Emerging Markets

Special Report

Highlights Korean stocks are facing downside risks over the next several months. Exports will continue to contract on falling semiconductor prices and retrenching global demand. Growth deceleration and low inflation will lead the central bank to cut rates in 2019. Within an EM equity portfolio, we are downgrading Korean tech stocks from overweight to neutral but remain overweight the non-tech sector. We are booking gains on our strategic long positions in EM tech versus both the broader EM equity benchmark and materials. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait to buy on a breakout and/or sell on a breakdown of the tapering wedge pattern. Feature   Decelerating and lately contracting South Korean exports have been a major drag on the economy and stock market (Chart I-1). The country is heavily reliant on manufacturing, with exports of goods contributing to nearly half of real GDP. Chart I-1Korean Stocks: Unsustainable Rebound? Although exports are currently shrinking, Korean domestic stock prices still rebounded. The rebound has mostly been driven by the information technology (tech) sector (Chart I-2). Is this recent rally justified by underlying fundamentals? Will share prices continue to rise in 2019? Our inclination is ‘no’ to both questions. There are still dark clouds on the horizon for both Korea’s business cycle and stock market. We are downgrading Korean tech stocks to neutral from overweight within a dedicated EM equity portfolio. However, we are maintaining our overweight in non-tech stocks relative to the EM equity benchmark. Lingering Risks In The Semiconductor Industry Korea’s dependence on the semiconductor sector has risen considerably in the past several years: Semiconductor exports have risen from under 10% to slightly above 20% of total goods exports (Chart I-3). As such, the outlook for semiconductor exports is a critical factor for future economic growth. Chart I-3Korea: Increasing Reliance On The Semiconductor Sector Table 1 lists the top 10 major exported goods from Korea, together contributing about 72% of total exports. Semiconductors are by far the largest component. Last year, overseas sales of semiconductors alone contributed to some 90% of growth in Korean exports, and about one-third of the country’s nominal GDP growth. Notably, Korea produces the largest quantity of DRAM and NAND memory chips in the world. Last year, Korean semiconductor companies accounted for about 70% of global DRAM and 50% of NAND flash global sales revenue. In 2019 Korean semiconductor exports will likely contract due to further deflation in DRAM and NAND memory prices (Chart I-4). Chart I-4Memory Prices Are Plunging The 2016-2017 surge in DRAM and NAND flash prices was due to supply shortages relative to demand. Last year, NAND prices plunged and DRAM prices began to fall as their supply-demand balances shifted to oversupply. This year, the glut will worsen. Demand Global demand for DRAM and NAND memory is slowing. Memory demand from the global smartphone sector – one important end-user market for DRAM and NAND memory chips – is contracting. According to the International Data Corporation (IDC), the global mobile phone sector is the biggest end-market for both DRAM and NAND memory chips, with nearly 40% market share in each. As major markets like China and advanced economies have entered the saturation phase of mobile-phone demand, global smartphone shipments are likely to decline further in 2019 (Chart I-5, top panel). Chart I-5Global Memory Demand Is Slowing DRAMeXchange1 expects global smartphone production volume for 2019 to fall by 3.3% from last year. In addition, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This contributed to strong DRAM demand and in turn higher semiconductor prices between June 2016 and May 2018. With the bust of bitcoin prices, this demand has vanished, which will further weigh on prices (Chart I-5, bottom panel). Supply High semiconductor prices in 2016-2017 boosted global production capacity expansion of DRAM and NAND memory chips. Based on data compiled by the IDC, global DRAM and NAND flash capacity expanded by 5.7% and 4.3% respectively in 2018 from a year earlier. As most of the global new capacity was added in the second half of 2018, the output of DRAM and NAND in 2019 will be higher than last year. Moreover, DRAM capacity will grow an additional 4% this year. Because of rising supply and slowing demand, both DRAM and NAND markets are in excess supply and have high inventories. DRAMeXchange forecasts that average DRAM prices will drop by at least another 20% in 2019, while NAND flash prices will fall another 10% from current levels. DRAM and NAND flash memory are the largest components of Korean tech producers. Yet they also sell many other tech products such as analog integrated circuits, LCD drivers, discrete circuits, sensors, actuators, and so on. Apart from the negative impact of declining global DRAM and NAND flash prices, the country’s semiconductor exports will also suffer from slowing demand in China in 2019. China, the biggest importer of Korean semiconductor products, has already shown waning demand. Its imports of electronic integrated circuits and micro-assemblies have contracted over the past two months in both value and volume terms (Chart I-6, top and middle panels). This mirrors a similar contraction in Korean semiconductor exports over the same period (Chart I-6, bottom panel). Chart I-6Weakening Chinese Semiconductor Demand Bottom Line: Korean semiconductor producers will likely face a contraction in their sales in 2019 due to weakening demand and deflating semiconductor prices. Diminishing Competitive Advantage Korea has been losing its competitive edge in key sectors like automobiles and smartphones. Even though the country remains highly competitive in the global semiconductor industry, it is beginning to show early signs of losing competitiveness there too. Improving competitiveness among other producers as well as a slowing pace of technological improvement and rising production costs are major reasons underlying Korea’s diminishing global competitiveness. Automobiles Korean auto manufacturers have lost market share in the global auto market. In China, the world’s biggest auto market, Korean brands’ market share has declined significantly in the past four years, losing out to both Japanese and German brands (Chart I-7, top three panels). Chart I-7Korea: Losing Market Shares In China's Auto Market Korean car companies have established auto manufacturing plants in China over the past decade. As a result, all Korean cars sold in China are produced within China, and automobile exports to China from Korea have fallen to zero (Chart I-7, bottom panel). Due to Korean auto manufacturers’ diminishing competitive advantage, Korean automobile production and exports peaked in 2012 in terms of volumes, and have been on a downtrend over the past seven years (Chart I-8, top panel). Chart I-8Further Decline In Korean Auto Output And Exports Is Possible While demand for Korean cars in the EU remains resilient, sales volumes in the U.S., China and the rest of world have been on a downward trajectory (Chart I-8, bottom three panels). Smartphones In the global smartphone market, Korea’s major smartphone-producing company – Samsung – has been in fierce competition with Chinese brands, and it seems to be losing the battle. Chart I-9 shows that while Samsung’s smartphone sales declined 8% year-on-year last year, smartphone sales from major Chinese smartphone producers (Huawei, Xiaomi, Oppo and Vivo) continued to grow at a pace of 20%. Chart I-9Korea: Losing Market Shares In Global Smartphone Market From 2012 to 2018, China’s share of global smartphone shipments rose from 6% to 39%. By comparison, Samsung’s share declined from 30% to 21% over the same period. Semiconductors Korean semiconductor companies – notably Samsung and SK Hynix – will likely remain the biggest producers in the memory market, given their advanced technology. However, there are still signs that Korean semiconductor companies will face increasing challenges in protecting their market share. Based on IDC data, Korean semiconductor companies’ share of global DRAM capacity will inch lower to 65% in 2019 from 65.4% in 2017, while their share of NAND capacity will decline to 53.8% from 57.5% during the same period. Meanwhile, China is focusing on boosting its self-sufficiency in terms of semiconductor production. At the moment there is still a three- to four-year technological gap between China and Korea in DRAM and NAND mass production, though the gap is likely to narrow. In the meantime, the U.S. will continue to create obstacles to prevent the rise of the Chinese semiconductor sector. However, these factors will only delay – not avert – the sector’s development and growth. We believe China will remain firmly committed to develop its semiconductor sector, particularly memory products, irrespective of the cost of investment necessary to do so. Similar to what has transpired in both automobile and smartphone production (Chart I-10), China will slowly increase its penetration in the semiconductor market with increasing capacity and a narrower technology gap over the next five to 10 years. After all, the world’s biggest semiconductor demand is in China. Chart I-10China: A Rising Star In Global Auto And Smartphone Market Significant increase in labor costs = falling export competitiveness for all sectors Korean President Moon Jae-in’s flagship economic policy, “income-led growth,” has resulted in dramatic increases in minimum wages since he took office in 2017, further damaging Korea’s competitiveness. The nation’s minimum wage was hiked by 7.3% in 2017, 16.4% in 2018 and will rise by another 11% to 8,350 KRW or $7.40 an hour, in 2019. As the president remains committed to meeting his campaign pledge of lifting the minimum wage to 10,000 KRW an hour, or about $8.90, this would require a further 20% increase in the next year or two. In addition, the government has also limited the maximum workweek to 52 hours since last July for businesses with more than 300 workers. Last month, the Cabinet further approved a revision bill whereby workers are eligible to receive an additional eight hours of wages every weekend for 40 hours of work that week. The new wage regulations have become a substantial burden on employers in all industries. The impact is more severe on small- and medium-sized enterprises (SMEs). According a recent survey, about 30% of SMEs have been unable to pay workers due to the state-set minimum wage. It is also affecting large manufacturers. According to a joint statement released in late December by the Korea Automobile Manufacturers Association and the Korea Auto Industries Cooperative Association, local automakers’ annual labor cost burdens will increase by at least 700 billion won (US$630 million) a year. As for auto parts manufacturers, a skyrocketing financial burden due to the new policy may threaten their survival. In addition, despite the KORUS FTA agreement reached between Korea and the U.S. last September, Korean auto manufacturers still fear they will be subject to new tariffs in 2019. On February 17, the U.S. Commerce Department submitted a report about imposing tariffs on imported automobiles and auto parts to U.S. President Donald Trump, who will make a decision by May 18. Our Geopolitical Strategy Service (GPS) team believes the odds of U.S. administration imposing auto tariffs on imported cars from Korea are small as this will be against the KORUS FTA agreement.2 Our GPS team also believes Japan is less likely to suffer a tariff than the EU, and even if Japan suffers a tariff along with the EU, Japan will negotiate a waiver more quickly than the EU. In both cases, Korea is likely to sell more cars in the U.S., but it will continue to face strong competition from Japan. Bottom Line: In addition to weakening global demand, a deterioration in Korea’s competitive advantage, due in large part to improving competitiveness among other producers and rising domestic wages, will negatively affect Korean exports. What About Domestic Demand? Record fiscal spending in 2019 will boost public sector consumption considerably, offsetting weakening consumption in the private sector. As the new wage policy will likely result in more layoffs and additional shuttering of businesses, domestic retail sales growth will remain under pressure (Chart I-11). Hence, an unintended consequence of the government’s higher income policy will be weaker aggregate income and consumer spending growth. Chart I-11KOREA The New Wage Policy May Trigger More Layoffs And Weaken Retail Sales Manufacturing and service sector jobs, including wholesale and retail trade and hotels and restaurants, account for 17% and 23% of total employment, respectively. Of all sectors, these two lost the most employees in January from a year ago. Meanwhile, due to the government’s deregulation of loans in 2014, Korean household debt has increased at a much faster pace than nominal income growth (Chart 12, top panel). As a result, Korea’s household debt has rapidly risen to 86% of its GDP as of the end of the third quarter of last year, from 72% four years ago – (Chart I-12, bottom panel). Elevated household debt at a time of rising layoffs will increase consumer anxiety and weigh on household spending. Chart I-12High Household Debt Will Weigh On Spending In order to combat an economic downturn, the government last month approved a record 467 trillion won ($418 billion, 26.5% of the country’s 2018 GDP) budget for 2019, up 9.5% from last year. The last time the budget increased by such a big scale was in 2009, when spending rose 10.7% in the wake of the global financial crisis. In addition, the government will front-load spending – with 61% of the budget to be spent in the first half of 2019. Household spending and government expenditures account for 48% and 15% of real GDP, respectively, while exports equal about 50% of real GDP. Hence, the increase in fiscal spending will not entirely offset the contraction in exports and slowdown in consumer spending. This entails a considerable slowdown in economic growth in 2019. Bet On Monetary Easing With growth disappointing and both headline and core inflation well below 2% (Chart I-13), the central bank will cut rates in 2019. Chart I-13Bet On A Rate Cut So far, economic growth has decelerated in the past 10 months, and recent data shows no signs of recovery. The country’s manufacturing sector is in contraction, with manufacturing PMI holding below the 50 boom-bust line in January (Chart I-14). Meanwhile, South Korea's unemployment rate rose to a nine-year high in January, with most of the job losses in the manufacturing and construction sectors. Chart I-14Manufacturing Sector: Still In Contraction Saramin, a South Korean job search portal, surveyed 906 firms in South Korea last month, 77% of which expressed unwillingness to hire new employees due to higher labor costs and negative business sentiment. Retail sales volume growth recently tumbled to 2-3%, pointing to faltering domestic demand (Chart I-11 above, bottom panel). The fixed-income market is not pricing in a rate cut in 2019. Therefore, investors should consider betting on lower interest rates. Shrinking exports and rate cuts will likely undermine the Korean won. Bottom Line: Economic deceleration and low inflation will lead the central bank to cut interest rates in 2019. Investment Implications The following are our investment recommendations: Downgrade the Korean tech sector from overweight to neutral within the EM space. We are reluctant to downgrade to underweight because many other emerging markets and sectors within the EM universe have poorer structural fundamentals than Korean tech. The tech sector accounts for 38% of the MSCI Korea Index, and 27% of the KOSPI in terms of market value. The stock with the largest weight in the MSCI Korea equity index is Samsung Electronics, with a share of 25%, followed by SK Hynix, with a ~5% share. Both are very sensitive to semiconductor prices. Specifically, semiconductor sales accounted for 31% of Samsung’s revenue, but contributed 77% of Samsung’s operating profit last year (Table I-2). Falling prices reduce producers’ profits by more than falling volumes.3 Hence, profits of semiconductor producers in Korea and globally will shrink in 2019. This will lead to a substantial selloff in Korean tech stocks (Chart I-15). Chart I-15Falling Memory Prices Will Trigger A Sell-Off In Korean Tech Stocks Meanwhile, China accounts for 33% of Samsung’s revenue, making it the largest market (Chart I-16). The ongoing economic slump in China’s domestic demand implies weaker demand for Korean shipments to China, which account for 28% of its exports and 14% of its GDP. ​​​​​​​ We are booking gains on our strategic long position in the Korean tech sector versus the EM benchmark index first instituted on January 27, 2010. This trade resulted in a 136% gain (Chart I-17, top panel). Chart I-16Taking Profits On Our Overweight Tech Positions Consistently, we are also taking profits on our long EM tech / short EM materials stocks trade, a strategic recommendation initiated on February 23, 2010 that has yielded a 186% gain (Chart I-17, second panel). The basis for this strategic position was our broader theme for the decade of being long what Chinese consumers buy and short plays on Chinese construction, which we initiated on June 8, 2010.4 Stay overweight non-tech equities within the EM space. The fiscal stimulus will have a considerable positive impact on the economy. Besides, Korean non-tech stocks have been weak relative to the EM equity benchmark, and in a renewed EM selloff they could act as a low-beta play (Chart I-17, bottom panel). We initiated our long Korean non-tech sector versus the EM benchmark index on May 31, 2018, which has so far been flat. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait and buy on a breakout or sell on a breakdown of the tapering wedge pattern. The KRW/USD has been in a tight trading range over the past eight months (Chart I-18) and is approaching a major breaking point – i.e., any move will be significant, which we expect will largely depend on the movement of the RMB/USD. Chart I-18Tapering Wedge Patterns The natural path for the RMB would have been depreciation versus the U.S. dollar. However, China may opt for a flat exchange rate versus the U.S. dollar given its promises to the U.S. within the framework of forthcoming trade agreements. We have been shorting the KRW versus an equally weighted basket of USD and yen since February 14, 2018. We continue to hold this trade for the time being. Investors should augment their positions if the KRW/USD breaks down or close this trade and go long the won if the KRW/USD breaks out of its tapering wedge pattern. With respect to fixed income, we continue to receive Korean 10-year swap rates as we expect interest rates to fall meaningfully. Local investors should overweight bonds versus stocks.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     Footnotes 1 DRAMeXchange, the memory and storage division of a technology research firm TrendForce, has been conducting research on DRAM and NAND Flash since its creation in 2000. 2 Please see the Geopolitical Strategy Weekly Report, "Trump's Demands On China", published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see the Emerging Markets Strategy Weekly Report “Corporate Profits: Recession Is Bad, Deflation Is Worse”, dated January 28, 2016, available at www.bcaresearch.com 4 Please see the Emerging Markets Strategy Special Report “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at www.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trade talks have been the primary driver of the rally in Chinese stocks and China-related assets over the past five months. While trade is important to China’s economy, Chinese domestic demand is the primary driver of China-related asset fundamentals, meaning that the recent equity rally has occurred on the back of a largely false narrative. The January surge in credit has brought the first concrete sign that Chinese domestic demand will eventually bottom, but the current pace of money & credit growth suggests that investable earnings are facing a “catch up” period of potentially material weakness. The need for a stabilization in the outlook for earnings argues against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch for the coming few months. Feature Chart 1 reviews the recent performance of the Chinese investable equity market, and highlights two important facts: Chinese equity performance bottomed in both absolute and relative terms at the end of October, and The relative performance trend versus global stocks has now retraced roughly 40% of the decline that occurred in 2018 Chart 1A Sizeable Retracement, Based On A (Largely) False Narrative For investors looking for an appropriate allocation to Chinese stocks and China-related assets more generally over the coming 6-12 months, it is important to understand what has driven this post-October outperformance. In our view, it is only the January surge in credit growth that has brought the first concrete sign that Chinese domestic demand will eventually bottom, meaning that China plays have been rallying for the past five months on a largely false narrative. This significantly complicates the cyclical investment outlook, even under the assumption of an imminent trade deal with the U.S. As we will detail below, several factors argue against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch. We will be watching closely over the next few months for confirmation that above-average credit growth will be sustained, and that the outlook for Chinese earnings is stabilizing. Dissecting The Rally: Mostly Driven By Trade Optimism, Not Easing During the week of October 29th, the equity market was buoyed somewhat by a statement emerging from the late-October politburo meeting. The statement cited the need for the government to take “more timely steps” to counter increasing downward pressure on the economy, which catalyzed a 6% bounce in investable stocks (3% for the domestic market) by Thursday, November 1st. However, to most investors, news of a much more significant event came on Friday, November 2nd: President Trump was looking to make a deal with China at the late-November G20 meeting in Argentina, and had asked key officials to begin drafting potential terms.1 The investable market rallied over 3% on the day in response to the news, and continued to rise until Monday December 3rd, the day after the 3-month trade talk agreement was struck. Chart 1 shows that while investible stocks nearly hit a new 2018 low in December, this was due to a significant sell off in global stocks: relative performance was flat during this period, and resumed its uptrend once global stocks began to rise. Chart 2 provides confirmation that trade talks have been the primary driver behind the rally in China-related assets as well. The chart shows the BCA Market-Based China Growth Indicator alongside a diffusion index of its 17 components, with the vertical line denoting the point where the prospect of a deal became public. The Fed’s shift to a more dovish posture following its December rate hike has certainly helped propel the global rally in risky assets, but Chart 2 makes it clear that a shift in the outlook for trade between the U.S. and China has been the more important factor driving the prices of China-related assets over the past few months. Chart 2Trump's Desire For A Deal Was The Turning Point For The Market In terms of its relative importance for the Chinese economy, the focus of investors on trade is mostly wrongheaded. Trade is important to China’s economy, but the domestic demand trend is a far more important driver for the fundamental performance of China-related assets. We have highlighted over the past year that investor attention has been focused on the wrong factor, underscoring the rally in Chinese stock prices over the past few months has been driven by a largely false narrative. From Trade, To Credit Chart 3 compares our leading indicator for the Chinese economy with a measure of coincident economic activity, and highlights that the sharp slowdown in growth that has occurred over the past few months represents a reversion to a level that would be more consistent with that of our leading indicator (which has been pointing to weaker economic activity for the better part of the past 18 months). In fact, Chart 3 implies that actual growth is still stronger than what monetary conditions, money, and credit growth would imply, meaning that a further slowdown should be expected over the coming several months. Chart 3Economic Activity Is Recoupling With Our Leading Indicator However, judging by January’s credit release, this further slowdown in growth may occur against the backdrop of a durable uptrend in our leading indicator. Our calculation of adjusted total social financing grew by nearly 5 trillion RMB in January, a very substantial rise that has seldom occurred over the past few years (Chart 4). Legitimate questions about the seasonal effects of the Lunar New Year remain, but Chart 5 shows that the January data was large enough to cause a visible tick higher in the YoY growth rate, caused a sharp rise in our ratio of new credit to GDP, and occurred alongside an easing in the contraction of shadow credit as a percent of total credit. These are clear signs that reluctant policymakers are responding to the need to stabilize a weak economy. Chart 4A Very Strong Surge In January Credit...Chart 5...Has Led To A Visible Uptick In Annual Growth The magnitude of the January surge suggests that there is now a legitimate basis to forecast an eventual bottom in Chinese domestic demand. Our December 5 Weekly Report outlined our key views for 2019,2 and in it we noted that “our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China”. The odds of a firming in growth have certainly gone up as a result of January’s data, although it remains unclear how strong the upturn in credit growth will ultimately be over the course of 2019. This, along with the desynchronizing effect of trade front-running and a truce-driven rally in Chinese stocks, significantly muddles the 6-12 month investment strategy outlook. From Credit, To Investment Strategy We noted in our December key views report that a tactical overweight stance towards Chinese stocks was probably warranted over the coming three months, in recognition of the fact that investors could bid up the market in the lead-up to a possible trade deal with the U.S. We argued that the conditions for a cyclical overweight stance (6-12 months) were not yet present but could emerge sometime this year, particularly if money & credit growth begin to pick up. Is the January surge in adjusted total social financing a sign that investors should increase their allocation to Chinese equities today? We agree that investors should put Chinese investable stocks on upgrade watch for the next few months, but three factors continue to argue against an immediate shift: Investors appear to have bid up Chinese stocks assuming not only that the trade deal with the U.S. will occur, but that it will result in a durable resolution to the dispute (including, presumably, the rolling back of all tariffs that have been imposed). Even under the assumption that a deal does occur, it may be less comprehensive than investors are assuming and could still cause some lasting negative implications for global trade. While the odds of a credit overshoot have legitimately risen,3 January’s credit number is only one data point and the month-over-month change in credit is always abnormally strong in the first month of the year. At a minimum, investors should wait until the February credit data is released in mid-March to judge whether a higher pace of credit growth will be sustained over the course of the year. The recent quarrel between Premier Li Keqiang and the PBOC over whether the January credit spike represented “flood irrigation-style” stimulus suggests that policymakers are still somewhat reluctant to significantly boost credit,4 underscoring the need to monitor whether the recent pace of growth will be sustained. As first highlighted in Chart 3 above, the inflection point in credit growth implies that economic activity will improve at some point in the months ahead, but the current pace of money & credit growth suggests that both activity and, crucially, the level of earnings are facing a “catch up” period of potentially material weakness before they durably bottom. Chart 6 illustrates this potential weakness by comparing the current circumstance of our leading economic indicator, our measure of coincident economic activity, and the level of forward earnings to the 2015/2016 episode. The chart shows that by comparison to today, the 2015/2016 episode had clearer sequencing: our leading indicator fell, coincident activity followed, and stock prices bottomed only once forward earnings had contracted materially. Chart 6In 2015/2016, Our Leading Indicator Led Activity, Earnings, And Relative Stock Performance This time around, our leading indicator peaked in Q1 2017, but activity remained stronger than our indicator would have suggested even though it peaked relatively soon afterwards. Incoming data over the past three months suggest that economic activity is now catching up to the downside, and forward earnings remain elevated. Chart 7 shows that Chinese net earnings revisions remain firmly in negative territory, at levels that have been historically been associated with contracting forward earnings growth. Chart 7Earnings Weakness Looks Set To Continue Panel 4 of Chart 6 is emblematic of the fact that the recent rally in Chinese relative performance, driven largely by a false narrative, has significantly complicated the cyclical investment outlook. If the January improvement in credit had instead come in late October when Chinese relative performance was near its low, it would have been much easier for us to recommend that investors move to an overweight stance in response to a legitimate fundamental improvement and to take the risk of being somewhat too early. Now, a razor sharp focus on the earnings outlook is necessary, and we are unlikely to recommend an increased allocation to Chinese stocks unless that outlook stabilizes. Table 1 presents one of the tools that we will be using to judge the outlook for earnings, based on a model that we presented in two recent reports.5 The table shows a series of earnings recession probabilities that are based on a variety of credit and exchange rate scenarios and conditional on a material improvement in Chinese exporter sentiment. Light colored cells represent an earnings recession probability of less than 1/3rd, and the circled cell shows roughly where we would be today if the new export order component of the NBS manufacturing PMI were to rise sharply back to its June 2018 level. Table 1Credit Needs To Rise Further And RMB Appreciation Needs To Slow For The Earnings Outlook To Stabilize The table makes two key points. First, even given January’s surge, new credit will have to improve relative to GDP over the coming months in order to stabilize the earnings outlook. Second, the more that China’s currency appreciates in response to a trade deal with the U.S., the higher the hurdle rate for credit. Chart 8 shows that CNY-USD is already deviating quite significantly from the level implied by interest rate differentials, suggesting that significant further currency appreciation may not be in the cards. But the bottom line for investors is that a rising currency has the potential to negate some of the reflationary effects of stronger credit, and is a risk that must be monitored alongside the effort to gauge the sustainable rate of credit growth. Chart 8While Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Footnotes 1 Please see “Trump Said To Ask Cabinet To Draft Possible Trade Deal With Xi”, dated November 2, 2018, available at Bloomberg News 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy and Geopolitical Strategy Special Report “China: Stimulating Amid The Trade Talks”, dated February 20, 2019, available at cis.bcaresearch.com. 4 Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. 5 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks”, dated January 16, 2019, and Weekly Report “A Gap In The Bridge”, dated January 30, 2019 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations