourth such hike last year; escalating Sino - U.S. trade tensions, which were depressing capex and demand for industrial commodities; and slowing growth generally ex U.S. (Chart 3). Positioning as if the Fed was too late in reversing the policies that led to tighter financial conditions in 2H18 and earlier this year, and in a manner consistent with a deepening of the Sino - U.S. trade war was not unreasonable. That said, a client at one of the Lone Star state's larger investment managers observed that the powerful rallies in markets for risky assets following Fed accommodative signaling beginning earlier this year strongly suggest the markets’ verdict — at least for the moment — is the Fed acted in time to arrest the risk of a global recession this year. Chart 3Global Growth Slowdown Likely Drove Policy Responses Chart 4BCA's GIA Index Signaling Industrial Commodity Rebound Added to this is the fact that the U.S. central bank is being supported by other systematically important central banks (specifically the PBOC, BOJ, and ECB), and that fiscal stimulus is being deployed globally. Against this backdrop, it is difficult to remain bearish re global aggregate demand going forward, which is to say demand for industrial commodities in particular should pick up this year and next. Indeed, this is starting to show up in our Global Industrial Activity (GIA) Index, which is heavily weighted toward EM industrial commodity demand (Chart 4).3 Oil Demand Will Roar Back In 2H19 Our updated 2019 demand estimates align with the EIA’s and IEA’s depressed 1H19 oil-consumption assessments: We now expect global consumption to grow 1.25mm b/d this year, down 100k b/d vs. our previous estimate. Next year, however, we expect demand to be up 1.50mm b/d in the wake of global stimulus, which is only 50k b/d below our June estimate.4 The IEA’s assessment of 1H19 demand weakness is particularly striking. In its latest forecast, the agency noted that in 2Q19, they show a global surplus of 500k b/d (i.e., supply exceeded demand), where previously they expected a 500k b/d deficit. This million-barrel swing – if it is confirmed when data are later revised with more accurate reporting – suggests the global economy did come close to entering recession earlier this year. We are not as bearish as the IEA, but we do incorporate the severity of the trend they highlight in our forecast. We expect 1H19 global demand grew 520k b/d y/y. In 2H19, like the IEA, we expect demand to come roaring back. We expect consumption to grow at a rate of slightly over 2mm b/d, whereas the IEA’s expecting a 1.8mm b/d rate (Table 1). We believe this momentum will be maintained into 1H20, with growth expected to come in at just over 1.8mm b/d, followed by a more subdued 1.35mm b/d growth rate in 2H20.5 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) It is important to note here that monetary stimulus hits the economy after “long and variable lags,” in the phrasing of Nobel laureate Milton Freidman. Therefore, we will be closely monitoring our demand estimates for signs the coordinated stimulus being deployed by central banks globally actually is translating into higher industrial commodity demand.6 It also is worthwhile pointing out there is a non-trivial risk – i.e., greater than Russian-roulette odds of 1:6 – the Sino – U.S. trade war metastasizes into a global trade war as positions on both sides harden. This could usher in a new Cold War, and see global supply chains broken and reconstituted within trading blocks. The transition to such a realignment of global trade no doubt would be volatile, but, at the end of the day likely would support commodity demand as supply chains are re-built. OPEC 2.0 Remains Sensitive To EM Demand On the supply side, we continue to expect OPEC 2.0’s production strategy to be driven by its primary goal – i.e., reducing global oil inventories. This means the coalition will continue to exercise production restraint: We expect OPEC 2.0 to reduce output by 540k b/d this year per this strategy. In addition to its inventory goals, we believe OPEC 2.0 also does not want to see Brent price go through $85/bbl. This is because many EM states removed fuel subsidies following the oil-price collapse of 2014 – 2016, and the demand-destruction effects of higher prices would be realized in fairly short order above $85/bbl.7 We view this as a binding constraint – prices above the $80 - $85/bbl range will destroy EM demand, which makes them counterproductive for OPEC 2.0. As a result, next year, we expect the producer coalition to gradually raise output by 800k b/d over the January – August 2020 period, to restrain prices below $80/bbl (Chart 5). It is worthwhile mentioning, since it came up repeatedly in conversations during our Texas swing, we do not share the view OPEC 2.0’s production restraint allows U.S. shale producers to increase production and steal market share from OPEC 2.0. This restraint does play a pivotal role in our balances estimates, and is part of the equation propelling prices higher in our modeling. It is a necessary condition for U.S. shale output to grow, but it is not sufficient. U.S. shale oil is filling a market need for light-sweet crude and condensate, and is attracting investment to meet this need. It does compete with light-sweet OPEC production ex Persian Gulf, but investment in these provinces has proven to be difficult to sustain and commit to over the long haul for a variety of reasons, many of which spring from the lack of rule of law, corruption, and hostile operating environments. Shale oil production, in addition to presenting an opportunity to tap into an abundant resource, allows E&Ps to operate in a low-risk political and geological environment, where contracts are enforced by a disinterested judiciary. In terms of its importance, these factors cannot be overestimated. More importantly, the medium and heavier crudes produced and marketed by KSA and Russia are not in direct competition with U.S. shale oil, which means OPEC 2.0’s leadership is not directly fighting for market share with this output. However, there are constraints to shale-oil production, coming mostly from capital markets. We are modeling slower U.S. onshore production growth this year and next, arising from capital constraints on shale-oil producers. Our recent Special Report on the financial performance of E&P companies and the Majors highlighted the importance they attach to prioritizing investors’ interests, which is clearly visible in the financial metrics of these companies.8 Chart 5OPEC 2.0 Will Raise Supply In 2020 To Keep Brent Prices Below /bbl Chart 6Capital Discipline Will Reduce U.S. Onshore Output In 2020 Consistent with our investor-driven framework for modeling U.S. output, we reduced our expectation for U.S. onshore supply growth by 160k b/d for next year (Chart 6). As a result, we now expect U.S. onshore production to grow by 1.2mm b/d to ~ 10.0mm b/d this year and by 900k b/d to ~ 10.8mm b/d next year – mostly from shales. We expect U.S. offshore production to increase 170k b/d this year and 130k b/d next year, to 1.9mm b/d in 2019 and 2.0mm b/d in 2020. Expect Tighter Balances, Steeper Backwardation The fundamental supply – demand expectations above combine to push our 2019 Brent forecast to $70/bbl from $73/bbl last month. We are holding our 2020 Brent forecast at $75/bbl. We continue to expect WTI to trade $7/bbl below Brent this year, and $5/bbl lower next year (Chart 7). As can be seen in the Chart of the Week, our balances estimates indicate inventory draws will resume this year, which will lead to a steeper backwardation in benchmark crude streams (Chart 8). Given this expectation, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close, expecting steeper backwardation in the benchmark forward curve as global inventories draw in 2H19. Bottom Line: Oil price volatility will remain elevated, as markets transition from the profound demand slowdown reported for 1H19 to a higher-growth footing (Chart 9). We expect Brent crude to average $70 and $75/bbl this year and next, with WTI trading $7 and $5/bbl lower, respectively. On the back of our expectation balances will tighten, we are getting long 1Q20 Brent vs. short 1Q21 Brent at tonight’s close. Chart 7Balances Will Tighten In 2H19, Following 1H19 Weakness Chart 8Backwardations Will Steepen, As Inventories Draw Chart 9Volatility Will Remain Elevated We are not sounding an all-clear on aggregate demand in the wake of the fiscal and monetary stimulus being deployed globally. The odds the Sino – U.S. trade war expands to encompass global markets are not trivial (we make them greater than 1:6 in our estimation), and this could keep demand and demand expectations uncertain for an indefinite period. Evidence of this will be visible in the options markets, which will price to higher implied volatilities for a longer period of time.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see The Polybius Solution published by BCA Research’s Geopolitical Strategy July 5, 2019. It is available at gps.bcaresearch.com. 2      OPEC 2.0 is the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. It was founded in 2016 to manage oil production, so as to reduce global inventory levels, which were bloated by a market-share war launched by the original OPEC cartel in 2014. In the political-economy framework driving our analysis, OPEC 2.0 treats U.S. and Chinese policy as exogenous factors, and maintains sufficient flexibility to respond to whatever these states do. We develop our paradigm for this in The New Political Economy Of Oil, published by BCA Research’s Commodity & Energy Strategy February 21, 2019. It is available at ces.bcaresearch.com. 3      Please see “Oil, Copper Demand Worries Are Overdone,” where we introduce and discuss the GIA index, published February 14, 2019, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4      The EIA has lowered its growth estimates for oil consumption six consecutive times this year, with the publication of this month’s forecast. This is the third time we’ve lowered our forecast. 5      Global oil demand is extremely difficult to estimate. It is an estimate subject to large revisions, as we discussed last year: From 2010 to 2016, “On average, the EIA has increased net demand (increases in estimated demand in excess of the increase in estimated supply) by about 470,000 b/d, with the lowest retroactive increase of net demand being 260,000 b/d (2012).” Copies of this research are available upon request. 6      Please see The Lag in Effect of Monetary Policy, by Milton Friedman (1961). Journal of Political Economy, University of Chicago Press, vol. 69, pages 447-466. 7      Please see With the Benefit of Hindsight: The Impact of the 2014-16 Oil Price Collapse, published January 13, 2018, by the World Bank for a discussion of subsidy removal by EM states. 8      Please see Shale-Oil E&Ps Turning A Corner?, published June 13, and U.S. Shales, GOM Production Reinforce Our Robust Production Forecasts, published July 11, 2019. These are available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Analysis on Brazil is available below. If banks in China are forced by regulators to properly recognize and provision for non-performing assets, large banks would become substantially undercapitalized while many small- and medium-sized banks (SMBs) would have little equity capital left. That would hammer their ability to finance the economy. Provided on aggregate SMBs have actually outgrown larger ones in terms of balance sheet size, the precarious state of the former’s financial health has become a matter of macro significance. The principal danger to shareholders of mainland banks is equity dilution. We reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position. Feature Chinese Banks: A Value Trap Chart I-1Chinese Bank Share Prices Are On Edge Banks are crucial to financing the private sector as well as all levels of government in China. Not only do banks originate a substantial share of credit, but also they account for 82% of purchases of government bonds. That is why today we revisit the fundamentals of the Chinese banking sector. Besides, their equity valuations appear very cheap, and many investors are tempted to buy their shares. Chinese banks’ financial ratios look healthy and valuations appear extremely cheap because they have not recognized and provisioned for non-performing assets. By expanding their balance sheets enormously and not provisioning for bad assets, their profits have mushroomed. Banks have retained a share of these profits, boosting their capital. Yet, their share prices have been flat over the past 10 years. Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner (Chart I-1). We highlight their poor financial health in the section below, where we perform stress tests for both large as well as small and medium sized banks (SMB). The principal danger to shareholders is equity dilution that will continue occurring among mainland banks (Chart I-2). Our bearish view on Chinese bank stocks has not been contingent on a systematic financial crisis but on inevitable and substantial equity dilution. Investment conclusions: Absolute return investors should stay clear of Chinese bank stocks – they are the ultimate value trap. For relative value traders, we reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position (Chart I-3). Chart I-2Beware Of Equity Dilution Chart I-3Our Trades On Chinese Banks   Large Versus Small And Medium Banks China’s banking system consists of five large banks (Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China, and Bank of Communications) and about 3150 small- and medium-sized banks (SMBs). All five large banks are publically listed but the central government still holds about 70-80% of their equity. About 36 of the SMBs are also listed but the central authorities in Beijing have a stake in some of the medium-sized banks. Notably, the central government has no equity in any of the small banks. In recent years, SMBs have been playing a greater role in sustaining the credit boom: First, on aggregate SMBs have actually outgrown the five large banks in terms of balance sheet size. The former’s risk-weighted assets1 (RWAs) of RMB 73 trillion exceeds the RMB 65 trillion of large banks (Chart I-4). Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner. The value of RWAs emphasizes banks’ claims on enterprises, non-bank financial institutions and households over holdings of government bonds. Hence, RWAs of banks are a more pertinent measure of non-government financing than total assets. Second, over the past 12 months large banks and SMBs have accounted for 40% and 60% of the rise in the aggregate banking system’s RWAs, respectively (Chart I-5). Therefore, further credit acceleration will be difficult to engineer if – as we discuss below – SMBs begin retrenching under regulatory pressures and amid tighter market financing in the wake of the Baoshang bank failure. Chart I-4SMBs Have Outgrown Large Ones Chart I-5SMBs Have Contributed Enormously To The Credit Boom   Finally, there has so far been no deleveraging among SMBs. Large banks’ RWAs-to-nominal GDP ratio has been in decline since 2014, but the same ratio for SMBs has not dropped at all (Chart I-6). This chart corroborates that the credit boom between 2015 and 2017 was driven by SMBs, rather than by large banks. In fact, SMBs along with shadow banking are what primarily drove the credit boom that occurred over the past decade. This confirms the thesis that the unprecedented credit bubble has spiraled beyond the central authorities’ control. While China’s entire banking system is in poor health, SMBs are in considerably worse shape than large ones. In particular: SMBs have much more assets classified as equity and other investments than large banks (Chart I-7). Equity and other investments stands for non-standard credit assets that are typically much riskier than loans and corporate bonds. This is the principal reason why in our stress test we use higher ratios of non-performing assets for SMBs than for large banks. Chart I-6No Deleveraging Among SMBs Chart I-7SMBs Exposure To Non-StandarD Credit Assets Is Huge Chart I-8Large Banks Versus SMBs Big banks are better capitalized than SMBs. The capital adequacy ratio among big banks is higher compared with the other banks (Chart I-8, top panel). Similarly, the ratio of non-performing loans (NPL) to total loans is considerably lower for large banks than for SMBs (Chart I-8, bottom panel). On the liquidity side, SMBs are more dependent on the wholesale funding market than their larger peers. Interbank transactions account for 10% of SMBs own liabilities. On the other hand, big banks are the main lenders in the interbank market. Bottom Line: SMBs have become more important than large ones in providing financing to companies and households. Yet these SMBs are much more vulnerable. A Stress Test We conducted separate stress tests on large banks and SMBs. Our findings are not optimistic. Some 71% of equity of SMBs will be wiped out if 14% of their RWAs turn sour (Table I-1). 43% of large banks’ equity will be impaired if 12% of their RWAs become non-performing (Table I-2). The reason we use RWAs rather than loans is because banks have been accumulating claims on enterprises, non-bank financial institutions and households beyond their loan books. Hence, RWAs better captures all credit assets. We use a higher impairment rate for SMBs than for large banks because the former have substantially more non-standard credit assets. Typically, the quality of non-standard credit assets is inferior to those of corporate bonds or loans. We used the following assumptions in our stress tests: For large banks, we assumed non-performing assets (NPAs) ratios of 10% in the optimistic scenario, 12% (baseline), and 14% (pessimistic) (Table I-2). For SMBs, we employed NPAs ratios of 12% (optimistic), 14% (baseline), and 16% (pessimistic) (Table I-1). The magnitude and duration of China’s current credit boom has considerably surpassed that of the 1990s, when Chinese banks held over 25% of non-performing loans (Chart I-9). Therefore, our stress test assumption that the NPAs ratio will rise above 10% is reasonable. Chart I-9China's Credit Booms In Perspective We applied a 30% recovery rate on NPAs. The recovery rate on Chinese banks’ NPLs from 2001 to 2005 was 20%. This occurred amid much stronger economic growth. Thus, an assumption of a 30% recovery rate today is realistic. Finally, we calculated overvaluations assuming the fair price-to-book value ratio for all banks is 1. How has it been possible for banks in China to continue expanding their balance sheets aggressively despite such moribund financial health? Banks can operate and expand their balance sheets with zero or even negative de facto equity capital, so long as they obtain liquidity from other banks or the central bank. This is how many Chinese SMBs have been operating in recent years. Barring institutional and regulatory constraints, banks theoretically can expand their balance sheets indefinitely by creating loans and deposits “out of thin air.” We have deliberated extensively in past reports that banks do not intermediate savings or deposits into loans and credit. Rather, they create deposits when they make a loan to or buy an asset from a non-bank entity. Loans and deposits are nothing other than accounting entries on banks’ books. It is regulators’ and shareholders’ forbearance – or lack of it – that allows banks to, or prevents banks from, expanding their balance sheets. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. For example, in April bank regulators released draft rules on how banks should classify all types of assets and provision for them. Over the past several years, many banks have transformed their bad loans into non-loan assets to disguise the true level of their non-performing loans (NPLs). The new regulation, if and when it is adopted and properly executed, will force banks to recognize NPAs and increase their provisions. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. Ultimately, this will substantially impair banks’ capital and dampen their ability to originate new credit – both in the form of making loans and buying securities. Consequently, the credit impulse will relapse and the business cycle recovery will be delayed. Bottom Line: If banks in China are forced by regulators to properly recognize and provision for NPAs, large banks would become substantially undercapitalized while many SMBs would have little equity capital left. That would hammer their ability to finance the economy. Investment Ramifications Given the increased importance of SMBs in China, the precarious state of their financial health has become a matter of macro significance. Even if regulators partially reinforce recognition of provisions for NPAs, aggregate credit growth will decelerate. A simple simulation to illustrate this point: If SMBs RWAs growth were to decelerate from 11% currently to 8%, large banks’ RWA annual growth would need to surge from 8% now to 16% for all banks’ RWA growth to accelerate from the current 9.5% to 12%. The latter is probably what is required to promote an economic recovery. Such a ramp-up in large banks’ RWAs is unlikely, given they would also be facing stricter regulatory requirements. The key point is that the positive effects of monetary and fiscal easing continue to be hampered by regulatory tightening on the credit system. The latter will delay a business cycle recovery in China. For now, although the credit plus fiscal spending impulse has picked up, economic growth has not yet revived (Chart I-10, top two panels). The reason has been a declining marginal propensity to spend among households and companies (Chart I-10, bottom two panels). We have discussed this issue at great length in past reports. Consistently, nominal industrial output, car sales and smartphone sales as well as total imports are either very weak or are in outright contraction (Chart I-11). All series in Chart I-11 and I-12 include June data. Chart I-10Stimulus Versus Marginal Propensity To Spend Chart I-11Chinese Economy: No Recovery So Far   Chart I-12Chinese Corporate EPS: The Outlook Is Downbeat Importantly, Chinese corporate per-share earnings in RMB are contracting for the MSCI investable universe and will soon be contracting for A-share companies as well (Chart I-12). We maintain our negative outlook for EM risk assets and China-plays globally due to our downbeat view on China’s credit cycle. This differs from BCA’s House View, which is positive on global/Chinese growth.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Brazil: Buy The Rumor, Sell The News? Having surged on the back of Congress’s initial approval of the social security reform, Brazilian financial markets are attempting to break above important technical resistance levels both in absolute and relative terms (Chart II-1 and Chart II-2). If the Bovespa decisively breaks above these technical resistance lines, it would mean it is in a structural bull market. A failure to break out will lead to a sizable setback. Chart II-1Are Brazilian Equities Poised For A Breakout In Absolute Terms… Chart II-2…And Relative Terms?     We upgraded Brazilian equity and fixed-income markets right after the first round of presidential elections on October 7, but then downgraded them in early April. In retrospect, the downgrade was a miscalculation. Presently, investor confidence in Brazil is very high, sentiment is very bullish and markets are overbought. Faced with the choice of chasing the market higher or waiting, we are opting for the latter. Pension Reform: Necessary But Not Sufficient Chart II-3Public Debt-To-GDP Ratio Will Rise Further The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio (Chart II-3). Table II-1 illustrates the savings from the social security reform adopted in the lower house. As estimated by the Independent Fiscal Institute, an advisory think-tank of the Senate, the reform would bring only BRL 744 billion of savings over the next decade. Is this sufficient to stabilize the public debt-to-GDP ratio? One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years – i.e., the government runs continuous robust primary fiscal surpluses. Yet, the pension bill falls short of achieving this goal. The estimated savings in the first four years will likely be around BRL 130 billion. This amounts to annual savings of BRL 33 billion. Chart II-4 demonstrates that savings from the reform are too small to flip the government’s (often optimistic) projected primary fiscal deficit into a surplus in the forecast period. One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years. Another scenario for stabilizing the public debt-to-GDP ratio is for interest rates to drop meaningfully below nominal GDP growth. Having plummeted amid very benign global and domestic backdrops, local currency bond yields still remain about 100 basis points above current nominal GDP growth (Chart II-5). It remains to be seen whether local currency borrowing costs will drop and stay below nominal GDP in the years to come. Chart II-4Primary Fiscal Balance Will Remain Negative Despite Pension Reform Chart II-5Borrowing Costs Remain Above Nominal GDP Growth   Overall, the pension reform in current form does not guarantee public debt sustainability in Brazil: It is simply insufficient to get the government to run recurring primary fiscal surpluses. Another prerequisite – nominal GDP growth exceeding local bond yields over next several years – is contingent on further reforms as well as on a substantial improvement in confidence among investors, companies and households. It Is All About Confidence The sustainability of public debt, economic growth and financial markets are interlinked, with the common thread being confidence. In a virtuous cycle, financial markets typically rally while the currency stays firm. Subdued inflation will allow the central bank to rapidly reduce interest rates. This will help boost confidence among businesses and consumers, buoying the economy. In turn, lower policy rates could sustain the stampede into domestic bonds, pushing government borrowing costs below rising nominal GDP growth. At that point, the country’s public debt dynamics will become sustainable, the risk premium will continue to fall, and the nation’s financial markets will be in a secular bull market. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. In this case, the central bank cannot slash interest rates. On the contrary, government bond yields – which are presently at record lows – could or will likely rise (Chart II-6 and Chart II-7). These events will hurt confidence and suppress nominal GDP growth below borrowing costs. This could aggravate investors’ anxiety over Brazil’s public debt, leading them to demand a higher risk premium. As a result, a vicious cycle could unfold. Chart II-6Government Bond Yields Are At Historical Lows Chart II-7Credit Spreads Are Very Tight   Chart II-8Commodity Prices And The BRL: Positive Correlation To be clear, we are not presently forecasting the onset of a vicious cycle. Nevertheless, given our negative view on EM risk assets and currencies, we expect a pullback in the Brazilian real and risk assets in the near term. The U.S. dollar is about to rally, as we discussed in detail in last week’s report. Commodities prices will tumble as China’s growth downshift persists. Given that the Brazilian real is a high-beta currency and is often positively correlated with commodities prices (Chart II-8), it could depreciate quite a bit. Patience is especially warranted in the case of Brazilian equities because share prices have decoupled from corporate profits and the business cycle. Stock prices have surged despite plummeting net EPS revisions and contracting profits of non-financial and non-resource companies (Chart II-9) and relapsing economic growth (Chart II-10). Clearly, the rally has been driven by expanding equity multiples due to progress on the social security reform. Chart II-9Stock Prices Are Diverging From Corporate Profits Chart II-10Domestic Demand Has Stalled   Bottom Line: A lot of good news has been priced into Brazilian financial markets. For now, the risk-reward profile is not attractive: investors should wait for a better entry point. This is true for both absolute return investors and dedicated EM equity and fixed-income managers. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. It is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. Usually, different classes of assets have different risk weights associated with them.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights Analysis on Indonesia starts below. The U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle. Ongoing weakness in the global economy – which is emanating from China/EM – will support the dollar in the coming months. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. A new trade: Long gold / short equal amounts of copper and oil. Feature Chart I-1The Dollar's Technicals Are Still Positive As we argued in last Week’s Report, emerging markets are facing a make-it-or-break-it moment. The U.S. dollar will serve as a litmus test. If the dollar pushes higher, EM risk assets will sell off. Conversely, if the greenback breaks down, EM risk assets will stage a sustainable cyclical rally. The basis of why the dollar will be a litmus test for EM risk assets is because the greenback is a counter-cyclical currency. It appreciates when global growth is relapsing and depreciates when global growth is reviving. In contrast, EM risk assets are pro-cyclical.  Hence, the negative correlation between EM risk assets and the dollar stems from their opposite-reaction functions to the global business cycle. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. In particular, the dollar’s advance-decline has also been holding above its 200-day moving average (Chart I-1, top panel). Critically, our composite momentum indicator for the broad trade-weighted dollar has not declined below zero (Chart I-1, bottom panel). All of the above affirm the U.S. currency’s relative resilience. When a market exhibits resilience relative to the headwinds it is facing, it is often a bullish sign. Our EM strategy takes its cues from the fact that the greenback has softened but has not broken down. An upleg in the trade-weighted dollar is consistent with our view of a pending relapse in EM risk assets. The Dollar: Review Of Indicators There are a wide range of indicators that herald further U.S. dollar appreciation: Liquidity in the U.S. dollar interbank market has been tightening. The top panel of Chart I-2 demonstrates that the effective fed funds rate has exceeded the interest rate that the Fed pays to banks on excess reserves (IOER) for the first time since 2009 (herein the difference between the two is referred to as the spread). The bottom panel of the same chart illustrates that in the periods when this spread is rising, the dollar tends to appreciate, and when the spread is flat or falling (the shaded intervals), the greenback weakens. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. A positive, rising spread reflects a shrinking supply of U.S. dollar liquidity in the interbank market relative to demand. Notably, Chart I-3 illustrates that the dollar - inverted in this chart - is more strongly correlated with U.S. banks’ excess reserves at the Fed than with interest rates. This implies that the argument that lower rates will drive down the value of the greenback is exaggerated. Chart I-2Another Dollar Positive Factor Chart I-3Do U.S. Rates Drive The Dollar? Chart I-4Investors Are Long EM Currencies Vs. Dollar One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback (Chart I-4). Remarkably, various emerging market currencies have rebounded to major technical resistance levels but have not yet broken out, despite a dramatic decline in U.S. interest rates and the risk-on phase in global financial markets (Chart I-5). It remains to be seen whether they can stage a decisive breakout. We have our doubts. Chart I-5AEM Currencies Have Not Yet Broken Out Chart I-5BEM Currencies Have Not Yet Broken Out   Finally, one aspect where we differ from the consensus is in terms of currency valuations. The U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value (Chart I-6). Often financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. Bottom Line: BCA’s Emerging Markets Strategy service maintains that the path of least resistance for the dollar is still up. Global Growth Conditions Are Still Conducive For Dollar Strength As discussed previously, the U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle (Chart I-7). Meanwhile, it is only loosely correlated with U.S. interest rates, as shown in the bottom panel of Chart I-3 on page 3. Chart I-6The U.S. Dollar Is Only Moderately Expensive Chart I-7The U.S. Dollar Is Counter-Cyclical   The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. Yet, this scenario would be dollar bullish. In this case the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. So far, neither economic data nor the performance of cyclical segments within financial markets are signaling a meaningful amelioration in the global business cycle: Global cyclical sectors’ relative performance against the global overall equity index is lingering close to its December lows (Chart I-8). This measure of global cyclicals is composed of equal-weighted share prices of global industrials, materials and semiconductors. Further, this global cyclical equity index has not outperformed 10-year U.S. Treasurys (Chart I-9). It is difficult to envision a looming global economic recovery when global cyclical equities are failing to outperform even government bonds. Chart I-8Global Cyclical Sectors Have Not Outperformed Chart I-9Global Cyclical Sectors Versus U.S. Bonds   The Chinese manufacturing PMI import sub-component – a leading indicator of Chinese imports – foreshadows renewed weakness in the EM ex-China, Korea and Taiwan currencies (Chart I-10). In turn, the Korean won and Taiwanese dollar are also vulnerable as China is by far their largest export destination, and their shipments to the mainland continue to shrink rapidly. Further, odds are high that the RMB will depreciate, dragging down the KRW and TWD along with it. Japanese foreign machinery tool orders and German industrial orders are in deep contraction, and have not improved even on a rate-of-change basis (Chart I-11, top and middle panels). Meanwhile, China’s imports of capital goods are contracting at a double-digit pace (Chart I-11, bottom panel). Chart I-10Chinese Imports Are Key To EM Currencies Chart I-11Global Trade Is Shrinking At A Fast Rate   Chinese auto sales improved dramatically in June, but almost entirely due to hefty price discounts. Such bulky price discounts (up to 50% in certain cases) cannot go on indefinitely. Auto sales will soon tumble as these incentives to purchase expire. While U.S. growth has slowed, it is still holding up better than the rest of the world. Consistently, not only have U.S. large caps been outperforming their global counterparts, but America’s equal-weighted equity index has also been outpacing that of its global peers (Chart I-12). Broad-based U.S. equity outperformance in local currency terms versus the rest of the world denotes U.S. growth outperformance, and heralds another upleg in the greenback. Bottom Line: Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. We continue to recommend a short position in a basket of currencies such as ZAR, CLP, COP, IDR, MYR, PHP and KRW against the dollar. We believe gold has made a major breakout. The biggest risk to our dollar-bullish view is not the dollar’s fundamentals, but China’s decision to diversify away from U.S. dollars and U.S. President Donald Trump’s determination to weaken the greenback. We discussed the latter at great length in our August 30, 2018 Special Report, and will deliberate on the former below. Buy Gold / Short Copper And Oil Despite our positive view on the dollar, we believe gold has made a major breakout (Chart I-13). Pairing a long position in gold with shorts in copper and oil will likely deliver solid returns with low volatility in the next three to six months and beyond (Chart I-14). Chart I-12U.S. Equity Outperformance Heralds A Stronger Dollar Chart I-13Gold Is In A Bull Market   Chart I-14Go Long Gold / Short Copper And Oil The primary reason to buy gold is not global inflation. Rather, it is due to China’s decision to accumulate the yellow metal. Unhappy with U.S. pressures and import tariffs, Chinese authorities have decided to materially reduce the share of dollars in their foreign exchange reserves. The People’s Bank of China (PBoC) holds 62 million ounces of gold. Hence, gold holdings represent only 2.8% of the $3.1 trillion stockpile of the PBoC’s total foreign currency reserves (Chart I-15). In contrast, U.S. assets account for 52%. In this regard, the Russian experience could act as a roadmap for Chinese policymakers. Hit by U.S. and EU economic and financial sanctions following Russia’s seizure of Crimea in 2014, the country decided to accelerate its diversification away from U.S. dollars into gold. Since then, the Russian central bank has continuously boosted its gold holdings, with the yellow metal now accounting for 22% of its foreign currency assets (Chart I-16). Chart I-15Chinese Central Bank's Gold Holdings Chart I-16Russian Central Bank's Gold Holdings   Even if the PBoC accumulates gold at a slower pace than the Russian central bank, the former’s bullion purchases will exert considerable upward pressure on gold prices due to its sheer size. In short, odds are that China’s central bank will be buying gold on any dips. To accommodate such a large buyer, the gold price will need to surge to discourage potential demand from other buyers. In contrast to gold, China’s demand for copper and oil will be subdued from a cyclical perspective. Copper demand will be tame due to weak capital spending growth. Regarding oil, as we argued in our June 21, 2018 report titled, China’s Crude Oil Inventories: A Slippery Slope, the nation has been importing more oil and petroleum products than it has been consuming. As a result, its crude oil inventories have swelled (Chart I-17, top panel). Adding China’s aggregate crude oil inventories to the OECD’s commercial inventories reveals that global inventories have not really declined since 2017 (Chart I-17, bottom panel). Simply put, crude inventories have moved from the OECD to China. Going forward, given both underlying subdued oil demand and elevated crude inventories in China, its oil imports are likely to expand at a slower pace vs. the past five years (Chart I-18). This combined with high net long positions among global investors in crude oil makes us negative on oil prices. This downbeat view on oil differs from BCA’s house view, which is bullish on the commodity. Chart I-17Oil Inventories: China + OECD Chart I-18China's Oil Demand   While we cannot rule out the risk that geopolitical tensions could escalate in the Middle East, we believe the appropriate strategy for investors should be to sell oil on strength. Besides, pairing this strategy with a long position in gold reduces potential drawdowns in the event of an outburst in U.S.-Iran tensions. Bottom Line: We recommend investors initiate the following position: Long gold / short equal amounts of copper and oil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Treading On Thin Ice Foreign investors have been rushing into Indonesian financial markets on expectations of the Fed cutting rates. As a result, Indonesian financial markets have been more resilient than we expected. While the Fed’s monetary policy is important for Indonesian financial assets, there are other critical drivers of the Indonesian economy and financial markets that investors should take heed of. Namely, global growth and domestic demand. Both factors are currently negative. Cracks are appearing in the Indonesian property market. Persisting exports contraction will keep the country’s current account deficit wide (Chart II-1). A wide current account deficit entails that the rupiah will remain heavily reliant on volatile foreign portfolio inflows. Lesser known but equally important, Indonesia’s domestic demand is anemic. Particularly, the marginal propensity to spend among businesses and consumers is diminishing (Chart II-2). Truck and passenger car sales are contracting, while motorcycle sales are edging closer to contraction (Chart II-3). Chart II-1Indonesian Exports: Double-Digit Contraction Chart II-2Indonesia: Domestic Spending Is Subdued   Critically, cracks are appearing in the Indonesian property market. Residential property prices are rising only by 2% from a year ago in local currency terms (Chart II-4). Additionally, domestic cement consumption is shrinking and revenues of two MSCI-listed real estate companies are also contracting.  Chart II-3Indonesia: Vehicle Sales Are Declining Chart II-4Cracks In Indonesia's Property Sector   Chart II-5Non-Bank Stocks Are Not Rallying Turning to the equity market, Indonesia’s stock market breadth is extremely narrow. The rally of the past several months has been almost entirely led by a few stocks, in particular by Bank Central Asia and Bank Rakyat Indonesia. In fact, these two banks - alone - now account for around 32% of the overall MSCI Indonesia market cap. Meanwhile, the performance of non-financial stocks has been extremely poor (Chart II-5, top panel). As for small cap stocks they are now below their 2016 lows (Chart II-5, bottom panel). This has occurred due to chronically weak profitability among non-financial companies. As for banks, in-line with ongoing deceleration in the real economy, their bad-loan provisions are now rising. Additionally, the aggregate banking system’s net interest margin is still falling. These will hurt banks’ profits. On the whole, the deepening growth slump in Indonesia warrants lower interest rates. Yet, reducing interest rates when faced with a wide current account deficit could trigger currency depreciation. At a certain point – when the frenzy about the Fed’s easing subsides, investors will realize the severity of the ongoing growth downturn in Indonesia and the need for lower rates. When this occurs, the rupiah will depreciate and the currency selloff will spread into equities and bonds. Bottom Line: The risk-reward profile of Indonesian markets is not attractive both in absolute term and relative to their EM peers. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations