Hong Kong SAR

Special Report

Highlights Like in any currency board, Hong Kong dollar money supply is not fully backed by foreign currency (FX) reserves. Yet, the Hong Kong authorities have large FX reserves to defend the currency peg for now. Regardless, mounting capital outflows and the ensuing currency defense will lead to higher interest rates. Contrary to Hong Kong, Singapore has a flexible exchange rate regime and will begin easing monetary policy soon. Interest rates in Singapore will drop relative to Hong Kong. We are therefore reiterating our short Hong Kong / long Singaporean property stocks strategy. Feature The recent popular protests in Hong Kong against the extradition bill will likely mark a regime shift – not only in the territory’s socio-political dynamics but also in its financial outlook. It seems the local authorities are still considering an adoption of the extradition bill. For now, the bill has been suspended, but it has not been withdrawn outright. In light of elevated political uncertainty over the one-country, two-systems model, it is reasonable to assume that capital outflows from Hong Kong will rise in the coming year or so.  In light of elevated political uncertainty over the one-country, two-systems model, it is reasonable to assume that capital outflows from Hong Kong will rise in the coming year or so. The question therefore becomes whether or not the Hong Kong Monetary Authority (HKMA) has sufficient foreign currency (FX) reserves to defend the Hong Kong dollar’s peg. Even though Hong Kong's broad money supply is not fully backed by FX reserves, we see no major risk to the currency peg at the moment. That said, mounting capital outflows will necessitate higher interest rates, as least relative to U.S. ones, to defend the peg. This is negative for Hong Kong’s property market and share prices. Are Hong Kong Dollars Fully Backed By FX Reserves? Hong Kong operates a linked-exchange rate system, which stipulates that its monetary base must be fully backed by FX reserves. The monetary base includes (Table I-1): The balance of the clearing accounts of banks kept with the HKMA (called the Aggregate Balance, which represents commercial banks’ excess reserves). Exchange Fund bills and notes – securities issued by the Exchange Fund to manage excess reserves/liquidity in the interbank market. Certificates of Indebtedness which are equivalent to currency in circulation. These certificates are held by note-issuing banks in exchange for their FX deposits at the Exchange Fund. The Exchange Fund is a balance sheet vehicle of the HKMA. Government-issued coins in circulation. Presently, Hong Kong’s FX reserves-to-monetary base ratio is 2.2 (Chart I-1on page 1). This ratio is well above the stipulated currency board rule of one: a unit of monetary base can be issued only when it is backed by an equivalent foreign currency asset. Chart I-1HK: FX Coverage Of Monetary Base Is Well Above 1 The reason the ratio is currently more than double where it technically should be is because the HKMA’s foreign exchange reserves also include the fiscal authorities’ foreign currency deposits at the Exchange Fund. Hence, the large pool of fiscal assets converted into foreign currency and sitting in the Exchange Fund has pushed the monetary base’s coverage ratio above two. As of December 31, 2018, the Exchange Fund’s foreign currency assets consisted of HK$743 billion of its own foreign currency reserves (net FX reserves), HK$1.17 trillion of the fiscal authorities’ foreign currency deposits, and HK$485 billion of foreign currency deposits by money issuing commercial banks (Table I-1). However, broad money supply in Hong Kong is not fully backed by foreign currency reserves (Chart I-2). At 0.45, this coverage ratio entails that each HK dollar of broad money supply is backed by 0.45 USD foreign currency reserves within the Exchange Fund. Broad money supply includes currency in circulation, demand, savings and time deposits, and negotiable certificates of deposits (NCDs) issued by licensed banks. Chart I-2HK: FX Coverage Of HK Dollars Is Only 0.45 Crucially, broad money supply does not include commercial banks’ reserves at the central bank in any economy, including Hong Kong. The pertinent measure of any exchange rate backing is the ratio of FX reserves to broad money supply (all local currency deposits plus cash in circulation). The motive is that households and companies can use not only cash in circulation but also their deposits to acquire foreign currency. With the ratio standing at 0.45, the Hong Kong monetary authorities do not have sufficient amounts of U.S. dollars to guarantee the exchange of each unit of local currency (cash in circulation and all deposits) into U.S. dollars in the event of a full-blown flight out of HK dollars. It is essential to clarify that the monetary authorities in Hong Kong have not deviated from the original framework of the currency board. This exchange rate mechanism was devised in 1983 in such a way that only the monetary base – not broad money supply – was supposed to be backed by foreign currency. In short, any currency board entails that only the monetary base – not broad money supply - is backed by FX reserves. Hong Kong is not an exception. Nevertheless, there is widespread perception in the financial community and among economists that all Hong Kong dollars are backed by foreign currency reserves, which is incorrect. Like in any banking system, when commercial banks in Hong Kong grant loans or buy assets from non-banks, they create local currency deposits “out of thin air.” These deposits are not backed by foreign currency, and commercial banks that create these deposits are not obliged to deposit FX reserves at the Exchange Fund. The credit boom in Hong Kong has accelerated since 2009 (Chart I-3, top panel). Consistently, since that time, the amount of local currency deposits has mushroomed – these deposits are not backed by foreign currency (Chart I-3, bottom panel).  Chart I-3Banks' Loans And Deposit Growth Go Hand-In-Hand On the whole, the currency board system in Hong Kong and elsewhere cannot guarantee full convertibility of broad money supply (all types of deposits). Therefore, these currency regimes are ultimately based on confidence. If and when confidence in the exchange rate plummets and economic agents rush to exchange a large share of their local currency cash in circulation and deposits into foreign currency, the monetary authorities’ FX reserves will not be sufficient. That said, there is presently no basis to argue that close to 45% of Hong Kong broad money supply (cash and coins in circulation and deposits of all types) is poised to panic-flood the currency market. Hence, we do not foresee a de-pegging of the HKD exchange rate for now. The currency will continue to trade within its HKD/USD 7.75-7.85 band. Bottom Line: Like in any currency board, the Hong Kong dollars are not fully backed by its FX reserves. However, the Hong Kong authorities have large FX reserves to defend the currency peg for some time. Liquidity Strains? According to the Impossible Trinity thesis, in an economy with an open capital account, the monetary authorities can control either interest rates or the exchange rate, but not both simultaneously. Provided Hong Kong has both an open capital account and a fixed exchange rate, the monetary authorities have little control over interest rates. Balance-of-payment (BoP) dynamics determine whether the HKMA has to buy or sell foreign currency to preserve the exchange rate peg. When the BoP is in surplus, the HKMA accumulates FX reserves, and vice versa.  The odds are rising that Hong Kong will begin experiencing capital outflows due to heightening political uncertainty over the one-country, two-systems model. Consistently, the BoP will swing from recurring surpluses to deficits and the HKMA will have to finance them by selling FX reserves (Chart I-4). By doing so, the monetary authorities will drain banks’ excess reserves, thereby tightening interbank liquidity. Chart I-4Balance Of Payments And FX Reserves Chart I-5Falling Excess Reserves = Higher Interbank Rates Notably, the HKMA’s FX reserves have plateaued, commercial banks’ excess reserves (the Aggregate Balance at the HKMA) have shrunk and money market rates have risen since 2016 (Chart I-5). Importantly, the latter has continued, even as U.S. interest rates have dropped over the past six months (Chart I-5, bottom panel). These dynamics are set to continue. To defend the HKD’s fixed exchange rate, interest rates in Hong Kong should rise and stay above those in the U.S. This will be the equivalent of pricing in a risk premium in Hong Kong rates due to higher political uncertainty in domestic politics as well as the ongoing U.S.-China trade confrontation. To defend the HKD’s fixed exchange rate, interest rates in Hong Kong should rise and stay above those in the U.S. On a positive note, the HKMA has ample room to mitigate liquidity strains resulting from FX interventions. In years when the BoP was in surplus, to prevent HKD appreciation the authorities purchased substantial amounts of U.S. dollars. As a result, the aggregate balance/excess reserves swelled, and Exchange Fund bills and notes were issued to absorb excess reserves (Chart I-6). Chart I-6HK Authorities Have Large Liquidity Firepower Going forward, with capital outflows causing tightening liquidity, the HKMA can redeem its own bills and notes to replenish the Aggregate Balance. This will ease interbank liquidity and preclude interest rates from shooting up dramatically. The HKMA’s liquidity firepower is sizable: the amount of Exchange Fund bills and notes is more than HK$1 trillion. This compares with aggregate balance (excess reserves) of HK$55 billion. Hence, potential interbank liquidity is HK$1.1 trillion (the Aggregate Balance plus the Exchange Fund’s bills and notes) (Chart I-6, top panel). There is no way to guesstimate potential capital outflows from Hong Kong. Hence, it is difficult to know what the equilibrium level of the interest rate spread over U.S. rates will be. The market will be re-balancing continuously, and the interest rate differential will fluctuate – i.e., it will be a moving target that ensures the fixed value of the currency. Bottom Line: Odds are that market-based interest rates in Hong Kong have to rise and stay above the U.S. ones for now. Heading Into Recession? With non-financial private sector debt close to 300% of GDP (Chart I-7) and property/construction and financial services sectors accounting for a large share of the economy, the Hong Kong economy is extremely sensitive to interest rates. Chart I-7Hong Kong: Leverage And Debt Servicing Chart I-8HK Economy Is In A Cyclical Downtrend Economic conditions have already been worsening, and any further rise in interest rates will escalate the economic downtrend: Private credit growth has decelerated and is probably heading into contraction (Chart I-8, top panel). The property market is one of the most expensive in the world. Property transactions have plunged and real estate prices will likely deflate (Chart I-8, middle panels). China’s weakening economy and subsiding Hong Kong business and investor confidence will hurt domestic demand. Retail sales volumes are already contracting (Chart I-8, bottom panel). Investment Implications The interest rate differential between Hong Kong and the U.S. has recently become positive after two and a half years of lingering below zero (Chart I-9). Odds are that it will remain positive at least over the next couple years. Therefore, even if U.S. interest rates decline further, Hong Kong rates will not. This has major investment ramifications: Hong Kong stocks will likely underperform U.S. and EM equity benchmarks, as its interest rate differential with the U.S. stays on the positive side and widens further (Chart I-10).  Chart I-9HK Interest Rate Spread Over U.S. Will Rise And Stay Positive Chart I-10Higher HK Interest Rates Herald HK Equity Underperformance The MSCI Hong Kong stock index is composed of financials (36% of market cap) and property stocks (26% of market cap). Therefore, domestic stocks are very sensitive to interest rates. Hong Kong companies are also very exposed to mainland growth. A recovery in the latter is not yet imminent. As a market neutral trade, we are reiterating our short Hong Kong property / long Singapore property stocks strategy. Chart I-11Favor Singapore Stocks Versus Hong Kong Ones All of this leads us to maintain our underweight stance on Hong Kong domestic stocks versus U.S. and EM equity indexes (Chart I-10). As a market neutral trade, we are reiterating our short Hong Kong property / long Singapore property stocks strategy. Hong Kong interest rates will rise above Singapore’s, leading to the former’s equity underperformance versus the latter across property, banks and probably the overall stock index (Chart I-11). For a more detailed discussion of Singapore, please see below.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com           Singapore: Monetary Easing Is Imminent Singapore’s stock market is at risk of selling off in absolute terms. However, the monetary authorities (MAS) will soon commence policy easing. This will differentiate Singapore from Hong Kong. While both Singapore and Hong Kong suffer from property and credit excesses and are facing a cyclical downtrend, the former – unlike the latter – can and will lower interest rates and allow its currency to depreciate to reflate the system. As a result, we are reiterating our short Hong Kong / long Singaporean property stocks strategy. Cyclical Headwinds Persist While both Singapore and Hong Kong suffer from property and credit excesses and are facing a cyclical downtrend, the former – unlike the latter – can and will lower interest rates and allow its currency to depreciate to reflate the system. Singapore’s cyclical growth outlook is worsening: Chart II-1 shows that the narrow money impulse is in deep contraction and the private domestic banks loans impulse is dipping into negative territory anew. The property sector – which is an important driver of Singapore’s economy – is depressed. Residential units sold has dipped, the high-end condominium market is virtually frozen and housing mortgage growth has stalled. These create formidable risks for Singapore’s real estate stocks’ absolute performance (Chart II-2). The latter account for 15% of the Singaporean stock market. Chart II-1Singapore: Money / Credit Impulses Chart II-2Singapore: Real Estate Stocks Are At Risk Meanwhile, there has been no signs of improvement in both domestic demand and exports. The top panel of Chart II-3 shows that the marginal propensity to spend among both consumers and non-financial businesses is diminishing. Specifically, the impulse for overall consumer loans is negative, while retail sales are contracting (Chart II-3, bottom panel). As for the business sector, it is also slowing down. Manufacturing PMI and new orders are in a contraction zone (Chart II-4). Chart II-3Private Consumption Is Weakening Chart II-4Business Sector Is Hit Hard Finally, corporate profitability of listed non-financial and non-property firms has massively deteriorated in the last decade. Chart II-5 illustrates that both return on assets (ROA) and return-on-equity (ROE) have been in a downward trend and have lately plunged. Shrinking profit margins have been the result of escalating unit labor costs (Chart II-6). In other words, productivity gains among listed non-financial companies have lagged behind wage increases. Chart II-5Corporate Profitability Is At 20-Year Low Chart II-6Rising Unit Labor Costs = Shrinking Profit Margins Monetary Policy Will Be Relaxed Chart II-7The Central Bank Has Been Withdrawing Liquidity The Monetary Authority of Singapore (MAS) conducts monetary policy by controlling the currency and by default allowing domestic interest rates to find their own equilibrium. Currently, the MAS’s monetary policy setting is restrictive – i.e. it is aiming to gradually appreciate the trade-weighted Singaporean dollar by withdrawing excess reserve from the banking system (Chart II-7, top panel). This in turn, is causing commercial banks to bid interbank rates higher (Chart II-7, bottom panel). Nevertheless, with the domestic growth deceleration intensifying and the private sector highly leveraged, the MAS will soon opt for policy easing. It will guide the trade-weighted exchange rate lower by injecting liquidity into the banking system and lowering interest rates. Bottom Line: The Singaporean economy needs lower rates and the MAS is not constrained by the currency peg as the HKMA is. Consequently, interest rates in Singapore will decline both in absolute terms and relative to Hong Kong ones. Investment Conclusion The cyclical downturn will deepen and Singapore share prices will drop in absolute U.S. dollar terms. Relative to the EM or the Asian benchmarks, we continue to recommend a neutral position on overall Singaporean equities for now. Importantly, Singapore is better positioned than Hong Kong because the former’s monetary authorities can lower interest rates and allow the currency to depreciate. Hong Kong monetary authorities cannot tolerate lower interest rates due to their peg to the U.S. dollar and budding capital outflows. Interest rates in Singapore will drop relative to Hong Kong. We are therefore reiterating our short Hong Kong / long Singaporean property stocks strategy (Chart I-11 on page 10).   Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes Fixed-Income, Credit And Currency Recommendations Equity Recommendations  

Highlights The March data brought the first signs of a stabilization in China’s “hard” economic data, albeit from a weak level. The April PMIs disappointed, but they remained in expansionary territory; this is in addition to a continued significant improvement in the trade-related subcomponents of the official survey. Chinese credit growth is unlikely to relapse over the coming year, despite recent investor concerns that Chinese policymakers may dial back their stimulus efforts. The pace of growth may moderate, but halting the uptrend in growth this year would constitute a major policy mistake that we do not expect. Chinese stocks may trend flat-to-down in the very near term as investors await a signed trade deal with the U.S. and further signs of a recovery in activity. Over the next 6-12 months, however, an overweight stance is warranted, barring a major relapse in our leading indicator. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, March’s data brought the very first (albeit modest) signs of stabilization in actual Chinese economic activity. While the April manufacturing PMIs released earlier this week disappointed, the trade related components of the official survey continued to improve meaningfully, which implies that an improvement in domestic demand is still early. This conclusion is not particularly surprising given that the first green shoots in the actual data are emerging from a depressed level of activity. Credit growth has only recently picked up, implying that actual activity will strengthen over the coming 6-12 months followed a signed trade deal and a continued (modest) uptrend in credit. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, the most significant recent development has been that Chinese stocks have sagged somewhat due to concerns that policymakers may meaningfully dial back their stimulus efforts over the coming year. In our view, recent statements from policymakers, as well as the fact that the recovery in activity is only now beginning, underscores that credit growth is unlikely to relapse over the coming year. It may not grow at the breakneck pace observed in the first quarter, but beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1 highlights that March brought the first sign of a stabilization in actual Chinese economic activity. When measured on a smoothed basis, the Li Keqiang index itself weakened further in March, but total import growth moved sideways and nominal manufacturing output ticked higher. We noted in our last Macro & Market review that future changes in activity measures were now more likely to reflect actual changes in underlying economic circumstances given that the previously beneficial tariff front-running effect had probably washed out of the data. March’s data confirms this view, and underscores that activity will pickup in the second half of the year. Chart 1The First (Albeit Tentative) Sign Of Economic Stabilization Chart 2 shows that the uptrend in our leading indicator for Chinese economic activity is so far modest, but also that it is now at a 2-year high relative to its 12-month moving average. The indicator is being weighed-down by weak money growth (M2 and our definition of M3), even though monetary conditions remain easy and our measures of credit growth picked up sharply in Q1. We doubt that the trend in Chinese money and credit growth can sustainably decouple in a scenario where the latter is sustainably improving, as it would imply that all of the credit improvement was originating from non-bank financial institutions. As such, we expect money growth to catch up to credit growth in the coming months. The annual change in the PBOC’s pledged supplementary lending injection remained in negative territory in March, and both floor space started and sold decelerated modestly further. Construction and sales activity continue to diverge, with the latter still pointing to a further slowdown in the former. We will be updating our Chinese housing outlook in a Special Report next week. April’s Caixin and official manufacturing PMI disappointed, but this overshadowed a continued significant improvement in the new export orders and import components of the official PMI (Chart 3). In our view, this is consistent with a stabilization in the export outlook, but implies that Chinese domestically-oriented manufacturing activity is not yet booming. Nonetheless, a signed trade deal, improving importer/exporter sentiment, and an uptrend in credit growth still implies that activity will pick up meaningfully later in the year. Chart 2Our Leading Indicator Is Now Modestly Trending Higher Chart 3Trade-Related Components Of The Official PMI Continue To Rise   Over the past month, Taiwanese and domestic Chinese stocks have been the best performers within “Greater China”, relative to the MSCI Hong Kong index, the MSCI China index, and the Hang Seng China Enterprises index. The latter in particular has lagged other Chinese equity indexes since late-March (Chart 4), and may be due for a catch-up. Over the nearer-term, Chinese stocks, especially the domestic market, have sagged due to concerns that Chinese policymakers may meaningfully dial back their stimulus efforts over the coming year. We discussed this risk in our April 17thWeekly Report,1 and noted that while we expected credit growth to moderate somewhat, a more meaningful slowdown, particularly if coupled with signals from policymakers that a much slower pace of growth is desired, could pose a risk to our overweight equity stance. The April manufacturing PMIs disappointed, but the trade-related components of the official survey continued to improve meaningfully. In our view, recent statements from policymakers, particularly from PBOC Deputy Governor Liu Guoqiang,2 underscores that credit growth is unlikely to relapse over the coming year; it will simply not be growing at the breakneck pace observed in the first quarter. Beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. Chart 5 highlights that Chinese consumer stocks have been the clear winners since the beginning of the year, particularly in the domestic market. Consumer stocks, including staples, sold off substantially in 2H2018 as investors responded to shockingly weak consumer spending data. Stimulus measures targeted to Chinese households, along with a meaningful improvement in some measures of consumer spending, has helped restore investor confidence in consumer stocks (which had previously been viewed as a bullish “no-brainer” structural trade). Chart 4Is An H-Share Catchup##br## Looming? Chart 5Chinese Consumer Stocks Have Been On Fire   The sharp rise in the 7-day interbank repo rate in April fed concerns among equity investors that Chinese policymakers might be in the process of paring back their stimulus efforts. However, as Chart 6 shows, China’s 7-day repo rate is extraordinarily volatile, and is affected by a variety of seasonal and technical factors. The chart shows that a 1-month moving average of the 7-day repo rate is broadly in line with the level that has prevailed over the past 9 months. In addition, the 3-month repo rate (which we have argued has been a more informative predictor of China’s monetary policy stance) remains well on the low end of its range over the past year. In short, despite investor concerns, Chinese interbank repo rates are not signaling a change in China’s monetary policy stance. Tighter monetary policy is not in the cards for this year. After having risen noticeably in late-March, Chinese onshore corporate bond spreads have fallen back to the low end of their trading range over the past 8 months. We continue to recommend that domestic investors hold a diversified portfolio of SOE corporate bonds, on the basis that actual bond defaults over the coming 6-12 months are likely to be materially lower than what investors are pricing in even though they are indeed likely to rise. Chart 7 shows that USD-HKD has eased somewhat over the past month from the top end of the band, and now trades closed at 7.845. This modest appreciation in HKD appears to have been catalyzed by a further reduction in the supply of interbank liquidity by the HKMA. While the appreciation in HKD is some modest good news for Hong Kong’s monetary authority, it remains reluctant to reduce liquidity in the system given how extremely weak loan growth is in Hong Kong. This implies that, barring a meaningful upturn in credit, a significant appreciation in HKD is not likely in the cards. Chart 6Interbank Repo Rates Are Not Trending Higher Chart 7A Modest Appreciation In HKD (Which Is Not Likely To Continue)   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see China Investment Strategy Weekly Report “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem,” dated April 17, 2019, available at cis.bcaresearch.com 2      During a PBOC briefing on April 25, Deputy Governor Guoqiang noted that “no one can bear it if policy swings back and forth between tightening and loosening many times a year”. Cyclical Investment Stance Equity Sector Recommendations

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Feature Valuations, whether for currencies, equities or bonds, are always at the top of the list of the determinants of any asset's long-term performance. This means that after large FX moves like those experienced so far this year, it is always useful to pause and reflect on where currency valuations stand. In this optic, this week we update our set of long-term valuation models for currencies that we introduced In February 2016 in a Special Report titled, "Assessing Fair Value In FX Markets". Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials and proxies for global risk aversion.1 These models cover 22 currencies, incorporating both G-10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning or middle of a long-term currency cycle. Second, by providing strong directional signals, they help us judge whether any given move is more likely to be a countertrend development or not, offering insight on its potential longevity. Finally, they assist us and our clients in cutting through the fog, and understanding the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Dollar: Back At Fair Value 2017 was a terrible year for the dollar, but the selloff had one important positive impact: it erased the dollar's massive overvaluation that was so evident in the direct wake of U.S. President Donald Trump's election. In fact, today, based on its long-term drivers, the dollar is modestly cheap (Chart 1). Fair value for the dollar is currently flattered by the fact that real long-term yields are higher in the U.S. than in the rest of the G-10. Investors are thus betting that U.S. neutral interest rates are much higher than in other advanced economies. This also means that the uptrend currently evident in the dollar's fair value could end once we get closer to the point where Europe can join the U.S. toward lifting rates - a point at which investors could begin upgrading their estimates of the neutral rate in the rest of the world. This would be dollar bearish. For the time being, we recommend investors keep a bullish posturing on the USD for the remainder of 2018. Not only is global growth still slowing, a traditionally dollar-bullish development, but also the fed funds rate is likely to be moving closer to r-star. As we have previously showed, when the fed funds rate rises above r-star, the dollar tends to respond positively.2 Finally, cyclical valuations are not a handicap for the dollar anymore. The Euro Chart 2The Euro Is Still Cheap As most currencies managed to rise against the dollar last year, the trade-weighted euro's appreciation was not as dramatic as that of EUR/USD. Practically, this also means that despite a furious rally in this pair, the broad euro remains cheap on a cyclical basis, a cheapness that has only been accentuated by weakness in the euro since the first quarter of 2018 (Chart 2). The large current account of the euro area, which stands at 3.5% of GDP, is starting to have a positive impact on the euro's fair value, as it is lifting the currency bloc's net international investment position. Moreover, euro area interest rates may remain low relative to the U.S. for the next 12 to 18 months, but the 5-year forward 1-month EONIA rate is still near rock-bottom levels, and has scope to rise on a multi-year basis. This points toward a continuation of the uptrend in the euro's fair value. For the time being, despite a rosy long-term outlook for the euro, we prefer to remain short EUR/USD. Shorter-term fair value estimates are around 1.12, and the euro tends to depreciate against the dollar when global growth is weakening, as is currently the case. Moreover, the euro area domestic economy is not enjoying the same strength as the U.S. right now. This creates an additional handicap for the euro, especially as the Federal Reserve is set to keep increasing rates at a pace of four hikes a year, while the European Central Bank remains as least a year away from lifting rates. The Yen Chart 3Attractive Long-Term Valuation, But... The yen remains one of the cheapest major currencies in the world (Chart 3), as the large positive net international investment position of Japan, which stands at 64% of GDP, still constitutes an important support for it. Moreover, the low rate of Japanese inflation is helping Japan's competitiveness. However, while valuations represent a tailwind for the yen, the Bank of Japan faces an equally potent headwind. At current levels, the yen may not be much of a problem for Japan's competitiveness, but it remains the key driver of the country's financial conditions. Meanwhile, Japanese FCI are the best explanatory variable for Japanese inflation.3 It therefore follows that any strengthening in the yen will hinder the ability of the BoJ to hit its inflation target, forcing this central bank to maintain a dovish tilt for the foreseeable future. As a result, while we see how the current soft patch in global growth may help the yen, we worry that any positive impact on the JPY may prove transitory. Instead, we would rather play the yen-bullish impact of slowing global growth and rising trade tensions by selling the euro versus the yen than by selling the USD, as the ECB does not have the same hawkish bias as the Fed, and as the European economy is not the same juggernaut as the U.S. right now. The British Pound Chart 4Smaller Discount In The GBP The real-trade weighted pound has been appreciating for 13 months. This reflects two factors: the nominal exchange rate of the pound has regained composure from its nadir of January 2017, and higher inflation has created additional upward pressures on the real GBP. As a result of these dynamics, the deep discount of the real trade-weighted pound to its long-term fair value has eroded (Chart 4). The risk that the May government could fall and be replaced either by a hard-Brexit PM or a Corbyn-led coalition means that a risk premia still needs to be embedded in the price of the pound. As a result, the current small discount in the pound may not be enough to compensate investors for taking on this risk. This suggests that the large discount of the pound to its purchasing-power-parity fair value might overstate its cheapness. While the risks surrounding British politics means that the pound is not an attractive buy on a long-term basis anymore, we do like it versus the euro on a short-term basis: EUR/GBP tends to depreciate when EUR/USD has downside, and the U.K. economy may soon begin to stabilize as slowing inflation helps British real wages grow again after contracting from October 2016 to October 2017, which implies that the growth driver may move a bit in favor of the pound. The Canadian Dollar Chart 5CAD Near Fair Value The stabilization of the fair value for the real trade-weighted Canadian dollar is linked to the rebound in commodity prices, oil in particular. However, despite this improvement, the CAD has depreciated and is now trading again in line with its long-term fair value (Chart 5). This lack of clear valuation opportunity implies that the CAD will remain chained to economic developments. On the negative side, the CAD still faces some potentially acrimonious NAFTA negotiations, especially as U.S. President Donald Trump could continue with his bellicose trade rhetoric until the mid-term elections. Additionally, global growth is slowing and emerging markets are experiencing growing stresses, which may hurt commodity prices and therefore pull the CAD's long-term fair value lower. On the positive side, the Canadian economy is strong and is exhibiting a sever lack of slack in its labor market, which is generating both rapidly growing wages and core inflation of 1.8%. The Bank of Canada is therefore set to increase rates further this year, potentially matching the pace of rate increase of the Fed over the coming 24 months. As a result of this confluence of forces, we are reluctant to buy the CAD against the USD, especially as the former is strong. Instead, we prefer buying the CAD against the EUR and the AUD, two currencies set to suffer if global growth decelerates but that do not have the same support from monetary policy as the loonie. The Australian Dollar Chart 6The AUD Is Not Yet Cheap The real trade-weighted Australian dollar has depreciated by 5%, which has caused a decrease in the AUD's premium to its long-term fair value. The decline in the premium also reflects a small upgrade in the equilibrium rate itself, a side effect of rising commodity prices last year. However, despite these improvements, the AUD still remains expensive (Chart 6). Moreover, the rise in the fair value may prove elusive, as the slowdown in global growth and rising global trade tensions could also push down the AUD's fair value. These dynamics make the AUD our least-favored currency in the G-10. Additionally, the domestic economy lacks vigor. Despite low unemployment, the underemployment rate tracked by the Reserve Bank of Australia remains nears a three-decade high, which is weighing on both wages and inflation. This means that unlike in Canada, the RBA is not set to increase rates this year, and may in fact be forced to wait well into 2019 or even 2020 before doing so. The AUD therefore is not in a position to benefit from the same policy support as the CAD. We are currently short the AUD against the CAD and the NZD. We have also recommended investors short the Aussie against the yen as this cross is among the most sensitive to global growth. The New Zealand Dollar Chart 7NZD Vs Fair Value After having traded at a small discount to its fair value in the wake of the formation of a Labour / NZ first coalition government, the NZD is now back at equilibrium (Chart 7). The resilience of the kiwi versus the Aussie has been a key factor driving the trade-weighted kiwi higher this year. Going forward, a lack of clearly defined over- or undervaluation in the kiwi suggests that the NZD will be like the Canadian dollar: very responsive to international and domestic economic developments. This gives rise to a very muddled picture. Based on the output and unemployment gaps, the New Zealand economy seems at full employment, yet it has not seen much in terms of wage or inflationary pressures. As a result, the Reserve Bank of New Zealand has refrained from adopting a hawkish tone. Moreover, the populist policy prescriptions of the Ardern government are also creating downside risk for the kiwi. High immigration has been a pillar behind New Zealand's high-trend growth rate, and therefore a buttress behind the nation's high interest rates. Yet, the government wants to curtail this source of dynamism. On the international front, the kiwi economy has historically been very sensitive to global growth. While this could be a long-term advantage, in the short-term the current global growth soft patch represents a potent handicap for the kiwi. In the end, we judge Australia's problems as deeper than New Zealand's. Since valuations are also in the NZD's favor, the only exposure we like to the kiwi is to buy it against the AUD. The Swiss Franc Chart 8The SNB's Problem On purchasing power parity metrics, the Swiss franc is expensive, and the meteoric rise of Swiss unit labor costs expressed in euros only confirms this picture. The problem is that this expensiveness is justified once other factors are taken into account, namely Switzerland's gargantuan net international investment position of 128% of GDP, which exerts an inexorable upward drift on the franc's fair value. Once this factor is incorporated, the Swiss franc currently looks cheap (Chart 8). The implication of this dichotomy is that the Swiss franc could experience upward pressure, especially when global growth slows, which is the case right now. However, the Swiss National Bank remains highly worried that an indebted economy like Switzerland, which also suffers from a housing bubble, cannot afford the deflationary pressures created by a strong franc. As a result, we anticipate that the SNB will continue to fight tooth and nail against any strength in the franc. Practically, we are currently short EUR/CHF on a tactical basis. Nonetheless, once we see signs that global growth is bottoming, we will once again look to buy the euro against the CHF as the SNB will remain in the driver's seat. The Swedish Krona Chart 9What The Riksbank Wants The Swedish krona is quite cheap (Chart 9), but in all likelihood the Riksbank wants it this way. Sweden is a small, open economy, with total trade representing 86% of GDP. This means that a cheap krona is a key ingredient to generating easy monetary conditions. However, this begs the question: Does Sweden actually need easy monetary conditions? We would argue that the answer to this question is no. Sweden has an elevated rate of capacity utilization as well as closed unemployment and output gaps. In fact, trend Swedish inflation has moved up, albeit in a choppy fashion, and the Swedish economy remains strong. Moreover, the country currently faces one of the most rabid housing bubbles in the world, which has caused household debt to surge to 182% of disposable income. This is creating serious vulnerabilities in the Swedish economy - dangers that will only grow larger as the Riksbank keep monetary policy at extremely easy levels. A case can be made that with large exposure to both global trade and industrial production cycles, the current slowdown in global growth is creating a risk for Sweden. These risks are compounded by the rising threat of a trade war. This could justify easier monetary policy, and thus a weaker SEK. When all is said and done, while the short-term outlook for the SEK will remained stymied by the global growth outlook, we do expect the Riksbank to increase rates this year as inflation could accelerate significantly. As a result, we recommend investors use this period of weakness to buy the SEK against both the dollar and the euro. The Norwegian Krone Chart 10The NOK Is The Cheapest Commodity Currency In The G-10 The Norwegian krone has experienced a meaningful rally against the euro and the krona this year - the currencies of its largest trading partners - and as such, the large discount of the real trade-weighted krone to its equilibrium rate has declined. On a long-term basis, the krone remains the most attractive commodity currency in the G-10 based on valuations alone (Chart 10). While we have been long NOK/SEK, currently we have a tactical negative bias towards this cross. Investors have aggressively bought inflation protection, a development that tends to favor the NOK over the SEK. However, slowing global growth could disappoint these expectations, resulting in a period of weakness in the NOK/SEK pair. Nonetheless, we believe this is only a short-term development, and BCA's bullish cyclical view on oil will ultimately dominate. As a result, we recommend long-term buyers use any weakness in the NOK right now to buy more of it against the euro, the SEK, and especially against the AUD. The Yuan Chart 11The CNY Is At Equilibrium The fair value of the Chinese yuan has been in a well-defined secular bull market because China's productivity - even if it has slowed - remains notably higher than productivity growth among its trading partners. However, while the yuan traded at a generous discount to its fair value in early 2017, this is no longer the case (Chart 11). Despite this, on a long-term basis we foresee further appreciation in the yuan as we expect the Chinese economy to continue to generate higher productivity growth than its trading partners. Moreover, for investors with multi-decade investment horizons, a slow shift toward the RMB as a reserve currency will ultimately help the yuan. However, do not expect this force to be felt in the RMB any time soon. On a shorter-term horizon, the picture is more complex. Chinese economic activity is slowing as monetary conditions as well as various regulatory and administrative rules have been tightened - all of them neatly fitting under the rubric of structural reforms. Now that the trade relationship between the U.S. and China is becoming more acrimonious, Chinese authorities are likely to try using various relief valves to limit downside to Chinese growth. The RMB could be one of these tools. As such, the recent strength in the trade-weighted dollar is likely to continue to weigh on the CNY versus the USD. Paradoxically, the USD's strength is also likely to mean that the trade-weighted yuan could experience some upside. The Brazilian Real Chart 12More Downside In The BRL Despite the real's recent pronounced weakness, it has more room to fall before trading at a discount to its long-term fair value (Chart 12). More worrisome, the equilibrium rate for the BRL has been stable, even though commodity prices have rebounded. This raises the risk that the BRL could experience a greater decline than what is currently implied by its small premium to fair value if commodity prices were to fall. Moreover, bear markets in the real have historically ended at significant discounts to fair value. The current economic environment suggests this additional decline could materialize through the remainder of 2018. Weak global growth has historically been a poison for commodity prices as well as for carry trades, two factors that have a strong explanatory power for the real. Moreover, China's deceleration and regulatory tightening should translate into further weakness in Chinese imports of raw materials, which would have an immediate deleterious impact on the BRL. Additionally, as we have previously argued, when the fed funds rate rise above r-star, this increases the probability of an accident in global capital markets. Since elevated debt loads are to be found in EM and not in the U.S., this implies that vulnerability to a financial accident is greatest in the EM space. The BRL, with its great liquidity and high representation in investors' portfolios, could bear the brunt of such an adjustment. The Mexican Peso Chart 13The MXN Is A Bargain Once Again When we updated our long-term models last September, the peso was one of the most expensive currencies covered, and we flagged downside risk. With President Trump re-asserting his protectionist rhetoric, and with EM bonds and currencies experiencing a wave of pain, the MXN has eradicated all of its overvaluation and is once again trading at a significant discount to its long-term fair value (Chart 13). Is it time to buy the peso? On a pure valuation basis, the downside now seems limited. However, risks are still plentiful. For one, NAFTA negotiations are likely to remain rocky, at least until the U.S. mid-term elections. Trump's hawkish trade rhetoric is a surefire way to rally the GOP base at the polls in November. Second, the leading candidate in the polls for the Mexican presidential elections this summer is Andres Manuel Lopez Obrador, the former mayor of Mexico City. Not only could AMLO's leftist status frighten investors, he is looking to drive a hard bargain with the U.S. on NAFTA, a clear recipe for plentiful headline risk in the coming months. Third, the MXN is the EM currency with the most abundant liquidity, and slowing global growth along with rising EM volatility could easily take its toll on the Mexican currency. As a result, to take advantage of the MXN's discount to fair value, a discount that is especially pronounced when contrasted with other EM currencies, we recommend investors buy the MXN versus the BRL or the ZAR instead of buying it outright against the USD. These trades are made even more attractive by the fact that Mexican rates are now comparable to those offered on South African or Brazilian paper. The Chilean Peso Chart 14The CLP Is At Risk We were correct to flag last September that the CLP had less downside than the BRL. But now, while the BRL's premium to fair value has declined significantly, the Chilean peso continues to trade near its highest premium of the past 10 years (Chart 14). This suggests the peso could have significant downside if EM weakness grows deeper. This risk is compounded by the fact that the peso's fair value is most sensitive to copper prices. Prices of the red metal had been stable until recent trading sessions. However, with the world largest consumer of copper - China - having accumulated large stockpiles and now slowing, copper prices could experience significant downside, dragging down the CLP in the process. An additional risk lurking for the CLP is the fact that Chile displays some of the largest USD debt as a percent of GDP in the EM space. This means that a strong dollar could inflict a dangerous tightening in Chilean financial conditions. This risk is even more potent as the strength in the dollar is itself a consequence of slowing global growth - a development that is normally negative for the Chilean peso. This confluence thus suggests that the expensive CLP is at great risk in the coming months. The Colombian Peso Chart 15The COP Is Latam's Cheapest Currency The Colombian peso is currently the cheapest currency covered by our models. The COP has not been able to rise along with oil prices, creating a large discount in the process (Chart 15). Three factors have weighed on the Colombian currency. First, Colombia just had elections. While a market-friendly outcome ultimately prevailed, investors were already expressing worry ahead of the first round of voting four weeks ago. Second, Colombia has a large current account deficit of 3.7% of GDP, creating a funding risk in an environment where liquidity for EM carry trades has decreased. Finally, Colombia has a heavy USD-debt load. However, this factor is mitigated by the fact that private debt stands at 65% of Colombia's GDP, reflecting the banking sector's conservative lending practices. At this juncture, the COP is an attractive long-term buy, especially as president-elect Ivan Duque is likely to pursue market-friendly policies. However, the country's large current account deficit as well as the general risk to commodity prices emanating from weaker global growth suggests that short-term downside risk is still present in the COP versus the USD. As a result, while we recommend long-term investors gain exposure to this cheap Latin American currency, short-term players should stay on the sidelines. Instead, we recommend tactical investors capitalize on the COP's cheapness by buying it against the expensive CLP. Not only are valuations and carry considerations favorable, Chile has even more dollar debt than Colombia, suggesting that the former is more exposed to dollar risk than the latter. Moreover, Chile is levered to metals prices while Colombia is levered to oil prices. Our commodity strategists are more positive on crude than on copper, and our negative outlook on China reinforces this message. The South African Rand Chart 16The Rand Will Cheapen Further Despite its more than 20% depreciation versus the dollar since February, the rand continues to trade above its estimate of long-term fair value (Chart 16). The equilibrium rate for the ZAR is in a structural decline, even after adjusting for inflation, as the productivity of the South African economy remains in a downtrend relative to that of its trading partners. This means the long-term trend in the ZAR will continue to point south. On a cyclical basis, it is not just valuations that concern us when thinking about the rand. South Africa runs a deficit in terms of FDI; however, portfolio inflows into the country have been rather large, resulting in foreign ownership of South African bonds of 44%. Additionally, net speculative positions in the rand are still at elevated levels. This implies that investors could easily sell their South African assets if natural resource prices were to sag. Since BCA's view on Chinese activity as well as the soft patch currently experienced by the global economy augur poorly for commodities, this could create potent downside risks for the ZAR. We will be willing buyers only once the rand's overvaluation is corrected. The Russian Ruble Chart 17The Ruble Is At Fair Value There is no evidence of mispricing in the rubble (Chart 17). Moreover the Russian central bank runs a very orthodox monetary policy, which gives us comfort that the RUB, with its elevated carry, remains an attractive long-term hold within the EM FX complex. On a shorter-term basis, the picture is more complex. The RUB is both an oil play as well as a carry currency. This means that the RUB is very exposed to global growth and liquidity conditions. This creates major risks for the ruble. EM FX volatility has been rising, and slowing global growth could result in an unwinding of inflation-protection trades, which may pull oil prices down. This combination is negative for both EM currencies and oil plays for the remainder of 2018. Our favorite way to take advantage of the RUB's sound macroeconomic policy, high interest rates and lack of valuation extremes is to buy it against other EM currencies. It is especially attractive against the BRL, the ZAR and the CLP. The only EM commodity currency against which it doesn't stack up favorably is the COP, as the COP possesses a much deeper discount to fair value than the RUB, limiting its downside if the global economy were to slow more sharply than we anticipate. The Korean Won Chart 18Despite Its Modest Cheapness, The KRW Is At Risk The Korean won currently trades at a modest discount to its long-term fair value (Chart 18). This suggests the KRW will possess more defensive attributes than the more expensive Latin American currencies. However, BCA is worried over the Korean currency's cyclical outlook. The Korean economy is highly levered to both global trade and the Chinese investment cycle. This means the Korean won is greatly exposed to the two largest risks in the global economy. Moreover, the Korean economy is saddled with a large debt load for the nonfinancial private sector of 193% of GDP, which means the Bank of Korea could be forced to take a dovish turn if the economy is fully hit by a global and Chinese slowdown. Moreover, the won has historically been very sensitive to EM sovereign spreads. EM spreads have moved above their 200-day moving average, which suggests technical vulnerability. This may well spread to the won, especially in light of the global economic environment. The Philippine Peso Chart 19Big Discount In The PHP The PHP is one of the rare EM currencies to trade at a significant discount to its long-term fair value (Chart 19). There are two main reasons behind this. First, the Philippines runs a current account deficit of 0.5% of GDP. This makes the PHP vulnerable in an environment where global liquidity has gotten scarcer and where carry trades have underperformed. The second reason behind the PHP's large discount is politics. Global investors remain uncomfortable with President Duterte's policies, and as such are imputing a large risk premium on the currency. Is the PHP attractive? On valuation alone, it is. However, the current account dynamics are expected to become increasingly troubling. The economy is in fine shape and the trade deficit could continue to widen as imports get a lift from strong domestic demand - something that could infringe on the PHP's attractiveness. However, on the positive side, the PHP has historically displayed a robust negative correlation with commodity prices, energy in particular. This suggests that if commodity prices experience a period of relapse, the PHP could benefit. The best way to take advantage of these dynamics is to not buy the PHP outright against the USD but instead to buy it against EM currencies levered to commodity prices like the MYR or the CLP. The Singapore Dollar Chart 20The SGD's Decline Is Not Over The Singapore dollar remains pricey (Chart 20). However, this is no guarantee of upcoming weakness. After all, the SGD is the main tool used by the Monetary Authority of Singapore to control monetary policy. Moreover, the MAS targets a basket of currencies versus the SGD. Based on these dynamics, historically the SGD has displayed a low beta versus the USD. Essentially, it is a defensive currency within the EM space. The SGD has historically moved in tandem with commodity prices. This makes sense. Commodity prices are a key input in Singapore inflation, and commodity prices perform well when global industrial activity and global trade are strong. This means that not only do rising commodity prices require a higher SGD to combat inflation, higher commodity prices materialize in an environment where this small trading nation is supported by potent tailwinds. Additionally, Singapore loan growth correlates quite closely with commodity prices, suggesting that strong commodity prices result in important amounts of savings from commodity producers being recycled in the Singaporean financial system. To prevent Singapore's economy from overheating in response to these liquidity inflows, MAS is being forced to tighten policy through a higher SGD. Today, with global growth softening and global trade likely to deteriorate, the Singaporean economy is likely to face important headwinds. Tightening monetary policy in the U.S. and in China will create additional headwinds. As a result, so long as the USD has upside, the SGD is likely to have downside versus the greenback. On a longer-term basis, we would expect the correction of the SGD's overvaluation to not happen versus the dollar but versus other EM currencies. The Hong Kong Dollar Chart 21The HKD Is Fairly Valued The troughs and peaks in the HKD follow the gyrations of the U.S. dollar. This is to be expected as the HKD has been pegged to the USD since 1983. Like the USD, it was expensive in early 2017, but now it is trading closer to fair value (Chart 21). Additionally, due to the large weight of the yuan in the trade-weighted HKD, the strength in the CNY versus the USD has had a greater impact on taming the HKD's overvaluation than it has on the USD's own mispricing. Moreover, the HKD is trading very close to the lower bound of its peg versus the USD, which has also contributed to the correction of its overvaluation. Even when the HKD was expensive last year, we were never worried that the peg would be undone. Historically, the Hong Kong Monetary Authority has shown its willingness to tolerate deflation when the HKD has been expensive. The most recent period was no different. Moreover, the HKMA has ample fire power in terms of reserves to support the HKD if the need ever existed. Ultimately, the stability created by the HKD peg is still essential to Hong Kong's relevance as a financial center for China, especially in the face of the growing preeminence of Shanghai and Beijing as domestic financial centers. As a result, while we could see the HKD become a bit more expensive over the remainder of 2018 as the USD rallies a bit further, our long-term negative view on the USD suggests that on a multiyear basis the HKD will only cheapen. The Saudi Riyal Chart 22The SAR Remains Expensive Like the HKD, the riyal is pegged to the USD. However, unlike the HKD, the softness in the USD last year was not enough to purge the SAR's overvaluation (Chart 22). Ultimately, the kingdom's poor productivity means that the SAR needs more than a 15% fall in the dollar index to make the Saudi economy competitive. However, this matters little. Historically, when the SAR has been expensive, the Saudi Arabia Monetary Authority has picked the HKMA solution: deflation over devaluation. Ultimately, Saudi Arabia is a country that imports all goods other than energy products. With a young population, a surge in inflation caused by a falling currency is a risk to the durability of the regime that Riyadh is not willing to test. Moreover, SAMA has the firepower to support the SAR, especially when the aggregate wealth of the extended royal family is taken into account. Additionally, the rally in oil prices since February 2016 has put to rest worries about the country's fiscal standing. On a long-term basis, the current regime wants to reform the economy, moving away from oil and increasing productivity growth. This will be essential to supporting the SAR and decreasing its overvaluation without having to resort to deflation. However, it remains to be seen if Crown Prince Mohamed Bin Salman's ambitious reforms can in fact be implemented and be fruitful. Much will depend on this for the future stability of the riyal. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 2 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary

Special Report

Highlights Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is highly concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely elevated debt service ratio. Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the current message from our DRM is that the odds of a deleveraging event over the coming year are low. Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Feature Hong Kong has appeared in the headlines of the financial press for two reasons over the past few months. The first is due to the recent weakness in the Hong Kong dollar (HKD), a topic that we addressed last week.1 The second was prompted by the BIS' March 2018 Quarterly Review, which noted that mainland China, Hong Kong, and Canada stood out among 26 jurisdictions as being the most vulnerable to a banking crisis according to their research. The BIS's warning is rooted in the fact that Hong Kong is a highly leveraged economy, but there are two additional reasons for investors to be cautious about the region: China's industrial sector is slowing, and monetary policy is tightening due to the region's direct link to U.S. interest rates. While Hong Kong has avoided the full brunt of rising U.S. rates over the past year thanks to plentiful interbank liquidity (which has limited the rise in 3-month HIBOR), we noted in last week's report that the weakness in the HKD likely means that gap between interbank rates and the base rate cannot get much wider. This means that further Fed rate hikes over the coming year are likely to feed more fully into tighter Hong Kong monetary conditions. In this report we review the extent and disposition of Hong Kong's indebtedness, and develop an indicator for investors to monitor in order to gauge the risk of a serious private sector deleveraging event. We conclude that while it is too early to position aggressively against Hong Kong stocks, the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn. For now, however, that appears to be a story for another day, and as we explain below, potentially a distant one. Breaking Down Hong Kong's Debt Chart 1 presents the basis for concern about Hong Kong's debt. The chart shows the BIS' nonfinancial private sector debt service ratio ("DSR", which includes both households and nonfinancial corporations) for the G10 countries alongside that of China, Hong Kong, and Canada. The chart shows that Hong Kong's DSR has risen nearly to 26%, a full 10 percentage points higher than the G10 average, and is now the highest among the 32 economies that the BIS has debt service data for. One important point to note is that among the three countries that the BIS recently singled out for concern, the disposition of Hong Kong's private sector debt is more similar to that of China than Canada. Chart 2 highlights that the private sector debt in China and Hong Kong is predominantly owed by the nonfinancial corporate sector, whereas in Canada the debt is more equally split among the two sectors, with households owing more in total. Chart 1Hong Kong's Debt Burden Hits##br## A New High Chart 2Unlike In Canada, Hong Kong's Leverage##br## Is A Corporate Sector Problem Normally we would be inclined to suggest that the skew in Hong Kong's debt towards the corporate sector makes it less risky than in other jurisdictions where elevated leverage is a household sector problem. The rationale is that while corporations can (and often do) misallocate their capital, firm borrowing is usually employed to acquire income-producing assets, with problems arising only when the value of those assets (or their potential to generate income) declines sharply. Household leverage problems, on the other hand, are almost always the result of a sharp rise in residential mortgage credit, and our view is that the purchase of residential property is fundamentally an act of consumption rather than a true investment. In addition, the past experiences of several countries have shown that housing-related leverage busts are particularly pernicious, in that the resulting recessions tend to be followed by long periods of subpar economic growth. But unlike in China where the majority of nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong's corporate debt does not have de-facto state backing and appears to be enormously concentrated in the real estate and financial sector. Over 80% of Hong Kong's total nonfinancial sector debt (which includes households) is provided by domestic banks, and Chart 3 shows that among bank loans to firms, 35% have been granted to property building & construction companies and another 22% to "financial concerns" and stockbrokers. This high concentration of corporate sector debt in the real estate sector means that investors should be legitimately concerned over Hong Kong's extremely high DSR. On the household side, we have made the case in a previous report that a replay of another spectacular housing bust (similar to what occurred in 1997) is highly unlikely despite the fact that Hong Kong house prices have vastly outstripped income over the past decade2 (Chart 4). Chart 3Loans To Businesses Are Highly Concentrated ##br##And Exposed To Property Chart 4Lofty House Prices Are A Red Herring: ##br##The Risk Is On The Business Side This suggests that, despite extremely elevated residential property prices, investors should be more concerned about a shock that will destabilize the commercial real estate market. Hong Kong households would not likely escape the impact of such a shock, since commercial and residential real estate prices move strongly in tandem (Chart 5). But in terms of watching for a "tipping point" that could push Hong Kong's private sector into a balance sheet recession, the trigger seems more likely to occur in the market for the former, rather than the latter. Bottom Line: Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is extremely concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely high debt service ratio. Chart 5Still, Households Will Be Hurt##br## If CRE Prices Fall Chart 6The BIS' Warning Thresholds ##br##Don't Seem To Apply To Hong Kong Timing The Onset Of A Balance Sheet Recession Our analysis above supports the recent warnings from the BIS that the risk of a banking crisis / private sector deleveraging event in Hong Kong is nontrivial. This raises the obvious question of how to gauge the timing of such an event in order for investors to properly position their exposure towards Hong Kong's financial markets. The BIS has itself investigated this question, and has published several reports on its "Early Warning Indicator" (EWI) approach.3 Table 1 presents a list of these indicators for several countries, and highlights that the two of the most informative measures (the credit-to-GDP gap4 and the overall debt service ratio) are flashing red for Hong Kong. In fact, Table 1 served as the basis for the BIS' warning in their most recent Quarterly Review that we noted above. The BIS' EWI research has focused on identifying thresholds for these measures that can predict a banking crisis within a three-year window based on the historical record. But in the case of Hong Kong, it is not clear that these thresholds apply. Chart 6 shows the credit-to-GDP gap and overall private sector DSR along with the more stringent BIS threshold noted in Table 1, and highlights that these measures have been flashing red for 4-8 years. Based on this approach, Hong Kong should have experienced a banking crisis long ago. Table 1BIS Early Warning Indicators For Stress In Domestic Banking Systems Rather than relying on the BIS' framework, we have instead constructed our own private-sector debt risk monitor for Hong Kong. In contrast to the BIS' measures, which have been specifically constructed to predict a banking crisis, the goal of our indicator is to help predict a serious credit-driven downturn regardless of its character (i.e. we abstract from whether the result of the downturn is a full-blown financial crisis or simply a prolonged period of economic stagnation). Chart 7Low Risk Of A Serious Credit-Driven ##br##Downturn, For Now Chart 7 presents our BCA Hong Kong Debt Risk Monitor (DRM) and its five equally-weighted components, a summary of which is provided below. All series have been scaled such that an increase in the DRM represents higher risk. Alpha: We have highlighted the importance of examining the alpha as well as the beta of regional equity returns in a previous report,5 and we include a composite indicator of Hong Kong's rolling alpha versus the global benchmark as a measure of Hong Kong-specific stock performance that adjusts for Hong Kong's riskiness. While this component of our DRM was quite elevated in early-2016 (signaling weak Hong Kong stock performance), it is presently in line with its historical average, and thus is not flashing a warning sign. Property Prices: Given the high concentration of Hong Kong's corporate sector debt in the real estate sector, our DRM includes the deviation of office & retail property prices from their 9-month moving average. Similar to the first component of our indicator, Hong Kong property prices are roughly in line with their trend and are not signaling serious economic weakness. Credit Impulse: The third component of our DRM is a simple bank credit impulse, calculated as the flow of credit over the past year as a percent of GDP. While this component has fallen well into "low risk" territory, over the past year, there are some tentative signs of a reversal that investors should monitor. Monetary Policy Stance: The fourth component of our DRM is a structural variable that attempts to measure whether U.S. (and thus Hong Kong) interest rates are either consistent or out of alignment with economic conditions in Hong Kong. This component is an average of two measures of the stance of monetary policy: 1) the difference between U.S. 10-year government bond yields and Hong Kong nominal GDP growth, and 2) the difference between the base rate and a Taylor Rule estimate for the region (with the latter acting purely as an estimate of the cyclical equilibrium interest rate).6 The chart shows that despite the onset of tighter monetary policy in the U.S. over the past few years, our gauge of Hong Kong's policy stance suggests that conditions are still easy, and that material further increases would likely be required in order to see this component rise to +1 sigma territory. Debt Service Ratio: The final component of our DRM is the BIS' total private sector DSR shown in Chart 6, acting as a second structural variable that captures the underlying debt servicing risk that the BIS has warned about. We extent the BIS' series back to the early-1990s on a best efforts basis, by adjusting the product of Hong Kong's prime rate and the total private sector debt-to-GDP ratio to best align with the official DSR series over the course of its history. Our extended series suggests that Hong Kong's debt servicing burden is indeed the highest that it has been over the past three decades, underscoring that our DRM is likely to rise materially if the cyclical factors included in the indicator deteriorate. The overall message of our DRM is that a threat to Hong Kong's economy from excessive debt does not appear to be imminent, despite the underlying risks highlighted by the BIS. While the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn, the odds of this occurring over the coming 6-12 months appear to be low. Bottom Line: Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the message from our DRM is that the odds of a deleveraging event over the coming year are low. The Spooky Implications Of The Natural Interest Rate Gap Interestingly, at least part of the benign reading of our DRM is due to the fourth component of the indicator, our gauge of Hong Kong's monetary policy stance, which suggests that there is ample room for further rate increases. In fact, in our view this observation carries much deeper significance than many may initially perceive, as it may explain why the BIS' early warning indicator thresholds have not worked in the case of Hong Kong, and why the region may avoid a debt crisis for a further significant period (but ultimately experience a much more painful collapse when it finally arrives). At root, the reason that U.S. 10-year Treasury yields remain exceedingly low relative to U.S. nominal GDP growth is because investors believe that real U.S. policy rates are likely to be much lower on average over the next 10-years than they have been historically (Chart 8). Abstracting from calendar-based cyclical considerations (such at the timing of the next U.S. recession), this fundamentally reflects the prevalent view among fixed-income investors that the U.S. natural rate of interest (or "r-star") has likely permanently declined. If true, this is of enormous importance for Hong Kong, as it suggests that the region will permanently "enjoy" easy monetary policy. This is because the substantial leveraging that has occurred in Hong Kong in response to low interest rates implies that there has been no impairment (yet) to Hong Kong's natural rate of interest (Chart 9). Chart 8A Low Estimate Of R-Star Has Depressed##br## U.S. Bond Yields Chart 9No Evidence Of A Low R-Star##br## In Hong Kong In some ways the dynamic we are describing is not new: the importation of easy monetary policy from the U.S. via competitive currency devaluation over the past decade has been a well-known phenomenon that was quite prominent during the early phase of the global economic recovery. But the fixed exchange rate regime in Hong Kong means that this process cannot be avoided without abandoning the peg, an event that itself could trigger a deleveraging event via a sharp decline in asset prices. The key point for investors is that if the U.S. natural rate of interest has indeed fallen materially and permanently below potential GDP growth, then Hong Kong will not experience tight monetary conditions even once the Fed has normalized short-term interest rates, unless it raises them well above equilibrium levels. This suggests that Hong Kong's private sector may perpetually leverage itself until debt service burdens reach some, as yet, unknown maximum level, precipitating what would likely become a cataclysmic recession. The fact that no crisis erupted in late-2015/early-2016 when the cyclical components of our DRM deteriorated significantly suggests that this level may be materially higher than is presently the case. Bottom Line: Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Investment Implications: Stay Neutral, For Now Chart 10Room For A Rise In Relative Earnings Momentum The picture painted by our above analysis suggests that a benign cyclical outlook for Hong Kong is arrayed against a negative (and potentially horrific) structural outlook. How should investors position towards Hong Kong equities in response? First, as noted above, our Debt Risk Monitor does not signal that there is an imminent threat facing the Hong Kong economy that would herald the potential for a major deleveraging event over the near-term. Second, while Hong Kong's earnings momentum is stretched in absolute terms, Chart 10 highlights there is room for a catchup versus global stocks, which could boost relative performance over the coming year. Third, relative valuation and technical conditions are at neutral levels (Chart 11), and thus do not provide any compelling basis to avoid Hong Kong stocks. But to us, the weight of this modestly positive assessment over the coming year is overshadowed by the structural outlook, meaning that we continue to recommend a neutral allocation towards Hong Kong stocks over the coming 6-12 months. The most investment-relevant conclusion from our analysis is that investors will one day be able to earn significant risk-adjusted returns from underweighting / shorting Hong Kong stocks once a serious credit-driven downturn begins. As an example, Chart 12 shows the impact of the Asian financial crisis on Hong Kong's relative performance, a period where our DRM rose sharply and persistently into "high risk territory". It took 12½ years for Hong Kong to rise to a new high in relative total return terms, and it has yet to do so in price terms. Chart 11Neutral Relative Valuation And ##br##Technical Conditions Chart 12One Day, Shorting Hong Kong Stocks##br## Will Be Enormously Profitable So while the economic and financial market conditions are not yet in place to act on a bearish structural view, we will be closely watching our Debt Risk Monitor over the coming months and years for signs of a significant deterioration, as it will likely provide a major opportunity for investors to earn outsized returns. Stay tuned! Bottom Line: Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Hong Kong Housing Bubble: A Replay Of 1997?", dated June 29, 2017, available at cis.bcaresearch.com. 3 For example, please see "Evaluating early warning indicators of banking crises: Satisfying policy requirements" by Mathias Drehmann and Mikael Juselius, BIS Working Paper No. 421, August 2013. 4 The BIS defines the credit-to-GDP gap as the difference between the credit-to-GDP ratio and its long-run trend, derived using a one-sided (i.e. backward-looking) Hodrick-Prescott (HP) filter. 5 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 6 Our Taylor Rule estimate for Hong Kong is constructed in a fashion similar to what we showed for China in our January 18 Weekly Report, using a neutral policy rate estimate of 5%. Cyclical Investment Stance Equity Sector Recommendations