Philippines

Foreign debt inflows into Philippines will be falling in coming months. Book profits on domestic bonds; and go short the peso.

Great Power Rivalry is taking another leg up as Russia and China further align their geopolitical interests. Investors should stay long USD-CNY, favor defensives over cyclicals, and markets like North America and DM Europe that have less exposure to geopolitical risk. 

Executive Summary Lingering Weakness In The Economy Is Reflected In Low Core Inflation The Philippine economy will struggle to gain traction as the fiscal thrust remains negative and monetary policy is tightening. Consistent with tepid growth, there are no genuine inflationary pressures in the Philippines. The country’s bond yields should drop in the months to come. Soaring trade and current account deficits will abate soon. Net debt portfolio outflows should ease and could turn into net inflows. These will help the peso find a bottom. Philippine stocks’ relative performance versus the EM benchmark will likely remain rangebound. The reason is that an uninspiring domestic economy in the Philippines is juxtaposed with a poor outlook for the overall EM equity benchmark. Recommendation Inception Date RETURN Book Profits On Long USD/Short PHP  2021-03-18 10.9% Go Long Philippine Local Currency 10-year Government Bonds 2022-08-18   Bottom Line: A struggling Philippine economy warrants that absolute return investors avoid Philippine stocks. EM and Emerging Asian equity portfolios should continue with a neutral allocation to the Philippines. Feature Chart 1Philippines Stocks Are Failing To Outperform Despite EM Being In A Bear Market Despite being traditionally a defensive market within EM, Philippine stocks failed to outperform the EM benchmark; even though the latter continues to do poorly in absolute terms (Chart 1, top panel). In November 2021, we upgraded this bourse from underweight to neutral, rather than overweight, because of our negative outlook on the peso and the headwinds emanating from rising US/ global interest rates for the rate-sensitive Philippine markets. That call has worked out in line with our view (Chart 1, bottom two panels).  Going forward, a neutral stance on the Philippines makes sense, but this time for a different reason than a vulnerable peso. The tepid domestic economic recovery does not justify turning bullish on this bourse in absolute or relative terms. On the currency front, the peso has depreciated markedly versus the dollar since early 2021. We now book profits on our short peso call as the risk-reward trade-off is no longer attractive.  Tight Policy Is Choking Growth The Philippine economy contracted marginally (-0.1%) in the second quarter of 2022 vis-à-vis the first on a seasonally adjusted basis. The drag was mostly from household consumption which shrank by 2.7% QoQ (also seasonally adjusted). A major cause for the insipid growth is the authorities’ rather tight policy. The hope that the government could ramp up fiscal spending during an election1 year did not pan out. The reason had to do with the already very steep fiscal and primary deficits, at 7.9% and 5.6% of GDP respectively (Chart 2, top panel). Notably, the country’s fiscal revenues have remained tepid as well. This also prevented authorities from ramping up fiscal spending. Weak tax collections (especially internal revenue collections), in turn, are a sign of feeble economic activity (Chart 2, bottom two panels). Further, over the coming year, the country’s fiscal stance will remain rather tight and provide little reprieve to the economy. The IMF estimates that the fiscal thrust for both 2022 and 2023 will be negative (Chart 3). Chart 2Already Steep Fiscal Deficts And Weak Revenues Preclude Further Stimulus Chart 3A Negative Fiscal Thrust Means Little Reprieve For The Economy   The Philippines’ monetary stance has also tightened over the past year. Banking system liquidity has fallen measurably since mid-2021. More recently, the central bank has raised rates by a cumulative 125 basis points since May to 3.25%. It has also indicated further hikes in the near future.  All this credit and fiscal tightening amid tepid domestic demand is weighing on business activity and credit growth. Bank loans were already rather weak since the advent of the pandemic in all sectors of the economy, barring real estate (Chart 4). Now, the credit impulse for the private sector appears to be peaking again – which does not bode well for economic growth (Chart 5).     Chart 4Tightening Policy Amid Weak Domestic Demand Will Hurt Credit Growth Chart 5Peaking Credit Impulse Does Not Augur Well For Economic Growth There is yet another reason why credit could be struggling to grow: firms’ reluctance towards capital investments. The share of capex in the economy has languished in a much lower level than it was before the pandemic (Chart 6). That is unlikely to change in any meaningful way in the foreseeable future as firms’ capacity-utilization levels are still low (Chart 8, bottom panel). Philippine Inflation Is Transitory The tepid growth in domestic demand is reflected in several aspects of the Philippine economy. Manufacturing sales, in both value and volume terms, are barely at 2018−2019 levels. Car sales are well below those levels (Chart 7). Chart 6Firms' Reluctance To Boost Capex Is Weighing On Domestic Demand Chart 7The Demand Side Of The Economy Remains Quite Weak   The supply side data are giving a similar message. Industrial production volumes are no higher than they were in 2018. The same holds true for manufacturing production (Chart 8, top panel). This might have weakened further recently, as the latest PMI data suggests (Chart 8, middle panel).  On another note, money supply has also begun to decelerate. Both narrow and broad money measures have rolled over (Chart 9), which is not a good sign for the economy. Chart 8The Supply Side Is Faring Not Much Better Chart 9Decelerating Money Supply Is Not A Positive Sign For The Economy   The lingering weakness in growth is evident in rather muted core inflation. While headline inflation has risen well above the central bank’s upper target of 4%, it is mostly due to a sharp rise in fuel prices, and to some extent in food prices. Once all the fuel and food related items are excluded, the core CPI turns out to be much lower at 2.3%, near the lower end of the central bank’s target band (Chart 10). Notably, crude oil prices might have peaked in this cycle given the deteriorating Chinese and global growth outlook. If so, that will bring down the Philippines’ headline CPI prints over the next several months. Easing headline inflation, in turn, will likely lead the country’s bond yields to roll over (Chart 11). Chart 10Lingereing Weakness In The Economy Is Reflected In Low Core Inflation Chart 11As Headline CPI Ease With Subsiding Fuel Prices, So Will Bond Yields Stay Neutral On Stocks The near-term outlook on Philippine stocks in absolute terms is not promising. The nation’s economic recovery is uninspiring, while the fiscal and monetary stance is unsupportive. Chart 12Philippine Stocks Will Struggle As Foreign Investors Continue To Leave The wider EM and global growth outlooks are also deteriorating. Foreign equity investors continue to be net sellers of Philippine stocks (Chart 12). Given this backdrop, it is hard to imagine that this market could usher in a sustainable bull market in absolute terms any time soon. Relative to the EM benchmark, Philippine stocks will likely remain rangebound. The reason is that overall EM stocks are also vulnerable. Notably, Philippine stocks usually do well relative to EM when the latter do poorly in absolute terms (Chart 1, top panel). The basis is as follows: EM stocks fall when EM/China (and global) growth decelerates. But growth deceleration generally comes with falling global interest rates. Falling global/US interest rates/bond yields are typically a tailwind for the rate sensitive Philippine stock markets. The reason is the prevalence of real estate, banking and utility sectors in the Philippines equity index. In the current episode, however, despite a growth deceleration in EM/China, interest rates are still rising globally – robbing Philippine stocks of their tailwinds. This is why this market is struggling to outperform the EM benchmark. The situation is unlikely to change in the next several months, as sticky inflation in much of the developed world will preclude their central banks from cutting interest rates. It therefore makes sense to continue with a neutral allocation to the Philippines in an EM equity portfolio for now.  Go Overweight Philippine Domestic Bonds Chart 13Elevated Bond Yields, Despite Little Genuine Inflation Indicates Relative Value In Bonds Philippine domestic bond yields are around 6%. Such high yields are unsustainable given the softness in the economy, and the lack of genuine inflationary pressures therein. As such, Philippine domestic bonds are a buy in absolute terms. Relative to their EM counterparts also, they have become attractive. Odds are that they will outperform their EM peers: Philippine bond yields are now nearly at par with that of EM – which is historically on the higher side (Chart 13, top panel). This is despite genuine inflationary pressures in the Philippines being on the lower side vis-à-vis most other economies in Latin America and EMEA. This entails that Philippine yields will come down relative to other EM yields in the months ahead as and when food and fuel prices ease. Philippine bond yields have also risen measurably relative to safe-haven (US treasuries) bonds over the past year and a half. Foreign investors are marginal buyers of Philippine bonds, and their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds. Chart 14 shows that whenever the yield differential widens enough (to over 300 basis points), the Philippines begins to attract net debt inflows. This is what is likely to happen now: the net debt outflows of the recent past should abate and could even turn into net inflows over the coming quarters. The fact that Philippine bond yields are likely to fall due to domestic considerations − weak growth and subsiding inflation − will also entice foreign investors. Finally, the peso has already fallen significantly over the past year and a half (discussed in more detail in the next section). As and when local bond yields will begin to fall, these bonds will attract more foreign debt inflows, which will support the peso. A stable exchange rate will make domestic bond investments more attractive for foreigners (Chart 13, bottom panel, and Chart 15). Chart 14Net Debt Portfolio Outflows Should Abate, And Could Turn Into Inflows Chart 15As Foreign Debt Inflows Resume, Bond Yields Will Fall And The Peso Will Bottom All this suggests that investors would do well to upgrade their allocation to Philippine domestic bonds from neutral to overweight. We also initiate a long position in 10-year domestic bonds, currency unhedged. Book Profits On The Short Peso Trade Chart 16The Peso Will Get A Support As The Current Account Deficit Bottoms Philippine external accounts deteriorated in a major way over the past year. As a result, the peso depreciated markedly − in line with our previous forecast. Now, however, investors should book profit on this trade, as the vulnerability of the peso has diminished: The root cause behind the peso depreciation has been this country’s plunging current account balance (Chart 16).  Current account deterioration, in turn, was caused by high crude prices. The latter led to mammoth trade deficits as exports rose at a much slower pace. But crude prices are now dropping and the nation’s oil import bill will likely subside meaningfully in the months ahead. The import cost of raw materials will also fall in line with falling resource prices. As a result, Philippine trade and current account deficits will likely bottom soon (Chart 17). That will help put a floor under the currency. Philippine capital account balance has remained in healthy surplus – buoyed by FDI and other investment inflows (Chart 18, top panel). Chart 17As Oil Import Costs Subside, The Trade Deficit Will Find A Floor Chart 18A Resumption In Debt Portfolio Inflows Will Keep Capital Account In Healthy Surplus If the ongoing net debt portfolio outflows subside and/or turn into inflows (as explained in the previous section), that will help keep the financial account balance afloat (Chart 18, bottom panel). Finally, the peso is no longer expensive vis-à-vis the US dollar in purchasing power terms (Chart 19). This entails only a limited downside from now on. Book Profits On Sovereign Credit Our negative outlook on the EM sovereign credits prompted us to recommend an overweight stance on Philippine credit relative to the EM benchmark. The reason is the defensive nature of the Philippine sovereign bond market: during periods of EM stress, Philippine sovereign spreads widen much less than their EM counterparts. That call has worked out well. This market has massively outperformed its EM peers (Chart 20). But now, we recommend that investors protect profits by downgrading their allocation to the Philippines from overweight to neutral. Chart 19The Peso Is No Longer Expensive Versus The US Dollar Chart 20Sovereign Bond Investors Should Book Profits After The Recent Outperformance One reason for that is that the relative excess return on Philippine bonds have surged recently to levels seen only during the height of EM stress in 2008-09 and then again in early 2020. As such, the relative performance might already be discounting a massive rise in EM spreads, and further outperformance may be hard to come by. Another reason for our cautious stance is Philippine external public debt. Though still low as a share of the economy at 15% of GDP, this has surged in the recent past. It therefore makes sense to pare back some of the exposure to Philippine sovereign credit and await a better entry point in future. Investment Recommendations Currency: The vulnerability of the peso has eased, and investors should book profits on our short PHP/long USD call. This trade has yielded 10.9% (including carry) since our recommendation on March 18, 2021. Equities: Absolute return investors should avoid Philippine stocks as its near-term outlook is not promising. EM and Emerging Asian equity portfolios should continue with a neutral allocation to the Philippines relative to the EM benchmark. Domestic Bonds: Given the improved peso outlook, and rather high relative yields, local currency bond investors should upgrade their allocation to the Philippines from neutral to overweight in EM domestic bond portfolios. For absolute-return investors, we recommend buying 10-year domestic government bonds, currency unhedged. Sovereign Credit: Philippine sovereign credit has massively outperformed its EM counterparts. We recommend that investors protect profits by downgrading their allocation from overweight to neutral. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1      The Philippines held its federal elections in May 2022. The new President Ferdinand Marcos Jr. took office on June 30, 2022.

Special Report

Executive Summary Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Chart 4Opinion Shifts Against China In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China​​​​​​ Chart 8China Threatens ASEAN With Import Substitution​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP​​​​​​ Chart 12BProductivity And Potential GDP​​​​​​ Chart 13Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China​​​​​​ Chart 15Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Highlights So far, both the demand and supply side of the Philippine economy have been rather weak; yet there are signs that growth is set to revive. Fiscal expenditures have bottomed. Bank lending is also reviving. Acceleration in broad money supply is usually a good omen for stronger economic activity (Chart 1). Being a defensive market within EM, Philippine stocks will benefit in an impending period of weak EM stock prices. Upgrade this bourse from underweight to neutral in an EM equity portfolio. Philippine sovereign credit is also defensive in nature relative to its EM peers. Stay overweight in an EM portfolio. A deteriorating external accounts outlook makes the peso vulnerable. The central bank will also likely tolerate a weaker currency. Stay short the peso versus the US dollar. A vulnerable peso renders Philippine domestic bonds unappealing. Stay neutral in an EM domestic bonds portfolio. Feature The steep underperformance of Philippine stocks over the past several years is due for a pause. While this bourse may not see a sustainable rally in absolute terms, a period of flattish relative performance vis-à-vis the EM benchmark is likely. We recommend upgrading this market from underweight to neutral within an EM equity portfolio (Chart 2). Chart 1Accelerating Fiscal Spending And Credit Is A Good Omen For Economic Growth Chart 2Philippine Stocks' Underperformance Is Set For A Breather But It's A Risk In Absolute Terms One reason why Philippine stocks are unlikely to rally in absolute US dollar terms is a vulnerable peso. Philippine external accounts will likely deteriorate further, and therefore the peso is set to continue to trade on the weaker side. Currency investors should stick with our recommended short the peso versus US dollar trade for now. Philippine domestic bonds also remain unattractive to foreign investors. Local bond yields are not high enough relative to those of safe-haven bonds (US treasuries). As a result, the country is witnessing net debt portfolio outflows. The nation’s sovereign USD bonds, however, will likely outperform the EM benchmark going forward and merit an overweight stance in an EM sovereign bond portfolio. A Feeble Economy …   The Philippine economy, so far, continues to be soft. Demand has been sluggish: manufacturing sales remain well below pre-pandemic levels – both in value and volume terms. So are car sales (Chart 3). On the supply side, production volume gives a similar message: they are still below pre-pandemic levels. Manufacturing PMI is barely in the expansion territory (Chart 4). In other words, there is palpable weakness in both the demand and supply side of the domestic economy. Chart 3The Demand Side Of The Economy Has Been Weak... Chart 4...So Has Been The Supply Side The soft domestic demand is also evident from the import cargo throughput in the country’s ports. While exports cargo has risen well above pre-pandemic levels, import cargo has not (Chart 5). Part of the reason behind the lingering frailty is muted fiscal spending. Over the past 12 months, the latter has decelerated measurably. To be sure, Philippine fiscal outlays during the entire pandemic period have not been extraordinary; and yet this has slowed further (Chart 6, top panel). Chart 5Weak Domestic Demand Is Also Evident In Still Subdued Imports Chart 6Govt Spending Had Decelerated, Even As QE Proceeds Remained Unspent   The sharp widening seen in the country’s fiscal deficits had more to do with dwindling fiscal revenues, rather than strong spending. In fact, central bank data shows that most of its government bond purchase proceeds (‘QE’ proceeds) are unspent – still sitting in the government’s accounts with the central bank, i.e., they have not been channeled into the economy (Chart 6, bottom panel). … But Plenty Of Dry Powder Going forward, however, that picture is likely to change. The country is heading into general elections in May 2022. Lawmakers therefore have an incentive to spend the amount currently lying in the central bank. The amelioration in the number of new Covid-19 cases has enabled a re-opening of the economy, which will make stimulus spending easier. In addition, the federal budget for 2022 passed last month1 includes an 11.5% hike in government outlays. With core CPI at 3%, this translates into a robust 8.5% government expenditure growth rate in real terms. Chart 7Credit Is Finally Reviving Beyond fiscal spending, the country’s bank credit might also gain some traction: During the pandemic, banks shunned loan disbursements. Lately, however, there are signs that credit is reviving (Chart 7). Real borrowing costs (prime lending rates deflated by core CPI) from banks are low, close to only 1%. Such low cost of credit should encourage new borrowing at a time when economic activity is resuming. On their part, banks have made sizeable provisions against the rising NPLs during the pandemic, and therefore have already taken a substantial hit on their books (Chart 8, top panel). Relatively cleaner balance sheets should encourage banks to lend. Banks have also been able to materially raise their operating efficiency in the past couple of years (by way of rising net interest income). As a result, operating margins have improved measurably. This has helped absorb part of the NPL-related losses and has somewhat cushioned the blow to banks’ bottom line (Chart 8, bottom panel). Relatively better margins (than otherwise would have been the case) should prompt banks to take relatively higher risks, i.e., expand their loan books going forward. Should fiscal authorities ramp up their spending, and should banks also begin to lend again, the activity that has resumed following a lessening of Covid-19 cases will get a fillip. Higher fiscal spending and bank credit will lift money supply in the economy, usually a good omen for stronger economic activity (see Chart 1 on page 1). Incidentally, inflation in the Philippines is under control. The relatively high headline inflation print is not indicative of any genuine inflationary pressures, and is due mostly to food prices, which account for 38% of the CPI basket. Core and trimmed mean CPI are much lower at around 3% (Chart 9, top panel). Chart 8Banks Have Cleaner Books Now As They Made Sizable NPL Provisions Chart 9There Are No Genuine Inflationary Pressures In The Philippines The central bank expects the headline inflation rate to decelerate to within its target band of 2% to 4% by the end of this year and settle close to the midpoint in 2022 and 2023. At the same time, Philippine nominal wages are barely growing (Chart 9, bottom panel). This implies that businesses have little margin pressures to raise their selling prices. Genuine inflationary pressures, therefore, are unlikely to become acute in the foreseeable future. That, in turn, will help keep fiscal and monetary policies accommodative.  Domestic Bond Yields Will Stay Flattish With the resumption of economic activity, will come higher fiscal revenues. That should help the Philippine fiscal deficit to narrow.  Narrower fiscal deficit in the Philippines is usually bond bullish (i.e., bond yields go down). Yet, lower bond yields will have negative implications for Philippine capital inflows. Foreign investors are the marginal buyers of Philippine bonds. And their appetite for the latter depends on how much extra yield the Philippines offers over safe-haven bonds (US treasuries). Chart 10 shows that whenever the yield differential narrows too much (to around 200 basis points), net debt portfolio inflows into the Philippines typically stop, and often turn into outflows. This is what is happening now. On the other end, when the differential widens enough (about 400 - 500 basis points), those outflows turn into inflows again. Chart 10The Philippines Need To Offer Relatively Higher Yields To Attract Capital Inflows Given that we expect US long-term bond yields to rise, if Philippine bond yields do not rise at an even faster pace, its yield differential would stay low. Thus, the country will be hard-pressed to see any debt portfolio inflows in the near future. The absence of foreign buyers, in turn, would put a floor under bond yields. This will counterbalance any yield-suppressing forces coming from improving fiscal deficits. Thus, overall, the country will likely see flattish yields over the next six to nine months. And The Peso, Shaky Chart 11Debt Dominates The Philippines' Capital Inflows Low bond yields and short-term interest rates will have negative ramifications for the currency: It’s the foreign debt flows, rather than equity investments, that dominate Philippine capital inflows. This is true for all categories of inflows: FDI, portfolio and other investments (Chart 11). The fact that debt investors are the dominant group among foreign investors has some implications. Debt investors do not like lower interest rates while equity investors do. As such, debt inflows into the Philippines diminish when the interest rates (bond yields) are relatively low. Muted foreign capital inflows, in turn, are bearish for the peso. The country’s current account outlook is also not rosy. The trade deficit has widened significantly, and the robust current account surplus has given way to deficits – in line with our forecast in our previous report. With domestic demand reviving (government spending, household consumption and business investment), imports will now likely grow faster than exports, and therefore, will weigh down on both trade and current account deficits further in the months ahead. Notably, the country’s overseas workers’ remittances have also rolled over in recent months. All these will be a headwind for the peso (Chart 12). As noted, the central bank does not expect inflation to overshoot their target in the next two years. They have also been a net buyer of US dollars year-to-date, i.e., they have been leaning against their currency. This implies that they would not mind a weaker currency – especially when the economy is still not strong, and inflation is not a threat. Incidentally, the peso is also about 7% expensive vis-à-vis the US dollar in purchasing power terms (Chart 13). Chart 12Current Account Balance Will Deteriorate As Rising Domestic Demand Fuels Imports Chart 13The Peso Is Somewhat Expensive In PPP Terms And Is Vulnerable To A Downside Equity Underperformance Is Late An improving fiscal balance is usually bullish news for Philippine stock multiples. The connection is via bond yields/interest rates. An improving fiscal balance leads to lower bond yields, which, in turn, boost this market which is dominated by interest rate sensitive sectors (real estate, financials/banks and utilities make up 50% of market cap). Chart 14Weak EM Stock Prices Herald Outperformance by The Defensive Philippine Markets Yet, in this cycle, an improving fiscal balance may not herald a material fall in the country’s bond yields due to net debt portfolio outflows (as explained above). Thus, Philippine stocks would miss the tailwind from rising multiples. A dim outlook for the peso also calls for caution on the part of absolute-return foreign investors. That said, the resumption of economic activity will lead to rising earnings, and that should provide some tailwinds for this market. Moreover, as a defensive market within EM, Philippine stocks usually outperform the overall EM benchmark during periods of weak EM stock prices. Incidentally, we have a negative outlook on EM stock prices over the coming several months (Chart 14). Weighing all the pros and cons, we infer that Philippine stocks’ relative performance will likely be rangebound over the next six to nine months. Sovereign Credit Will Outperform Chart 15The Philippines' Sovereign Credit Outperforms During EM Risk-Off Periods, Stay Overweight A negative outlook on overall EM sovereign credit warrants overweighting Philippine sovereign credit relative to its EM brethren. The reason is the defensive nature of the Philippine sovereign bond market – just like its equity market. During periods of stress, Philippine sovereign spreads widen much less than its EM peers. Chart 15 shows that in each of the last three risk-off periods (2008-09, 2015, 2020), Philippine sovereign credit massively outperformed the EM benchmark. The basis for the defensive features of Philippine sovereign credit is that the nation’s external public debt is quite low at 18% of GDP, down from 25% ten years back. Of this, foreign bonds outstanding are 10% of GDP, down from 12% ten years back (the rest being loans and contingent liabilities). Such low debt means the defensive nature of this market is unlikely to change soon. Hence, it makes sense to overweight Philippine sovereign bonds in view of impending sovereign credit spreads widening in the broader EM universe. Investment Conclusions Stocks: The Philippine economy will likely see some traction in the months ahead as fiscal spending rises and bank credit revives. This bourse’s relative performance will also benefit in an impending risk-off period in emerging markets. Asset allocators should upgrade this market from underweight to neutral in an EM equity portfolio. Our underweight call on this market vis-à-vis an EM equity portfolio has yielded a gain of 16% since we recommended it in October 2018. The Peso: The peso remains vulnerable in the face of deteriorating external accounts. Currency investors should stay with our recommended long USD/ short PHP trade for now. This call has yielded 2.1% so far since our recommendation on March 18, 2021. Chart 16Philippine Domestic Bonds Warrants A Neutral Allocation In An EM Portfolio Domestic Bonds: Local currency bond yields in the Philippines are likely to stay flattish despite the slated improvements in the country’s fiscal balance. The peso is also set to stay weak. These call for a cautious stance on Philippine domestic bonds. Yet, they tend to do well relative to their EM counterparts during periods of EM stress – as they did in 2015 and in 2020 (Chart 16). Since another such period is around the corner, we recommend that investors maintain a neutral allocation of Philippine local currency bonds in an EM portfolio.    Sovereign Bonds: Philippine sovereign bonds are set to outperform their EM counterparts. Asset allocators should stay overweight the Philippines in a dedicated EM sovereign bonds portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 Passed in the third and final reading in the lower house and sent to the Senate, the upper house.

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Chart 2DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Chart 10Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights All Filipino assets are linked by a common thread: the country’s fiscal balance. The prevalence of interest rate sensitive sectors in its stock market and the dependence on foreign debt inflows has given the country’s bond yields a primacy. Stocks, bonds, currency - they all rise and fall together exacerbating the returns for investors. Asset allocators should stay underweight this bourse in an EM equity portfolio. Currency investors should consider shorting the peso. Feature Chart 1Filipino Stocks, Bonds And Currency - All Move In Sync... Philippine stocks have exhibited a typical bear market pattern with lower highs and lower lows for several years. Relative to their Emerging Markets counterparts, they peaked in 2016 (Chart 1). Interestingly, the country’s relative equity performance versus the EM benchmark correlates both with the country’s government bond prices and the currency (Chart 1, bottom panel). The question is: what makes all the assets in the Philippines move in sync? More importantly, what can we expect of these various asset classes going forward? The answer lies in the unique structure of the Philippine market and its macro backdrop. In this report we will explain what drives Philippine assets and how to position for the future. Drivers Of Philippine Bonds A common thread that connects all Philippine assets – stocks, bonds and currencies –   is the country’s fiscal balance (Chart 2). The basis of the correlation between the fiscal balance and bonds is straightforward. A lower fiscal deficit means a smaller issuance of bonds. A lower supply of bonds helps raise their price (i.e., lowers bond yields); and vice versa. This general rule held up for much of the past two decades, until the pandemic hit (Chart 2, top panel). A second driver of bond yields is foreign investors’ appetite towards Philippine bonds. International investors have been the marginal buyers of bonds: the top panel of Chart 3 shows that whenever net debt inflows into the Philippines were positive, bond yields fell (shown inverted in the chart). The shaded areas in the chart denote periods of net debt inflows. Chart 2... As They Are Connected By A Common Thread: Fiscal Balance Chart 3Net Debt Inflows Push Down Bond Yields, But Very Low Bond Yields Leads To Outflows The only exception, again, was in the immediate aftermath of the pandemic last year. Even though there were net debt outflows at that time, bond yields fell. This was because the central bank purchased a massive amount of bonds (Chart 4, top panel). Chart 4Central Bank Bought Massive Amounts Of Govt Bonds, But The Money Is Laying Unspent Importantly, the foreign appetite for Philippine bonds has a self-limiting factor. That factor is the yield differential between Philippine and safe-haven bonds (US treasuries). The bottom panel of Chart 3 shows that whenever the yield differential narrowed to around 200 basis points, net debt inflows typically stopped and often turned into outflows. On the other end, when the differential widened enough (about 400-500 basis points), those outflows turned into inflows again. This dynamic can sometimes override the fiscal balance effect. For instance, in 2013 bond yields began to rise even though the fiscal balance was still improving. The reason was that the yield differential had narrowed down to below 200 basis points, turning net debt inflows into net outflows. These interactions have investment implications. Given that the US long-term bond yields are expected to rise further, the Philippines will be hard pressed to see any debt portfolio inflows: The yield differential is now close to 200 basis points – which acted as a limiting factor in previous cycles. Indeed, the country is now witnessing net debt outflows. This will put a floor under bond yields. If the Philippines were to attract foreign debt inflows, it would need to offer much higher bond yields than safe-haven bonds. But those high interest rates would be detrimental to an economy still reeling from the effects of the pandemic. Authorities are unlikely to let Filipino government bond yields rise much more and will probably resort to more central bank bond buying to prevent it. In any case, new bond issuance will likely not be as large as it was in 2020 – capping the upside in yields. Part of the reason is that the central government has not yet spent all the money it borrowed last year. This is evident in the government’s high balance with the central bank. The bottom panel of Chart 4 shows that while the government’s borrowings from the central bank via bond sales sky-rocketed, its deposits at the central bank also surged to nearly the same extent. This indicates that the government’s spending did not keep pace with its borrowing, and a significant amount of the money remains untouched. The bottom line is that Philippine bond yields are quite low at present and are unlikely to see any major trend, upwards or downward, over the next 6 to 12 months. Drivers Of The Peso Chart 5The Current Account Balance Has An Impact On The Currency The primary driver of the major trends in the peso is the country’s balance of payments (BoP). One component of the BoP, the current account, directly influences the currency: a stronger current account is better for the peso; and vice versa (Chart 5).  The effect of the other component, the financial account, is more nuanced. This is because the financial account is decidedly dependent on the ebbs and flows of the debt portfolio inflows to the Philippines. It’s the foreign debt investments (and not equity investments) that are the swing factor in Philippine foreign inflows – as those dominate both portfolio inflows and FDI inflows into the country (Chart 6). The fact that debt investors are the dominant group among foreign investors has some implications. Debt investors prefer higher interest rates while equity investors do not. As such, capital inflows into the Philippines suffer when the interest rates (bond yields) stay relatively low. Muted capital flows, in turn, are bearish for currency.  Hence, seen from that angle, it’s the bond yields and the relative bond yields, specifically, that are the all-important driver of the Philippine currency (Chart 7). Notably, the cyclical peaks in the peso in 2007 and again in 2013 coincided with the bond yields and the relative bond yields bottoming (yields and relative yields are shown inverted on the charts). Chart 6Financial Account Inflows Are Mostly Made Out Of Debt Inflows... Chart 7...Making Bond Yields The Ultimate Driver Of The Peso By the same logic, since absolute and relative bond yields are now quite low, it will be hard for the Philippines to attract enough debt inflows. As such, the peso will miss the tailwind from capital inflows. Chart 8Impending Trade And Current Account Weaknesses Will Weigh On Currency Finally, the current account surplus will also likely narrow going forward. The improvement in the current account over the past year can be mostly attributed to a much sharper drop in imports compared to exports (Chart 8, top panel). As and when the pandemic subsides, odds are that imports will rise to close to pre-pandemic levels. That means the trade deficit will widen. The other significant component of the current account, overseas workers’ remittances, are already back to pre-pandemic levels as of the end of 2020; therefore, it has limited room to grow. All this means that the current account surplus will likely narrow going forward (Chart 8, bottom panel). That would be another headwind for the peso. Drivers Of Philippine Stocks The fiscal balance, once again, has a prime role in Philippine stock markets. The country’s equity multiples move with the ebbs and flows of its fiscal balance (Chart 9). Chart 9Filipino Stock Multiples Move With The Ebbs And Flows Of The Fiscal Balance The connection is via interest rates (i.e., bond yields). The Philippine stock market is dominated by interest rate sensitive sectors such as real estate, financials, and utilities – who traditionally made up over 60% of the Philippine MSCI index. Falling bond yields usually benefit these stocks, pushing up their valuations, while rising yields hurt them. Lower rates also encourage more business. Demands for property and new loans go up, benefitting the economy and stock prices. That said, the prevalence of interest-rate-sensitive sectors in the stock market has some significant investment implications: For one, returns on Philippine stocks and bonds often rise and fall together. This means that, in a local balanced portfolio, bond holdings rarely give enough protection during a risk-off phase, as bond returns tend to be negative at the same time when stock returns are negative (Chart 10). The only exception was for a short while during the immediate aftermath of the pandemic - thanks to the central bank’s massive bond purchases.   The dependence on interest-rate-sensitive sectors has turned the Philippines into a defensive market within an EM equity universe. Philippine stocks tend to underperform the EM MSCI benchmark when overall emerging markets stocks rise, and vice versa (Chart 11). The basis is as follows: EM stocks rise when EM growth accelerates. But growth acceleration usually comes with rising global interest rates. Since rising global/US and, eventually, local bond yields are a headwind for Philippine stocks, the latter underperform their EM brethren during these periods. Chart 10Prevalence of Rate Sensitive Stocks Means Bonds Give Little Protection During Risk-Off Phases... Chart 11...And A Defensive Nature Within An EM Equity Universe Chart 12The Peso Often Exacerbates The Philippines Stock Returns Finally, Philippine stocks’ relative performances are highly positively correlated with the peso: they usually go up and down together (Chart 12). What this means from the point of view of a foreign investor is that not only do all Philippine assets (stocks and bonds) move together, but also the currency exacerbates those moves. The near-term outlook for stocks is not promising. The lack of a strong fiscal stimulus and muted credit growth means the nation’s economic recovery will be lackluster. Even though the central bank has eased monetary policy in an unprecedent manner – by cutting the policy rate by an impressive 200 basis points and engaging in massive government bond buying – the benefits from those actions have not transpired to the larger economy. As pointed out earlier, much of the central bank’s bond purchase proceeds are still sitting in the government’s account with the central bank, rather than being spent (Chart 4, above). Indeed, fiscal expenditures have grown by just 12% year-over-year as of December 2020, a very ordinary pace. The absence of a strong fiscal stimulus was one reason why the economy shrank by 9.5% in real terms last year.  Chart 13Banks Are Reluctant To Expand Their Loan Books... Banks, on their part, have been shy in expanding their loan books: bank credit is contracting despite their mushrooming excess reserves/liquidity at the central bank. In other words, the money multiplier has collapsed (Chart 13). Part of the reason for banks to avoid lending is a remarkable spike in bad loans. Banks’ yearly provisioning and loan losses have surged: from less than 0.5% of outstanding loans to over 2% last year. That resulted in a significant hit to their net profits. The reason why operating profits have done well is aggressive cuts of various operating costs (Chart 14). Going forward, facing surging NPLs, banks will likely stay somewhat reluctant to disburse new credit. That will not augur well for an economic recovery. Notably, banks are a major sector in the Philippine stock index. Their contracting earnings will bode ill for the overall market. Chart 14...As Their NPL Provisioning Skyrocketed, Hurting Net Profits Chart 15Economic Activity Is Still Languishing At Low Levels All this is weighing on the larger economy. For instance, manufacturing production, both in value and volume terms, is still languishing at much lower levels compared to pre-pandemic times (Chart 15). A lingering economic weakness does not portend a bright outlook for risk assets.   Structural Outlook: Rays Of Hope Despite the country’s subdued near-term outlook, we would be remiss if we did not point out the improved structural story of the Philippines that has taken place over the past several years – before the pandemic upset the trend. Chart 16A New Capex Cycle Had Begun In The Philippines Before Being Upset By The Pandemic The Philippines kickstarted a new capex cycle in 2015. That began with a fiscal boost: the share of capital expenditure in total fiscal expenditures went up. Private sector capex followed suit. Taken together, overall capital investment rose by an impressive 10 percentage points of GDP within a few years (Chart 16). That led to a surge in the country’s capex-to-consumption ratio – a very welcome development for a chronically underinvested economy (Chart 17, top panel). What’s more, the quality of the capital expenditure also improved. The share of investments in durable equipment relative to structures went up (Chart 17, bottom panel). This is important as investments in the building of structures, such as residential and retail or commercial spaces, are not as productivity-enhancing as is spending on new plants and machinery. The rise in equipment and machinery capex was also corroborated by a spike in capital goods imports. Overall, the last decade saw the Philippines capex-to-GDP ratio improving the most among its neighboring countries (Chart 18). Chart 17Rising Capex Relative To Consumption Is Bullish For The Long Term Outlook Chart 18Philippines Capex-To-GDP Ratio Improved The Most In The Last Decade Philippines Capex-To-GDP Ratio Improved The Most In The Last Decade   Even though the improvement has come from a rather low base, the incremental benefits of capex will be more discernible in the Philippines. The rising capital spending helped improve the country’s productivity trend measurably (Chart 19). This was crucial as the Philippines had begun to witness a deceleration in its labor force growth. A higher rate of productivity helped offset the effect of a decelerating labor force and held up the economy’s potential growth rate. Indeed, the country’s productivity trend has been among the best in Asia in recent years (Chart 20). Chart 19Rising Capital Spending Improved Productivity Significantly... Chart 20...Making The Philippines One Of The Best In Asia All that said, the advent of the pandemic has derailed the Philippines’ capital spending plans completely. Post-pandemic, if the country can get back to its capex-led growth strategy, that could have very positive long-term implications for the economy and its financial markets. If not, Philippines’ potential will likely slip down a notch with negative macro ramifications. In either case, we will keep a close watch on the developments and will keep you posted. Investment Conclusions Domestic Bonds: As explained above, Philippine bond yields will likely stay in a trading range for the rest of the year. We therefore continue with our present recommendations of a neutral allocation of Philippine local currency bonds in an EM portfolio. The Peso: The path of least resistance for the peso is down. Both the country’s current account and the capital account are slated to be a headwind for the currency. Furthermore, if the central bank engages in another round of bond buying this year to push down bond yields, that will add more downward pressure on the peso. Investors should consider shorting the peso versus the US dollar. Stocks: Chart 21Foreign Investors Apathy Will Make It Hard For Philippines Stocks To Rally The near-term outlook for stocks is bearish. Foreign equity investors continue to be net sellers. It will be hard for this market to rally and outperform the EM benchmark without their buying (Chart 21). In terms of stocks’ absolute valuation, this bourse is not attractive. In terms of relative valuation however, they have cheapened. The trailing P/E ratio at 19.6 and the price/ book ratio of 1.8 are both at about a 15% discount to their emerging markets peers. Weighing all the pros and cons over a cyclical horizon, we recommend continuing to underweight this market in an EM equity portfolio for now.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Chart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering   On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Chart I-13Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations