China
Highlights Beyond the healthcare vote and its implication for Trump's fiscal stimulus, other risks lurk in the background. Market complacency is at historical extremes but Chinese reflation is rapidly dissipating. The euro could benefit in this environment, especially as markets price in a Macron victory. Longer-term, the euro remains hampered by its two-speed recovery, which will limit the capacity of the ECB to lift rates. Stay long EUR/AUD, short USD/JPY and NZD/JPY. Feature The dollar correction continues. The recent wave of dollar weakness has been dubbed a reversal of the "Trump trade". There is some truth to this. The difficulty President Trump and House Speaker Ryan are facing to pass the American Health Care Act (their replacement for Obamacare) is raising questions about how much tax cuts and infrastructure spending Trump will actually be able to implement. Even if the House votes in favor of the new bill (which is still an unknown at the time of writing), the Senate remains a question mark. So the narrative goes, if the Trump stimulus is at risk, the economy will be weaker, the Fed will not hike interest rates as much as anticipated, and the dollar will falter. While there is validity to this thesis, we think the picture is more nuanced. The potential for less fiscal stimulus in the U.S. is a real worry, but our main concern is that the global industrial sector's growth improvement does not continue the way investors expect. In this environment, the dollar is likely to perform poorly against European currencies and the yen, but hold its own against EM and commodity currencies. We are positioned for such a development. These trends would be reminiscent of the kind of dollar dynamics that emerged in late 2015 / early 2016. Chinese Reflation Matters Too! What underpins our thesis? As our sister service, Global Alpha Sector Strategy, has highlighted in this week's report, the Yale Crash Confidence index has hit 100%, indicating that all of the respondents surveyed expect the stock market to go up in 2017. Moreover, the Minneapolis Fed's market-based implied probability of a 20% or more selloff in the S&P 500 has fallen below 10%, the lowest level since 2007.1 With this high degree of complacency, a rollover in the global economic surprise index represents a major risk for the asset most levered to the global industrial sector (Chart I-1). To us, the key behind the 2016 rebound in global industrial activity was China. While Chinese growth is not about to experience a sharp slowdown, it is unlikely to improve further. To begin with, Chinese monetary conditions are already rolling over (Chart I-2). The big improvement in this indicator in 2016 was the crucial ingredient behind the rebound in global trade, global industrial activity, and all the assets levered to these phenomena. Chart I-1Surprises Are Not ##br##Growing Anymore Chart I-2Chinese Monetary Conditions ##br##Are Tightening We are seeing tentative signs of a mini liquidity crunch emerging in the Chinese interbank system. Seven-day repo rates, a key benchmark for Chinese lending terms, have surged from 3.8% at the end of last week to 5.5% on Tuesday, before settling at 5%, the highest level in two and a half years (Chart I-3). By allowing this volatility, policymakers are most likely sending a warning shot to the Chinese real estate sector, which has been a key driver of Chinese metal demand in 2016. This sector alone accounts for 20% and 32% of global refined copper and steel consumption, respectively. Also, as we have highlighted previously, fiscal stimulus was another key factor behind the floor put under Chinese industrial production and fixed asset investment last year. However, Chinese fiscal spending peaked at a 25% yoy growth rate in November 2015 and is now near 0%. This suggests that a key source of stimulus in China has been removed. It is true that Chinese fiscal stimulus is heavily conducted through credit policy. In this context, the recent rise in Chinese borrowing rates does indicate that the Chinese authorities are not intent in jacking up growth anymore. The reduced growth target for this year is a clear re-affirmation of this change in focus. We are seeing signs that these adjustments are starting to bite. The growth rate of new capex projects started has rolled over and is now flirting with the zero line. As Chart I-4 highlights, this indicator provided a very positive signal for the AUD last year and is now forewarning potential risks. Chart I-3Is The PBoC Sending A Message##br## To The Real Estate Industry? Chart I-4Big Risk For##br## The AUD Additionally, the Canadian venture exchange, an index of high risk, small-cap Canadian equities has historically displayed a tight correlation with Chinese GDP growth (Chart I-5). This market is experiencing a negative divergence between its MACD and prices, potentially an early sign that investors are beginning to worry about China. Risk assets globally are not ready for these developments. In fact, EM spreads are hovering near cycle lows, junk spreads are extremely narrow, the VIX is also near cycle lows, and our global complacency indicator suggests that investors are not ready for negative Chinese surprises (Chart I-6). Not only would a negative surprise out of China cause a repricing of all these factors, but periods of market stress - even shallow stress - are associated with rising correlation among assets and among individual equities. The low level of correlation among S&P 500 constituents has been an important factor behind the fall in the VIX and the rise in margin debt. A rise in risk aversion could get turbo-charged by a rectification of these low correlations, prompting a temporary wave of debt liquidation (Chart I-7). Chart I-5A Key China Gauge Is Losing Momentum Chart I-6Complacency Abounds Chart I-7Correlation Risk In this environment, U.S. stocks could easily correct by 5% to 10%. EM stocks may have even more downside as they are more directly exposed to the biggest risk factor: China. From a currency market perspective, this means that defensive currencies could outperform pro-cyclical ones. This is why we remain long the USD against a basket of commodity currencies, but short against the yen - the most countercyclical currency of all. We also are long the euro against the AUD. These views make our publication more cautious about the near-term outlook than BCA's house view. Bottom Line: Risks beyond the outlook for tax cuts in the U.S. lurk in the background. The Chinese authorities have moved away from stimulating the economy, and some early cracks are showing. A collapse is not in the cards, but given the high degree of complacency present across markets, a disappointment in a supposedly perfect environment would create a headwind for EM and commodity currencies but boost the defensive EUR and JPY. Why Long EUR/AUD Tactically? While the negative view on the AUD fits cleanly in the narrative described above, our motivation to be long the euro is more multifaceted: The euro area has negative nominal interest rates and a current-account surplus of 3.3% of GDP, meaning it exhibits key characteristics of a funding currency. In a risk-off event where unforeseen FX market volatility rises, funding currencies perform well. We expect a further normalization of the French OAT / German bunds spread as we get closer to the French election. Macron is beating Le Pen by more than 20% in second-round polling (Chart I-8). This gap is five times greater than the advantage Clinton held over Trump at a similar point in the U.S. presidential campaign. As we argued in a joint Special Report co-published with our Geopolitical Strategy team seven weeks ago, this kind of advantage is highly unlikely to be overcome by May 7. Thus, the euro area break-up risk premium can narrow between now and then.2 Finally, the number of investors expecting rising short and long rates has bottomed in Europe relative to the U.S. Historically, this indicator has provided valuable lead on EUR/USD. It is currently painting a tactically bullish story for the euro (Chart I-9). Moreover, in the event of market stress, with investors pricing in two more rate hikes by year end in the U.S., but none in Europe, the scope for temporary downward revisions in the U.S. is higher than in Europe. This could put more upward pressure on this indicator and therefore, the euro. Chart I-8Macron: En Marche! Chart I-9Short-Term Euro Upside Together, these factors suggest that the euro could rebound toward 1.12 before the middle of 2017. Again, our favored currency to play this move is against the AUD. EUR/USD: Short-Term Gain But Long-Term Pain Chart I-10Monetary Policy Is The ##br##Common Shock In Europe What about the longer term dynamics for the euro? We are more skeptical of the common currency's ability to rally durably, and we are expecting the euro to fall below parity by mid-2018. Based on our months-to-hike indicator, the market expects the ECB to hike by the fall of 2018. We disagree and think the first hike could come much later. While the economic rebound in Europe is real, it seems to be very dependent on the high degree of easing that has been put in place by the ECB. As Chart I-10 illustrates, the credit impulse - a measure underpinning domestic economic activity - and the euro have moved very closely together. While we do not imply that the credit impulse's rebound has reflected the fall in the euro, their tight co-movement has been driven by a similar factor: easy money. Thus, a removal of that easy money could prompt a reversal of that domestic improvement. Even more crucially, the conditions in the periphery are what really matters to the ECB. At the beginning of the millennium, the ECB was acting as Germany's central bank, keeping rates too low for the periphery, but alleviating Germany's deflationary tendencies. Today, the ECB behaves as the periphery's central bank. Germany seems ready to handle higher interest rates, but the same is not true for most other European countries. To begin with, even within the core, wage dynamics remain tepid. French and Dutch wages continue to slow while Austrian wage growth has collapsed near 0% (Chart I-11A). If the situation is poor in most core countries, it is dismal in the periphery. Wages are still contracting in Greece and Portugal, and growing at a sub 1% pace in Spain and Italy (Chart I-11B). These differentiated wage trends reflect the fact that worker shortages in the periphery are simply inexistent, while in Germany, they are commonplace (Chart I-12). Chart I-11AOnly Germany Is Witnessing##br## Strong Wages... Chart I-11BOnly Germany Is Witnessing ##br##Strong Wages... Chart I-12...Because Germany Has The##br## Tightest Labor Market.... As a result, the dynamics in core inflation remain muted. German core inflation has been extremely stable near 1% for six years now, but is hitting record lows levels of 0.3% in France (Chart I-13A and Chart I-13B). Core inflation also remains near 0% in most peripheral nations. Chart I-13A...Explaining Europe's Bifurcated Core Inflations Chart I-13B...Explaining Europe's Bifurcated Core Inflations When the Fed first increased rates in 2015, U.S. wages were growing at 2%. This is a far cry from current levels in Europe. Moreover, the first U.S. rate hike was a mistake considering the subsequent deceleration in growth and poor performance of risk assets. Thus, the Fed experience is probably not an example for the ECB to emulate. Moreover, rising interest rates represent a risk for debt servicing ratios in many European countries, limiting the ECB's ability to hike if nominal growth does not pick up further. The Netherlands, Belgium, Portugal, and France rank amongst the countries with the highest private-sector debt servicing costs as a percent of income. Meanwhile Italy and Portugal score extremely poorly when this metric is applied to the public sector (Chart I-14). The Italian and Portuguese cases are especially worrisome as rising stress caused by rising rates will further lift government rates. An argument has also been made that for the ECB, what matters is the headline rate of inflation. We would argue that since Draghi became the leader, this inflation measure is less relevant. But nonetheless, let's temporarily entertain this premise. It has also been argued that if European and U.S. statistical agencies treated housing similarly, inflation on both sides of the Atlantic would be the same. As Chart I-15 illustrates, this is no longer true. Chart I-14Debt Service Payments Are ##br## A Problem In Europe Chart I-15European Inflation Is Lower, ##br##No Matter What This line of reasoning also forgets that since 2014, the U.S. has endured a 22% appreciation in the trade-weighted dollar, which could have already curtailed nearly 1% to U.S. GDP growth, a significant amount of monetary tightening. However, the euro has greatly depreciated over this time frame, representing a large monetary easing. Due to these highly divergent monetary backdrops, one can deduce that endogenous inflationary pressures are much greater in the U.S. than in the euro area. All these factors suggest that it will be hard for the ECB to increase rates by the end of 2018. Thus, on a cyclical basis we would fade this recent massive fall in the ECB's months-to-hike metric (Chart I-16). On the U.S. ledger, the labor market is clearly tightening and the U6 unemployment rate is now congruent with levels where wages have gained traction in previous cycles (Chart I-17). This suggests that the market is correct to expect the Fed to hike much more aggressively in the coming years. In fact, while the near future might be filled with political complexity, we continue to expect fiscal stimulus to materialize in the U.S by 2018, suggesting upside risk to the Fed's forecast. Chart I-16Too Soon! Chart I-17The U.S. Labor Market Is Tight Finally, equilibrium real rates in Europe are probably substantially lower than in the U.S. Not only have European interest rates been historically lower than in the U.S., but also, slower population growth alone would justify lower neutral rates. This highlights that the scope for the ECB to hike is limited compared to the Fed. These bifurcated monetary dynamics will continue to support the USD on a 12-18 months basis, and as a corollary, hurt the euro despite its apparent cheapness on a PPP basis. Bottom Line: The months-to-hike in the euro area has fallen to less than 20 months. While Germany could handle higher rates, poor wage and core inflation dynamics in the rest of the euro area suggest it is still much too early to increase rates. Moreover, without a more significant pick-up in growth, many European nations will face dire debt-servicing situations if the ECB hikes rates durably. Meanwhile, the U.S. is moving closer to full employment, a situation warranting higher rates. The euro could fall below parity by mid-2018. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Alpha Sector Strategy Weekly Report, "Caveat Emptor" dated March 24, 2017 available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution" dated February 3, 2017 available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 March weakness has been because of a mix of monetary and fiscal disappointments. The Fed's "unhike" initiated the downtrend as markets were surprised by the dovish tone of the Fed's communications. Now, President Trump and his team are facing difficulties passing the American Health Care Act. Markets are extrapolating this difficulty to the realm of fiscal policy in general. Nevertheless, it is unlikely for the DXY to breach the 98-99 support level this month. The stronger current account number of USD -112.4 billion was supported by high foreign income, suggesting a key warning sign for the USD cyclical bull market is not present. Stronger new home sales monthly growth of 6.1% highlights that domestic economic activity remains robust, meaning the Fed is unlikely to disappoint over the life of the business cycle. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Political risks have been exaggerated in Europe, with the Dutch and Austrian elections confirming that populist successes in Europe are overstated. As such, the French election will likely be market-bullish with a Le Pen defeat. This entails a further normalization of OAT / Bund spreads, and a short-term bullish outlook for the euro, which is likely to settle above 1.10. Corroborating this view, the MACD is currently above 0 and outpacing the signal line, a bullish development. Inflationary pressures are building up in Europe with German PPI at 3.1% annually in February. However, outside Germany, even the core, let alone the periphery, seems to be struggling, with poor wage growth. The ECB will therefore need to stay easy for longer to protect the euro area's weakest members, capping the long-term upside to rates and the euro. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has continued to rally, with USD/JPY trading below 111 over the last couple of days. We continue to be bullish on the yen on a tactical basis, as we believe that the global industrial sector will fall short of investors' expectations. This is an environment where the dollar will probably appreciate against EM currencies, but falter against the yen. On a cyclical basis we remain yen-bearish, as U.S. rates should continue to go up, while Japanese rates will continue to be anchored around 0%. The Bank of Japan will continue with this policy, as the depreciation of the yen has given a boost to exports, which are now growing at 11.3% on a yearly basis, as well as to the economy as a whole, which should yield higher inflation expectations over time. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The British pound rallied on Tuesday following the unexpected surge in headline inflation in February from 1.8% to 2.3%. This number is significant, because inflation has broken through the BoE's target. The central bank remains cautious, as the MPC pointed out that the rise in inflation is not domestic, but rather a reflection of the fall in the pound. However, we believe that internal inflationary pressures might start to emerge: the U.K. economy is doing much better than expected and the labor market is tight. Recent data highlights this, and opens the possibility that the pound could rally, particularly against the euro: Retail sales growth and retail sales ex fuel growth came in at 3.7% and 4.1% respectively, outperforming expectations. The CBI Distributive Trades Survey monthly growth also beat expectations, coming in at 9%. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As mentioned last week, the AUD's strength was a temporary feat. Before declining, the Aussie was initially lifted by high house price growth of 7.7% annually for 4Q2016, really surpassing expectations. The RBA minutes highlighted a need for the current monetary policy to remain very accommodative: labor market conditions remain mixed, household perceptions of personal finances is at average levels, wage growth remains subdued, and inflation is expected to rise only slowly. The outlook for the AUD is therefore likely to remain poor. Corroborating this view is a contracting Westpac Leading Index number of -0.1% that may be foretelling weak data. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Yesterday, the RBNZ kept its policy rate unchanged at 1.75%. Governor Graeme Wheeler once again asserted that the kiwi remains overvalued, although he welcomed the recent depreciation of the trade-weighted kiwi. More depreciation might be in the cards, particularly against the U.S. dollar and the yen. Global FX Vol stands at very low levels, thus any uptick could severely hamper the NZD, a carry currency. Furthermore, the tightening in Chinese monetary conditions will likely weigh on commodity currencies. Nonetheless, the NZD could perform well against the AUD as domestic inflationary pressures in Australia are much weaker than in New Zealand. Additionally, the tightening in Chinese monetary conditions should be more harmful for the AUD, given that iron is more sensitive to economic activity than dairy products. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has sustained the recent oil shocks well, helped by the USD's weakness. Indeed, Canadian data has generally been positive: Manufacturing shipments increased 0.6% monthly in January, much above the expected -0.4%; Wholesale sales increased 3.3% in January on a monthly basis; Monthly retail sales picked up to 2.2% and 1.7% when autos are excluded; The 2017 government budget marginally loosened fiscal policy. As the greenback is likely to display further downside, the short-term outlook for USD/CAD is negative. This is corroborated by the negatively trending MACD line. However, Governor Poloz is likely to maintain a dovish tilt relative to the Fed, signifying longer-term CAD weakness. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Following the surge in the Euro, EUR/CHF has moved back to 1.07. This has eased some pressure off the SNB, which was active in the foreign exchange market to preserve the floor in this cross. The early returns of this policy seem positive, as data is showing a gradual recovery in Switzerland: The SNB's trimmed mean core inflation measure (TM15) is now in positive territory and continues to rise. Swiss PMI has surged so far this year, and now stands at the highest level since 2011. So far these improvements are not enough to prompt a change in policy by the SNB, as inflation needs to be sustained at a higher level and corroborated by wages. Nevertheless, we will continue to monitor economic developments in Switzerland to assess whether the SNB could remove its floor under EUR/CHF. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week, as the sharp decline in oil has been offset by a downturn in the U.S. dollar. The outlook for the krone remains poor though, as the economy is weak, and inflation is falling quickly. Recent data illustrates this: After a gradual slowdown, non-financial business credit is now heading into outright contraction. Employment is contracting at a 1% rate, while wages are contracting at a 4% pace. Core inflation has plunged to 1.5% from its peak of 4% around 6 months ago. This poor economic outlook leads us to believe that the dovish bias of the Norges Bank will stay entrenched for the time being, putting downward pressure on the krone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Inflationary pressures continue to emerge in Sweden. We believe these pressures are likely to pick up further. USD/SEK has broken down below a key trend line that has underpinned its rally since May 2016, suggesting that as the euro continues to rebound, the SEK will also outperform the USD. However, it remains to be seen if the SEK can outperform the euro: while the SEK tends to be more sensitive to the dollar's weakness than the euro, the Riksbank is likely to want to make sure that the early signs of inflation in Sweden do indeed generate a durable way out of any deflationary tendencies in this economy. This means that the Swedish central bank is likely to try to weigh on any strength in the SEK, especially against the euro. However, as inflation is indeed coming back, the Riksbank will likely be forced to abandon its super-dovish stance later this year. The SEK will ultimately rally further against the euro on a 12-18 months basis. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Chart of the WeekCopper Term Structure, Inventories##br## Are Not Reflecting Scarcity Transitory supply disruptions and financial demand have kept copper prices buoyant, but these influences will wane. A surge in inventories (Chart of the Week), coupled with slower Chinese demand growth as reflationary policies wind down, will prevent a sharp rally in copper prices. A stronger USD also will weigh on base metals in general, copper in particular. Energy: Overweight. We continue to expect oil inventories to draw throughout the rest of this year and next and are positioned for a backwardated forward curve in WTI. We are adding to our long Dec/17 vs. short Dec/18 WTI spread, which, as of our Tuesday mark to market, is up 183.33% since it was elected on Mar 13/17, and going long Dec/17 Brent vs. short Dec/18 Brent position basis tonight's close, as a strategic position. We also are adding a tactical position in WTI, buying $50/bbl calls vs. selling $55/bbl calls for July, August and September delivery basis tonight's close. Base Metals: Neutral. We remain neutral base metals longer term. Transitory supply disruptions in copper markets will subside, while reflationary stimulus in China will wane, keeping a lid on prices near term (see below). Precious Metals: Neutral. Gold rallied 3.7% following the Fed's rate hike last week. We expect this to reverse as the Fed ratchets up its hawkish rhetoric. Our long volatility position in gold - i.e., long a June put spread vs. long a June call spread - is down 27.5%, following the post-FOMC meeting rally. Ags/Softs: Underweight. We remain bearish, and are comfortable on the sidelines going into the month-end planting-intentions report from the USDA. Higher output of corn and beans in South America and a well-supported USD keep us bearish. Feature Actions taken by Chinese policymakers to slow the property market, wind down reflationary policies, and resume the pivot to services- and consumer-led growth will be critical to the evolution of copper demand, hence prices. Near term, we expect transitory supply disruptions in key mines in Chile, Peru and Indonesia will be addressed, and ore output will be restored. A stronger USD will present a headwind to copper demand, and will lower local production costs in Chile, Peru, Indonesia and elsewhere. Supply And Demand Shocks In the short-term (i.e. 2-3, months), copper prices should remain supported by the disruptions at Escondida in Chile, Grasberg in Indonesia, and more recently at Peru's biggest mine, Cerro Verde. Additionally, flooding in Peru is disrupting copper mining and transport operations beyond Cerro Verde, forcing the declaration of force majeure. BHP Billiton's third meeting with union officials at its Escondida mine failed to end to the strike. This is the world's largest mine - producing ~ 1.1mm MT/yr, or 5% of world supply. Escondida hasn't produced any copper since the strike began on Feb 9/17. This has reduced Chilean copper output 12% yoy as of February, and reduced Chile's GDP by ~ 1%. Unions this week showed interest in resuming talks with management, however. A settlement between PT Freeport Indonesia (PT-FI) and the Indonesian government re export permitting for Grasberg output has yet to materialize. PT-FI produced ~ 500k MT last year. As of this week, PT-FI restarted producing around 40% of its capacity. Lastly, strike action at the Cerro Verde mine is set to end today by order of the Peruvian government, but union officials said the strike would resume Friday if no agreement is reached with management. Cerro Verde produced ~ 500k MT of copper last year; the mine currently produces 50% of its capacity, after replacement workers were hired by the company. The lost output of these three mines accounts for ~ 10% of the global copper mine output. These developments clearly represent a transitory, albeit unexpected, supply shock with effects that should start to dissipate as these issues are resolved. It is worthwhile noting that copper is trading lower in the wake of this news, suggesting markets either prepared for labor action ahead of time - building precautionary inventories ahead of the labor-contract negotiations now underway - or that demand growth is slowing. We think a combination of both likely explains the price weakness following the transitory supply disruptions noted above. On the demand side, any optimism about rising copper prices due to an expected $1 trillion fiscal package in the U.S. is misplaced. Indeed, increased U.S. infrastructure spending - a largely unknown demand-side factor in terms of its details and dimensions - does not figure prominently in our assessment of future copper and based metals prices. The U.S contribution to global copper demand, and to base metals consumption in general, remains limited and has been decreasing in the last decades. U.S. copper demand now represents ~ 7.5% of world copper demand. Therefore, the U.S. market has a relatively small influence on copper prices compared to China, which accounts for close to 50% of global demand (Chart 2A and Chart 2B). Chart 2AU.S. Copper Consumption Pales Relatively To China Chart 2B We believe recent run-up in copper prices mainly was due to financial demand rather than physical demand (Chart 3). This elevated demand from financial investors could elevate price volatility, as any new fundamental information that provokes a sudden change in the copper outlook - e.g., faster restart to once-sidelined production, say, at Glencore's Katanga Mining facilities in the DRC, which are scheduled to be back on line later this year and next - could lead to an exodus of investors out of their long positions. Copper ETF holdings and copper open interest have been elevated in past weeks, and can have a significant effect on the evolution of copper prices (Chart 4).1 Prices have started to trend lower, a development that bears watching, given the still-high speculative holdings of the red metal. Chart 3Speculators Are Exiting Copper, ##br##Even As Supply Disruptions Mount Chart 4China PMI Vs. Copper Net Speculative Positions: ##br##Spec Positioning Matters For The Red Metal Global Copper Fundamentals Keep Us Neutral Looking at the next 6 to 12 months, we see no clear evidence to be bullish copper given supply-demand fundamentals. On the supply side, Australia's Department of Industry, Innovation and Science (DIIS) estimates mine output will be up 3.1% this year to 21mm MT - roughly in line with our estimates - and 4.1% next year to 21.8mm MT. Refined output hit a record high of almost 23.6mm MT last year, and is expected to increase 2.5% next year to 24mm MT. By 2018, the DIIS expects refined output to be up 4%, at 25mm MT. Large production gains were reported by the International Copper Study Group (ICSG) for Peru, where mine output was up 38% at 650k MT last year, offsetting lower mine production in Chile, where output was down 3.8% to 220k MT. Global production estimates by the DIIS for 2016 were in line with ICSG estimates for both mine production and world refined production. The ICSG estimates were released earlier this week. Global demand was up 3% last year at 23.4mm MT, and is expected to increase 2% this year to 24mm MT and 3% next year to 24.6mm MT, based on DIIS's estimates. These estimates also are in line with the ICSG's assessment of global sage. The ICSG estimated global demand last year was up ~ 2%. As is apparent, global supply and demand for copper have been, and will remain, relatively balanced this year and next (Chart 5).2 This will be supported by countervailing fundamentals: Global economic activity is picking up, especially in the manufacturing sectors of major economies, which will be supportive for copper prices (Chart 6); and, running counter to that, A strong USD, coupled with inventories at close to 3-year-high levels, will keep copper prices from escalating dramatically.3 Chart 5Global Copper Market Is Balanced Chart 6Global Growth Synchronization Is Underway China's Reflationary Policies Will Wind Down While reflationary policies launched over the past couple of years will continue to stimulate the Chinese economy in 2017, the fiscal and monetary impulses from them are waning. China's manufacturing sector, fixed-asset investment and the property sector are expected to stay strong during the first half of the year, which will support copper demand (Chart 7). However, this stimulus is winding down, and, following the 19th National Congress of the Communist Party in the autumn, we expect it to decline at a faster pace: These lagged effects of the wind-down of fiscal and monetary stimulus will be apparent - particularly in the property markets. Policymakers likely will reduce and re-direct policy stimulus to support consumer- and services-led growth, and continue to invest in the country's electricity grid, which accounts for about a third of China's copper demand. Net, demand likely will grow, but at a slower pace. Global copper inventories are now at an elevated level, which suggests there is no alarming scarcity in the market. This is corroborated by the contango observed in the copper futures market (Chart of the Week). An important takeaway from last week's People's Congress is that the main objective of Premier Li's work plan is to maintain economic and social stability. This primary objective is now more important than the Communist's Party's growth objective, and can be seen in the lower GDP growth target approved by policymakers (6.5%) going forward. The Chinese fiscal impulse already has started to roll over - government expenditures are now growing at a rate of close to 7.5% versus a peak of 29% in Nov/15 (Chart 8). This poses a risk to the downside for base metals prices, given that much of China's base-metals demand is dependent on government expenditures. Chart 7Fixed Asset Investments Are Resilient Chart 8Expansionary Chinese Fiscal Policy Is Slowing Down Chart 9China Might Have Reached A Sustainable Growth Path That said, recent data from China showing resilient industrial activity and fixed-asset investments despite the roll-over in government expenditures gives hope the economy reached a sustainable growth path and that it will stay buoyant throughout the year (Chart 9). China's Red-Hot Property Market Will Cool China's housing sector has, since the economy's liberalization in the late 1990s, grown into one of the most important drivers of its GDP. Most of the 2002 - 2010 increase in base metal prices - nearly 85% - can be explained by the spectacular growth in the Chinese housing sector.4 Building construction accounts for close to 45% of total copper consumption in China (Chart 10). Within that, residential construction makes up 70% of China's real estate investment, according to Australia's DIIS.5 Globally, China accounts for a third of the copper used in construction, according to the CME Group.6 This equates to ~ 10% of global copper usage. Chart 10Building Construction Is Crucial For Copper Demand In 2016, the Chinese real estate sector experienced extremely high growth, which was mainly fueled by easy access to credit, interest-rate cuts, easing of mortgage rules and an income effect from reflationary policies. This tendency reversed in late 2016 - early 2017, as can be seen in Chart 11. Looking forward, the evolution of the housing market will rely heavily on the policy path taken by the Chinese government. In the second half of 2016, the high level of speculative demand apparent in the property market red-flagged Chinese authorities that a price bubble was developing, producing an inflated debt load that posed a risk to future economic growth. President Xi repeatedly affirmed that China's priority going forward will be to keep the economy stable. This implies keeping the property market stable by nudging investment behavior and expectations to control the supply-side of the market. This is reflected in President Xi statement: "houses are for living in, not for speculating" during the recent Peoples Congress.7 Chinese authorities will maintain loan restrictions and stricter selling conditions implemented late last year, for first- and second-tier cities, where prices increased dramatically. First-tier newly constructed residential building prices were up on average by 18% year-on-year in February 2017, and the National Bureau of Statistics of China's sales price index of residential buildings in 70 large and medium-sized cities was up 11.3% in 2016. For other cities - where home inventories are still elevated and prices are relatively stable - the government could keep its facilitating policies in place, to encourage consumption and to draw down inventories of unsold homes. These developments will introduce downside risk to copper prices, given the importance of Chinese residential construction. Still, the Chinese government cannot allow real estate prices to drop suddenly, or even to slow too much, given that housing remains the main savings vehicle - directly or indirectly - for households. According to Xi and Jin (2015), Chinese citizens save around 70-80% of their wealth via the property market. It is true that financial innovation and the opening of Chinese financial markets should help households save using alternative strategies. However, changing households' savings behavior is not an instantaneous process. Moreover, we believe reflationary policies in other sectors of the economy will remain accommodative during the first half of the year, as headline and core inflation are still at relatively low levels (Chart 12). And, as mentioned previously, we expect continued investment in China's power grid, which will support copper prices this year and next. As the consumer economy grows, we would expect demand for electricity to continue to grow. Chart 11China's Property Market Peaked In 2016 Chart 12Inflation Close To Six-Year Lows Bottom Line: Combining these opposing effects, Chinese demand should remain high enough to maintain copper prices at a relatively stable level in 2017. However, following the 19th Communist Party later this year, we expect reflationary stimulus to wind down and for fiscal and monetary policy to be directed to supporting consumer- and services-led growth, which is less commodity intensive than heavy industrial and investment-led growth. We strongly believe the Communist Government will strengthen its focus on stronger enforcement of environmental regulations, which will introduce new supply-demand dynamics to the copper market. We will be exploring the "greening" of China in subsequent research, and its implications for base metals demand. Hugo Bélanger, Research Assistant Commodity & Energy Strategy hugob@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We found that year-on-year variations in copper prices and in speculative long open interest exhibit a feedback loop - there is two-way Granger causality between them (i.e., they are endogenously related and each of their lagged values explain variation in the other's current price). The causality is stronger from copper prices to speculative long open interest; however, it also is significant the other way around. This means that in period of high speculative interest in copper - similar to what we experienced following the U.S. presidential election in late 2016 - the open interest variable is actually driving copper prices in the short term. We have also been able to explain copper prices by modeling year-on-year percentage change in the broad U.S trade-weighted index (TWI), Chinese PMI and in speculative long open interest. We find a 1% increase in the yoy speculative long open interest leads to a 0.19% increase in yoy copper prices. The adjusted R2 of the regression is 0.84. 2 The ICSG estimated there was a 50k MT deficit last year, trivial in a 23.4mm MT market. 3 We estimated the long-term relationship between copper prices, china PMI, world copper consumption and the U.S. TWI using a cointegrating regression. Interestingly, we found that, in equilibrium, a 1% increase in the China PMI variable translates to a 1.17% increase in copper prices. This relation can obviously be thrown out of equilibrium following an exogenous shock to the fundamentals of any of the variables in the model. The adjusted R2 of the regression is 0.71. 4 Please see "The Evolution of The Chinese Housing Market and Its Impact on Base Metal Prices," published by the Bank of Canada, March, 2016. It is available at http://www.bankofcanada.ca/wp-content/uploads/2016/03/sdp2016-7.pdf. Using an approach that accounts for the uncertainty around the official data, the lack of consistency in the data and the high level of seasonality and volatility in the data, the authors concluded that the Chinese GDP would have been around 9% lower at the end of 2010 in a scenario in which the housing market did not grow after 2002. Following this, they estimated two vector-error-correction models (VECM), one with the actual level of global activity, and one where the Chinese activity is 9% lower. 5 Please see "China Resources Quarterly" published by Australia's DIIA. It is available at https://industry.gov.au/Office-of-the-Chief Economist/Publications/Documents/crq/China-Resources-Quarterly-Southern-autumn-Northern-spring-2016.pdf 6 Please see "Copper: Supply and Demand Dynamics," published by the CME Group January 27, 2016. 7 Please see "Xi says China must 'unswervingly' crackdown on financial irregularities" published by Reuters. It is available at http://ca.reuters.com/article/businessNews/idCAKBN1671A0 Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016
Highlights The U.S. Treasury is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment in April. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers. The risk of that at the moment is low. The current episode of Chinese capital outflow can be largely viewed as the unwinding of the RMB "carry trade". The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Beyond the near term, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Feature As we go to press this week, the Federal Reserve has just released its interest rate decision. The 25-basis-point rate hike was well anticipated, and the markets should be assuaged by the fact that the Fed does not anticipate a more rapid pace of rate hikes than it did in December. As far as China is concerned, the RMB, which has been put on the backburner by global investors in recent months, is once again back in the spotlight, as its descent against the dollar has resumed after a relatively calm period. Both Chinese interest rates and the USD/CNY have been pushed higher by the latest moves in U.S. Treasury prices and the broad dollar trend (Chart 1). Chart 1The U.S. Connection Beyond The Currency Manipulator U.S. Treasury Secretary Steven Mnuchin signaled late last month that he wants to use a regular review process of foreign-exchange markets to identify currency manipulators, which means the U.S. administration intends to follow normal legal procedure to decide if China is manipulating its currency. This is a significant departure from President Donald Trump's repeated campaign trail promises, and has reduced the odds of an immediate clash between the U.S. and China on the RMB. If the Treasury follows the formal process laid out in statutory law, it is unlikely to label China as a currency manipulator in the upcoming semi-annual assessment to be published in April, simply because the country does not meet all the conditions required for being charged with currency manipulation, as discussed in detail in our previous report.1 Even if China was indeed labeled a currency manipulator in the April assessment, the existing procedure does not authorize the administration to immediately impose punitive measures. Instead, the law requires the Treasury to negotiate with the allegedly "guilty" party to correct the currency manipulation and remove unfair trade practices. Even if negotiations fail, the punitive measures that the Treasury must follow under the existing legal framework are largely symbolic for a country like China. The recommended remedial measures such as prohibiting federal procurement from offending countries and seeking additional surveillance through the International Monetary Fund are hardly biting for China. In short, a "currency manipulation" charge, even if it were imposed, would mostly be a symbolic move, and the real economic consequences would be limited. A bigger threat is the possibility that President Trump unilaterally imposes punitive tariffs or import quotas on Chinese goods through administrative powers, which would be far more unpredictable and would inevitably lead to harsh retaliation from the Chinese side. The risk of that at the moment is low. President Trump appears to be occupied with domestic issues and has notably toned down his anti-China rhetoric. Meanwhile, President Xi is reportedly scheduled to visit the U.S. next month, at which time he will likely seek to improve bilateral ties. We expect both sides will try to set up a new high-level mechanism for effective communication and negotiations over key policy issues to replace the annual U.S.-China Strategic and Economic Dialog (S&ED) under the Obama administration. Given the numerous "China hawks" in President Trump's inner circle, trade frictions between the two countries will likely increase, but the risks appear to be pushed out to at least next year. Where Did The Money Go? China's official foreign reserves have stabilized at around US$3 trillion in recent months, compared with a peak of over US$4 trillion in the second quarter of 2014. The common perception is that the People's Bank of China (PBoC) has been fighting a constant bleed of domestic capital, and the rapid decline in its foreign reserves means an ever-smaller war chest, which will eventually force the PBoC to surrender. There has been open debate within China's policy-making circles and prominent think-tanks on whether the PBoC should protect the RMB exchange rate or preserve its official reserves. While the decimal changes in China's official reserves have been grabbing headlines among the financial media of late, much less known is China's total international investment positions. In fact, China having a hefty current account surplus means the country's domestic savings exceed its domestic investment, and subsequently the excess savings become holdings of foreign assets - the PBoC's official reserves are just a part of the country's growing total foreign claims. Therefore, it is important to have a closer look at China's total foreign investment positions to understand cross-border capital flows. On the asset side, since the second quarter of 2014 when official reserves peaked out, China's total foreign assets have continued to grow, albeit at a slower pace (Chart 2). The decline in official reserves has been more than offset by increases in other forms of investments. Specifically, direct overseas investments, foreign loans and holdings for foreign securities increased by US$503 billion, US$170 billion and US$79 billion, respectively, between Q2 2014 and Q3 2016, the latest available data points, compared with a US$792 billion decline in official reserves during the same period. In other words, the country as a whole has continued to accumulate foreign assets, but the corporate sector and households have been increasing their holdings at the same time that the public sector has been trimming positions. On the liability side, the Chinese corporate sector has been paying back foreign debt aggressively since Q2 2014, which also increased demand for foreign currencies and contributed to the decline in the PBoC's official reserves. Loans and trade credit taken by Chinese firms dropped by US$423 billion between Q2 2014 and Q3 2016. The outstanding balance of total foreign loans and trade credit at the end of Q3 2016 stood at US$583 billion, almost half the US$1 trillion peak in Q2 2014 (Chart 2, bottom panel). Regarding foreigners' claims in China, the RMB fluctuation has had no meaningful impact on both foreign direct investments (FDIs) and foreigners' investments in Chinese domestically listed securities such as stocks and bonds. In fact, both FDIs and foreign investments in Chinese securities have continued to rise despite heightened anxieties on the RMB (Chart 3). However, foreigners' liquid holdings of Chinese financial assets, cash and savings deposits have dropped by US$100 billion from a peak of US$441 billion in Q2 2014 to US$340 billion at the end of Q3 2016. This could well be the withdrawal of foreign "hot money" that flew into China in previous years. Chart 2Where Did The Money Go? Chart 3Foreign Investment In China: The Ins And Outs Taken together, the decline in China's official reserves appears less disconcerting. Chinese companies' debt repayments and foreign "hot money" repatriation accounted for the lion's share of the decline in Chinese foreign reserves since 2014. Therefore, the current episode can be largely viewed as the unwinding of the RMB "carry trade": In previous years, when the RMB was appreciating against the dollar, Chinese firms undertook loans in dollars and foreign 'hot money" also rushed into China - the tide has been reversing as the USD/CNY trend has shifted. The PBoC's official reserves have functioned as a reservoir to buffer volatile cross-border capital flows driven by short-term speculative incentives. Chinese Foreign Reserves: The Big Picture While the dominant concern at the moment is that Chinese official reserves, still by far the largest in the world, are not enough to maintain exchange rate stability, easily forgotten is that the consensus was the opposite a mere three years ago (Chart 4). Back then the prevailing view was that the country had too much foreign reserves, which was both a waste of resources and an economic burden. While popular perceptions in the marketplace always swing dramatically, it is important to keep the big picture in mind. At the onset, official reserves currently account for 50% of China's total international investment positions. This is a notable decline from a peak of 71% in 2009, but still far higher than any other major economy (Chart 5). For example, Japanese official reserves account for 16% of total international claims, 26% for Taiwan, and a mere 2% for the U.S. Chart 4Chinese Official Reserves Are ##br##Still By Far The Largest Chart 5Chinese International Assets Are ##br##Primarily Official Reserves As China's foreign assets are primarily represented in official reserves, the return of China's foreign claims is extremely low, as official reserves are mainly invested in risk-free highly liquid assets, with achieving higher returns always having been of secondary consideration. The average return of Chinese foreign assets has been hovering around 3%, not much higher than U.S. Treasury yields (Chart 6). By contrast, foreign investments in China are primarily engaged in the real economy and are able to garner much higher yields. This mismatch, ironically, has led to a net loss in China's international investment position. In other words, even though China is a massive net creditor to the rest of the world, the country's net investment income has in fact been negative, as the country pays a lot more to foreign investors than it gets from its own overseas investments. Chart 6China Gets Less Than It Pays This mismatch has been one of the key reasons why the PBoC in previous years tried to encourage domestic entities to hold foreign assets directly rather than through official channels in the form of foreign reserves. The more recent rapid increase in capital outflows from the Chinese corporate sector and households has challenged the PBoC's near-term priority to maintain exchange rate stability, prompting the authorities to tighten capital account controls to support the RMB. From a big-picture point of view, however, the Chinese authorities will likely continue to encourage domestic entities to directly acquire foreign assets to improve the returns of the country's overall international investment positions. All in all, the near term CNY/USD cross rate will remain largely determined by the Fed action and the broad trend of the dollar, but the PBoC will continue to intervene to prevent major currency depreciation. The RMB is unlikely to depreciate against the greenback more than other major currencies in a period of dollar strength. The grand trend of increasing Chinese overseas investment by the private sector will resume once the downward pressure on the RMB dissipates. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?," dated November 24, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Global stocks and bonds have priced in a goldilocks scenario - strong growth and low inflation/interest rates. In the short term, global bond yields are set to rise further. Risk assets, especially EM ones, are vulnerable on the back of higher bond yields. Thereafter, global bond yields will roll over decisively as inflation worries subside. Risk assets will probably recover some lost ground in this phase. Toward the end of this year, growth disappointments in EM/China will resurface and EM risk assets will sell off again. Feature The near-term risks to emerging markets (EM) and global stocks over the next three months or so are potential inflation anxieties in the U.S. and around the world, and a further rise in U.S./global interest rate expectations. Yet looking beyond the short-term, it is not clear that the rise in global inflation will be lasting. Timing zigzags in financial markets is almost impossible. However, if we were to try to speculate on potential swings in financial markets over the next 12 months, our prediction would be that the current growth acceleration will soon lead to heightened inflation worries, and global bond yields will climb further. Having already rallied a lot, global share prices will likely relapse, with EM risk assets being hardest hit on the back of rising U.S. bond yields. Thereafter, there will likely be a period of calm when inflation worries subside due to growth disappointments, and bond yields roll over decisively. Risk assets will probably recover some lost ground in this phase. Yet this calm phase might not last too long as EM/China growth will relapse considerably again toward the end of this year. In short, another global growth scare driven by EM/China is likely to transpire later this year. Any potential U.S. trade protectionist measures will play into this scenario - augmenting U.S. inflation expectations initially when adopted and then, when implemented, dampening global growth. Please note that this is the view of BCA's Emerging Markets Strategy service, which differs from BCA's house view that is cyclically positive on global stocks/risk assets. Neither the inflation fears/higher interest rates episode nor the growth scare phase that we believe is in the cards later this year are bullish for EM risk assets. Therefore, we maintain that the risk-reward for EM risk assets is extremely unattractive at the current juncture, even if global growth stays firm for now. More Upside In Bond Yields Inflation has been accelerating in the U.S. and China: The average of U.S. trimmed-mean CPI and PCE, median CPI and market-based core CPI inflation has risen above 2% (Chart I-1). The individual components are shown in Chart I-2. Chart I-1U.S. Inflation Measures Are In Uptrend Chart I-2Broad-Based Rise In U.S. Inflation BCA's U.S. wage tracker - a mean of four different wage series - is also accelerating (Chart I-3, top panel), signaling a tightening labor market. Wages are critical to inflation dynamics because not only are wages the largest cost component of a business but also higher wages entail more consumer spending, making it easier for companies to raise prices. That said, what drives cost-push inflation is not wages but unit labor costs. In the U.S., unit labor costs have been rising signaling accumulating pressure on businesses to raise prices (Chart I-3, bottom panel). In China, core (ex-food and energy) consumer, retail and trimmed mean consumer inflation are in an uptrend (Chart I-4). Chart I-3U.S. Wages And Unit Labor ##br##Costs Argue For More Inflation Upside Chart I-4China: Inflation Is Picking Up However, disposable income (a proxy for wages) growth in China remains subdued, given economic growth has been very weak (Chart I-5, top panel). Hence, there are no imminent wage pressures in China like there are in the U.S. That said, unit labor costs in China are still rising because output per hour (productivity) growth has decelerated notably (Chart I-5, bottom panel). Real (adjusted for inflation) interest rates have not yet increased much and remain low worldwide. As global growth conditions remain robust and inflation data surprise on the upside, interest rates both in nominal and real terms will likely rise. In the U.S., 10-year Treasury yields adjusted for the average consumer price inflation (currently running at 2.0%) stand at 0.35% (Chart I-6, top panel). Consistently, U.S. 10- and 5-year TIPS yields are 0.6% and 0.2%, respectively (Chart I-6, bottom panel). Provided U.S. growth remains robust and the labor market continues to improve, there are no reasons for U.S. TIPS yields to stay at these low levels. Chart I-5China: Wage Proxy And Unit Labor Costs Chart I-6U.S. Real Yields Are Low A strong U.S. dollar could have been an impediment to a potential rise in real rates, but year-to-date the greenback has been tame. In addition, U.S. share prices and high-yield corporate bonds are handling the news of Federal Reserve tightening well. All of this opens a window for both nominal and real U.S. bond yields to rise in the near term. On the whole, either the U.S. dollar will spike soon or U.S. interest rates will climb further. The latter will eventually cause the greenback to appreciate. This will be especially troublesome for EM risk assets. In China, the real deposit rate has turned negative (Chart I-7, top panel). In the past, when the real deposit rate was negative, the central bank hiked interest rates (Chart I-7, bottom panel). If households do not get a more attractive deposit rate, they will opt for foreign currency, real assets like property or riskier investments domestically. All of this entails negative consequences for China's financial stability. Considering the above as well as improved growth in China and higher bond yields globally, we expect mainland policymakers to tolerate marginally higher interest rates. Notably, China's onshore domestic corporate bond yields, swap rates and the interbank repo rate have already been rising since last autumn - a trend that will likely persist for now (Chart I-8). Chart I-7China: Real Deposit Rates Have Turned ##br##Negative China: Real Deposit Rate Is Negative Chart I-8China: Interest ##br##Rates Are In Uptrend We do not have strong conviction on how persistent and pervasive the nascent inflation uptrend will be in the U.S. and China. Inflation is driven by numerous structural and cyclical variables, and they often work in opposite directions. The outlook for these variables is not identical to draw a definite conclusion about the inflation trajectory in the long run. In this report, we cover just one aspect of inflation - how liquidity and money relate to and drive consumer prices (please see the section below). Bottom Line: Odds are that there could be a global inflation/interest rates scare in the near term, and bond yields will continue rising in the next two to three months. Monetary-Liquidity Approach To Inflation As Milton Friedman famously stated: Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. Yet a relevant question is which monetary aggregates do really impact inflation. Identifying specific monetary aggregates that impact inflation will help us gauge the outlook for the latter. Central bank liquidity provisioning to banks does not necessarily cause inflation to rise. It is money/credit creation by commercial banks that generates higher inflation. In any banking system, it is commercial banks that create loans. Central banks emit and supply banks with liquidity - commercial banks' reserves held at the central bank - but the monetary authorities do not create money directly, except when they finance the government or non-bank organizations directly or buy financial assets from them. Money is created by commercial banks when they originate loans. Similarly, money is destroyed when a loan is repaid to a bank. Commercial banks do not need savings and/or deposits to originate loans. They create a deposit themselves when they grant a loan. Yet banks require liquidity (reserves at the central bank) to settle their payments with other banks. Banks seek liquidity in various ways, such as by attracting deposits, borrowing money from the central bank and in interbank markets as well as raising funds abroad, among other methods. When a bank attracts deposits, these deposits constitute outflows of deposits from other banks, or a drainage of cash in circulation that was once a deposit at another bank and was cashed out. In short, these deposits do not fall out of the sky, and do not constitute new deposits/savings in the banking system and the economy. On the whole, when a commercial bank extends a loan it creates a new deposit, and thereby new money - i.e. it increases money supply. When a bank attracts a deposit, it does not create a new deposit or new money. The existing money/deposit simply moves from one bank to another, or from cash to deposit. The amount of money supply does not change. A bank does not need liquidity (reserves at the central bank) for each loan it generates. It requires liquidity (reserves at the central bank) only to settle its balance with other banks or to meet minimum reserve requirements. If a bank creates a loan but still has excess reserves at the central bank, it might not require liquidity to "back up" the loan.1 This is the reason why quantitative easing programs implemented by central banks in the advanced countries did not produce high inflation. Even though central banks conducting QEs - the Fed, the European Central Bank and the Bank of Japan - supplied a lot of banking system liquidity, and commercial banks' reserves at the central bank skyrocketed, commercial banks initially were reluctant to originate new loans. Where are we presently in money/credit cycles in major economies? Chart I-9 demonstrates broad money growth for the U.S., the euro area, China and EM ex-China. Broad money growth is still strong across the world. In addition, there is a reasonable, albeit not perfect, correlation between broad money and inflation as depicted in Chart I-10. In China, money aggregates in 2015-16 were distorted by the LGFV debt swap. Outside this episode, there is a reasonable relationship, as one would expect: broad money growth explains swings in inflation. The key message from this chart is that the rise in inflation is possible in the near term but is unlikely to prove sustainable and lasting in these largest three world economies if broad money growth continues downshifting. The reason behind the drop in broad money growth is a notable slowdown in bank loans in the U.S. and China (Chart I-11). Chart I-9Broad Money Growth Across World Chart I-10Broad Money Growth And Inflation Chart I-11Bank Loan Growth Slowdown In The U.S. And China It is a safe bet that with more upside in global and local interest rates, bank loan growth is likely to slump in China/EM. Furthermore, given the credit bubble in China and the authorities' efforts to contain risks, odds are that bank loan and overall credit growth will decelerate by the end of this year. On another note, the sheer size of the credit bubble in China is also corroborated by the amount of outstanding broad money. In common currency (U.S. dollar) terms, the outstanding amount of broad money (M2) is almost two times larger in China than M2 in the U.S. and M3 in the euro area (Chart I-12). This is despite the fact that China's nominal GDP is US$11 trillion, smaller than U.S. GDP of US$19 trillion, and comparable to euro area GDP of US$12 trillion. In fact, the outstanding broad money supply in China in absolute U.S. dollar terms is only slightly less than the combined broad money supply in the U.S. and euro area. Chart I-13 illustrates broad money as a share of country GDP in all three economies. The upshot is that Chinese commercial banks have created much more money relative to GDP than U.S. and euro area banks. Chart I-12China's Money Supply Is ##br##Enormous In U.S. Dollars And... Chart I-13...Relative To GDP The question is why China has not had high inflation despite such immense money overflow. The answer is that China has been investing a lot, and the supply of goods and services in China has risen very rapidly too. That said, this money has created a property market bubble in China. We will discuss/debate the issues surrounding China's money, credit and savings in a forthcoming China Debate piece with our BCA colleagues. Bottom Line: What ultimately drives economic cycles and inflation is money created by commercial banks, not central bank liquidity provisioning to banks. China/EM broad money growth is still unsustainably strong and it will fall further. Growth Scare Before Year End? Chart I-14China: Corporate Bond Prices Are Falling If EM/China credit growth decelerates, as we expect to happen toward the end of this year, it will not only cap inflation but also cause a growth scare. Although U.S. and euro area growth could soften a notch from current levels, the main downside to global growth stems from EM/China, as we have repeatedly written. Given China's onshore corporate bonds rallied dramatically in 2015-'16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015 (Chart I-14). Chart I-15U.S. And German Bond Prices More Downside? This will in turn cause corporate bond issuance and other non-bank financing to slump. This will occur at time when bank loan growth is already decelerating, and the authorities are aiming to reduce speculative activity in the financial system via a regulatory clampdown. Ultimately, higher borrowing costs along with regulatory tightening of banks' off-balance-sheet operations will cause a slowdown in China's domestic credit flows in the second half of 2017. The rest of EM will decelerate on the back of a China slowdown, which will reverberate via lower mainland imports and declining commodities prices. In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation. Bottom Line: A renewed slump in China/EM growth later this year will trigger growth disappointments globally. Investment Strategy It seems global stocks and bonds have priced in a goldilocks scenario - strong growth and low inflation/interest rates. DM bond yields will likely rise further. Remarkably, both U.S. and German 30-year bond prices have already fallen by 23% from their July highs and there might be more downside (Chart I-15). BCA's Relative Risk Indicator for U.S. stocks versus U.S. Treasurys is over-extended at a very high level (Chart I-16). When this indicator has historically been at similar levels underweighting stocks versus bonds has paid off. Notably, when inflation is rising equity multiples should shrink. This has often been the case in the U.S., though not lately (Chart I-17). Chart I-16U.S. Stocks-To-Bonds Relative Risk Indicator Chart I-17Rising Inflation = Compressing Multiples Chart I-18A Number Of EM Currencies Are Facing Resistance EM risk assets warrant an underweight position across equities, credit and currencies. The list of our country allocation within the EM universe for stocks, credit and local bonds is provided on page 14. Commodities prices in the near term are at risk from a strong U.S. dollar and later in the year from a slowdown in Chinese growth. Several EM currencies are at a critical technical juncture (Chart I-18). We expect these resistance levels not to be broken. We recommend shorting a basket of the following EM currencies versus the U.S. dollar: MYR, IDR, TRY, ZAR, BRL, CLP and COP. On a relative basis, we overweight RUB, MXN, THB, TWD, INR, PLN, HUF and CZK. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For more detailed discussion on the process of money and credit creation, please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, links available on page 16. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Geopolitics will not spoil the stock rally yet; European election risks remain overstated; In China, look beyond the National Party Congress; China's reforms could re-launch in 2018 ... ... But India's reforms are gaining momentum now. Feature The global economy continues to surprise to the upside, with the latest round of global purchasing managers' indices (PMIs) confirming that the business cycle continues to accelerate (Chart 1). In the context of firming global growth, the Fed's decision to hike rates may not produce as violent of a reaction from the dollar as last year, giving way to further upside in stocks. And while investors continue to fret about valuations, U.S. stocks are expensive only relative to history, not relative to competing assets, as our colleague Lenka Martinek of the U.S. Investment Strategy service points out (Chart 2).1 Chart 1Because I'm Happy Chart 2U.S. Stocks Pricey By History, Not Peers What geopolitical news could break up the party over the next six months? Europe: As we argued three weeks ago, the European electoral calendar is unusually busy (Table 1).2 However, we have also posited in our 2017 Strategic Outlook that Europe will be a red herring this year, allowing risk assets to "climb the wall of worry."3 The first test of this thesis comes today, with the Dutch general elections taking place. The polls suggest that the Dutch electorate is not following the populist trend of the Brexit referendum and U.S. election (Chart 3), but rather in the footsteps of the little noticed Austrian presidential election in December, which saw the populist presidential candidate defeated. Dutch Euroskeptics, who have led the polling throughout the last twelve months, are bleeding support as election day approaches. Meanwhile, in France, Marine Le Pen is struggling to keep momentum going with only a month and a half to the first round. Thus far, our thesis on Europe is holding. Table 1Busy Calendar For Europe This Year Chart 3Dutch Euroskeptics Are An Overstated Threat The U.S.: Investors will finally get to put numbers to President Trump's rhetoric when the White House announces its budget on March 16. As we argued last week, President Trump is who we thought he was: an economic populist looking to shake up America's status quo. That suggests he will err on the side of greater deficits and large middle-class tax cuts. We do not think Congress will bar his way, as it has rarely restrained a Republican president from profligacy (Chart 4). We could be wrong, but it is unclear if a more fiscally responsible budget would be negative for the markets. On one hand, it may disappoint optimistic growth projections, but on the other, it would mean that the Fed would have no reason to err on the side of more rate hikes in 2017. Meanwhile, while we continue to fear protectionism's impact on the market, it is unlikely that the Trump White House will focus on trade when so many domestic priorities are looming this summer. Russia: As we argued in a Special Report with the Emerging Markets Strategy group last week, Russia may be entering a low-beta paradigm - escaping from its close embrace with oil prices - due to the combination of orthodox monetary policy, modest structural reforms, and growing confidence in its geopolitical predicament.4 This is not the time for President Putin to rattle nerves in the West. He does not want to give Europe and the U.S. a reason to cooperate. We therefore expect Russia's geopolitical risk premium to continue to decline, a boon for European risk assets (Chart 5). Chart 4Budgets: Republican Presidents##br## Get What They Want Chart 5Russia's Calm##br## Is Europe's Profit From a tactical perspective, we believe that the confluence of geopolitical forces supports our continued overweight of developed-market equities versus those of emerging markets. Within developed markets, the BCA House View is to prefer euro-area equities due to overstated geopolitical risks and favorable valuations relative to the U.S. equity market. BCA's Global Investment Strategy has pointed out that euro-area equities are one standard deviation undervalued relative to the U.S., when one applies U.S. sector weights to them (Chart 6). In addition, BCA's U.S. Bond Strategy service believes that Treasury yields have more room to rise, with growth putting upward pressure on inflation and the Fed in a rate-hike cycle. This makes sense to us given that no major geopolitical risk is materializing and considerable upside risk exists in U.S. growth due to Trump's populist policies. Chart 6European Stocks Still A Buy Relative To U.S. In what follows, we take a break from poring over geopolitical risks in Europe and the U.S. and focus on emerging markets. Since January, very few investors have asked us about EM politics, save for the occasional question about Brazil. However, the two Asian giants - China and India - are both a source of risk: the first a downside, left-tail risk and the second an upside, right-tail risk. China: What Comes After The Party Congress This Fall? Since 2013, we have been outspoken in our low expectations for China's structural reforms.5 This view was confirmed with a series of stimulus efforts that displaced reforms, including the local government debt swap program in 2014 and extensive fiscal and monetary easing in 2015 and especially 2016.6 The upside of weak reforms was better-than-expected growth in the short run, as stimulus took effect. Indeed, China has pulled off a remarkable economic turnaround since early last year: infrastructure and housing investment have increased, the weaker yuan has boosted exports, and the global recovery in commodity prices has helped producer prices to recover, easing deflationary pressures (Chart 7). Chart 7Deflationary Pressures Easing Chart 8Stimulus Dropped Off Accordingly, Chinese policymakers, who are attempting to strike a balance between stimulus and restructuring, have begun leaning against the economy's gathering momentum. Government spending has collapsed now that a 6.5% GDP growth "floor" has been established (Chart 8). A new round of property market regulatory tightening began last fall, though it has had little impact so far. Also, the People's Bank of China has begun draining some liquidity (Chart 9). Signals coming out of the "Two Sessions" over the past two weeks, namely the National People's Congress, suggest that the Chinese leadership is content with the current state of affairs. Policymakers set their growth targets for 2017 a little lower than last year's targets and a little higher than last year's actual performance (Table 2).7 It is a line so thin that it is almost imperceptible. They do not want significant change. Chart 9PBoC Draining Liquidity Table 2China's Economic Targets For 2017 This stance fits with a deeper desire to keep the economy on an even keel during a pivotal year for Chinese politics. The legislative session took place under the shadow of the Communist Party's impending 19th National Party Congress - the "midterm" meeting of the party that happens every five years and features extensive promotions, rotations, and retirements for the party leadership. This year's congress promises to be especially influential because of Xi Jinping's ascendancy and the fact that around 70% of the upper tier of leaders will be replaced. Chart 10, which we have been showing clients over the past year to dampen expectations of stimulus, reveals that the party congress is not normally an excuse to throw open the floodgates of credit and government spending. Rather, it is a reason to avoid anything that might rock the boat, whether stimulus or reform. Chart 10Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses Thus while government spending has declined, it should be expected to rise again if growth slows down too much for too long. There may be a period of slowdown and market jitters before the leaders reach for the fiscal lever again, but the "Socialist Put" remains in place. Meanwhile, we are not surprised that structural reforms continue to suffer. It is not that China has eschewed all reforms but rather that its reforms have focused on centralizing power for the ruling party and alleviating some outstanding social grievances. These are positive in themselves but they do not address the key concerns of foreign investors relating to economic openness, financial stability, and the role of the state. The recent imposition of capital controls and a host of non-tariff barriers in the name of "state security" exemplify a negative trend. The delayed rollout of the property tax is also a sign of Beijing's proclivity to delay policies that may be financially risky.8 And Beijing has only tentatively attempted to cut back state-owned enterprises. Simply put, a push to overhaul any significant sector or sub-sector does not fit Beijing's priorities at the moment. However, if growth, debt, or asset prices should climb too rapidly, then we expect countermeasures to tamp them down. Even on the geopolitical front - where we have a high conviction view that tail risks to financial markets are higher than the market perceives them to be, both in China and the broader Asia Pacific - there have been some signs of the U.S. and China playing ball on a shared desire for "stability," at least for the moment.9 While we expect a negative geopolitical shock, the market will only believe it when it sees it. All of the above suggest that China will focus on "maintaining stability" this year even more than usual due to the party congress. This is clearly bullish, especially given improving U.S. and global growth. However, the mantra of "stability" and "party congress" should not prevent investors from looking beyond October or November of this year. Chart 11China Needs More##br## Credit For Same Growth Chart 12China Gets Old ##br##Before It Gets Rich Even assuming that China experiences no significant internal or external economic shocks from now until this fall, it is important to remember that China's growth potential is still slowing for structural reasons. Productivity is collapsing and credit dependency is rising (Chart 11). The slowdown stems from deep shifts such as the end of the debt supercycle in the U.S. (weak external demand), the tipping point in Chinese demographics (higher dependency ratio) (Chart 12), and the extremely rapid build-up in corporate debt (Chart 13). Chart 13Corporate Debt Skyrockets Chart 14As Good As It Gets This is what leads our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, to surmise that China is at the peak of its current economic mini-cycle. This is "as good as it gets," as he shows in Chart 14. Barring a situation in which Xi somehow fails to consolidate power at the party congress, the market impact will depend on which of two scenarios follows: First scenario: Xi achieves a dominant position in all party and state organs, yet 2018 sees a continuation of the current pattern of mini-cycles of stimulus, lackluster reform, and foreign policy aggressiveness. Xi implicitly deems the strategic cost of reform too great, as we argued he would do over the past four years, and dedicates his stint in office to the accumulation of power. Perhaps a successor will be able to use these powers to enact painful reforms in the mid-2020s; that is not Xi's immediate concern. This is short-term bullish for global and Chinese growth, long-term bearish for Chinese assets. Second scenario: Xi achieves a dominant position and uses his power to reinvigorate the country's stalled reforms. Hints of big measures emerge in the wake of the party congress in November or December, and January 2018 begins with a bang. This would necessarily mean that Xi accepts slower growth, or even that he imposes it through tighter fiscal policy, real credit control, SOE failures, and aggressive overcapacity cuts. However, Chinese productivity would begin to recover. This is short-term bearish for Chinese and global growth. However, it is the most bullish outcome for the long-term performance of Chinese assets. In China's current state - with capital controls newly reinstituted (Chart 15), Xi lauding the "central role" of SOEs in development, and Xi's administration still focused on purging the party and controlling the media - the second scenario admittedly seems far-fetched. Chart 15Are Capital Controls Working? Moreover, Xi seems averse to risky experiments at home that could weaken the country in the face of unprecedented strategic threats from the United States and Japan. Nevertheless, a 2018 reform push should not be dismissed out of hand. Why? Because an overbearing state, credit excesses, and weak productivity really do threaten the sustainability of the Chinese economy and hence the Communist Party's grip on power. Xi must keep them in check, as the current gestures toward tighter policy indicate. The government has overseen a massive monetary and credit expansion to protect the country from faltering external demand since 2008. As the current account surplus has declined, the country's massive savings have built up at home in the form of debt (Chart 16).10 Yet the investment avenues are restricted by the role of the state. As a result, the inefficient state-supported sector is getting propped up while the shadow financial sector grows wildly and creates murky systemic risks that are difficult to monitor and control. The PBoC has undertaken further extraordinary actions to keep financial conditions loose (Chart 17). Chart 16Savings Invested At Home Chart 17PBoC Lends A Helping Hand What signposts should investors watch for to see which path Xi will take after the party congress? Jockeying ahead of the party congress: The latest NPC session saw some political maneuvering. Several sixth generation leaders made appearances and spoke to media.11 Xi's supposed favorite, Chen Min'er, Party Secretary of Guizhou, distinguished himself by cutting reporters short at a press conference. Meanwhile former President Hu Jintao appeared publicly alongside his apprentice, Hu Chunhua, Party Secretary of Guangdong. Elite party gatherings in the summer, especially any retreat at Beidaihe, should be watched closely for any clues of who may be up and who down, and what general policy trajectory may be forthcoming. Xi's future: First, will Xi Jinping and Li Keqiang establish clear successors for their top two positions in 2022?12 A failure to do so will suggest that Xi intends to stay in power beyond his de facto term limit of 2022. This would mean that Xi will prioritize his own future over painful structural reforms. On the other hand, a clear commitment to a leadership transition in five years may re-focus the Xi-Li administration towards their initial commitment to economic restructuring. National Financial Work Conference: This conference is held every five years, usually connected with a major new financial reform or regulatory push, and due sometime in 2017. The government is looking into serious changes to financial regulation - including the creation of a super-ministry to house the various regulatory agencies. This, or the broader attempt to ensure adequate capitalization of banks, could be behind the delay. New central banker: Central bank governor Zhou Xiaochuan, in office since 2002, may step down this fall. He could be replaced with another technocrat to little fanfare, but his exit introduces the opportunity for shaking up the PBoC regime as a whole. Other new officials: A slew of other appointments and reshuffles will take place this year as a generation of leaders born before the Revolution retires. A new director of the state economic planner, the National Development and Reform Commission, was just named, while late last year a new finance minister took his post. These officials have yet to make their mark. Their statements should be watched closely for any shifts in economic policy emphasis. Time frames for reforms: The market is still waiting for concrete proposals and time frames for major reform initiatives, particularly opening up to foreign competition and restructuring state-owned enterprises. Overcapacity cuts have also had mixed results. We do not expect major advances on big structural reforms this year due to the party congress, but details that can be gleaned about the process and timetables could be important. Bottom Line: Watch for signs of a renewed reform drive after the nineteenth National Party Congress. Xi is not going to reverse what he has done so far. And China is not going to become a market economy on the ideal western model. But a pivot point could be in the cards next year for China to pursue some pro-efficiency reforms that it has already set out for itself in a more resolute way. Xi's decision to stay in power beyond 2022 would be bearish for reforms as it would incentivize the current "Socialist Put" model of policymaking over a genuine paradigm shift. India: What Comes After Modi's Big Win? Prime Minister Narendra Modi has won a crushing victory in India's most populous state, Uttar Pradesh, positioning himself, his Bharatiya Janata Party (BJP), and National Democratic Alliance (NDA) coalition very well for the 2019 general elections. Policymaking is going to become easier for the ruling party - though there are still serious political and economic constraints. We have been long Indian equities relative to EM equities since the "Modi wave" began with Modi's victory in the Lok Sabha or lower house in 2014.13 The end of the commodity bull market signaled an opportunity for India, which imports about a third of its energy. The decline of global trade also heralded the outperformance of domestic demand-driven economies like India. Further, Modi's sweeping victory held out the promise for a reform agenda of tighter monetary and fiscal policy that would reduce inflation and make room for private investment to grow. This would make Indian risk assets attractive, especially relative to other EMs, which were at that time either lagging at reforms or failing to undertake them entirely. Since then we have seen Modi rack up a key legislative victory - the passage of the Goods and Services Tax, in the process of implementation - and engineer a surprise "demonetization" effort late last year to increase bank deposits, bring the country's gray markets into the open, and flush out crime and corruption.14 The ruling coalition's gains in Uttar Pradesh and a few other state elections this year are a striking vindication of popular support after this highly unconventional and controversial maneuver.15 Uttar Pradesh is the most important of these elections. It was slated to be a grand testing ground for Modi well before demonetization. It is the most populous Indian state, with about 200 million people, and the third largest state economy (producing about 10% of GDP). It is the second-poorest state, with a GDP per capita of about $730, it has the highest proportion of "scheduled castes" (untouchables), and ranks around the middle of states in terms of the Hindu share of population - all challenges for the landed, pro-business, Hindu nationalist BJP (Map 1). Politically, aside from its inherent heft in population and centrality, Uttar Pradesh sends the most representatives of any state to India's upper house (31 seats), the Rajya Sabha, where Modi lacks a majority. It is thus a key source of federal power and an important state ally. Map 1Modi's Saffron Wave Takes The Indian Core Given the above, it is hugely bullish that Modi's BJP romped to a historic victory in the state election, winning 312 out of 403 seats (about 39.7% of the vote), up from 47 seats previously. His coalition rose to 324 seats total (Chart 18). The BJP now has the largest majority of any party in the state since 1980. These results were not anticipated. A close election was predicted and opinion polls had BJP winning 157 seats, short of the 202 needed for a majority. This was only slightly ahead of its closest rival, an alliance made up of the local Samajwadi Party and its national partner, the left-leaning Indian National Congress (INC). Exit polls even suggested that the Samajwadi-INC coalition had edged ahead of the BJP. The immediate takeaway is that Modi will have better luck governing Uttar Pradesh itself now that the state government is on his side. Individual states hold the key to reform in India because of the country's size and socio-economic disparities. The state will now be expected to implement Modi's policies faithfully and push approved policies forward on its own. The second takeaway is that while Uttar Pradesh will not give Modi control of India's upper house of parliament, the Rajya Sabha, it will give him a better position there. The BJP has 56 seats in the upper house (fewer than the INC's 59), and the ruling coalition has 74, out of a total of 250. The coalition needs 52 seats for a simple majority. Uttar Pradesh will deliver 10 seats at most by the 2019 general election. Modi would have to win almost every seat of the 56 non-allied seats coming open between now and 2019 in order to win the upper house by that time (Chart 19). That is unlikely, but Modi is moving in the right direction and an upper-house majority cannot be ruled out in the long run. Chart 18Modi's Big Win In Uttar Pradesh Chart 19Modi's National Position Improves Of course, Modi has already shown with the Goods and Services Tax that he can pass very difficult legislation through the upper house without controlling a majority there. This achievement last year was perhaps an even greater surprise than the victory in Uttar Pradesh, which reinforces it. Modi also has a secret weapon: in case of a national emergency, however defined, he can call a joint session of parliament, where his coalition would carry the day. This is now more likely because it is the Indian president who is responsible for calling a joint session, and Modi is now more likely to get his candidate into that position due to the win in Uttar Pradesh. President Pranab Mukherjee, who is affiliated with the INC, will step down on July 25. Though Modi does not have all the votes in the electoral college to choose the president outright, smaller parties may fall in line now that the BJP has so much national momentum.16 Controlling the presidency will also give Modi greater influence over constitutional obstacles and gradually over the legal system. Separately, in August, Modi's alliance will be able to choose the vice president as well. More broadly, the Uttar Pradesh election marks a victory for Modi's style of appealing to voter demand for greater economic development as a general priority over longstanding religious and caste grievances that frequently determine electoral outcomes in state elections. This is a hugely significant indication for India's economic structural reform and nation building. Bottom Line: Modi's victory in Uttar Pradesh is proof that for all of India's sprawling inefficiencies, its political system is capable of responding to the large public demand for economic development. Do not underestimate reform momentum now. Modi's political capital remains high. Investment Conclusions The conventional wisdom has for decades been that China is better at reforming its economy because of its authoritarian regime, whereas India democratized too early and has thus lagged at reforms. We have never agreed with this simplistic view of economic reforms. Structural reforms are always and everywhere painful. As such, they require political capital. As our "J-Curve of Structural Reforms" posits, reforms deplete political capital as the pain spreads through the economy and opposition mounts among both the elite and the common man (Chart 20). Eventually, the government is faced with a "danger zone" in which the pain of reforms lingers, the benefits remain beyond the horizon, and all political capital is exhausted. Many leaders chose to water down the reforms, or back off from them altogether, at this point. Chart 20The J-Curve Of Structural Reform On the surface, authoritarian regimes have massive political capital with which to burst through the danger zone of reform. But this assumption is not entirely correct. In China's case, the political capital for reform came after disastrous performances by the "conservative" political forces. Reformers in China were buoyed by the failures of the "Cultural Revolution" (which ended in 1976) and the 1989 Tiananmen Square protests. Each political and social crisis gave the reformers an opening - following a consolidation period - to pursue controversial economic reforms at the expense of "conservative" forces. The fruit of these reform efforts has been the growth of China's middle class. And while this middle class expects reforms in the delivery and quality of public services, it is not interested in seeing a slowdown in economic growth, no matter how temporary or healthy it may be. As such, Chinese leaders are faced with a significant hurdle to their reform preference: how to convince the public that a slowdown is needed in order to restructure the economy. We are unsure whether the upcoming party congress will make a difference. However, we can see a scenario where President Xi decides to pursue market-friendly reforms because he sees an increase in his political capital. In particular, he may feel that he has cemented his personal dominance over his intra-party rivals and that the aggressive foreign and trade policy emanating from the Trump White House gives him a foil to blame for any downturn in growth. Reform would also be a return to Xi's original agenda, and would conform to the playbook of former president Jiang Zemin, whose precedents Xi has followed in some other areas. Given Xi's modus operandi, a post-consolidation reform drive would be executed relatively effectively and would therefore present short-term risks to Chinese and hence global growth, despite the long-term improvement. Markets are definitely not expecting such a policy pivot at the moment. China bulls are content with the current reforms, while China bears see no chance of the Xi administration changing tack. While we are just beginning to see the potential for a turn in Chinese policymaking towards reforms, India is a much clearer example of a reformist administration. Modi will feel empowered by the Uttar Pradesh election, a political recapitalization of sorts. Foreign investment will likely continue cheering Modi's ongoing revolution (Chart 21). The question now is whether Modi intends to use the infusion of political capital for genuine reforms. After all, the economy is not looking up (Chart 22). Chart 21Foreign Investors Cheer On Modi Chart 22Indian Economy Still Weak The evidence is mixed. First, Modi has not maintained strictness on fiscal spending and the budget deficit is creeping back to where it was when he took over the reins (Chart 23). Rising government spending along with higher commodity prices suggest that inflation will continue making a comeback (Chart 24). Poor food production is also driving up inflation. And higher spending and inflation pose a key threat to the sustainability of the reform agenda, since rising government bond yields will crowd out private investment. Chart 23Losing Budgetary Discipline? Chart 24Inflation Makes A Comeback Second, the RBI will be less likely to pursue a tighter monetary policy with both political influence and weak growth pressing on it. Moreover, Indian stocks are not all that cheap. In 2014, valuations were favorable and the backdrop included cheap commodities, fiscal prudence, and Modi's electoral success. Today, India is trading at its historical mean relative to EM (Chart 25), but using the equal sector weighted P/E ratio, by which India was very cheap back in 2014, India is at a 52% premium now (Chart 26). Chart 25Indian Stocks Trading##br## At Mean Against EM Chart 26Indian Stocks Pricey##br## Versus EM Sector-Weighted We are therefore taking this opportunity to close our long India / short EM trade for a 28% gain (since May 2014). We will reassess Modi's structural reform priorities in future research and gauge whether a new entry point is warranted. We remain optimistic on India in the long run as Modi certainly has the political capital for reforms. The question is whether he plans to use it. Meanwhile, we remain skeptical about China's long-term trajectory. To become fully optimistic about Chinese risk assets in absolute terms, we need to see the Xi administration chose short-term pain for long-term gain. For the time being, China continues to repress its structural problems rather than deal with them head on, relying on minimal openness, high and rising leverage, and state-owned banks and companies. India may be lagging in its reform effort, but it has at least established market reforms as a priority. And the Modi administration has built political capital through the slow and painful democratic process. Over the long term, India's approach is more sustainable. If President Xi wastes the opportunity afforded to him by the upcoming party congress, we suspect that China will face a much higher probability of left-tail economic risks than India over the long term. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "How Expensive Are U.S. Stocks?," dated March 13, 2017, available at usis.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and "China: The Socialist Put And Rising Government Leverage" in Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA China Investment Strategy, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 8 Please see Chong Koh Ping, "No plans for NPC to discuss property tax," Straits Times, March 5, 2017, available at www.straitstimes.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. 11 China's leadership is typically referred to in terms of "generations," with Mao Zedong and his peers the first generation, Deng Xiaoping and his cohort the second, Jiang Zemin the third, Hu Jintao the fourth, and Xi Jinping the fifth. The fifth generation was born in the early 1950s, the sixth generation was born in the early 1960s. 12 Xi may tweak retirement norms to let close allies, like Wang Qishan, the anti-graft attack dog, stay on the Politburo Standing Committee. This might also suggest that Xi himself intends to overstay his age limit in 2022. 13 Please see Geopolitical Strategy Special Report, "Long Modi, Short Jokowi," dated August 28, 2014, available at gps.bcaresearch.com, and Emerging Markets Strategy Special Report, "Long Indian / Short Indonesian Stocks," dated July 30, 2014, available at ems.bcaresearch.com. 14 Please see "India: Demonetization And Opportunities In Equities," in Emerging Markets Strategy Weekly Report, "EM: Untenable Divergences," dated December 21, 2016, available at ems.bcaresearch.com. 15 Though the mixed results also indicate persistent regional differences. Modi's coalition won seats in Uttarakhand and Manipur but lost them in Goa and Punjab. Gujarat, Modi's home state, will hold elections later this year. Himachal Pradesh will also vote this year and will be a subsequent testing ground. 16 Please see Gaurav Vivek Bhatnagar, "BJP Sweep in UP Will Impact Decision on President, Rajya Sabha Numbers," The Wire, March 12, 2017, available at https://thewire.in/116044/bjp-sweep-will-impact-decision-president/
Highlights The Chinese government plans a smaller policy push in this year's budget, but is not aiming at a lower growth rate. Maintaining stability remains the priority over promoting growth and progress. Chinese growth has continued to accelerate. Odds of a relapse are low in the next one to two quarters. The sharp recovery in producer prices will likely support private sector investment. The regained strength in construction equipment sales of late could be a harbinger of increasing housing starts. The PBoC has both the willingness and resources to intervene and maintain control over the RMB exchange rate. The CNY/USD cross rate will remain largely determined by the broad trend of the dollar. Feature Chinese lawmakers and senior government officials are convening in Beijing this week for the annual plenary session of the People's Congress, China's parliament. The 3000-member Congress is expected to ratify Premier Li Keqiang's work report, approve his budget and endorse some key initiatives that the central government plans to unveil for the year. Overall, maintaining stability, both socially and economically, remains the focal point of Premier Li's work plan, but the government is planning a smaller policy push on growth in its budget compared with last year. Meanwhile, the latest growth figures out of China confirm that the economy has continued to build momentum. Odds of a near term relapse are low. Reading Policy Tea Leaves Premier Li's blueprint for 2017 offers little surprises, and we doubt that the government is aiming at a lower growth rate for the year. The minimum GDP growth target for 2017 was set at 6.5%, not much different from last year's target as well as realized GDP performance for the whole year (Table 1). Meanwhile, other key macro variables have also been adjusted slightly lower from last year's targets, but are slightly higher than last year's growth rates. For example, government agencies expect investment spending and broad money supply to grow by 9% and 12%, respectively, in 2017, a tick lower than last year's targets, but higher than a growth rate of 7.9% and 11.3%, respectively, in 2016. Furthermore, the government's growth priority is also reflected in a higher target for creating jobs. Table 1Table: The Growth Target China's growth recovery since mid-last year has given the government some comfort in staying the course on policy rather than engaging in fresh stimulus. On the fiscal front, there are some initiatives to reduce the corporate tax burden and administrative fees, but the overall budget deficit target will be maintained at 3%, unchanged from last year, which implies no fresh fiscal thrust to support the economy. Meanwhile, infrastructure spending on railways, waterways and highway construction is only expected to be marginally higher than last year's levels. On the monetary front, the Premier has pledged a prudent and neutral policy stance. Headline CPI is expected to increase by 3% in 2017, compared with 2.5% in December 2016. This reflects the government's eased concerns over deflation rather than an anticipation of inflation risk. Building on last year's efforts, the government continues to plan to remove excess capacity in certain industries. The focus remains on steelmakers and coalmines, but some other sectors are also being singled out such as construction materials, ship-building and coal-fire thermal industries. Last year's "de-capacity" campaign has led to a dramatic turnaround in business conditions in steelmakers and coalmines, which suggests the slack in the economy may not be as big as commonly perceived.1 These efforts deserve close attention in terms of their impact on other industries as well as on the overall economy. Finally, Premier Li has also pledged to further advance market-oriented reforms. The government plans to improve governance, reduce administrative red tape, simplify the tax code and increase private sector access to key industries. Meanwhile, the government intends to continue to push "mixed ownership" reforms, or partial privatization, among the country's state-owned enterprises (SOEs), including electricity, petroleum, natural gas, railways, civil aviation, telecom and military equipment. Financial sector reforms are being directed towards boosting the efficiency of financial resources, improving corporate sector access to financing, enhancing supervision over financial institutions and preempting financial risks. These reform initiatives are largely incremental, which probably underscores the authorities' preference for stability ahead of the Party Congress later this year. All in all, the central government plans a smaller policy push in this year's budget, and intends to let the economy run on its own momentum. Aggressive policy reflation is not in the cards unless a relapse in the economy threatens job creation. The government has reiterated its pledge for further reforms, but has so far offered few hopeful signs of bold steps. Overall, maintaining stability remains the priority over promoting growth and progress. China Growth Watch Key macro indicators to be released in the next several days will offer a reality check on how the Chinese economy has fared since the beginning of the year as the holiday seasonal factor wears off. Early indicators confirm that the economy has continued to accelerate. Real time activity trackers for the industrial sector, such as the daily coal intake at thermal power plants and average daily output at major steelmakers, have continued to accelerate (Chart 1). The sharp increase in imports compared with a year ago also confirmed strengthening domestic demand. The recovery in Chinese domestic activity is also reflected in neighboring countries. Sales to China from Korean and Taiwanese exporters have increased sharply from a year ago (Chart 2). As the biggest trading partner of these countries, China has played a pivotal role in the cyclical recovery of their respective economies. Chart 1Real Time Activity Monitor##br## Has Continued To Strengthen Chart 2A Sharp Turnaround##br## In Chinese Demand In short, the Chinese economy has demonstrated some remarkable strength of late. Last year's low base may have exaggerated the year-over-year comparison in some macro figures, but there is little doubt the economy's strong recovery has continued into the New Year. Looking forward, the risk is still tilted to the upside, at least over the next three to six months. First, purchasing manager indexes (PMIs) for both the manufacturing and service sectors have been above the 50 threshold, with broad-based improvement in all major components. BCA's China Leading Economic Indicator remains in a clear uptrend, heralding further improvement in macro numbers (Chart 3). Second, the sharp recovery in producer prices will likely support capital expenditure, especially among private enterprises. Some commentators have attributed China's rising PPI to the increase in global commodities prices rather than being a reflection of the Chinese business cycle. We disagree. While it is certainly true that the mining sector and materials producers have enjoyed the biggest boost in their pricing power since last year due to rising commodities prices, the improvement in Chinese PPI is rather broad-based. Our diffusion index for producer prices, which measures the percentage of sectors witnessing higher PPI, has also recovered strongly (Chart 4). In fact, the current reading suggests almost all sectors are experiencing rising output prices rather than only the resource sector. At a minimum, this should put a floor under capital expenditure in the manufacturing sector. Chart 3Strengthening LEI Points ##br##To Further Growth Acceleration Chart 4Broad-Based Improvement##br## In PPI Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels during the boom years prior to the global financial crisis. Historically, construction machines sales have been tightly correlated with real estate development (Chart 5). If history is any guide, the regained strength in construction equipment sales of late could be a harbinger of an impending boom in new housing starts. This means efforts to rein in housing activity since last October have done little to dampen developers' confidence.2 Meanwhile, we have highlighted the risk of slowing infrastructure construction by the state sector, which could weigh on overall capital spending3 - any improvement in real estate investment would offer an important offset. Ongoing housing sector development deserves close attention in the coming months. Finally, the growth outlook in other major developed economies has also improved, which should benefit Chinese exporters. A recent Special Report published by our sister publication, The Bank Credit Analyst, found broad-based evidence of improving activity across countries and industrial sectors.4 Retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies, and orders and production are gaining strength for goods related to both business and household final demand. As far as China is concerned, a mini-cycle global upturn bodes well for exports. We were surprised by February's weak Chinese export numbers and for now, we suspect it reflects noise rather a trend. Unless protectionism backlash out of the U.S. derails normal trade links, we expect Chinese exports should continue to strengthen,5 which should allow the Chinese economy to gain additional momentum (Chart 6). Chart 5An Impending Boom In Housing Construction? Chart 6Chinese Exports: Better Days Ahead? Bottom Line: Chinese growth has continued to accelerate. Odds of a relapse are low in the one to two quarters. The RMB: Back In The Spotlight The Federal Reserve is well expected to raise its benchmark policy rate again next week, which has prompted a bidding up of the U.S. dollar against other majors as well as the RMB. In Premier Li Keqiang's work report presented to the People's Congress this week, the Chinese government appears to have omitted the usual commitment to maintain "exchange rate stability," which is being interpreted by some as a sign the government may allow for much greater fluctuations of the RMB against the dollar. To be sure, achieving a free-floating exchange rate has been China's long-stated reform target, and it is impossible to predict the exact next step of the People's Bank of China. However, a few broad judgements should still hold. First, we doubt the PBoC will tolerate unorderly fluctuations in the exchange rate in the near term. A weaker currency can be viewed as a reflection of domestic weakness. Moreover, sharper RMB depreciation begets greater capital outflows, which could quickly degenerate into a vicious circle - all of which is against the government's intentions of maintaining stability, especially ahead of the Party Congress late this year. Chart 7A Weak RMB, Or A Strong Dollar? Second, it is unlikely the PBoC will sacrifice domestic monetary policy independence in order to defend the exchange rate. The PBoC's recent policy tightening is as much a response to the stronger domestic economy as it is a forced response to higher U.S. interest rates. Tighter capital account controls will remain the dominant policy tool to deter domestic capital outflows and support the RMB if needed. Finally, fundamental factors do not support significant RMB depreciation against the dollar, given Chinese exporters' competitiveness and the country's large external surpluses. China's recent growth improvement should further weaken the case for a much cheaper RMB. In short, the PBoC has both the willingness and resources to intervene and maintain control over the exchange rate. The CNY/USD cross rate will remain largely determined by the broad trend of the dollar, and the RMB is unlikely to depreciate against the dollar more than other major currencies, if the dollar uptrend resumes (Chart 7). We will follow up on these issues in next week's report. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Global Growth Pickup: Fact Or Fiction?" dated February 23, 2017, available at bca.bcaresearch.com. 5 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations