Argentina

GeoMacro team partners with BCA’s Emerging Markets Strategy to examine political reforms in Argentina. Our colleague Juan Egaña argues that the time is not right to go long Argentinian assets and that Buenos Aires must avoid the mistakes of the Macri era: opening to foreign capital flows too soon without addressing structural macro imbalances. However, the Milei administration is on the right path with potentially global implications.

GeoMacro team partners with BCA’s Emerging Markets Strategy to examine political reforms in Argentina. Our colleague Juan Egaña argues that the time is not right to go long Argentinian assets and that Buenos Aires must avoid the mistakes of the Macri era: opening to foreign capital flows too soon without addressing structural macro imbalances. However, the Milei administration is on the right path with potentially global implications.

We dig into the USD-denominated Emerging Market Sovereign Index to see which credit tiers and countries offer value relative to US Credit.

While it may be tempting to bottom fish, we advise that investors maintain a cautious stance on Argentinian sovereign credit. Even though the election of a right-wing candidate in the coming months may boost investor sentiment, the country still faces major headwinds: more currency devaluation, and another possible default/debt restructuring.

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields The Destiny Of EM Equities is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments EM: Growing Risk Of A Breakdown EM: Growing Risk Of A Breakdown Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic? Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated Global Semi Stocks Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Downside Risks to Bond Prices Downside Risks to Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart III-1Downside Risks to Bond Prices Downside Risks to Bond Prices Downside Risks to Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields China's Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth bca.ems_wr_2019_08_22_s1_c3 bca.ems_wr_2019_08_22_s1_c3 Chart I-4China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Investors Are Very Bullish On EM No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. Chart I- The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract Philippine Exports Will Contract Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Philippine Equities Are Expensive Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation The Exchange Rate And Inflation The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? A Top In The Business Cycle? A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Severe Fiscal Tightening Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking The Business Cycle Is Peaking The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Things Could Get Worse Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Things Could Get Worse Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com

Analysis on the Philippines and Argentina are below. Highlights Analysis on the Philippines starts on page 9 and Argentina on page 12. Relative return on capital for non-financial corporations points to continuous EM equity underperformance versus the U.S. and probably versus other DMs as well. Taking into consideration the poor corporate profitability, EM equity valuations are not attractive in absolute or relative terms. The rationale for continuous U.S. dollar appreciation is a superior return on capital in the U.S. relative to the rest of the world. Short the Korean won and the Philippines peso versus the U.S. dollar. Feature In general, the most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. The outlook for corporate earnings and profitability at the current juncture is poor for EM in both absolute terms and versus the U.S. Further, the U.S. dollar is in the process of breaking out. As this breakout transpires, EM equities will continue to underperform their U.S. and probably DM counterparts. The most important drivers of relative equity performance between emerging and developed markets are corporate profitability and exchange rates. Corporate Profitability Chart I-1Relative Corporate Profitability And Share Prices: EM Versus U.S. Relative Corporate Profitability And Share Prices: EM Versus U.S. Relative Corporate Profitability And Share Prices: EM Versus U.S. Chart I-1 shows relative share prices in common currency terms along with the average of relative return on equity (RoE) and return on assets (RoA) for non-financial companies in EM and the U.S. This chart portends that in the medium- and long term, relative RoE and RoA explain relative equity prices in common currency terms reasonably well. Importantly, both RoE and RoA are ratios and are therefore not impacted by exchange rates. Consequently, it is reasonable to use RoE and RoA to gauge both share prices and exchange rates. Critically, relative RoE and RoA are not impacted by currency movements either. Further, we use EBITDA to calculate these profitability ratios for both EM and the U.S. As a result, they are not influenced by last year’s U.S. tax cuts as well as by corporate depreciation and one-off adjustments (Chart I-2). What’s more, we use data for non-financial companies because profitability measures for financial companies, especially banks, are contingent on their recognition of bad loans and provisioning. If banks lend a lot but do not provision, their profitability becomes unjustifiably inflated. Chart I-2Non-Financials Corporate Profitability: EM And U.S. Non-Financials Corporate Profitability: EM And U.S. Non-Financials Corporate Profitability: EM And U.S. Going forward, the outlook for EM versus DM share price performance largely hinges on currency market dynamics. If the dollar experiences a broad-based upsurge, which appears to be emerging, EM will likely underperform not only the U.S., but DM ex-U.S. as well. The rationale is that currency depreciation will be more positive for equity markets in Europe, Japan, Canada and Australia than for EM bourses. The former group does not have U.S. dollar debt, while currency weakness will boost the profits of their non-financial companies. Meanwhile, many EM companies are sitting on U.S. dollar debt, and as such currency depreciation is toxic for them. Bottom Line: Relative RoE and RoA for non-financials point to continuous EM underperformance versus the U.S. Profitability And Equity Valuations Is it possible that EM corporate profitability is currently improving, and valuations are already discounting a lot of the negatives? Shouldn’t relative corporate profitability be compared with relative equity valuations between EM and the U.S.? For now, there are no signs that EM corporate profitability is improving. On the contrary, our best indicator for EM EPS in dollar terms points to continuous profit contraction until the end of this year (Chart I-3). As EM EPS shrinks, RoE and RoA will also decline. Stabilization and potential improvement in China’s growth could benefit EM corporate revenues and profits toward year-end. However, to date, China’s imports from EM and the rest of the world continue to contract. China’s credit and fiscal spending impulse leads its manufacturing PMI's import sub-component by nine months and predicts a bottoming around August (Chart I-4). Chart I-3EM EPS Is ##br##Contracting EM EPS Is Contracting EM EPS Is Contracting Chart I-4Chinese Imports Will Stabilize Around August Chinese Imports Will Stabilize Around August Chinese Imports Will Stabilize Around August Notably, the continued deterioration in EM top and bottom lines implies that EM ex-financials’ RoE and RoA will roll over at their 2008 lows -- reached at the nadir of the global recession (Chart I-5). Investors should elect the multiples they want to pay for companies that cannot deliver RoE and RoA above their 2008 lows. Chart I-5EM Corporate Profitability And Multiples EM Corporate Profitability And Multiples EM Corporate Profitability And Multiples Taking into consideration such historically low RoE and RoA, EM equity valuations do not appear cheap. The bottom panel of Chart I-5 illustrates that, stripping out the 10% of sub-sectors with the highest and lowest multiples, EM equity multiples are at their historical mean. As to U.S. corporate profits, the key risks are a strong dollar and a potential profit margin squeeze. Nevertheless, a rising dollar is an even bigger risk to EM equities than it is to U.S. equity prices. U.S. share prices always outperform EM equities in common currency terms when the greenback is appreciating. Bottom Line: After adjusting for corporate profitability, EM equity valuations are not attractive in absolute or relative terms. Return On Capital Drives Exchange Rates The U.S. dollar is attempting to break out, and odds are that it will succeed. This will again challenge EM risk assets, as the latter typically perform poorly when the greenback appreciates. The rationale for continuous U.S. dollar appreciation is the superior return on capital in the U.S. relative to the rest of the world. Currency markets are often driven by relative return on capital.1 Chart I-6 shows the average of U.S. non-financials’ RoE and RoA relative to the same measure for DM ex-U.S. Broadly, the long-term trends in the narrow trade-weighted dollar have tracked the relative corporate profitability ratios between non-financial companies in the U.S. and other DMs. Relative return on capital at the moment suggests an upleg in the greenback. Chart I-6Relative Return On Capital And U.S. Dollar Relative Return On Capital And U.S. Dollar Relative Return On Capital And U.S. Dollar The thesis that exchange rate gyrations are steered by the relative trajectory of return on capital is especially true in EM. As exhibited in Chart I-7, relative RoE and RoA between EM- and U.S.-listed non-financial companies foreshadows EM exchange rate movements reasonably well, and points to further EM currency depreciation. Chart I-7Relative Return On Capital And EM Currencies Relative Return On Capital And EM Currencies Relative Return On Capital And EM Currencies While interest rate differentials also correlate with exchange rates in DM, the former often reflect a relative return-on-capital differential. For example, when an economy performs well amid rising interest rates, it implies that its potential growth and potential return on capital are sufficiently high. Typically, the currency of that country will tend to appreciate. By contrast, when an economy struggles amid rising interest rates, it is a sign that its potential growth and potential return on capital are poor, and that the current level of interest rates is unsustainably high. In this scenario, the exchange rate will most likely depreciate despite rising interest rates. In a nutshell, return on capital is an important driver of exchange rates. Chart I-8Interest Rates Do Not Drive EM Currencies Interest Rates Do Not Drive EM Currencies Interest Rates Do Not Drive EM Currencies In developing countries, the interest rate differential with the U.S. cannot be used to forecast exchange rates. As can be seen from Chart I-8, high-yielding currencies such as the ZAR and BRL have often been negatively correlated with their respective interest rate spread over U.S. rates. Crucially, in the case of high-yielding EM currencies, exchange rate swings often steer interest rates. When these currencies depreciate, both their interest rates and their spread over U.S. rates rise. In contrast, appreciation of high-yielding EM currencies prompt interest rates in their respective economies to drop, and their spread with U.S. rates to narrow. Bottom Line: U.S. relative return on capital is ascending versus both EM and other DM, heralding further dollar appreciation. Investment Observations And Conclusions The snapshot of the above analysis is that the relative return on capital explains both relative share price performance and exchange rates. Chart I-9 demonstrates that EM relative equity performance tracks the trajectory of EM relative EPS versus the U.S. in both common and local currency terms. Chart I-9EM Versus U.S.: EPS And Stock Prices EM Versus U.S.: EPS And Stock Prices EM Versus U.S.: EPS And Stock Prices It is tempting to bet on a mean reversal in EM relative equity performance against the U.S. However, our indicators do not point to such a reversal in EM underperformance for now. In short, we continue to recommend underweighting EM stocks versus DM in general and versus the U.S. in particular. Finally, the U.S. dollar is poised to stage a meaningful rally. Last week, we showed that currency volatility has dropped to historic lows. Typically, this occurs before a major market move (Chart I-10). Our view has been one of dollar appreciation, and recent market actions vindicate this stance. In our Special Report on Korea published on February 28, we flagged a tapering wedge pattern in the KRW/USD exchange rate and recommended going long the KRW on a breakout, or short on a breakdown. The won seems to have broken down, so we now recommend shorting the KRW versus the U.S. dollar (Chart I-11). In the meantime, we are taking profits on our short KRW/long equal-weighted basket of the U.S. dollar and JPY trade. This trade has generated a 3.9% gain since its initiation on February 14, 2018. Chart I-10The Dollar Is On Verge Of Major Move The Dollar Is On Verge Of Major Move The Dollar Is On Verge Of Major Move Chart I-11The Korean Won Is Breaking Down The Korean Won Is Breaking Down The Korean Won Is Breaking Down ​​​​​​To play EM exchange rate depreciation, we continue to recommend shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   The Philippines: Dovish Central Bank Amid Rising Inflation = Currency Plunge Philippine stocks have outperformed the EM benchmark lately and have risen in absolute terms due to the sharp drop in U.S. rates (Chart II-1). Chart II-1Philippine Stocks Relative Performance Philippine Stocks Relative Performance Philippine Stocks Relative Performance Yet, investors have been ignoring the buildup in genuine inflationary pressures in the economy. Consequently, the latter will carry negative repercussions for Philippine financial markets. In particular, unit labor costs are on the cusp of rising precariously. For instance, the minimum wage in Metro Manila increased by 5% in 2019 – the highest largest hike in six years. Meanwhile, President Rodrigo Duterte issued an executive order raising salaries for government workers and military personnel. Worryingly, President Duterte is also attempting to pass a bill to abolish contractual labor. The latter is a very favorable form of hiring for employers. President Duterte made the successful passing of this bill a top priority and has been urging Congress to fast-track it. In the meantime, President Dueterte issued an executive order banning companies from hiring certain types of contract-based employment. This policy is already starting to take a toll on companies. For instance, Murata Manufacturing, a Japanese electronics parts maker, saw its labor costs surge by 20% in the Philippines as it was ordered to convert 400 of its contract employees to full-time workers. Higher labor costs will push up inflation and/or squeeze companies’ profit margins. Investors have been ignoring the buildup in genuine inflationary pressures in the economy. In the meantime, the Philippines’ fiscal policy remains extremely stimulative. Government expenditures are currently growing at an 18% rate annually. This is despite the fact that the fiscal deficit is widening sharply (Chart II-2, top panel). Chart II-2The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit The Philippines: A Large Twin Deficit Consequently, higher wages and fiscal spending will keep domestic demand robust, worsening the Philippines’ current account deficit (Chart II-2, bottom panel). The latter is a form of hidden inflation as it gauges the level of excess demand relative to the productive capacity of the economy. Crucially, given president Duterte’s reluctance to cut government spending, it will be up to monetary policy to solely contain inflation. Yet the independence of Philippine’s central bank – Bangko Sentral ng Pilipinas or BSP – is questionable: In March, president Duterete appointed his former budget secretary Benjamin Diokno as the new governor of the central bank. Therefore, the BSP will continue to err on the side of easy monetary policy and will further fall behind the curve. In particular, the BSP might justify staying on hold by the fact that headline and core inflation are now falling. However, that might prove to be a temporary development. Muted headline and core consumer inflation mainly reflect the crash in oil prices late last year. In particular, core inflation dipped because prices of items sensitive to oil prices – such as transportation costs and electricity – fell. The recent spike in oil prices will push inflation higher in the coming months. Crucially, the Philippines inflation problem is genuine in nature because it emanates from higher wages, rising unit labor costs and credit and fiscal stimulus-driven demand excesses. Genuine inflation coupled with a central bank that is behind the curve is a disastrous recipe for the currency. We recommend shorting the peso versus the U.S. dollar. A plunging Philippine peso will cause local bond yields to rise, hurting the stock market. While the central bank could choose to defend the currency by selling foreign exchange reserves, such policy will shrink the banking system liquidity – excess reserves at the BSP – which will result in higher interbank rates. On the whole, the BSP is facing the Impossible Trinity dilemma: given the nation has an open capital account, it cannot control both interest rates and the exchange rate simultaneously. Commercial banks and property stocks – which make up 15% and 29% of the Philippines MSCI market cap – will sell off hard as the currency depreciates and interest rates come under upward pressure. We continue to recommend shorting property stocks. The previous rise in interest rates is already hurting interest-rate sensitive sectors in the Philippines as credit growth is slowing sharply – albeit from a high level (Chart II-3). Commercial banks will in turn face rising NPLs and will be forced to raise provisions markedly. Both NPLs and provisions are currently too low in light of the relentless credit boom of the past several years. Finally, commercial banks have been lowering their provisions to boost their profits (Chart II-4, top panel). This means provisions will have to rise aggressively and bank earnings will contract severely. This will come on top of low net interest income margins (Chart II-4, bottom panel). Chart II-3Philippine Real Estate Stocks Are Ignoring Slowing Credit Growth Philippine Real Estate Stocks Are Ignoring Slowing Credit Growth Philippine Real Estate Stocks Are Ignoring Slowing Credit Growth Chart II-4Weak Profitability Ahead For Commercial Banks Weak Profitability Ahead For Commercial Banks Weak Profitability Ahead For Commercial Banks Bottom Line: We are initiating a new trade: short the PHP against the U.S. dollar. Equity investors should continue underweighting Philippine stocks relative to the EM benchmark, and within this bourse short property stocks. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Argentina: A Point Of No Return? The Argentine peso remains vulnerable due to deficient external funding and public debt sustainability concerns. A lack of external funding and a depreciating peso are causing rising inflation and interest rates. The latter are spurring a downfall in the economy diminishing incumbent President Mauricio Macri’s re-election chances. Chart III-1A Point Of No Return? A Point Of No Return? A Point Of No Return? Importantly, a depreciating peso, as well as high and rising external and domestic borrowing costs are making public debt unsustainable. All of these dynamics are feeding into plunging investor confidence creating a powerful negative feedback loop. Argentina may have reached a point of no return (Chart III-1). The odds that the authorities can stabilize financial markets are rapidly diminishing. Foreign currency-denominated public debt currently stands at $250 billion, and the country’s foreign debt service obligations for 2019 alone are $40 billion. We estimate the country will require an additional $10 billion of external funding this year (Table III-1). Chart III- Given worsening investor sentiment, both the public and private sectors will not be able to raise external funding. As icing on the proverbial cake, potential U.S. dollar appreciation and portfolio outflows out of EM will reinforce the turmoil in Argentine markets. Argentina may have reached a point of no return. The odds that the authorities can stabilize financial markets are rapidly diminishing. Hence, without the IMF’s authorization for the central bank to use a large share of its foreign currency reserves to defend the exchange rate, the peso will continue to fall. How much more downside could there be in Argentina’s financial markets and economy? When compared with the major financial crises, bank share prices could drop much more. For example, Argentine banks stocks plunged by 95% in U.S. dollar terms during the nation’s 2001-2002 crisis (Chart III-2, top panel). During the 1997-1998 Asian financial crisis, bank equities in Korea and Thailand on average dropped by 95% in dollar terms (Chart III-2, bottom panel). Chart III-2History Suggests More Downside In Argentine Equities History Suggests More Downside In Argentine Equities History Suggests More Downside In Argentine Equities Chart III- By comparison, since their peak in January 2018, Argentine banks are down 66% in dollar terms. Hence, more downside should not come as a surprise. As to currency depreciation, the peso’s real effective exchange rate has so far depreciated by 36% and remains undervalued by one standard deviation (Chart III-3). This compares with median and mean of 52% devaluations during previous crises in Argentina (Table III-2). Thus, more downside is likely in the currency in both real and nominal terms. The contraction in economic activity in this recession has so far been 6.5% (Table III-2). This is on par with median and mean contractions of 7% during previous crises but economic activity can undershoot this time. Chart III-3The Currency Can Get Cheaper The Currency Can Get Cheaper The Currency Can Get Cheaper Bottom Line: Investors should continue to avoid Argentine financial markets, as the downside could still be substantial. Do not catch a falling knife.   Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Footnotes 1 We herein use the term return on capital in a broader sense. Equity Recommendations Fixed-Income, Credit And Currency Recommendations