Emerging Markets

Highlights Why did S&P 500 profit margins fall in 2019?: Compensation gains, trade tensions and spotty growth were the most likely culprits, though the absence of standardized disclosure hinders full attribution. Was it a one-off, or the beginning of a trend?: We believe that profit margins have likely peaked, though we expect that they will contract only modestly this year. The outcome of the election could have a significant margin impact going forward. The coronavirus outbreak may be worsening around Wuhan, but it does not appear to be metastasizing elsewhere: Our China strategists foresee an extended lockdown of Hubei province, but expect that the rest of the Chinese economy will be able to overcome it. They are cautiously optimistic about the prospects for containment. Sustainability What a difference a year makes. Last President’s Day, the S&P 500 was more than 5% below its September 2018 peak (18% below its current level), amidst widespread fears that the Fed may have tightened into a recession. The month-long government shutdown was an embarrassing own goal, and trade tensions loomed as a threat to corporate earnings and global growth. It would take another two months before the S&P 500 fully recovered, only to have the yield curve invert soon thereafter. The coronavirus epidemic (COVID-19) has the curve flirting with inversion again, but stocks have shrugged off the growth risks. They continue to scale the wall of worry as self-appointed bubble spotters’ blood pressure soars, leaving them sputtering like Judge Smails or the bank official overseeing Charles Foster Kane’s trust. While we acknowledge that COVID-19 and Bernie Sanders’ post-Iowa-and-New Hampshire position at the head of the Democratic pack could yet become problematic for markets and the economy, our take aligns much more closely with Fed Chair Powell’s House testimony last week. “There’s nothing about this expansion that is unstable or unsustainable.” COVID-19 Update Chart 1What Happens In Hubei Our China Investment Strategy colleagues were encouraged by the latest Chinese data on the outbreak. Although they foresee that Wuhan, and quite possibly all of Hubei province, will be shut down through the end of March, they do not think the action will thwart China’s nascent growth recovery. In their estimation, domestic companies will be able to reroute their supply chains with minimal disruption. If the equity market avoids a virus-related plunge, as they expect, the economy may dodge the deleterious impact on confidence that might otherwise emerge. Our sanguine China outlook encountered some resistance from clients, who have been surprised at how swiftly markets seemed to put the outbreak aside, and skeptical of official reports that seemed a little too good to be true. We suggested that they employ a trust-but-verify approach similar to ours. We are taking official data as given, while using other countries’ data as a reasonableness check. We are monitoring the magnitude of PRC policy efforts to mitigate the virus’ drag and remaining vigilant for any signs of global supply chain disruptions. Bottom Line: Our China strategists were heartened by official reports indicating that the coronavirus has been mostly contained in Hubei province (Chart 1), but are actively seeking out other evidence for corroboration before concluding that the worst is over. Making Sense Of Declining Profit Margins As we showed last week, S&P 500 profit margins narrowed across 2019, with 2% EPS growth lagging 5% growth in per-share revenue. Margins do not remain fixed over time, but the contraction represented a notable shift after several years of steady margin expansion. Even when EPS declined on a year-over-year basis for four straight quarters across 2015 and 2016, margins mainly held their own as revenues, which contracted year-over-year for six consecutive quarters, had it worse (Chart 2). Chart 2Fun While It Lasted We primarily attribute last year’s decline to gains in labor’s share of income. Although average hourly earnings growth decelerated from 2018 to 2019, real unit labor cost growth flipped from negative to positive. Tariffs also likely detracted from income, as domestic businesses were surely not able to pass through all of their increased cost of goods sold to their customers against a backdrop of persistently low inflation and limited pricing power. Decelerating US and global growth was also a drag (Chart 3). Chart 3Growth Decelerated Everywhere In 2019 Have Profit Margins Peaked? Excepting meaningful structural changes, profit margins are a mean-reverting series. Following steady margin expansion over three business cycle expansions spanning nearly three decades, mean reversion is an unappealing prospect for equity investors (Chart 4). Unless corporate tax rates are raised, though, the mean going forward will be higher than the mean established when federal taxation was more onerous. Additionally, an in-depth Bank Credit Analyst study argued that profit margins have not grown as much as it would appear to the naked eye,1 but they are elevated, and their future direction will influence prospective equity returns. Chart 4Margins Have Thrived In The Last Three Expansions A definitive analysis of S&P 500 margins would compile detailed revenue and expense data for each constituent in the index, but compiling the bottom-up data would repeatedly bump up against inconsistent disclosure conventions across companies and industries. For now, we will have to content ourselves with what we can glean from top-down analysis. Margins shrank in 2019 because of rising real unit labor costs, increased tariffs and global growth deceleration. Employee compensation is far and away the single biggest expense item for businesses as a whole. Changes in compensation are therefore the most consistently critical driver of changes in margins. Other key factors include: overall economic growth, growth relative to capacity, globalization, competitive intensity, and growth of the capital stock. GDP Growth Over time, growth in a company’s revenues should converge with the weighted average of economic growth in the countries in which it operates. The sensitivity of any given company’s net income to changes in sales revenue depends on its operating leverage, but any company with at least some fixed costs will see its margins expand as sales rise. We expect that US GDP growth will moderate going forward, given that hoped-for increases in economic capacity do not appear to have offset the growth overhang from the stimulus package’s increased deficits.2 For the current year, however, we expect that an acceleration in non-US growth may largely offset moderating US growth for the aggregate S&P 500. (Chart 5) Chart 5Sales Growth Feeds Operating Leverage The Output Gap The degree of excess capacity in the economy is most easily proxied by the output gap, the difference between the economy’s actual output and its long-run potential output, which is a function of productivity and labor force growth. Pricing power is directly related to the output gap; it’s weak when the gap is negative, and robust when the gap is positive. Excess capacity is the enemy of profits, and margins benefit when it is worked off, even if positive output gaps can’t persist indefinitely (Chart 6). With the economy continuing to grow at close to its estimated trend rate, the output gap isn’t likely to have an impact this year. Globalization allows US companies to tap lower-cost inputs in the developing world. Chart 6Excess Capacity Erodes Pricing Power Globalization Globalization has been a major force promoting margin expansion over the last 20 to 30 years, granting US-domiciled businesses access to the developing world’s lower-cost inputs. Outsourcing saves money and global supply chains have significantly reduced product costs. Tariffs and other trade barriers are an obstacle to outsourcing, and it is our in-house geopolitical strategists’ view that the US will continue to backtrack from globalization no matter which party captures the White House in November. Changes in the sum of exports and imports as a share of GDP provide a simple proxy for changes in the intensity of globalization (Chart 7). Chart 7More Open Borders = Higher Margins Competitiveness Margins are directly related to the intensity of globalization, but they are inversely related to the intensity of competition, which is itself inversely related to the degree of industry concentration. The laissez-faire approach to anti-trust enforcement which has generally prevailed since the Reagan administration has promoted concentration. Businesses gain pricing power as their industries move along the spectrum from perfect competition toward monopoly, just as they gain increasing power to set wages as individual labor markets move toward monopsony. Pressure for federal action to reverse the four-decade trend toward concentration will rise if the Democrats win the White House, especially as our Geopolitical Strategy service holds that the party that takes the presidency will also take the Senate. Productivity Changes in margins are directly related to the pace of productivity gains. Workers are able to do more in a given period of time when they’re endowed with more and/or better tools, and investment provides those tools. Increases in the size of the capital stock lead to productivity gains. The NFIB survey suggests that small businesses are poised to increase capital expenditures, and the capex intentions components of the regional Fed manufacturing surveys have begun pointing in that direction as well, but investment has consistently disappointed since the crisis (Chart 8), and productivity growth has been tepid for an extended period of time as a result. Chart 8Investment Pays Off In Higher Margins Unit Labor Costs Rising labor costs by themselves do not necessarily mean that margins will contract. If output increases more than rising wages, margins will expand. We therefore watch unit labor costs, which measure output-adjusted changes in compensation. Growth in real unit labor costs is our preferred measure for their additional insight into profitability, given that changes in the overall price level are a solid proxy for changes in sales prices. When real unit labor costs are falling, corporate margins are likely expanding as revenue gains can be expected to outpace employees’ compensation per unit of output. Given the especially tight labor market, we expect real unit labor costs to continue to rise, chipping away at profit margins (Chart 9). Chart 9Persistently Negative Real Unit Labor Costs Have Boosted Margins Taxes, Interest Rates And The Dollar The biggest driver of after-tax margins in recent years has been the 40% reduction in the top marginal federal corporate income tax rate from 35% to 21% beginning in 2018. We expect no material corporate tax changes if the president wins re-election, while we would expect that an incoming Democratic administration, fortified by House and Senate majorities, would prioritize increasing corporate tax revenues. We expect a modest rise in interest rates over the year, which is unlikely to materially impact firms’ interest expense. We expect that the dollar will weaken in 2020, as incremental growth in the rest of the world exceeds incremental growth in the US, providing the S&P 500 with a modest margin tailwind. Bottom Line: On balance, we expect that the S&P 500 will face modest margin headwinds in 2020. If the Democrats assume control of the White House and both houses of Congress next January, downward pressure on margins could intensify. Investment Implications Falling margins against a backdrop of tepid revenue growth suggest that 2020 S&P 500 earnings growth will be nothing to write home about. Stocks will have to get an assist from multiple expansion if they are to continue producing double-digit annual returns. We do not think multiple expansion is much of a stretch – it would be consistent with the latter stages of previous bull markets – but equities do not need to generate double-digit returns to top the prospective returns on offer from Treasuries, credit-sensitive fixed income or cash. As long as the margin compression unfolds slowly, equities will merit at least an equal-weight allocation in balanced portfolios as will spread product in dedicated fixed income portfolios. Corporate profit margins would quickly feel the burn in a Sanders administration. We expect that profit margins will compress slowly, as it remains our base case (albeit with limited conviction) that the president will win re-election. Under a Democratic regime, however, corporate tax rates would likely rise, anti-trust enforcement would likely unwind some of the buildup in industry concentration, and organized labor would gain a more sympathetic ear in Washington. If Bernie Sanders were to win the presidency instead of one of the Democratic moderates, margin compression would likely unfold much more rapidly (and multiples would be at immediate risk, to boot). The upcoming election is thus approaching something of a binary outcome for equities. We still see monetary policy as the swing factor for the ongoing expansion, and financial market returns, and we therefore remain constructive on the economy and risk assets. The election could upend that framework, however, passing the baton from the Fed to elected officials. We will be tracking the primary and general election ups and downs closely.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the October 2012 Bank Credit Analyst Special Report, "Are US Corporate Profit Margins Really All That High?" available at www.bcaresearch.com. 2 The economic case for the stimulus package rested on the expectation that it would promote investment in the capital stock that would not otherwise occur (via immediate expensing of investments and repatriation of capital held overseas) and facilitate labor force participation. A capex burst that followed its passage quickly fizzled, and we are of the opinion that the minor provisions intended to expand labor force participation have had little effect.

Special Report

Highlights Geopolitical sparks in the Mediterranean point to the revival of realism or realpolitik in places where it has long been dormant. Europe is wary of Russia but will keep buying more of its natural gas. This will be a source of tension with the United States. Turkey is wary of Russia but will continue choosing pragmatic deals with Moscow that fly in the face of Europe and the United States. Turkey’s intervention in Libya is small but symbolic. Increases in foreign policy aggressiveness are negative signs for Turkey as they stem from domestic economic and political instability. Short Turkish currency, equities, and local government bonds. The recent increase in immigration into Europe will fuel another bout of populism if it goes unchecked. Feature “Multipolarity,” or competition among multiple powerful nations, is our overarching geopolitical theme at BCA Research. The collapse of the Soviet Union did not lead to the United States establishing a global empire, which might in theory have provided a stable and predictable trade and investment regime. The United States lashed out when attacked but otherwise became consumed by internal struggles: financial crisis and political polarization. Under two administrations the American public has demanded a reduced commitment to international affairs. Europe is even less likely to project power abroad – particularly after being thrown on the defensive by the Syrian and Libyan revolutions and ineffectual EU responses. Turkey’s aggressive foreign policy is a symptom of global multipolarity – which makes the world less predictable for investors. Emerging markets have risen in economic and military power relative to their developed counterparts. They demand a redistribution of global political power to set aright historical grievances and address immediate concerns, such as supply line insecurities, which increase alongside a rapidly growing economy. Multipolarity is apparent in Russia’s resurgence: pushing back on its borders with Europe and NATO, seeking a greater role in the Middle East and North Africa, interfering in US politics, and cementing its partnership with China. Multipolarity is equally evident when medium-sized powers – especially those that used to take orders from the US and Europe – seek to establish an independent foreign policy and throw off the shackles of the past. Turkey is just such a middle power. Strongman President Recep Tayyip Erdogan initially sought to lead Turkey into a new era of regional ascendancy. The Great Recession and Arab Spring intervened. Domestic economic vulnerabilities and regional instability have driven him to pursue increasingly populist and unorthodox policies that threaten the credit of the nation and security of the currency. A coup attempt in 2016 and domestic political losses in 2019 drove Erdogan further down this path, which includes aggressive foreign policy as well as domestic economic stimulus. The Anatolian peninsula has always stood at the crossroads of Europe and Asia, as well as Russia and Africa. Turkey’s efforts to change the regional status quo to its favor, increase leverage over its neighbors in Europe and the Middle East, and deal with Russia’s Vladimir Putin from a position of strength, are causing the geopolitics of the Mediterranean to heat up. It has now intervened in the Libyan civil war. In this special report, we focus on this trend and ask what it means for global investors. Unfinished Business In Libya Chart 1Haftar Is Weaponizing Libya’s Oil As the Libyan conflict enters its sixth year this spring, the battle for control of the western bastion of Tripoli rages. Multiple efforts to mediate the conflict between Field Marshal Khalifa Haftar of the Libyan National Army (LNA) and Prime Minister Fayez al-Sarraj of the UN-recognized Government of National Accord (GNA) have failed. Ceasefire talks in Moscow, Rome, and Berlin have fizzled. Instead, fighting has finally hit oil production, with the state-run National Oil Corp (NOC) declaring force majeure on supplies on January 18. Tribal leaders who support Haftar have blockaded eastern ports (Chart 1). Previously the mutual dependence of the rival factions on oil revenues ensured production and exports went mostly undisturbed. LNA forces control nearly all key oil pipelines, fields, ports, and terminals in Libya. The exceptions are the Zawiyya and Mellitah terminals and offshore fields (Map 1). However the National Oil Company (NOC), headquartered in the GNA-controlled Tripoli, is the sole entity controlling operations and the sole marketer of Libyan oil. Map 1Libya’s Oil And Natural Gas Infrastructure: Monopolized By Haftar General Haftar’s blockade – which has ground oil production to a halt – displays his ability to weaponize oil to obtain concessions from the Tripoli-based government. Tribal leaders behind the blockade are calling for a larger share of oil revenues, for which they are at the mercy of the LNA and NOC. With little progress in Haftar’s push to gain control of Tripoli, and Libya more generally, the conflict has reached a stalemate. Not one to back down, Haftar’s decision to cut off oil sales from the Tripoli government, which also cuts off revenues to his own parallel administration, is a brute attempt to force a settlement. Haftar’s gambit follows Turkey’s decision to intervene in Libya on behalf of Sarraj and the GNA. Turkey has deployed roughly 2,000 Syrian fighters, as well as 35 Turkish soldiers in an advisory capacity. Turkey apparently feared that Haftar, who has substantial backing from Egypt and the Gulf Arabs as well as Russia and France, was about to triumph, or at least force a settlement detrimental to Turkish interests. Bottom Line: Turkey’s decision to intervene in the Libyan civil war – while limited in magnitude thus far – raises the stakes of the conflict, which involves the EU, Russia, and the Arab states. It is a clear signal of the geopolitical multipolarity in the region – and a political risk that is flying under the radar amid higher profile risks in other parts of the world. Political Interests: Islamist Democracy Versus Arab Dictatorship The Libyan civil war is a proxy war between foreign nations motivated by conflicting economic and strategic interests in North Africa and the Mediterranean. But there is an ideological and political structure to the conflict that explains the alignment of the nations: Turkey is exporting democracy while the Arab states try to preserve their dictatorships. Haftar’s primary supporters include Egypt, the United Arab Emirates (UAE), and Saudi Arabia. These states see monarchy as the way to maintain stability in a region constantly on the edge of chaos. Islamist democracy movements, such as Egypt’s Muslim Brotherhood, pose a threat to their long-term authority and security. They try to suppress these movements and contain regimes that promote them or their militant allies. They are willing to achieve one-man rule by force and thus support military strongmen like Egypt’s Abdel Fattah el-Sisi and Libya’s General Haftar. On the other side of the conflict stand the backers of the GNA – Turkey and Qatar – which support political Islam and party politics (Chart 2). Turkey’s Erdogan and his Justice and Development Party (AKP) are sympathetic to Hamas in the Palestinian territories and Egypt’s Muslim Brotherhood. They want to ensure a lasting role for Islamic parties in the region, which strengthens their legitimacy. They do not want Libya’s Islamists to suffer the same fate as their affiliates in the Muslim Brotherhood – removal via a military coup. Chart 2Turkey Sees A Place For Political Islam Chart 3Turkey Steps In Amid Qatar Embargo The political conflict is mirrored in the Persian Gulf in the form of the air, land, and sea embargo imposed on Qatar in 2017 at the hands of the Saudis, Egyptians, and Emiratis. The Qatar crisis followed a 2014 diplomatic rift and the 2011 Arab Spring, when Qatar supported protesters and democracy movements against neighboring regimes. The embargo strengthened Turkey-Qatar relations, as Turkey stepped in to ensure that Qataris – who are heavily dependent on imports – would continue to receive essentials (Chart 3). Bottom Line: The alliances forged in the Libyan conflict reflect differing responses to powerful forces of change in the region. Established monarchies and dictatorships are struggling to maintain control of large youth populations and rapidly modernizing economies. Their response is to fortify the existing regime, suppress dissent, and launch gradual reforms through the central government. Their fear of Islamist movements makes them suspicious of Tripoli and the various Islamist groups allied with the GNA, and aligns them with Khalifa Haftar’s attempt to impose a new secular dictatorship in Libya. Meanwhile Turkey, with an active Islamist democracy, is seeking to export its political model, and Muslim Brotherhood-esque political participation, to gain influence across the region, including in Libya and North Africa. Economic Interests: The Scramble For Energy Sources Chart 4Europe Addicted To Russian Gas The Libyan proxy war is also about natural resources, for all the powers involved. Turkey’s intervention reflects its supply insecurity and desire to carve a larger role for itself in the east Mediterranean economy. Turkey needs to secure cheap energy supplies, and also wants to make itself central to any emerging east Mediterranean natural gas hub that aims to serve Europe. Europe’s increasing dependency on natural gas imports to meet its energy demand, and Russia’s outsized role – supplying the EU with 40% of its needs – have encouraged a search for alternative suppliers (Chart 4). Israel is attempting to fill that role with resources discovered offshore in the eastern Mediterranean. Given its strategic location, Turkey hopes to become an energy hub. First, it is cooperating with the Russians. Presidents Putin and Erdogan inaugurated the Turkish Stream pipeline (TurkStream) at a ceremony in Istanbul on January 8. The pipeline will transport 15.75 billion cubic meters (Bcm) of Russian natural gas to Europe via Turkey. This is part of Russia’s attempt, along with the Nord Stream 2 pipeline, to bypass Ukraine and increase export capacity, strengthening its dominance over Europe’s natural gas market (Map 2). Map 2Russia’s Latest Pipelines Bypass Ukraine Europe and its allies are wary of Russian influence, but the EU is not really willing to halt business with Russia, which is a low-cost and long-term provider free from the turmoil of the Middle East. Despite the significant growth in US natural gas supplies, the relatively higher cost makes Russian supplies comparatively more attractive (Chart 5). Chart 5Russian Gas Is Competitive In European Markets … Chart 6… As US Attempts To Gain Market Share The result will be tensions with the United States, which expects the Europeans to honor the security relationship by buying American LNG (Chart 6) and will always abhor anything resembling a Russo-European alliance. American legislation signed on December 20 would impose sanctions on firms that lay pipes for Nord Stream 2 and TurkStream. Second, Turkey wants to become central to eastern Mediterranean energy development. A series of offshore discoveries in recent decades has sparked talk of cooperation among potential suppliers (Table 1). There is a huge constraint on developing the fields quickly, as there is no export route currently available for the volumes that will be produced. While the reserves are not significant on a global scale, their location so close to Europe, and growing needs in the Middle East, has generated some interest. Table 1Recent East Mediterranean Discoveries Are Relatively Small, But Geopolitically Attractive However, Europe and Israel – the status quo powers – threaten to marginalize Turkey in this process: A meeting of the energy ministers of Egypt, Cyprus, Greece, Israel, Italy, the Palestinian territories, and Jordan in Cairo last July resulted in the creation of the Eastern Mediterranean Gas Forum to promote regional energy cooperation. Turkey – along with Lebanon and Syria – was excluded. Turkey seeks access to natural resources – and to prevent Israel, Egypt, and Europe from excluding it. The EastMed Pipeline deal – signed by Greece, Cyprus, and Israel on January 2 – envisages a nearly 2,000 km subsea pipeline transporting gas from Israeli and Cypriot offshore fields to Cyprus, Crete and Greece, supplying Europe with 9-12 Bcm per year (Map 3). The project enjoys the support of the European Commission and the US as an attempt to diversify Europe’s gas supplies and boost its energy security.1 But it would also be an alternative to an overland pipeline on Turkish territory. Map 3The Proposed EastMed Pipeline Would Marginalize Turkey Egypt has two underutilized liquefied natural gas plants – in Idku and Damietta – and has benefited from the 2015 discovery of the Zohr gas field. Egypt has recently become a net exporter of natural gas (Chart 7). It signed a deal with Israel to purchase 85.3 Bcm – $19.5 billion – of gas from Leviathan and Tamar fields over 15 years. Egypt sees itself as an energy hub if it can re-export Israeli supplies economically. Note that Russia and Turkey have some overlapping interests here. Russia does not want Europe to diversify, while Turkey does not want to allow alternatives to Russia that exclude Turkey. Thus maintaining the current trajectory of natural gas projects is not only useful for Russia’s economy (Chart 8) but also for Turkey’s strategic ambitions. Chart 7Egypt Also Aims To Become East Mediterranean Gas Hub Of course, while Russian pipes are actually getting built, the EastMed pipeline is not – for economic as well as geopolitical reasons. Europe is currently well supplied and energy prices are low. At an estimated $7 billion, the cost of constructing the EastMed pipeline is exorbitant. Chart 8Maintaining Energy Dominance Advances Russia’s Strategic Ambitions Too Still, Turkey must make its influence known now, as energy development and pipelines are necessarily long-term projects. The chaos in Libya presents an opportunity. Seizing on the Libyan GNA’s weakness, Turkey signed an agreement to provide for offshore maritime boundaries and energy cooperation as well as military aid. The EastMed pipeline, of course, would need to cross through Turkish and Libyan economic zones (see Map 3 above).2 Turkey is incapable of asserting its will militarily in the Mediterranean against powerful western naval forces. But short of war, it is capable of expanding its claims and leverage over regional energy and forcing the Israelis and Europeans to deal with it pragmatically and realistically rather than exclude it from their plans. Part of Turkey’s goal is to cement an alliance with Libya – at least a partitioned western Libyan government in any ceasefire brokered with Haftar and the Russians. Bottom Line: While Turkey and Russia support opposing sides in the Libyan conflict, both benefit from dealing directly with each other – bypassing the western powers, which are frustrated and ineffectual in Libya. Both would gain some direct energy leverage over Europe and both would gain some influence over any future eastern Mediterranean routes to Europe. In Libya, if either side triumphs and unites the country, it will grant its allies oil and gas contracts almost exclusively. But if the different foreign actors can build up leverage on opposing sides, they can hope to secure at least some of their interests in a final settlement. Turkey Needs Foreign Distractions The foregoing would imply that Turkey is playing the game well, except that its foreign adventures are in great part driven by domestic economic and political instability. After all, Turkey’s maritime claims are useless if they cannot be enforced, and offshore development and pipeline-building are at a low level given weak energy prices and slowing global demand. Economically, in true populist fashion, Erdogan has repeatedly employed money creation and fiscal spending to juice nominal GDP growth. The result is a wage-price spiral, currency depreciation, and current account deficits that exacerbate the problem. The poor economy has mobilized political opposition. Over the past year, for the first time since Erdogan rose to power in 2002, his Justice and Development Party is fracturing. Former Turkish deputy prime minister Ali Babacan, a founding member of the AKP, as well as former prime minister Ahmet Davutoglu, have both announced breakaway political parties that threaten to erode support for the AKP. Local elections in 2019 resulted in a popular rebuke in Istanbul. Thus Erdogan is distracting the public with hawkish or nationalist stances abroad that are popular at home. Turkey has taken a strident stance against the US and Europe, symbolized by its threats to loose Syrian refugees into Europe and its purchase of S400 missile defense from Russia despite being a NATO member. Military incursions in Syria aim to relocate refugees back to Syria (Chart 9). Chart 9Erdogan Is Distracting Turks With Popular Foreign Stances Chart 10No Love Lost Toward The West Turkish public opinion encourages close cooperation with Russia and a more aggressive stance against the West (Chart 10). This is a basis for Russia and Turkey to continue cutting transactional deals despite falling on opposite sides of conflicts in Syria, Libya, Iran, and elsewhere. Erdogan’s pretensions of reviving Ottoman grandeur in the Mediterranean fall in this context. Elections are not until 2023, but we expect Erdogan to continue using foreign policy as a distraction. The opposition is trying to unite behind a single candidate, which could jeopardize Erdogan’s grip on power. The insistence on stimulus at all costs means that Erdogan is not allowing the economic reckoning to occur now, three years before the election. He is trying to delay it indefinitely, which may fail. Libya may not get resolved, however. Allies of Haftar’s LNA – specifically Egypt, Saudi Arabia, and the UAE – will be motivated to intensify their support of him for fear that a loss would revive domestic interest in political Islam. Egypt especially fears militant proxies being unleashed from any base of operations there. The LNA currently serves as a buffer between Egypt and the militant actors in Libya. If Haftar is defeated, Egypt’s porous western border would provoke a harsh reaction from Cairo. The threat of a revival of Islamic State in Libya has united the Egyptian people – a critical variable in the administration’s vision of a stable country. That has provided Egypt’s Sisi an excuse to flex his muscles through military exercises. Neither Russia nor NATO will be moved to bring a decisive finish to the conflict, as neither wishes to invest too heavily in it. Bottom Line: Erdogan has doubled down on populism at home and abroad. His assertive foreign policy in Syria and now Libya may end up exacerbating economic and political pressures on the ruling party. What Is The Endgame In Libya? There are three possible scenarios to end the current stalemate between the Haftar’s forces and the internationally recognized GNA: Military: An outright military victory by either Haftar or Sarraj is highly unlikely. While Haftar’s forces enjoy military and financial support from the UAE, he lacks popular support in Tripoli – which has proved to be challenging to takeover. Similarly, Sarraj’s army is not strong enough to confront the eastern forces and reunify the country. The merely limited involvement of foreign actors – including Turkey – makes a military solution all the more elusive. The most likely path to a quick military victory comes if foreign actors disengage. This will only occur if they are punished for their involvement, and thus it requires a major neutral power, perhaps the United States, to change the calculus of countries involved. But the US is eschewing involvement and the Europeans have shown no appetite for a heavy commitment. Diplomatic: A negotiated settlement is eventually likely, given the loss of oil revenues. A ceasefire would assign some autonomy to each side of the country. Given Haftar’s ambitions of conquering the capital and becoming a strongman for the country as a whole, the diplomatic route will be challenging unless his Gulf backers grow tired of subsidizing him. Financial: Haftar could win by breaking the NOC’s monopoly on oil. In the past, the LNA failed at selling the oil extracted from infrastructure under its control. If Haftar manages to market the oil without the aid of the NOC then he will be able to guarantee a stream of revenue for his forces and at the same time starve the Tripoli government of financing. This would pose an existential risk for the GNA. The key challenge in this scenario is to obtain international backing for LNA sales of Libyan crude supplies. Libya’s partition into two de facto states is the likeliest outcome. Bottom Line: Unless one of the constraints on a military, diplomatic, or financial end to the conflict is broken, the current stalemate in the Libyan conflict will endure. A partition of Libya will be the practical consequence. Turkey hopes to boost its regional influence through Tripoli, and thus increase its leverage over Europe, but a heavy investment could result in fiscal losses or spiral into a broader regional confrontation. Investment Implications While it is not clear how long the current blockade on Libyan ports will last – or the associated over 1 million barrels per day loss of production – oil supplies will remain at risk so long as the conflict endures. However, unlike supplies in the Gulf or in Venezuela, Libyan crude is of the light sweet grade. There is enough global spare capacity – from US shales – to make up for the Libyan loss, at least over the short term. The fall in Libyan supplies is occurring against the backdrop of oil markets that have been beaten down by the decline in demand on the back of the coronavirus impact (Chart 11). The OPEC 2.0 technical panel recommended additional output cuts of 600 thousand barrels per day last week, and is waiting on a final decision by Russia. We expect the cartel to tighten supplies to shore up prices. The instability in Libya could also affect Europe through immigration. The conflict re-routes migrants through the western route and thus could result in an increased flow to Spain and Portugal, rather than Italy which was previously their landing pad (Chart 12). A meaningful pick up would have a negative impact on European domestic political stability, especially with Germany in the midst of a succession crisis and incapable of taking a lead role. Chart 11Libyan Blockade Comes Amid Demand Shock Chart 12Refugees Will Favor Western Route Across The Mediterranean Erdogan’s foreign adventurism, and aggression against the West, poses a risk for Turkish markets. We remain underweight Turkish currency and risk assets. Our Emerging Markets strategists expect foreign capital outflows from EM to weigh on Turkey’s currency, local fixed-income and sovereign credit relative to EM benchmarks. Go short the Turkish lira relative to the US dollar. Bottom Line: Historically, the Mediterranean was the world’s most important waterway. It was the “life line” of the British empire. The US succeeded the British as the guarantor of Suez and corralled both Turkey and Greece into a single alliance under the Truman Doctrine. This status quo held until the twenty-first century. Since 2000, Russia has revived, US foreign policy in the Middle East has become erratic, and the Europeans have lost clout. Turkey is seeking to carve a space for itself and challenge the settlements of the past, all the way back to the 1923 Treaty of Lausanne. Yet in the wake of the Great Recession its economy is unstable and its populist leaders are taking greater risks abroad. The result will be greater friction with Europe, or the Arab states, or both. Given Turkey’s mismanagement at home, and limited gains to be made in Syria or Libya, Turkish assets will be the first to suffer from negative surprises.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 The Eastern Mediterranean Security and Energy Partnership Act of 2019 is an American bi-partisan bill the lends full support for the East Med pipelines and greater security cooperation with Israel, Cyprus, and Greece. The US Senate also passed an amendment to the National Defense Authorization Act last June which ended the arms embargo on Cyprus. 2 Turkey has also been engaging in drilling activities in disputed waters near Cyprus – which Ankara argues it is undertaking in order to protect Turkish-Cypriot claims – motivating EU economic sanctions in the form of travel bans and asset freezes on two Turkish nationals.

Highlights Bulk commodity markets – chiefly iron ore and steel – could see sharp rallies once Chinese authorities give the all-clear on COVID-19 (the WHO’s official name for the coronavirus). These markets rallied sharply Tuesday, as President Xi vowed China would achieve its growth targets this year, which, all else equal, likely will require additional monetary and fiscal stimulus. China accounts for ~ 70% of the global trade in iron ore, and ~ 50% of global steel supply and demand. COVID-19-induced losses have hit Chinese demand for steel hard, forcing blast furnaces to sharply reduce output. However, this partly is being countered by transitory weather- and COVID-19-related disruptions that are reducing iron ore exports from Brazil and delaying Australian shipments. Iron ore inventories could be drawn hard in 2Q and 2H20 to meet demand as steelmakers rebuild stocks and construction and infrastructure projects restart (Chart of the Week). The Chinese Communist Party celebrates its 100th anniversary next year. To offset the COVID-19-induced drag on domestic growth this year, which could take GDP growth below 5%, and a weak GDP performance next year additional stimulus is an all-but-foregone conclusion. Feature When policymakers really want to jumpstart GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. There is a compelling case a strong rally in iron ore and steel will accompany the containment of COVID-19, reversing the 14% and 4% declines in both since the start of the year (Chart 2). Chief among the drivers of the rally will be the increase in fiscal and monetary stimulus required to restore Chinese GDP growth disrupted by the COVID-19 outbreak, which could reduce annual growth closer to 5% than the ~ 6% rate policymakers were targeting. Chart of the WeekLow Iron Ore Stocks Setting Up A Rally Chart 2Policy Stimulus Will Reverse Declines In Iron Ore And Steel Prices There are a number of reasons for expecting this. 2020 marks the terminus of the decade-long policy evolution that was supposed to end with the realization of the “Chinese Dream.” Chief among the goals that were to be realized by the end of this year – which will usher in the 100th anniversary of the founding of the Chinese Communist Party in 2021 – are a doubling of per capita income and of GDP.1 The Communist Party in China has numerous policy levers it can pull to respond to worse-than-expected growth and economic shocks. These policies consume a lot of bulk commodities and base metals. When policymakers really want to jump-start GDP growth, their playbook typically turns to the real economy via policies that encourage construction, infrastructure development and manufacturing. This was clearly seen following the Global Financial Crisis (GFC) in 2008-09 (Chart 3). Even before the COVID-19 outbreak, policymakers made it clear they wanted to stabilize growth following the Sino-US trade war at the conclusion of the Central Economic Work Conference (CEWC) in December. Nominal wages and per capita income growth had been falling since 3Q18, imperilling one of the principal goals of the “Chinese Dream.” Chart 3Policy Stimulus Will Lift GDP And Iron Ore And Steel Prices Policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q- 4Q20 if their goal is simply to achieve 6% p.a. growth this year. Following that CEWC meeting, our colleagues at BCA’s China Investment Strategy (CIS) anticipated policymakers would announce growth targets at the National People’s Congress (NPC) meeting next month in the range of 5.8 and 6.2% p.a. growth, noting, “the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms.”2 The growth rate required to put the economy on track to deliver on the “Chinese Dream” is now much higher following the COVID-19 outbreak, which could shave ~1% or more off China’s growth this year alone. This suggests policymakers will aim for annualized quarterly growth of ~ 6.5% in 2Q-4Q20 if their goal is simply to achieve 6% p.a. growth this year. This predisposes us to expect significant monetary and fiscal stimulus this year after the all-clear is sounded and the economy can return to its day-to-day activities. In addition – and by no means least of the concerns driving policymakers’ decisions – the 100th anniversary of the founding of the CCP will be celebrated next year, something policymakers at all levels have been looking forward to showcase the success of their revolution. A Boon For Bulks As monetary policy eases, the construction growth trajectory should pick up smartly. China accounts for ~ 70% of the global trade in iron ore. It is expected to import ~ 1.1 billion MT this year and next, based on estimates published by the Australian government’s Department of Industry, Innovation and Science in its December 2019 quarterly assessment (Chart 4). China will account for ~ 50% of global steel supply and demand, or roughly 900mm MT/yr in 2020 and 2021. The COVID-19 outbreak reduced utilization rates at the close to 250 steel mills monitored by Mysteel Global in China to 78%, a drop of 2.3pp.3 Platts estimates refined steel production could fall by 43mm MT by the end of February.4 Most of China’s steel output goes into commercial and residential construction (~ 35%), infrastructure (~20%), machinery (~ 20%), and automobile production (~ 7%), based on S&P Global Platts estimates.5 Residential construction began to recover last year, and residential housing inventories were declining relative to sales (Chart 5). In our view, once the COVID-19 infection rate falls outside Hubei Province – the epicenter of the outbreak – markets will begin pricing in a revival of commercial and residential construction in China. As monetary policy eases, the construction growth trajectory should pick up smartly (Chart 6). Chart 4China Dominates Iron Ore, Steel Markets   Chart 5Resumption Of Construction Will Lift Demand For Bulks Chart 6Easier Money And Credit Policy Will Revive Construction Infrastructure spending already was on track to increase prior to the COVID-19 outbreak, based on our CIS colleagues’ reading of the CEWC statement issued in December, which “suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year.”6 This fiscal push will be supported by additional spending at the local government level, and by the issuance of special-purpose bonds by these governments with proceeds earmarked for infrastructure development (Chart 7). “A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019,” according to our CIS colleagues. Chart 7Pump Priming Will Boost Infrastructure Spending Bottom Line: Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Whether it rises at double-digit growth rates remains to be seen, however. Expect Chinese Consumers To Come Out Spending Infrastructure fixed asset investment will be supported by easier credit and fiscal policy in China. Prior to the outbreak of COVID-19, consumer confidence was running high (Chart 8), and employment prospects have bottomed and turned higher, although they still indicate contraction. (Chart 9). This boded well for consumer-spending expectations, particularly for autos (Chart 10). Chart 8Consumer Confidence Was High Prior to COVID-19 Outbreak ... Chart 9... And Job Prospects Were Improving ... At ~ 7%, China’s automobile production remains a marginal contributor to overall steel consumption. Nonetheless, a meaningful pickup in automobile production following the depressed growth rate of the past 15 months would move steel demand upward. China’s share of world auto sales is ~30% (Chart 11). Chart 10... Thus Lifting Prospects For Chinese Auto Sales   Chart 11Policy Stimulus Will Revive Chinese Auto Sector Accommodative monetary and fiscal policies in China point toward higher growth for the auto sector. However, it is important to note the revival in auto production needs to be driven by consumer demand – if it is led simply by restocking, the rebound will not be sustainable. The recovery we are expecting will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. Bottom Line: Auto consumption and production were recovering in late 2019; however, the strength of the recovery did not match previous stimulus programs (2009 and 2016). The recovery we are expecting this year will support steel and metal consumption at the margin, but the outlook for infrastructure and construction remains key due to their higher weight in total steel consumption. If these other sectors remain constructive for metal demand (or at least are not contracting or slowing drastically), the boost from the auto sector will meaningfully contribute to higher iron ore and steel prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Oil prices halted their decline and rose 1% on Tuesday as the number of daily confirmed cases of the Wuhan coronavirus decelerated in China. As of Tuesday, the daily growth in cases dropped to 5%, down from 6% the previous day. Investors will closely monitor this number for any sign of a durable slowdown in daily confirmed cases. Separately, the US Energy Information Administration revised down its global demand growth estimates for 2020 to 1.0mm b/d from 1.3mm b/d last month, reflecting the effects of the coronavirus and warmer-than-expected January temperatures in the northern hemisphere. We will be updating our global oil balances next week. Base Metals: Neutral Iron ore prices fell 14% since the COVID-2019 outbreak in January. Investors are assessing how the iron ore market will balance weaker demand expectations in China amid lower supply – largely a result of falling Brazilian ore exports. Brazil’s total iron ore exports fell ~19% y/y in January due to heavy rainfall and lower production at Brazilian miner Vale. The company’s output never fully recovered from the 2019 dam incident and remains a risk to iron ore supply in 1Q20. Vale lowered its March sales guidance by 2mm MT. Low Chinese port inventories raise prices’ vulnerability to supply disruptions (Chart 12). Precious Metals: Neutral Gold remains well bid despite a strong US dollar, fueled by safe-haven demand. The yellow metal’s price fell slightly on Tuesday as investors’ concerns over the coronavirus eased. Based on our fair-value model, prices averaged $55/oz above our estimate in January. Investors – i.e. global ETF holders and net speculative positions reported by the US CFTC – have been important contributors to the latest gold rally. Investors’ total holding of gold reached a record high 113mm oz last week. Nonetheless, we believe there is still opportunity for this group to further support prices: the share of gold allocation vs. world equity-market capitalization is still low at 0.24%, vs. its peak of 0.42% in 2012 (Chart 13). Ags/Softs:  Underweight March wheat futures were down 1.8% at Tuesday’s close, settling at the lowest level of the year after the USDA called for ‘stable supplies’ of the grain for the 2019/2020 U.S. marketing year. For corn, ending stocks were unchanged relative to the January projection, while world production was revised slightly upwards. March corn futures finished 2¢ lower at $3.7975/bu. The USDA also estimated higher soybean exports on the back of increased sales to China. However, soybean price gains were limited by higher production and ending stocks abroad. Chart 12Low Iron Ore Inventory Raises Exposure To Supply Disruptions Chart 13A Higher Share Of Gold Holdings Could Support Prices Further   Footnotes 1     The “Chinese Dream” is a phrase coined by President Xi Jinping, following the 18th Party Congress of the Chinese Communist Party in 2012, when the overarching goal of transforming China into a “moderately well-off society” was memorialized in writing. These goals were crystalized in terms of progress expected in per capita income and GDP, both of which were to be doubled in the decade ending this year. Please see Why 2020 Is a Make-or-Break Year for China published by thediplomat.com February 13, 2015. 2     Please see A Year-End Tactical Upgrade, published by BCA Research’s China Investment Strategy December 18, 2019, for an in-depth analysis of policy guidance coming out of the Economic Work Conference last December. It is available at cis.bcaresearch.com. 3    Please see WEEKLY: China’s blast furnace capacity use drops to 78% published by Mysteel Global February 10, 2020. 4    Please see China steel consumption to plunge by up to 43 mil mt in February due to coronavirus published February 6, 2020, by S&P Global Platts. 5    Please see China Macro & Metals: Steel output falls, but property creates bright spots published by S&P Global Platts December 6, 2019. 6    Please see footnote 2 above. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights An analysis on Turkey is available on page 10. In the short term, EM share prices will likely continue searching for a direction as visibility is extremely low. Beyond the near term, an appropriate strategy for EM equity investors is buying breakouts and selling breakdowns. The forthcoming stimulus from China is not a surefire guarantee of an immediate cyclical recovery. Low and falling willingness to spend among Chinese consumers and enterprises could overwhelm the positive boost from the stimulus. Forecasting changes in willingness to spend is not straightforward. Elsewhere, we are recommending a new trade: Short Turkish banks / long Russian banks. Feature Chart I-1EM Vs DM Equities: The Path Of Least Resistance Is Down EM risk assets and currencies as well as China-related financial markets are facing higher than usual uncertainty. Not only are the magnitude and duration of the coronavirus shock to the mainland’s economy unknown, but also both the scale of China’s forthcoming stimulus and its multiplier are highly uncertain. How should investors navigate through such uncertainty? For EM equity investors, an appropriate strategy is buying breakouts and selling breakdowns. Presently, we maintain a neutral stance on the absolute performance of EM stocks. We initiated a long position on December 19 and closed it on January 30 to manage risks amid the coronavirus outbreak. For asset allocators, we continue to recommend underweighting EM within global equity and credit portfolios (Chart I-1). As to exchange rates, investors should stay short a basket of EM currencies versus the US dollar. The EM equity index and EM currencies have been in a trading range in the past 12 months (Chart I-2). In the short term, markets will likely continue searching for a direction as visibility is extremely low. Beyond the near term, however, EM share prices and currencies are unlikely to remain in a narrow trading range. They will either break out or break down. Which way the market swings is contingent on corporate profits and the business cycle. A Framework To Assess Shocks What framework should investors use to gauge economic and financial market outcomes? We recommend the following: When a system – in this case the Chinese economy – is hit by an external shock, its most likely trajectory depends on the duration and magnitude of the shock as well as the initial health of the system. If the system is balanced and robust, a moderate shock can certainly shake it, but will not knock it over. A V-shaped recovery is most likely in this case. By contrast, if the system is unbalanced and precarious, a measured tremor could produce an outsized negative impact. As a result, this economy is more likely to experience a U-shaped recovery. No one can gauge with any precision the impact of the coronavirus outbreak on China’s economy. The only thing we can assess is the health of the mainland economy prior to this exogenous shock. Beyond the near term, EM share prices and currencies are unlikely to remain in a narrow trading range. Which way the market swings is contingent on corporate profits and the business cycle. In this regard, we present the following analysis on both the economy’s cyclical condition and structural vitality: 1. Cyclically, China’s growth was ostensibly bottoming when the coronavirus outbreak occurred. The top panel of Chart I-3 illustrates that – at that time – the Chinese broad money impulse foreshadowed a revival in nominal industrial output from late 2019 until mid-2020. In the second half of this year, however, the same indicator projected renewed growth deterioration. Chart I-2EM Stocks And Currencies Are In A Trading Range: How Long Will It Last? Chart I-3Without The Coronavirus Outbreak, Chinese Recovery Would Have Been Muted And Short-Lived   Notably, the broad money impulse has often led the credit and fiscal spending impulse, and it currently signals a rollover in the latter sometime in the first half of 2020 (Chart I-3, bottom panel). Chart I-4EM Corporate Profits: Modest And Temporary Improvement Consistently, China’s narrow money growth had been projecting a muted and only temporary rebound in EM corporate profits – which are often driven by the Middle Kingdom’s business cycle – from late 2019 until the middle of 2020 (Chart I-4). Thereafter, EM profit growth was set to relapse anew. In short, even prior to the coronavirus outbreak, our indicators were signaling that any economic improvement on the back of the Chinese government’s 2018-19 stimulus would have been muted and short-lived from late 2019 until mid-2020. Hence, the negative shock from the public health emergency could end up nullifying the pending recovery. 2. Structurally, as we have written extensively, China has enormous credit and money excesses. The economy has become addicted to rampant money and credit creation. This, along with the misallocation of capital and the resulting growth in the number of zombie companies, makes the system vulnerable, even to moderate shocks. It is reasonable to assume that there are some companies that enjoy great financial health, some zombies that are unable to service their debt at all, and a certain number of enterprises that generate just enough cash flow to service their debt. While the coronavirus-induced downtrend in the economy will not materially change the financial status of healthy or zombie businesses, it will likely alter the financial standings of debtors that were on the proverbial edge. Assuming the unavoidable drop in cash flows due to the country’s sudden shutdowns, these debtors will struggle to service their debt. This will likely alter their short-to-midterm decision making. For example, if they were planning to expand their operations and hire more employees, these plans are likely to be shelved for now. Low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. In short, the coronavirus-induced shutdowns are cutting into cash flows, but they do not in any way reduce debt burdens. Chart I-5 illustrates that debt servicing costs as a share of income for companies and households in China are among the highest in the world. Chart I-5China Has A High Debt Service-To-Income Ratio Notably, this measure for China is relative to nominal GDP while for other countries it is relative to disposable income. Disposable income is smaller than GDP as it takes into account taxes paid. Therefore, on a comparable basis, this ratio for China will be meaningfully higher than the one shown on Chart I-5. Bottom Line: Provided the Chinese economy is highly leveraged, it is reasonable to conjecture that the recovery following the adverse shock from the coronavirus will be U- rather than V-shaped. Stimulus: Yes. Multiplier: Unknown. It is a given that the Chinese authorities will inject more fiscal and monetary stimulus into the system. Nevertheless, the ultimate size of stimulus is unknown. So far, the following has been announced: On the monetary and credit side: A RMB300 billion re-lending quota to supply special low-cost funds to assist national commercial banks and local banks to provide preferential interest rate loans to key enterprises for epidemic prevention and control; On February 3, open market operation rates were cut by 10 basis points, and the key 7-day repo rate fell by 45 basis points; The People’s Bank of China injected liquidity1 via open market operations; The People’s Bank of China encouraged banks to lower lending costs for small and medium enterprises by 10% in some provinces. Critically, the banking regulatory authority has indicated it will allow an extension of the transition period for the implementation of the New Asset Management Regulation beyond 2020. Chart I-6Marginal Propensity To Spend Varies From Cycle To Cycle On the fiscal side: Additional local government debt quotas of RMB848 billion have been approved, on top of the previously authorized quota of RMB1 trillion in November 2019; the front-loaded debt quota will offer local governments more flexibility with their budgets and support growth via public investment; Cumulatively about RMB66 billion in supplementary funds has been deployed to support local governments and businesses, according to the Ministry of Finance; The authorities have delayed or partially waived taxes, social security fees, and government-owned rents for affected businesses; The government has instituted refunds of unemployment insurance premiums to enterprises who retain most employees in some cities; The central government will provide temporary interest rate relief (equivalent to 50% of the re-lending policy rate) on loans to key enterprises involved in the fight against the epidemic. However, stimulus in and of itself is not a sufficient condition on which to bet on a V-shaped recovery. Stimulus (or in the opposite scenario, tightening) does not always immediately entail an economic recovery (or on the flip side, a downturn). For one, policy stimuli always work with a time lag. In addition, the size of stimulus is still unknown. What’s more, the multiplier of the stimulus varies from cycle to cycle. Chart I-7Chinese Households Are Indebted We gauge the magnitude of any stimulus in China by observing money, credit and fiscal spending impulses. The multiplier is in turn contingent on economic agents’ (households and enterprises) propensity to spend. The impact of a large amount of stimulus can be offset by a low/falling marginal willingness to spend (a lower multiplier). Before the coronavirus outbreak, the marginal propensity to spend in China had improved slightly for households and had barely stabilized in the case of companies (Chart I-6). It is plausible to assume that a negative shock to confidence will likely dent both households’ and companies’ marginal propensity to consume. This is especially true since both economic agents are highly leveraged, as discussed above (Chart I-7). Finally, the leads and lags between the measures of stimulus like money impulses or credit and fiscal spending impulses and EM stocks in general and Chinese share prices in particular are not constant, as illustrated in Chart I-8 and Chart I-9. Chart I-8China: Share Prices And Money Impulse Chart I-9EM Stock Prices And China Credit And Fiscal Impulse   Bottom Line: Forthcoming stimulus is not a surefire guarantee of an immediate cyclical rally – neither for EM risk assets and currencies, nor for other China-related plays. This does not mean that a rally will not occur. Rather, gauging the timing and potential drawdown that precede it are almost impossible. The basis is that low and falling willingness among households to consume and among enterprises to invest and hire could overwhelm the positive boost from the stimulus. Unfortunately, forecasting changes in willingness to spend is not straightforward. Investment Strategy Chart I-10An Inconclusive Message From This Reliable Indicator We are currently neutral on EM stocks in absolute terms. We will be watching for market-based indicators to signal a breakout or breakdown and will adjust our strategy accordingly. One of our favorite indicators – the Risk-On /Safe-Haven currency ratio – is presently inconclusive (Chart I-10). Relative to DM, EM share prices broke to new lows last week as illustrated in Chart I-1 on page 1. We continue recommending an underweight position in EM within a global equity portfolio. Consistently, we are reiterating our long-standing short EM / long S&P 500 strategy. The US dollar’s technical profile is bullish (Chart I-11), which entails that its bull market is not yet over. We continue shorting an equally-weighted basket of BRL, CLP, COP, ZAR, KRW, IDR and PHP against the US dollar. We are also short the CNY versus the greenback on a structural basis. Within the EM currency space, we favor the MXN, RUB, CZK, THB and TWD. Finally, EM exchange rates hold the key to the performance of both EM local currency and US dollar bonds. Given our negative view on the currency, we are reluctant to chase the decline in domestic bond yields and narrowing spreads in the sovereign credit space (Chart I-12). Chart I-11The US Dollar Rally Is Intact Chart I-12EM: Local Bond Yields And Sovereign Spreads Are Too Low   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Doubling Down On Unsound Policies Despite the steep drop in oil prices, Turkish stocks have failed to outperform the EM equity benchmark (Chart II-1). When a market fails to outperform amid a historically bullish backdrop, it is often a sign of trouble ahead. The basis for the decoupling between Turkey’s relative performance and oil prices is President Erdogan’s doubling down on populist and unorthodox macro policies. He is eager to boost growth at any cost. As a litmus test of aggressive expansionist policies, local currency broad money growth has already surged to 24% (Chart II-2). In brief, these overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of investors from the country’s financial markets. Chart II-1A Bearish Sign For Turkish Equities Chart II-2Turkey: Rampant Money Creation   Chart II-3Turkey: Booming Fiscal Spending First, the central bank has cut interest rates to below inflation. The outcome is negative policy rates in real terms. Moreover, the central bank has resumed plentiful liquidity provisioning to banks to prevent interbank rates from rising. Second, government expenditures are surging (Chart II-3). Ballooning government borrowing is largely being financed by commercial banks – i.e., the latter are involved in outright monetization of public debt (Chart II-4, top panel). Chart II-4Public Debt Monetization By Commercial Banks In the past two years, banks have purchased some TRY 250 billion of government bonds. This has boosted their share of holdings of government local currency bonds from 45% to 58% (Chart II-4, bottom panel). This has not only capped local bond yields, but also enormously expanded money supply. When a commercial bank purchases a bond from a non-bank entity, it creates a new deposit (broad money supply), as we discussed in November 29, 2018 report. The authorities have also announced tax cuts on various consumer goods in order to boost consumption. This is leading to a resurgence in consumer goods imports. In short, the trade balance is bound to widen again as domestic consumption resumes. Third, the government is forcing both state-owned and private banks to substantially boost credit flows to the economy. Last week, the AKP proposed a new banking bill that could force banks to fund large-scale projects. Further, the banking regulator is penalizing banks that fail to meet a “credit volume criteria’ by lowering the interest rate banks receive on their required reserves at the central bank. Crucially, the authorities are forcing banks to cut lending rates. Banks’ net interest rate margins have declined to all-time lows (Chart II-5). It will narrow further as they continue to cut lending rates, while holding deposit rates high to avoid flight from local currency deposits into US dollars. Banks, especially public ones, have dramatically accelerated their credit origination. This will lead to capital misallocation and potentially to non-performing loans (NPLs). On banks’ balance sheets, NPLs have been, and will remain, artificially suppressed. Neither banks nor regulators are incentivized to provision for potential loan losses.  Insolvent banks can operate indefinitely so long as their shareholders and regulators allow it, and the central bank provides sufficient liquidity. This will most certainly be the case in Turkey in the years to come. Constraints in such a scenario are surging inflation and currency devaluation. Turkish authorities have whole-heartedly opted for these lax fiscal, monetary and bank regulatory policies. This entails that inflation and currency devaluation are unavoidable. Overly expansionary policies will undermine the currency, lift inflation and lead to a further exodus of foreign investors from the country’s financial markets. Lastly, surging wages and unit labor costs corroborate that inflationary pressures are genuine and rampant (Chart II-6). The minimum wage is set to increase by another 15% this year. Chart II-5Banks' Net Interest Margins At All Time Lows Chart II-6Turkey: Wages Are Surging   The government has been trying to regulate prices in the consumer sector by putting administrative price caps in place. Yet inflation remains persistently high in both goods and services sectors. Investment Recommendation Chart II-7Excessive Stimulus Is Bearish For The Lira The Turkish lira is again on a precipice. Only government intervention can temporarily prevent a major down leg. We are reiterating our underweight call on Turkish stocks within an EM equity portfolio. As a new trade, we are recommending a short Turkish banks / long Russian banks position. In contrast to Turkey, Russia’s macro policies have been, and remain, extremely orthodox. The new Russian government is poised to boost fiscal stimulus and the economy will accelerate with low inflation. We will discuss Russia in next week’s report. Finally, a surging fiscal and credit impulse in Turkey often leads to higher inflation and downward pressure on the currency (Chart II-7). As such, local currency government yields offer little protection at these levels against a depreciating currency. Therefore, investors should underweight the Turkish currency, local fixed-income and sovereign credit relative to their respective EM benchmarks. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Footnotes 1     We published A Primer On Liquidity on January 16, 2020 illustrating that the linkages from liquidity provisions by central banks and both increased spending in the real economy and higher asset prices are ambiguous. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations