Emerging Markets
Highlights Overall Strategy: The global economy is entering a reflationary sweet spot that will last for the next two years. Investors should overweight equities, maintain slightly below benchmark exposure to government bonds, and underweight cash over a 12-month horizon. Fixed Income: Global bond yields will rise only modestly over the next two years, reflecting an abundance of spare capacity in many parts of the world. A major bond bear market will begin towards the end of the decade, as stagflationary forces gather steam. Equities: Investors should underweight the U.S. for the time being, while overweighting Europe and Japan in currency-hedged terms. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate another 6% from current levels. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is approaching a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks later this year. Feature I. Key Theme: A Reflationary Window The global economy is entering a reflationary sweet spot where deflationary forces are in retreat but fears of excess inflation have yet to surface. Activity data are surprising to the upside and leading economic indicators have turned higher (Chart 1). Falling unemployment in most major economies is boosting confidence, fueling a virtuous cycle of rising spending and even further declines in joblessness. Manufacturing activity is bouncing back after a protracted inventory destocking cycle (Chart 2). In addition, the stabilization in commodity prices has given some relief to emerging markets, while fueling a modest rebound in resource sector capital spending. Meanwhile, easier fiscal policy is providing a welcome tailwind to growth. The aggregate fiscal thrust for advanced economies turned positive in 2016 - the first time this has happened in six years. We expect this trend to persist for the foreseeable future. Reflecting these developments, market-based measures of inflation expectations have risen, offsetting the increase in nominal interest rates. In fact, real rates in the euro area and Japan have actually declined across most of the yield curve since the U.S. presidential election (Chart 3). This should translate into higher household and business spending in the months ahead. Chart 1Global Growth Is Accelerating Chart 2Inventory Destocking Was A Drag On Growth Chart 3Falling Real Rates In The Euro Area And Japan Supply Matters Yet, there has been a dark side to this reflationary trend, and one that could sow the seeds for stagflation as the decade wears on. Simply put, much of the reduction in spare capacity over the past eight years has occurred not because of much faster demand growth, but because of continued slow supply growth. Chart 4 shows that output gaps in the main developed economies would still be enormous today if potential GDP had grown at the rate the IMF forecasted back in 2008. Chart 4AWeak Supply Growth Has Narrowed Output Gaps Chart 4BWeak Supply Growth Has Narrowed Output Gaps Unfortunately, we do not expect this state of affairs to change much over the coming years. The decline in birth rates that began in the 1960s has caused working-age populations to grow more slowly in almost all developed and emerging economies (Chart 5). In some countries such as the U.S., the downward pressure on labor force growth has been exacerbated by a structural decline in participation rates, especially among the less educated (Chart 6). Chart 5Slowing Workforce Growth Chart 6U.S.: The Less Educated Are Shunning The Labor Force Productivity growth has also fallen (Chart 7). Part of this phenomenon is cyclical in nature, reflecting the impact of several years of weak corporate investment in new plant and equipment. However, much of it is structural. As Fed economist John Fernald has shown, the slowdown in productivity growth since 2004 has been concentrated in sectors that benefited the most from the adoption of new information technologies in the late 1990s (Chart 8).1 Recent technological innovations have focused more on consumers than on businesses. This has resulted in slower productivity growth. Chart 7Slowing Productivity Growth Around The World Chart 8The Productivity Slowdown Has Been ##br##Greatest In Sectors That Benefited The Most From The I.T. Revolution To make matters worse, human capital accumulation has decelerated both in the U.S. and elsewhere, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the rate it did in the 1990s (Chart 9). Educational achievement, as measured by standardized test scores, has also peaked, and is now falling in many countries (Chart 10). Chart 9The Contribution To Growth ##br##From Rising Human Capital Is Falling Chart 10Math Skills Around The World From Deflation To Inflation To reiterate what we have discussed at length in the past, the slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on.2 Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 11). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period during which productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 12). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Chart 12An Aging Population Eventually Pushes Up Interest Rates Is Debt Deflationary Or Inflationary? The answer is both. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Moreover, once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. Acting on that incentive also becomes easier as the output gap evaporates. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to maintain interest rates at ultra-low levels, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, an adverse economic shock, etc. In contrast, if the output gap is already close to zero, a promise to let the economy run hot is more likely to be taken seriously. The U.S. Economy: Still In A Reflationary Sweet Spot The stagflationary demons described above will eventually come back to haunt the U.S., but for now and probably for the next two years, the economy will remain in a reflationary sweet spot. After a weak start to 2016, growth has bounced back. Real GDP grew by 3.5% in Q3. The Atlanta Fed's GDPNow model points to still-healthy growth of 2.9% in Q4. We expect growth to stay robust in 2017, as improving confidence and a stabilization in energy-sector investment lift overall business capex, homebuilding picks up after contracting in both Q2 and Q3 of 2016, and rising wages push up real incomes and personal consumption. Above-trend growth will continue to erode spare capacity. The headline unemployment rate has fallen to 4.6%, close to most estimates of NAIRU. Broader measures of unemployment, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 13). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are all at or above 2007 levels (Chart 14). In contrast to most measures of labor market slack, industrial utilization still remains quite low by historic standards (Chart 15). In fact, the Congressional Budget Office's "capacity utilization-based" estimate of the output gap stands at around 3% of GDP, whereas its "unemployment-based" estimate is close to zero. Chart 13U.S. Labor Market: Not Much Slack Left Chart 14Most U.S. Labor Market Measures ##br## Are Back To Pre-Recession Levels Chart 15U.S.: Industrial Capacity Utilization Remains Low A strong dollar, as well as the ongoing decline of the U.S. manufacturing base, partly explain the low level of industrial utilization. However, another important reason bears noting: Years of depressed real wage growth has made labor scarce compared with capital. The free market solution to this problem is higher wages for workers. Good news for Main Street; but perhaps not so good news for Wall Street. Stagflation Is Coming, Just Not Yet While inflation will creep higher in 2017, a major spike is unlikely over the next two years. There are two main reasons for this. First, if the economy does run into severe capacity constraints, the Fed will have to step up the pace of rate hikes. Higher interest rates will push up the value of the dollar, curbing growth and inflation. Second, the historic evidence suggests that it takes a while for an overheated economy to generate meaningfully higher inflation. Consider how inflation evolved during the 1960s. U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 due to rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 16). The relationship between economic slack and inflation is depicted by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 17). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Chart 16It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 17The Phillips Curve Has Flattened The adoption of inflation targeting, coupled with more transparent Fed communication, has helped anchor inflation expectations. This has flattened the Phillips curve. A flatter Phillips curve implies a lower "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. Going forward, the temptation to exploit the flatness of the Phillips curve may be too great to resist. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that she is at least willing to entertain the idea. Interest rates are still fairly low and a few more hikes are unlikely to cause much distress among corporate and household borrowers. As rates continue to climb, however, this may change, making it difficult for the Fed to further tighten monetary policy. This is especially the case if potential real GDP growth remains lackluster, as this would make it harder for borrowers to generate enough income to service their debts. Trump's budget-busting fiscal deficits may also put some pressure on the Fed to eschew raising rates too much in an effort to hold down interest costs. Even if such political pressures do not materialize, the challenges posed by the zero bound constraint on nominal interest rates could still justify efforts to raise the Fed's 2% inflation target. After all, if inflation were higher, this would give the Federal Reserve the ability to push down real rates further into negative territory in the event of an economic downturn. Admittedly, such a step is unlikely to be taken anytime soon. Nevertheless, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF; San Francisco Fed President John Williams; and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. The bottom line is that inflation is likely to move up slowly over the next two years, but could begin to accelerate more sharply towards the end of the decade. Japan: The End Of Deflation? Like the U.S., Japan has also entered a reflationary window. Retail sales surprised on the upside in November, rising 1.7%, against market expectations of 0.8%. Industrial production and exports continue to rebound, a trend that should persist thanks to the yen's recent depreciation (Chart 18). Stronger economic growth is causing the labor market to heat up. The Bank of Japan estimates that the "labor input gap" is now positive, meaning that the economy has run out of surplus workers (Chart 19). Reflecting this, the ratio of job openings-to-applicants has reached a 25-year high (Chart 20). Chart 18Japan: Some Positive Economic News Chart 19Japan: Labor Market Slack Has Evaporated, But Industrial Capacity Utilization Has Fallen Chart 20Japan: Sign Of Tightening Labor Market Wage growth so far has been tepid, but that should change over the next two years. The labor force expanded by 0.9% year-over-year in November - the latest month for which data are available - largely due to the continued influx of women into the labor force. Chart 21 shows that the employment-to-population ratio for Japanese prime-age women now exceeds that of the U.S. by three percentage points. As Japanese female labor participation stabilizes, overall labor force growth will turn negative, pushing up wages in the process. Chart 21Japan: Female Labor Force ##br##Participation Now Exceeds The U.S. In contrast to the Fed, the BoJ is unlikely to tighten monetary policy in response to higher inflation. As a consequence, real yields will continue to fall as inflation expectations rise further. This will lead to higher net exports via a weaker yen, as well as increased spending on interest-rate sensitive goods such as consumer durables and business equipment. Indeed, a virtuous circle could develop where an overheated labor market pushes down real rates, causing aggregate demand and inflation to rise, leading to even lower real rates. If this occurs, growth could accelerate sharply, avoiding the need for more radical measures such as "helicopter money." In short, Japan may be on the verge of escaping its deflationary trap. This is something that could have happened shortly after Prime Minister Abe assumed office, but was short-circuited by the government's lamentable decision to tighten fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. Europe: Fine... For Now The European economy grew at an above-trend pace in 2016. Real GDP in the EU is estimated to have expanded by 1.9%, compared to 1.6% in the U.S. The euro area is estimated to have grown by 1.7% - the first time that growth in the common currency bloc exceeded the U.S. since the Great Recession. Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators (Chart 22). Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting (Chart 23). Chart 22Euro Area Growth Will Remain On Solid Footing In 2017 Chart 23The European Commission Recommends Greater Fiscal Expansion Ongoing efforts to strengthen the euro area's banking system will also help. As we noted in the "Italian Bank Job," the costs of cleaning up the Italian banking system are modest compared with the size of the Italian economy.3 The failure to have done it earlier represents a massive "own goal" by the Italian and EU authorities. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany's economy will overheat. Chart 24 shows that the German unemployment rate has fallen to a 25-year low, while wage growth is now running at twice the rate as elsewhere in the euro area. Chart 24German Labor Market Going Strong An overheated German economy will help the periphery in two important ways: First, higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area's biggest economy. Second, faster wage growth and stronger domestic demand in Germany will erode the country's gargantuan current account surplus of nearly 9% of GDP. This will put downward pressure on the euro, giving the periphery a further competitive boost. Of course, all this rests on the assumption that Germany accepts an overheated economy. One could objectively argue that it is in Germany's political best interest to do so, as this may be the only means by which to hold the euro area together. One could also argue that rebalancing German growth towards domestic demand, and away from its historic reliance on exports, would be in the country's long-term best interest. One might also contend that German banks would accept a few more years of low rates if this helped lower nonperforming loans across the euro area, while also paving the way for the eventual abandonment of ZIRP and NIRP. Chart 25Italy Lags Peers On Euro Support Whatever the merits of these arguments, they clash with Germany's historical antipathy towards inflation. This means that political risk could escalate over the coming years. Against the backdrop of growing anti-establishment sentiment - fueled in no small measure by the EU's deer-in-the-headlights response to the migration crisis - Europe's populist parties will continue to make gains at the polls. Timing is important, however. With unemployment trending lower, our hunch is that any truly disruptive populist shock may have to wait until the next recession, which is likely still a few years away. BCA's Geopolitical Strategy team holds a strong conviction view that Marine Le Pen, the leader of the eurosceptic National Front, will be defeated in the second round of the presidential election in May. They also think that Angela Merkel will cling to power, partly because Germany still lacks an effective anti-establishment opposition party. Italy is more of a concern, given that support for the common currency among Italians has been falling and is now lower than virtually anywhere else in the euro area (Chart 25). Nevertheless, our geopolitical strategists assign very low odds to Italy following Britain's example and voting to leave the EU. Indeed, it is still not even clear that the U.K. will actually follow through and exit the EU. Brussels is likely to play hardball with the U.K. during the negotiations slated to begin in March. EU officials are keen to send a clear warning to other EU members who may be tempted to leave the club. It is still quite possible that another referendum will be held in one or two years concerning the terms of the negotiated agreement that would govern Britain's future relationship with the EU. Given how close the first referendum was, there is a reasonable chance that U.K. voters will choose EU membership over a bad deal. In that case, Brussels will back off from its threat that triggering Article 50 would irrevocably lead to the U.K.'s expulsion from the EU. China: Still In Need Of A Spender-Of-Last Resort Investor angst about China rose to a fever pitch early last year, but has since faded into the background. The main reason for this is that the deflationary forces which once threatened to precipitate a hard landing for the economy have abated. Growth has picked up and producer price inflation has risen from -5.3% in early 2016 to 3.3% in November (Chart 26). As our China strategists have argued, the end of PPI deflation is a major positive development for the Chinese corporate sector, as it improves its pricing power while reducing its real cost of funding (Chart 27). Real bank lending rates deflated by the PPI rose to near-record highs early last year, but have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This has bestowed dramatic relief on some highly-levered, asset-heavy industries. These industries were the biggest casualties of the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bode well for banks. Chart 26China: Improving Growth Momentum Chart 27China: Real Interest Rates Dropping ##br## Thanks To Easing Deflation Unfortunately, the reflationary forces in China are masking deep underlying problems. Structural reform has been patchy at best; credit continues to expand much faster than GDP; and speculation in the real estate sector is rampant (Chart 28). Meanwhile, capital continues to flow out of the country, taking the PBOC's foreign exchange reserves down from a high of $4 trillion in June 2014 to $3.1 trillion at present. There are no easy solutions to these problems. Tightening monetary policy could help fend off capital flight, but this would hurt growth and potentially plunge the economy back into deflation. This week's spike in interbank rates is evidence of just how sensitive the economy has become to any withdrawal of monetary accommodation (Chart 29). Chart 28China: Credit Continues Expanding And The##br## Real Estate Sector Is Getting Frothy Chart 29China: Yet Another Spike In Interbank Rates As we controversially argued in "China Needs More Debt," China's underlying problem is a chronic excess of savings.4 This has kept aggregate demand below the level commensurate with the economy's productive capacity. In the past, China was able to export some of those excess savings abroad via a large current account surplus, which peaked at 10% of GDP in 2007 (Chart 30). However, China is now too large to export its way out of its problems. It was one thing for China to run a current account surplus of 10% of GDP when its economy represented 6% of global GDP. It is quite another to do so when the economy represents 15% of global GDP, as it does now. This is especially the case when other economies are also keen to have cheap currencies. Faced with this reality, the government has been trying to buttress aggregate demand by funneling a huge amount of credit towards state-owned companies, which have then used these funds to finance all sorts of investment projects. The problem is that China no longer needs as much new capacity as it once did. As trend GDP growth has slowed, the level of investment necessary to maintain a constant capital-to-output ratio has fallen by about 10% of GDP over the past decade.5 China's aging population will eventually lead to a drop in savings. Government plans to strengthen the social safety net should also help this transition along by reducing household precautionary savings. However, these are long-term developments. Over the next couple of years, China will have little choice but to let credit grow at a rapid pace. The good news is that China has ample domestic savings to continue financing credit expansion. The ratio of bank loans-to-deposits remains near all-time lows (Chart 31). The government also has plenty of fiscal resources to safeguard the banks from losses on nonperforming loans extended to local governments and state-owned enterprises. Chart 30China Used To Rely On Large ##br##Current Account Surplus To Export Excess Savings Chart 31China: Banks Have Ample Deposit Coverage All that may not be enough, however. Given the risks to financial stability from excessive investment by state-owned enterprises, the government may have little choice but to cajole households into spending more by suppressing bank deposit rates while purposely engineering higher inflation. The resulting decline in real rates will reduce the incentive to save while helping to inflate away the mountain of debt that has already been accumulated. II. Financial Markets Equities Chart 32Investors Are Optimistic Deflation is bad for equities, as is stagflation. But between deflation and stagflation there is reflation - and that is good for stocks. This reflationary window should remain open for the next two years. As such, we expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter-term horizon of less than two months and a longer-term horizon exceeding two years. The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Chart 32 shows that bullish sentiment is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while. We expect global equities to correct 5%-to-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S. As my colleague, Mark McClellan, has shown, Europe and Japan are considerably cheaper than the U.S., even after adjusting for sector skews and structural valuation differences.6 The relative stance of monetary policy also favors Europe and Japan. Neither the ECB nor the BoJ is likely to hike rates anytime soon. This means that rising inflation expectations in these two economies will push down real rates, weakening their currencies in the process. Emerging markets are a tougher call. The combination of a strengthening dollar, growing protectionist sentiment in the developed world, and high debt levels are all bad news for emerging markets. EM equity valuations are also not especially cheap by historic standards (Chart 33). Nevertheless, a reflationary environment has typically been positive for EM equities. The tight correlation between EM and global cyclical stocks has broken down over the past three months (Chart 34). We suspect the relationship will reassert itself again over the course of 2017, giving EM stocks a bit of a boost. Chart 33EM Stocks Are Not Particularly Cheap Chart 34EM Stocks Are Lagging On balance, EM equities are likely in a bottoming phase where returns over the next 12 months will be positive but not spectacular. BCA's favored markets are Korea, Taiwan, China, India, Thailand, and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil, and Peru. Turning to global equity sectors, a bias towards cyclical names is appropriate in an environment of rising global growth. Longer term, our equity sector specialists like health care and technology names. The outlook for financial stocks remains a key area of debate within BCA. Most of my colleagues would still avoid banks. I am more partial to the sector. As I argued in September in "Three Controversial Calls: Global Banks Finally Outperform," steeper yield curves will boost net interest margins over the next few years while rising demand for credit will support top-line growth (Chart 35). On a price-to-earnings basis, global banks are quite cheap, despite being much better capitalized than they were in the past (Chart 36). Chart 35AHigher Yields Will Benefit Banks Chart 35BHigher Yields Will Benefit Banks Lastly, in terms of size exposure, we prefer small caps over large caps. Small capitalization stocks tend to do better in reflationary environments (Chart 37). The ongoing retreat from globalization will also benefit smaller domestically-focused firms at the expense of those with large global footprints. In the U.S. specifically, small caps face a potential additional benefit. If the new Trump administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Chart 36Global Banks Are Cheap ##br##And Better Capitalized Since The Crisis Chart 37Reflationary Backdrop ##br##Favors Small Caps Outperformance Fixed Income And Credit Back in March 2015, we predicted that the 10-year Treasury yield would fall to 1.5% even if the U.S. economy avoided a recession.7 The call was notably out of consensus at the time, but proved to be correct: The 10-year yield reached a record closing low of 1.37% on July 5th. As luck would have it, on that very same day, we sent out a note entitled "The End Of The 35-Year Bond Bull Market," advising clients to position for higher bond yields. Global bonds have sold off sharply since then, with the selloff intensifying after the U.S. presidential election. As discussed above, inflation in the U.S. and elsewhere will be slow to rise over the next two years. Hence, global bond yields are unlikely to move significantly higher from current levels. Indeed, the near-term path for yields is to the downside if our expectation of a global equity correction proves true. However, once the stagflationary forces described in this report begin to gather steam towards the end of the decade, bond yields could spike higher, imposing significant pain on fixed-income and equity investors alike. Regionally, we favor Japanese and euro area bonds relative to their U.S. counterparts over a 12-month horizon. Inflation in both Japan and the euro area remains well below target, suggesting that neither the BoJ nor the ECB will tighten monetary policy anytime soon. In contrast, the Fed is likely to raise rates three times in 2017, one more hike than the market is currently pricing in. In addition, we would underweight U.K. gilts. While U.K. growth will decelerate next year as uncertainty over the Brexit negotiations takes its toll, a weaker pound and some fiscal loosening will keep the economy from flying off the rails. In this light, the market's expectations that U.K. rates will rise to only 0.66% at end-2019 seems too pessimistic. Elsewhere in the developed world, our global fixed-income strategists are neutral on Canada and New Zealand bonds, but are underweight Australia. A modest underweight to EM government bonds is also warranted. Turning to credit, a reflationary backdrop is positive for spread product insofar as it will keep defaults in check, while also propping up the appetite for riskier assets. That said, U.S. high-yield credit is now quite expensive based on our fundamental models (Chart 38). Private-sector leverage remains at elevated levels and our Corporate Health Monitor is still in deteriorating territory (Chart 39). Rising government yields could also prompt yield-hungry investors to move some of their money back into sovereign debt. On balance, U.S. corporate spreads are likely to narrow slightly this year, but corporate credit will still underperform equities. Regionally, we see more upside in European credit, given the ECB's continued bond-buying program and greater scope for corporate profit margins to rise across the region. Chart 38U.S. High-Yield Valuations Chart 39U.S. Corporate Health Keeps Deteriorating Currencies And Commodities BCA's Global Investment Strategy service has been bullish on the dollar since October 2014, a view that has generated a gain of nearly 17% for our long DXY trade recommendation. We reiterated this position last October in a note entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"8 where we predicted that the dollar would rally a further 10%. Since that report was published, the real trade-weighted dollar has gained 4%, implying another 6% of upside from current levels. Chart 40Real Rate Differentials Are Driving Up The Dollar Both economic and political forces have conspired to keep the dollar well bid. The resurgent U.S. economy has pushed up real rate expectations in the U.S. relative to its trading partners. Chart 40 shows the amazingly strong correlation between the trade-weighted dollar and real interest rate differentials. Rate differentials should widen further over the coming months as investors price in more Fed rate hikes, and rising inflation expectations abroad push down real rates in economies such as Japan and the euro area. As we predicted in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Wins And The Dollar Rallies," Donald Trump's triumph on November 8th has given the greenback an additional boost. Progress in implementing any of Trump's three signature policy proposals - fiscal stimulus, trade protectionism, and immigration restrictions - will cause the U.S. output gap to narrow more quickly than it otherwise would, forcing the Fed to pick up the pace of rate hikes. Chart 41The Pound Is A Bargain The adoption of a "destination-based tax system" would further strengthen the dollar. Under the existing corporate tax structure, taxes are assessed on corporate profits regardless of where they are derived. In contrast, under a destination-based system, taxes would be assessed only on the difference between domestic sales and domestic costs. In practice, this means that imports would be subject to taxes, while exports would receive a tax rebate. In the simplest economic models, the imposition of a destination-based tax has no effect on domestic economic activity, inflation, or the distribution of corporate profits across the various sectors of the economy. This is because the dollar is assumed to appreciate by precisely enough to keep net exports unchanged. For that to happen, however, the requisite change in the currency needs to be quite large. For example, if the Trump administration succeeds in bringing down effective corporate tax rates to 20%, the required appreciation would be 1/(1-tax rate)=25%. Under current law, the required appreciation would be over 30%! In reality, the dollar probably would not adjust that quickly, implying that the transition period to a destination-based tax system would disproportionately benefit exporters at the expense of importers. Partly for this reason, the proposal will probably be heavily watered down if it is ever passed. Nevertheless, overall U.S. policy will continue to be biased towards a stronger dollar. Looking at the various dollar crosses, we still see more downside for the yen. The BoJ's policy of pegging the 10-year nominal yield will result in ever-lower real yields as Japanese inflation expectations rise. The euro should also continue to drift lower, most likely reaching parity against the dollar later this year. The pound could dip further if an impasse is reached during Brexit negotiations, as is likely at some point this year. That said, sterling is now very cheap, which limits the downside for the currency (Chart 41). Chart 42The Dollar Has Weighed On Gold The Chinese yuan will continue to grind lower, in line with most other EM currencies. As we discussed in March 2015 in a report entitled "A Weaker RMB Ahead," China's excess savings problem necessitates a weaker currency. The real trade-weighted RMB has fallen by 7% since that report was written, but a bottom for the currency remains elusive.9 As noted above, the Chinese government may have no choice but to boost household spending by suppressing deposit rates while working to engineer higher inflation. Negative real borrowing rates will keep capital flowing out of the country, putting downward pressure on the yuan. The overall direction of the Canadian and Aussie dollars will be dictated by the path of commodity prices. A reflationary environment tends to be bullish for commodities. Nevertheless, an uncertain macro outlook in China muddies the waters. We prefer oil over metals, given that the former is more geared towards growth in developed economies while the latter is heavily dependent on Chinese demand. This also makes the Canadian dollar a more attractive currency than the Aussie dollar. Lastly, a few words on gold: The combination of political uncertainty, rising inflation expectations, and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar. The strengthening of the dollar clearly was a factor undermining gold prices in the second half of 2016 (Chart 42). On balance, we would maintain a modest position in gold for the time being, but would look to increase exposure later this year as the dollar peaks. Peter Berezin Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 John G. Fernald, "Productivity and Potential Output Before, During, and After the Great Recession," Federal Reserve Bank of San Francisco, Working Paper 2014-15, (June 2014), and John G. Fernald, "The Pre-Great Recession Slowdown in U.S. Productivity Growth," (November 16, 2015). 2 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. 5 Back in 2007, trend growth was around 10%. Consistent with the empirical literature, let us assume that an appropriate capital-to-GDP ratio is 250% and that the capital stock depreciates at 5% a year. With a trend growth of 10%, China needs 2.5*10%=25% of GDP in new investment before depreciation to keep its capital-to-GDP ratio constant, and an additional 2.5*5%=12.5% of GDP in investment to cover depreciation, for a grand total of 37.5% of GDP in required investment. With a trend GDP growth rate of 6%, however, the required investment-to-GDP ratio would only be 2.5*6%+2.5*5%=27.5%. 6 Please see The Bank Credit Analyst Monthly Reports Section 2, "Are Eurozone Stocks Really That Cheap?" dated June 30, 2016, and "Japanese Equities: Good Value Or Value Trap?" dated November 24, 2016, available at bca.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 06, 2015, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights Today we are publishing an overview of EM external debt. As EM currencies have resumed their depreciation over the past few months, the issue of foreign currency debt has once again become acute. Feature The tables and charts in this report rank EM countries by size of external debt relative to their GDP, and also provide details about foreign liabilities by category of borrower (government, non-financial companies or financials), by type of debt (loans versus bonds issued) and by maturity (short-term up to 1 year versus medium- and long-term). The charts and tables particularly elaborate on short-term external debt across various types of borrowers. In our opinion, from a macro perspective the most relevant statistic are foreign funding requirements, which are calculated by subtracting the current account balance from external debt servicing in the next 12 months. The chart below shows that based on this parameter the most vulnerable countries are Turkey, Malaysia and Colombia, while the least exposed ones are Korea, China and Thailand. Chart 1Dependency On Foreign Funding Table 1External Debt Statistics Chart 2Overall Outstanding External Debt Ranking Chart 3Government External Debt Ranking Chart 4Non-Financial Corporate External Debt Burden Chart 5Financials External Debt Burden Chart 6Outstanding External Inter-Company Loans Table 2Short-Term External Debt Statistics ##br##(Does Not Include Intercompany Debt) Table 3Short-Term External Debt Statistics ##br##(Does Not Include Intercompany Debt) Table 4Short-Term External Debt Statistics ##br##(Does Not Include Intercompany Debt) Table 5Short-Term External Debt Statistics ##br##(Does Not Include Intercompany Debt) Chart 7Aggregate External Short-Term Debt Chart 8Non-Government External Short-Term Debt Chart 9Companies' External Short-Term Debt Chart 10Financials' External Short-Term Debt Table 6Short-Term External Debt Composition Table 7Short-Term External Debt Composition Chart 11Financials' Short-Term Foreign Loans Chart 12Private Sector Short-Term Foreign Loans Table 8EM Aggregate (Excludes Taiwan And China) Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe Chart 3BJoblessness Still Elevated In Europe Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Dear Client, We are pleased to present our 2017 Outlook for Grains & Softs, covering corn, wheat, soybeans and rice in the grain markets, and cotton and sugar. This is our last regular Weekly Report for the year. You should have received BCA's annual "Mr. X" interview on December 20, and we trust you found it stimulating and insightful. We will resume regular publishing on January 5th with our annual Review and Outlook summarizing the performance of our market recommendations for 2016, with an eye on where we see value going into the New Year. As a preview, the average return on our recommendations this year was 33.1%, led by our Energy recommendations, which were up an average 95.1% in 2016. Please see page 15 of this week's report for a summary. The Commodity & Energy Strategy team wishes you and yours a wonderful holiday season and a prosperous New Year. Turning to the Ags, we believe there is a limited downside for grain prices in 2017. The downtrend since August 2012 may form a bottom next year under the assumption of normal weather conditions. However, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories. Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. We have three investment strategies: We look to go long wheat versus cotton, long corn versus sugar, and long rice versus soybeans. Kindest regards, Robert P. Ryan, Senior Vice President Chart 1Ag In 2017: A Reversal Of Grain ##br##Underperformance? Feature Limited Downside For Grains; Softs ... Not So Much As of December 20, the CCI grain index had declined 0.3% since the beginning of this year. In comparison, sugar and cotton prices rallied 19.8% and 9.6% during the same period of time, respectively. For individual grains, soybean prices were up 15.4%, while corn, wheat and rice declined 2.4%, 14.2% and 18.2%, respectively. Cotton and sugar outperformed grains considerably this year (Chart 1, panel 1). Among grains, soybeans had the best run, while wheat and rice had the worst (Chart 1, panel 2). Going forward, the question is: Will these trends continue into 2017, or is a reversal likely to occur? For now, we cannot rule out the possibility of a continuation of these trends, but a reversal is possible, depending on weather conditions. We will tread water carefully and re-evaluate our calls next April when U.S. farmers' planting decisions are made, and the outlook for the South American soybean and sugar harvests become clearer. Grains In 2017: Likely Bottoming With Potential Upside We believe there is limited downside for grain prices in 2017. Four consecutive years of supply surpluses have driven grain prices down by more than 50% since August 2012, when grain prices reached all-time highs (Chart 2, panels 1 and 2). In the meantime, global grain inventories also rose to their highest levels since 2002 (Chart 2, panel 3). True, it is difficult to get bullish on such elevated inventories. Another year of supply surpluses obviously would send prices lower. Will that happen? No doubt, it could. But we believe the odds are fairly low. A Dissection Of This Year's Supply Increase Global grain output grew 5.2% this year, the second highest rate of growth since 2005. Yield growth, mainly due to extremely favorable weather, contributed 87% of the supply increase, while acreage expansion accounted for the rest (Chart 3, panels 1 and 2). Chart 2Grain: Too Much Supply In 2016... Chart 3...Less Supply in 2017? Now, with yields of corn, soybeans and wheat all at record highs, and rice yields near their record highs, grain yields are more likely to have a pullback than a continuation of growth in 2017. If global grain yields revert to their trend line as the third panel of Chart 3 suggests, global grain yields will decline 1.4% in 2017. This year, the world aggregate harvested grain acreage only grew 0.7%. Currently low grain prices are discouraging grain plantings, while new supportive policies in Argentina and a strengthening dollar are likely to encourage grain sowing in the southern hemisphere. Taking all related factors into account, we expect a 0.2 - 0.5% expansion in global grain acreage next year. Based on our analysis, we believe world grain output is likely to decline about 1% next year, assuming normal weather conditions. On the other side of the ledger, global grain demand has been growing steadily over the past 30 years (Chart 3, panel 4). Last year demand grew 3.4%. In 2017, low prices likely will boost consumption. Therefore, we expect similar growth in global grain demand next year. In the current crop year, the global grain market has a supply surplus of 55 million metric tons (mmt). Based on our calculations, given the assumptions we've outlined above, a 1% decline in global grain output coupled with 3.4% growth in global grain demand will swing the grain market into a supply deficit of 58 mmt. If we assume a more conservative scenario in which global grain output does not decline at all, a 2.2% rate of growth in global consumption still will send the global grain market into a supply deficit. The odds of seeing this scenario unfold are relatively high, given that the average growth in global grain consumption was 2.5% over the past 10 years, and 2.9% over the past four years, when grain prices were mired in a downtrend. We believe this would clearly be positive to global grain prices. Considering the elevated global grain inventories and the expected supply deficit we foresee, we believe, even if prices do not move to the upside, the downside for grain prices should be at least limited in 2017 as inventories are drawn down. In addition to the supply deficit, rising oil prices are supportive to grain prices as well. All else equal, higher oil prices will increase the production cost of grains. Bottom Line: We expect limited downside for grain prices next year. The 2017 Outlook For Individual Grains Corn, soybeans, wheat and rice prices are highly correlated with each other (Chart 4, panel 1). In terms of end consumption, they can all be consumed as either human food or animal feed. In terms of supply, farmers rotate among these crops depending on their profit outlook, soil conditions, and government policies. In 2017, we believe wheat and rice likely will outperform corn and soybeans, for two reasons: Crop-rotation economics and inventories. Chart 4Wheat & Rice May Outperform ##br##Corn & Soybeans In 2017 Firstly, global acreage rotation still favors soybeans most, then corn, over wheat and rice. If we rebase grain prices back to the beginning of 2006, corn and soybean prices are currently 62% and 67% higher than they were at the start of this interval. In comparison, wheat and rice prices are only 19% and 16% higher, respectively (Chart 4, panel 1). The U.S. is the world's biggest corn exporter, the second-largest soybean and wheat exporter. Informa Economics, a private consulting firm, projects 2017 soybean plantings will rise 6.2% to 88.862 million acres, while corn and winter wheat plantings will fall 4.6% and 8.1% to 90.151 million acres and 33.213 million acres, respectively. If these projections are realized, the 2017 U.S. winter wheat planted acreage will be the lowest since 1911. Winter wheat accounts for about 70% of U.S. total wheat production. Secondly, wheat and rice inventories ex-China declined, while corn and soybean inventories ex-China increased. Yes, it is true that the world wheat and rice stocks-to-use ratios rose to the highest since 2002 and 2003, respectively. (Chart 4, panel 2). But this does not show the full picture for these markets: 58% of global rice inventories and 44% of global wheat inventories are in China, even though that country accounts for only 12% of global rice imports and 2% of global wheat imports. China is unlikely to export these inventories to the world: the country tends to hold massive grain inventories, in order to prevent domestic food crises. This means that global wheat and rice importers outside China, which account for about 88% of the global rice trade and 98% of the global wheat trade, will compete for inventories outside China. The third panel of Chart 4 shows the rice stocks-to-use ratio for the ex-China world has already dropped to its lowest level since 2008, while the wheat stocks-to-use ratio ex-China already has declined for two years in a row. This is positive for wheat and rice prices. In comparison, the soybean and corn stocks-to-use ratios ex-China looks much less promising. Both ratios are at or near record highs (Chart 4, panel 3). China only accounts for 2% of the global corn trade, therefore corn importers outside China will have more abundant supplies available to them in 2017. China is the largest buyer of soybeans, accounting for 63% of the global soybean trade. The country will have more bargaining power, on the back of increasing competition among major soybean exporters (the U.S., Brazil and Argentina). In the meantime, China's central policy is currently focused on encouraging domestic soybean plantings mainly at the cost of corn, which is negative for global soybean prices and good for global corn prices. In 2016, the corn acreage in China fell for the first time since 2004 while its soybean acreage jumped 9.1% - the largest increase since 2001 (Chart 4, panel 4). Chart 5Downside Risks To Grains Downside Risks To Our Grain View Grain prices could decline more than 10% from current levels next year, if favorable weather results in a slight drop (less than 1.4%) or even an increase in global grain yields. Also, if grain prices rise significantly in 2017H1 - for whatever reason - this likely would spur plantings and depress prices. If either of these events transpire, we will re-evaluate our grain view. A strengthening dollar is also a major risk to our view. BCA's Foreign Exchange Strategy expects a further 5%-7% appreciation in U.S. dollar in 2017. We believe most of the negative effects of a strengthening dollar already are reflected in depressed grain prices, as the U.S. dollar has already appreciated 36% since July 2011. At the end of last week, the U.S. dollar was only 2% lower than all-time highs reached in February 2002 (Chart 5, panel 1). Another risk to watch is acreage expansion in Argentina, Brazil and the Former Soviet Union (FSU) region. All of these countries/regions had massive currency depreciations and supportive agricultural policies this year, especially in Argentina (Chart 5, panels 2, 3 and 4). However, our calculations show that for corn and wheat, acreage increases in these countries/regions are mostly offset by declines in the U.S. With an expectation of a continuing decline in U.S. wheat and corn plantings, we expect an insignificant growth in overall global wheat and corn acreage. For soybeans, however, the acreage expansion could pose a downside risk as all top three producers (the U.S., Brazil and Argentina) are likely to increase their plantings. We will re-evaluate the grain market at the end of March, when the U.S. posts its planting intentions for all major crops. Softs In 2017: Less Positive Than Grains Both cotton and sugar prices had strong rallies in 2016, following the second consecutive year of supply deficits (Chart 6). Global cotton acreage has declined 19% during the past five years when cotton prices fell significantly from peak prices in 2011. This is the main reason for the 18.3% decline in global cotton production during the same period of time and also for the two consecutive years of supply deficit in 2015 and 2016. For sugar, the El Niño phenomenon that ended this past summer hurt sugar plantings and crop development in major producing countries (Brazil, India, China and Thailand) in both 2015 and 2016, resulting in two years of supply deficit and a supercharged rally in 2016 sugar prices. Both cotton and sugar prices fell from their 2016 highs, with a 9.6% drop for cotton and a 23.4% decline for sugar. However, we are still tactically bearish on both commodities as speculators' net long positions are still crowed (Chart 7). Chart 6Cotton & Sugar: Supply Deficit in 2016 Chart 7Cotton & Sugar: Crowed Net Long Spec Positions Strategically, we are neutral cotton and bearish sugar. For cotton, global demand will stay sluggish in 2017. Even though there has been no growth at all in global cotton demand for the past three years, the bad news is that there still are no signs of improvement in global textile demand (Chart 8). On the supply side, global cotton output may rise significantly next year, if farmers shift some of their grain acreage to cotton due to a better profit profile for cotton (Chart 9). We believe, barring extreme weather, the global cotton market will become more balanced next year, leaving us neutral in our price outlook. For sugar, with weather patterns back to normal and the extreme rally in prices this year, sugar output in India, Thailand, China and the EU (European Union) should receive a strong boost. In addition, a strengthening U.S. dollar will also encourage sugar production in those countries whose currency had massive depreciation like Brazil, Russia and India (Chart 10). Chart 8Cotton: Demand Does Not Look Good Chart 9Cotton: Supply Will Increase In 2017 Chart 10Sugar Production Will Recover On the demand side, average global sugar consumption growth was only 1.3% p.a. during 2013-2015, even though average sugar prices declined every year during that period. This year, global demand growth slowed to only 0.6%, as average sugar prices were 35% higher than last year. If sugar prices go sideways, the average prices will still be higher than this year, which may result in an even slower growth in global sugar demand. Given an extremely oversupplied corn market, cheaper corn syrup will replace sugar in its industrial uses. Chart 11Ag Investment Strategies: ##br##Focus On Relative-Value Trades Our calculations indicate the global sugar market is likely to have a supply surplus next year, which will be a big shift from this year's supply deficit. This likely will pressure sugar prices lower. Upside Risks To Our Softs View Both the cotton and sugar markets are still in supply deficits, which means any unfavorable weather in the major producing countries could send prices sharply higher. For sugar, Brazilian sugarcane mills could favor ethanol production instead of sugar in 2017 if the country keeps hiking gasoline prices and promotes ethanol consumption. So far, the sugar/ethanol price ratio in Brazil still favors sugar production. This can change quickly if ethanol prices in Brazil rise faster than sugar prices in 2017. We will monitor this risk closely. Investment Strategy Our Ag strategies continue to focus on relative-value investments. As such, we look to go long wheat versus cotton, long corn versus sugar, and long rice versus soybeans through the following recommendations: Long July/17 wheat vs. short July/17 cotton: We recommend putting this relative trade on if the wheat-to-cotton ratio drops to 5.75 (current: 6.14) (Chart 11, panel 1). Long July/17 corn vs. short July/17 sugar: We put a limit-buy order at 17 on this position on November 3, 2016. Since then, this ratio rose 12.8% and only declined to 17.47 on November 9. Now, we suggest initiating this position if the ratio falls back to 18.5 (Chart 11, panel 2). Long November/17 rice vs. short November/17 soybeans: We recommend putting this relative-value trade on if the ratio drops to 0.95 (current: 1.01) (Chart 11, panel 3). Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Investment Views and Themes Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades
Highlights 1.How Will The European Economy Cope With Higher Interest Rates? 2. How Will The European Stock Market Cope With Higher Interest Rates? 3. How Will The EU Respond To The Start Of Brexit? 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? Feature Our strong sense is that the promised elixir of 'Trumponomics' has disoriented investors' concept of value. Suddenly thrown out of their comfort zone, long-term investors are struggling to assess: how much of Trumponomics is reality and how much is just fantasy? Chart of the WeekBrexit And Pound/Euro As rational and analytical long-term investors have become disoriented, emotional and impulsive short-term traders have been left unchecked to drive markets (Chart I-2). Chart I-2Markets Are Excessively Emotional Understand that the financial markets are an ecosystem in which long-term investors jostle with short-term traders. The stable equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. And therein, perhaps, lies the essence of life itself. The descriptions "rationality and analysis" versus "emotion and impulse" are not judgements. They are simply the very different qualities needed to do very different jobs. Long-term investors must take time to rationalise and analyse the concept of fundamental value; whereas traders must use their immediate emotions and impulses to ride short-term market momentum. Therefore what happens in 2017 will depend on what the rational and analytical long-term investors conclude after their pause for reflection. This brings us to our five pressing questions for the coming year. 1. How Will The European Economy Cope With Higher Interest Rates? Now you could argue that the level of interest rates is very low by historical standards, even after last week's rate hike by the Federal Reserve. However, it is the change in interest rates that drives the change in credit growth (Chart I-3); and it is the change in credit growth that drives the change in GDP growth (Chart I-4). Chart I-3The Change In Bond Yield Drives##br## The Change In Credit Growth... Chart I-4...And The Change In Credit Growth Drives ##br##The Change In GDP Growth You could also argue that a 25bps hike in the Fed funds rate constitutes the tiniest of baby steps of monetary tightening. The problem is that bond yields have already jumped many multiples of this: the U.S. 15-year and 30-year bond yield and mortgage rate have spiked by over 75bps; the German 30-year bond yield is up 90bps; the Italian 30-year bond yield is up 100bps; and so on. It is these substantial increases in market interest rates that will weigh on credit-sensitive sectors and prospective 6-month GDP growth. Chart I-5Despite Dollar Strength, The Trade-Weighted##br## Euro Has Hardly Budged Another argument we hear is that higher bond yields are simply discounting better growth prospects ahead. The problem here is the inter-temporal distribution of growth. Higher market interest rates are a near-certain headwind to be felt within 3-6 months. Whereas Trumponomics is a very uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Then there is the geographical distribution of growth. Trumponomics, at best, would boost U.S. growth. Yet market rates have also gone up aggressively in Europe, where there would be a minimal boost to growth. Bear in mind that despite dollar strength, the trade-weighted euro has depreciated just 3% from its October high (Chart I-5). Likewise, emerging market economies will see minimal growth benefits. Whereas higher dollar funding costs, stronger dollar-linked currencies, and the threat of protectionism constitute a meaningful headwind. The bigger question is: can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? There is much debate about this issue at BCA, but on balance this publication believes that the tide has not turned. 2. How Will The European Stock Market Cope With Higher Interest Rates? Trumponomics is not the structural game changer that the market seems to believe. But even if we are wrong on this, there is one over-arching relationship that will hold true irrespective: the relationship between stock market valuation and subsequent 10-year total nominal return (Chart I-6). This long-term relationship is independent of the economic backdrop: Keynesian, monetarist, neo-classical, deflationary, inflationary, or Trumponomics. Chart I-6Long-Term Returns Always Depend On Valuation The reason is that the 10-year total nominal stock market return comprises two components: the nominal income received through the next 10 years; and the terminal value of the market at the end of the 10 years. Crucially, an environment that boosts one component symmetrically depresses the second component, and vice-versa. For example, inflation boosts nominal income received, but depresses the terminal value (because the discount rate is then much higher). Deflation has the opposite effect. Therefore the relationship between valuation and subsequent 10-year total nominal return is environment-independent. Today, stock markets are priced to generate very low single-digit 10-year returns. But with the recent spike in long-term interest rates, investors can now obtain similar 10-year returns from bonds. In other words, the equity risk premium is dangerously compressed. Emotional and impulsive short-term traders do not care about this structural relationship, but rational and analytical long-term investors ultimately do. Bear in mind that the cross-asset and cross-sector moves over the past six weeks - whether in equity market, bond yield and dollar elevation, or bank outperformance, or yield-proxy and defensive underperformance - are all just various guises of the Trump reflation trade. We expect that rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now. The trade: an unwinding of the various guises of the Trump reflation trade is likely, at least tactically. 3. How Will The EU Respond To The Start Of Brexit? Chart I-7Brexit Must Not Be A Gift To Le Pen The silence is deafening. While there is much daily noise from the U.K. about the type of Brexit it wants, the EU has been intentionally silent. Once the formal legal process of Brexit begins, it will be the EU that holds the balance of power on what Brexit ultimately looks like. The chatter from some U.K. government quarters is that it can negotiate advantageous Brexit terms. Good luck with that. Given the proximity of the French Presidential Election in April/May, the EU's opening position has to be uncompromising - so as to not hand Marine Le Pen any gifts (Chart I-7). The EU must make an example of the U.K. "pour encourager les autres". And if exiting the EU must come with a demonstrable cost, one casualty would be the pound. That said, 2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive. For example, if the Supreme Court grants the Scottish parliament a greater say in the terms of Brexit, it could compromise Theresa May's current strategy. The pound would rally on that tail-event possibility. The trade: the pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other (Chart of the Week). A good strategy might be to sell the middle of the distribution. There are many permutations of this but one example would be to short the pound and simultaneously buy call options at, say, €1.30. 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? Chart I-8Pegs Get Broken 2016 was the year when QE peaked. The ECB committed to lowering its monthly asset purchases. More significantly, the BoJ shifted its policy aim from targeting an amount of asset purchases to targeting a price (or yield) on the 10-year JGB. Thereby, the central bank policy experiment has moved into a more dangerous phase. As we explained in Dangers Of Linear-Thinking In A Non-Linear World 2 economies and markets are complex, non-linear systems. The inherent unpredictability of a non-linear system makes it futile and dangerous to aim for an over-precise point target in anything that we do. And that principle applies to central banks as much as to anybody else. Indeed, a 2% inflation target is a price target, albeit a price of a basket of goods and services, and the annual change of that price. The track record of any central bank achieving its self-imposed 2% inflation target in recent years is truly disastrous. Recall also that the Swiss National Bank had to break the franc's peg with the euro, one of the more recent in a long list of failed price pegs (Chart I-8). Our Fixed Income strategists believe the JGB 0% yield peg will hold. Nevertheless, the risk is underestimated that the BoJ will have to break the peg, in 2017 or beyond. The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero. The trade: stay underweight French OATS. 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? One defining feature of the last 40 years is a steady sequence of private sector credit booms which have inevitably turned to busts: notably, Japan in 1990, the Asian 'tigers' in 1998, the U.S. in 2007, and the U.K., Spain and other European countries in 2008 (Chart I-9). Chart I-9Credit Booms Sequentially Turned To Bust. Who's Next? In this defining feature, China's is the last of the major credit booms that hasn't turned to bust - yet. Admittedly, the ability of the Chinese authorities to 'extend and pretend' is probably greater than elsewhere in the world, and this might prevent another violent tipping point. Irrespective, the debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation. With private sector indebtedness (including SOEs) now at, or beyond, the level where every other credit boom peaked, China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses. The trade: go long euro/yuan. And with that, we are signing off for 2016. I do hope that this year's reports have provided some insight during particularly turbulent times, and that you might have even enjoyed the reading experience! It just remains for me to wish you a Merry Christmas and a successful and happy 2017. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Published on February 11, 2016 and available at eis.bcaresearch.com. Fractal Trading Model* Pleasingly, two of our open trades hit their profit targets: long platinum / short palladium and short the Greek 10-year bond. Given the extended break, we are not opening any new trades over the Christmas and New Year holiday period. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2016 and their long-term implications. We will resume our regular publishing schedule on January 5, 2017. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature Senior Chinese policymakers conveyed in Beijing last week for their annual economic work conference - a high-profile gathering where top officials review the past year's economic performance and set the broad policy tone and development priorities for the coming year. The key messages from this year's meeting suggest that "stability and progress" remain a top priority, but that the importance of a GDP growth target appears less significant. Policymakers recognize the mounting challenges both globally and domestically, which suggests the policy environment will stay accommodative, especially on the fiscal front. Furthermore, the authorities intend to make material progress on "supply-side" reforms, which is both an admission of defeat in terms of progress this year and a pledge for more aggressive efforts going forward. We will be addressing China's policy orientation, growth outlook and asset prices in the New Year. As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their long-term implications. A V-Shaped Recovery Under The Economic "New Normal" Chart 1V-Shaped Rebound##br## In The Economic New Normal The Chinese economy entered 2016 with worsening growth deceleration, but ended the year with a V-shaped rebound in industrial activity - even though GDP growth remained curiously stable1 (Chart 1). Destocking in the housing market and de-capacity in some industrial sectors were listed as two top priorities of the government for 2016, both of which were abruptly reversed as the year unfolded: strong home sales depleted housing inventories more quickly than expected, leading to a dramatic increase in home prices in major cities - prompting policymakers to re-impose restrictions on housing demand.2 Meanwhile, de-capacity in steel mills and coal mines greatly constrained domestic supply of related products, leading to both a massive increase in imports and a sharp rally in prices as demand improved. As a result, the authorities scrambled to remove some administrative constraints on domestic production on these two industries. The economy's V-shaped growth performance this year challenges some conventional thinking on China's growth fundamentals, particularly on the housing market and overcapacity. On housing, there is no doubt that some regions have abundant supply, which may take a long time to clear. On an aggregate level, however, the massive increase in home prices in some major cities suggest housing inventories may be much smaller than generally perceived.3 Similarly, overcapacity is widely regarded as a chronic feature of the Chinese economy inherent to its investment-heavy growth model - steelmakers and coalmines being two prime examples. However, the dramatic turnaround in these two industries this past year defies this widely held consensus.4 At minimum, China's overcapacity issue cannot be analyzed in isolation from a global context as well as from the current stage of the business cycle. Chart 2Monetary Conditions And ##br##Business Conditions Furthermore, while "supply-side" reforms were listed as a key theme for 2016, improvement in the industrial sector was to a large extent due to measures that boosted aggregate demand. Fiscal spending remained robust at the beginning of the year, following strong acceleration in 2015. More importantly, monetary conditions began to ease notably from the beginning of the year, leading to a notable improvement in business conditions among industrial enterprises (Chart 2). Nonetheless, the growth "new normal" envisioned by the Chinese leadership underlines the assumption of an "L-shaped" growth trajectory. Therefore, the V-shaped rebound in some key industrial indicators was both surprising and possibly unwelcome from the policymakers' point of view. The authorities will likely continue to switch priorities between supply side reforms and demand-side management going forward. Premature withdrawal of policy stimulus remains a key risk for the economy as well as financial markets. From Deflation To Inflation? 2016 marked a decisive end to Chinese producer price deflation, which lasted for more than four years. PPI, still falling at a 5% annual rate at the beginning of the year, turned up sharply toward the end of 2016, rising by over 3% in November, likely even higher this month. Investors' perception on Chinese producer prices and the broader inflation picture has also shifted dramatically. A mere few months ago China was widely blamed for exporting deflation to the rest of the world, which has quickly been replaced by a consensus that China is now exporting inflation. The sudden shift may have to some extent contributed to the bond market riot of late both globally and within China. The end of PPI deflation is a major positive development for the Chinese corporate sector, as it both improves its pricing power and also reduces its real cost of funding (Chart 3). Real bank lending rates deflated by PPI stayed at close to record highs early this year, and have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This is a dramatic relief for some highly levered asset-heavy industries. Importantly, these industries were the biggest casualties in the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bodes well for the banking sector. Nonetheless, it is wrong to conclude that the end of PPI deflation in China means the country will export inflation going forward: Rising producer price inflation, measured as year-over-year growth, is to some extent due to the base effect. In terms of level, producer prices have clearly stopped falling, but gains have been rather mild and still remain at relatively low levels. It is too soon to worry about inflation (Chart 4, bottom panel). Easing deflation has also been attributable to the falling trade-weighted RMB this year (Chart 4, top panel), as producer prices typically follow exchange rate performance by about six months. While PPI may continue to follow the RMB higher in the coming several months, the trade-weighted RMB depreciation has already stalled, which may cap any additional upside in PPI. Unless the economy continues to recover strongly and/or the RMB resumes its depreciation, it is premature to expect PPI to continue to rise going forward. Chart 3Easing Deflation Helps Reduce##br## Real Interest Rates, Massively Chart 4PPI Inflation##br## In Perspective Domestic inflation does not necessarily lead to rising export prices, if a weaker RMB is the main factor to boost domestic prices (Chart 5). Indeed, rising Chinese domestic producer prices also means Chinese export prices in RMB terms have also been rising. Measured in U.S. dollar terms, however, Chinese export prices are still falling on a year-over-year basis. Similarly, U.S. import prices from China measured in RMB terms have been rising smartly, but in dollar terms are still been falling. This is positive for Chinese exporters' profitability, but is not inflating U.S. prices. Finally, a word on the sharp increase in Chinese bond yields. While growth improvement and easing deflation may have contributed to the sharp rebound in Chinese bond yields in recent weeks, global factors are likely more important. Chart 6 shows Chinese government bond yields have been increasingly synchronized with U.S. Treasurys in recent years, an interesting development considering China's still relatively closed capital markets. The rising correlation could be driven by economic fundamentals due to the tight connection between these two economies. Rising U.S. bond yields reflects changes in growth and inflation expectations in the U.S., which also impact the Chinese economy. Furthermore, the 123-basis-point spike in U.S. Treasurys since July 2016 has narrowed the yield gap with Chinese government bonds, which in turn has pushed up Chinese yields. This means that Chinese interest rates may remain under upward pressure should U.S. Treasury yields continue to grind higher. Chart 5End Of Chinese Deflation Does Not ##br## Necessarily Inflate The World Chart 6Chinese Bonds: ##br##The Global Connection Bottom Line: Easing deflation is good news for Chinese domestic firms, but it does not mean that China is about to export inflation to the rest of the world. Chinese government bond yields may have also made a cyclical low, and will likely continue to move higher along with global yields. The RMB's Bumpy Transition The RMB officially joined the Special Drawing Right (SDR) basket of the IMF in October, a historical moment marking an emerging country being admitted to the "elite currency" club. Joining the SDR helps promote the international status of the Chinese currency, which may offer some longer-term benefits.5 The immediate challenge for policymakers, however, is to fend off the constant downward pressure on the RMB against the dollar. More specifically, the People's Bank of China (PBoC) has clearly signaled its intention to allow the exchange rate to float, but has been deeply troubled by the potential of a downward spiral between capital outflows and outsized RMB depreciation. Overall, 2016 marks a tentative transition of the RMB exchange rate mechanism to a dirty float scheme. Indeed, the PBoC at the beginning of 2016 explicitly presented its formula of how the RMB's daily official fixing rate against the dollar is calculated. Strictly following this formula would lead to a largely stable trade-weighted RMB. In reality, however, the PBoC appears to have deliberately targeted a weaker exchange rate: the RMB was soft-pegged to the dollar whenever the dollar weakened against other currencies, and it was allowed to fall against the dollar whenever it strengthened broadly. As a result, the RMB depreciated by almost 10% in trade-weighted terms from its 2015 peak, which in no small part helped the economy reflate. However, this strategy also reinforced an already well-entrenched expectation of the RMB's one-way descent against the greenback. Shorting the RMB became a risk-free bet, which further encouraged capital outflows. There has been a rush to purchase foreign assets by the corporate sector, likely also incentivized by the RMB outlook.6 It is unclear how the PBoC will break this dilemma going forward. We expect the central bank will stay the course in further lowering the trade-weighted RMB, while at the same time tightening capital account controls to prevent capital flight.7 Its large current account surplus and official reserves should offer plenty of resources to maintain control. Its tight grip on the exchange rate may be progressively relaxed as it perceives the trade-weighted RMB to be "cheapened enough," which could generate two-way flows of capital. From this perspective, joining the SDR helps attract long-term foreign capital for Chinese risk-free assets. Bottom Line: Joining the SDR marks a historic milestone for the RMB, but the near-term significance is largely symbolic. The RMB's soft peg to the dollar is over. The PBoC is experimenting with a new exchange rate regime. Market Volatility And Financial Reforms Chart 7Policy Uncertainties And ##br##Equity Valuations The dramatic stock market rollercoaster ride in 2015 had already seriously damaged Chinese policymakers' credibility. The short-lived circuit-breaker system designed to curb market fluctuations in fact greatly exaggerated volatility at the beginning of the year, which further exposed the regulators' incompetency. Global investors' anxiety on China's macro situation has eased notably in recent months. However, Chinese stocks have ended the year largely flat, even though the industrial sector has staged a sharp recovery with strong earnings growth. Perceived high and rising policy uncertainty clearly dampens investors' appetite for Chinese assets, resulting in a large valuation discount to their global peers (Chart 7). Underneath, regulators' apparent policy blunders in the past two years represent a deeper and more systemic challenge than just incompetency. The country's rapidly developing financial system and capital markets have become increasingly complex, while the regulatory system lagged way behind. The current regulatory framework is poorly coordinated with sometimes conflicting priorities, leaving potentially systemically important developments falling through the cracks. The dramatic buildup of leverage in the stock market in 2015 outside of regulatory oversight was a prime example. This year, the leverage situation in commodities and bond markets has also been poorly scrutinized. A key reform initiative for the financial sector under the "reform blueprint" published a few years ago was to improve coordination among different regulators. The authorities plan to enhance supervision on systemically important financial institutions and systemically important financial infrastructure such as payment, clearing and custody systems to improve coordination of macro-prudential measures as well as collaboration on key financial statistics and information - all of which has yet to begin. The dramatic financial market volatility and policy blunders of late have created a pressing need to accelerate the process. In short, preventing financial risks has become an increasingly important priority of the government, and will remain a key task for 2017, as noted from last week's economic work conference. This necessarily involves fundamental reforms of the country's financial regulatory framework. We will follow up on these issues in the New Year. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth, Cyclical Risks And The Rally In Commodities," dated December 1, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Chinese Housing Market Conundrum," dated May 25, 2016 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016 available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition," dated October 20, 2016 available at cis.bcaresearch.com. 6 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets," dated December 15, 2016 available at cis.bcaresearch.com. 7 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity," dated December 8, 2016 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations