Brazil

Highlights Brazilian growth will recover modestly in 2017, but it will be insufficient to stabilize the public debt-to-GDP ratio. With interest rates still at double digits, public debt dynamics will become unsustainable as the ratio reaches or surpasses 85-90% of GDP over the next couple of years. The central bank has been financing the government by buying local currency bonds. Going forward, the path of least resistance, and most likely scenario, is direct or indirect public debt monetization by the central bank of Brazil. This will allow the nation to avoid fiscal stress/crisis but the price for it will be large exchange rate depreciation. In the end, investors will lose capital in Brazilian financial markets in U.S. dollar terms. Feature Brazil's financial markets have rallied sharply over the past 12 months, even as the economy has continued to disappoint. Growth has fallen short of even our downbeat expectations, yet the tremendous rally in its financial markets had sent our bearish strategy wide of the mark. In the past year, we have argued that even if the Brazilian economy recovers, it is likely headed towards a public debt trap because the recovery will be muted and the starting point of fiscal accounts/government debt is already quite poor. So, has Brazil achieved escape velocity - i.e., has growth gained enough momentum to thwart concerns about public debt sustainability? Escape Velocity Chart I-1Despite A Strengthening Global Economy, ##br##Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing It is tempting to conclude that the rally in Brazilian markets has been so powerful that the country has broken away from its five-year bear market, and hence that public debt sustainability is not an issue at all. In other words, financial markets seem confident that Brazil has achieved escape velocity. We do not think so. Notably, in recent months Brazil's economy has surprised to the downside, despite the ongoing improvement in global growth: Brazil's manufacturing PMI overall index has rolled over decisively, despite broad-based strength in the global business cycle (Chart I-1). More importantly, export prices in general, and iron ore and soybean prices in particular, have rallied a lot in the past year. Hence, the external sector has been a positive force for the economy, yet the latter has failed to revive. Having appreciated dramatically, the currency is no longer cheap. This is confirmed within Brazil's trade dynamics since export volumes are slipping relative to import volumes. As fiscal spending growth has until now been decent, the epicenter of the retrenchment has clearly been household consumption and business investment (Chart I-2 and Chart I-3). Chart I-2Brazilian Households Are ##br##Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Chart I-3...As Is The ##br##Business Sector ...As Is The Business Sector ...As Is The Business Sector Household debt-service costs remain elevated at 22% of disposable income (Chart I-4). This, and ongoing job losses, are keeping a lid on consumer spending. Manufacturing production is still collapsing, and capacity utilization is at a 20-year low (Chart I-3, bottom panel). This is not a sign of a competitive exchange rate or vibrant manufacturing sector. Due to the economic contraction, Brazil's primary and overall fiscal deficits have reached 2.5% and 8.9% of GDP (Chart I-5), respectively, despite the authorities' attempts to secure considerable one-off revenues. Chart I-4Brazil: Elevated Household Indebtedness ##br##Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Chart I-5Brazil's Fiscal Accounts Brazil's Fiscal Accounts Brazil's Fiscal Accounts Remarkably, the level of Brazil's real GDP has already contracted by 7.6% from its peak in 2014, producing the worst depression in more than 116 years (Chart I-6). Bottom Line: Not only has Brazil failed to achieve escape velocity, but also its growth dynamics have underwhelmed even the most pessimistic of forecasts. As a result, public debt dynamics have become unsustainable. Fiscal And Credit Impulses In 2017 Going forward the outlook for Brazil's economy will hinge on credit and fiscal impulses: If government spending rises by 6.3% in 2017, which is equivalent to the 2016 IPCA inflation rate as mandated by the fiscal spending cap (known as PEC 55), the federal fiscal spending impulse in 2017 will be 79 billion BRL, or 1.23% of GDP (calculated using our 2017 nominal GDP estimate) (Chart I-7, top panel). Chart I-6Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Chart I-7Fiscal And Credit Impulses Fiscal And Credit Impulses Fiscal And Credit Impulses The impact of fiscal policy on growth is defined by government spending and taxes. Odds are that taxes need to be hiked to achieve the 2017 budget targets. Unless growth recovers strongly, doubtful in our view, there are non-trivial odds of impending tax hikes. The latter will counteract the positive fiscal impulse from government expenditures. The credit impulse is calculated as an annual change in credit growth, or the second derivative of the outstanding stock of credit. If we assume private and public banks' credit growth will be 0% and -5%, respectively, in 2017 overall loan growth will contract by 2.5%, and the credit impulse will be 0.54% of GDP (Chart I-7, middle panel). Even though interest rates are declining, real (inflation-adjusted) rates remain high at 5.4%, and banks' balance sheets are impaired by mushrooming NPLs following the credit boom years. This will preclude a revival in loan growth in the banking system. Aggregating the fiscal spending and credit impulses together, there will be about a 2% boost to nominal GDP growth in 2017 (Chart I-7, bottom panel). However, as it is likely that taxes will rise, the overall combined effect on the economy will be less than that. Bottom Line: Odds are that the aggregate fiscal and credit impulse will be only mildly positive in 2017 - assuming no tax hikes. This portends only moderate nominal GDP growth in 2017. Government Debt Simulation Revisited The Brazilian economy will probably recover and our baseline view assumes real GDP growth will be modestly positive for 2017. However, the recovery will not be vigorous enough to halt the exponential rise in the public debt-to-GDP ratio. Table I-1 presents a scenario analysis for Brazil's public debt. Table I-1Brazil: Public Debt Sustainability Scenarios 2016-2019 Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? We considered three scenarios: base case, optimistic and pessimistic. For each scenario, we have made assumptions for nominal GDP growth, nominal government revenue growth, nominal government expenditure growth (based on the fiscal spending cap), and on the average (or blended) interest rate on all local currency public debt. Chart I-8Brazil's Is Headed Towards ##br##A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis In our base case scenario, the public debt-to-GDP ratio reaches 84% in 2018 and 91% in 2019 (Chart I-8). With double-digit interest rates, the 91% public debt load spirals out of control. In short, even in our base case scenario, which assumes a return to modest growth in 2017 and a decent recovery in economic activity in 2018 and 2019, Brazil is unlikely to avoid a debt trap. For the base case, we use the following assumptions For nominal GDP growth in 2017 we use the most recent Brazilian Central Bank Survey year-end forecast of real GDP growth of 0.5% plus our estimate of 5% inflation to arrive at 5.5%. In 2018, we assume real GDP growth of 2.5% plus 4.5% inflation to arrive at 7%. And in 2019 we also assume growth of 7%. For nominal government revenue growth, we use 5% in 2017 and 8% for both 2018 and 2019, as we assume government revenue reasonably tracks nominal GDP growth. A caveat: the actual 2016 federal government revenue growth number of 4.3% was heavily boosted by non-recurring revenues such as privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL, tax amnesty/repatriation programs, and so on. In brief, the government used all means at its disposal to boost its revenue via one-off items. As these are non-recurring and impossible to predict, we did not attempt to account for them. Yet, in future, these non-recurring sources of fiscal revenue will be harder to come by. To be consistent, we do not incorporate one-off expenditures, such as financial support for local governments, or recapitalization of public banks and state-owned companies. In a nutshell, we assume potential one-off public sector revenues will offset one-off expenditures. With the dire state of the economy, and likely need for bailouts and financial assistance from the federal government, this is a reasonable assumption. Besides, with most states and local governments near bankruptcy, staving off insolvency remains a much more urgent matter that will likely drain central government coffers in the near term. As to nominal government expenditures, since these are capped by the previous year's inflation rate due to the fiscal spending cap (or PEC 55), we use 6.3% growth in 2017 (i.e. 2016 IPCA inflation), and 5% in both 2018 and 2019, respectively. Investors, however, should keep in mind that the spending cap only applies to primary expenditures. Critically, it does not include interest on public debt, spending on education and health in 2017, and nonrecurring expenditures. If anything, federal government spending will likely exceed the 2017 cap as the government may spend more on healthcare and education to offset overall fiscal austerity. Table I-2Composition Of Brazilian Federal Debt Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? For the average, or blended, interest rate on public debt, we used calculations by Dr. Jose Carlos Faria, Chief Brazil Economist at Deutsche Bank.1 We use Dr. Faria's assumptions for local currency average interest rate on public debt in 2017, 2018 and 2019, for our pessimistic scenario. The impact of lower policy interest rates (i.e. the central bank's SELIC rate) on the public debt service is a drawn out process because not all debt is rolled/re-priced over every year. Table I-2 illustrates the breakdown of Brazil's public debt by type. Therefore, the impact of declining interest rates on public debt dynamics will be slow. Bottom Line: With interest rates still in the double digits, Brazil's public debt dynamics will become unsustainable if the ratio reaches or surpasses 85-90% of GDP. The odds are substantial that this limit will be breached in the next few years. The best cure for debt sustainability is growth. So far, however, Brazil has failed to achieve growth strong enough to stabilize its public debt trajectory. A Word On Social Security Reform It is widely accepted that pension (social security) reform is desperately needed to help keep Brazil's public debt on a sustainable path. It does appear that reforms will be passed this year, as they have good momentum in Congress. That said, it will take many years for the positives of pension reforms to kick in and help the fiscal accounts, and in turn improve Brazil's public debt profile. According to the IMF,2 it will take roughly until 2020-2025 to see any decrease in social security expenses as a percentage of GDP, even if the reforms involve an increase in the retirement age, a benefits freeze, and a removal or change of the indexation of pensions to the minimum wage (and/or a change to the minimum wage formula). Bottom Line: The benefits of social security reform will only come into effect after 2020-30 or so, if passed in full. Therefore, they will not prevent Brazil's public debt-to-GDP ratio from surpassing the 85-90% mark in 2019. A Way Out: Debt Monetization? Chart I-9Brazil's Central Bank Has Been ##br##Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Being strangled by economic contraction, high debt/fiscal deficits, and a lack of political capital to embark on painful fiscal austerity, the path of least resistance for any country in general and Brazil in particular is debt monetization. That would lead to a considerable exchange rate depreciation. There are already hints that the central bank has been funding the government since 2014. In particular: The Brazilian central bank's domestic currency assets have expanded dramatically - by 640 BRL billion, or 10% of GDP - since January 2015 (Chart I-9). Most of this balance sheet expansion - 460 BRL billion or 7% GDP has been due to the rise in the central bank's holdings of federal government securities (Chart I-10). On the liability side of the central bank's balance sheet, a considerable rise has occurred in Banco Central do Brasil repos with commercial banks and deposits received from financial institutions. The amount of outstanding repos and these deposits has risen by 220 BRL billion since January 2015 (Chart I-11). Chart I-10The Central Bank Has Been ##br##Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... Chart I-11....But Withdrawing Liquidity Via ##br##Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received Essentially, the central bank has purchased 460 BRL billion of government securities since January 2015 and, hence, injected a lot of liquidity into the banking system. Then, Banco Central do Brasil simultaneously withdrew liquidity via repo agreements and deposits received from financial institutions. This has basically sterilized half of the central bank's government bond purchases, i.e. the operation withdrew half of the liquidity expansion that was first made. Without the central bank intervention to buy 460 BRL billion of government securities in the past two years, the 626 BRL billion and 557 BRL billion overall fiscal deficits in 2015 and 2016, respectively, would not have been financed and local bond yields would have risen. Chart I-12The BRL Is Expensive Again The BRL Is Expensive Again The BRL Is Expensive Again Looking ahead, as the fiscal accounts continue bleeding, public debt burden will rise to around 85% of GDP and the banking system - wounded by non-performing loans - will struggle to expand its balance sheet further. In turn, the central bank might be tempted to continue monetizing the government's debt without, however, sterilizing its operations. In such a scenario, the currency will depreciate meaningfully. Markedly, Brazil's real effective exchange rate has risen above its historical mean and is somewhat expensive (Chart I-12). Brazil needs lower interest rates, more abundant banking system liquidity and a cheaper currency to embark on a sustainable recovery. The latter is required to avoid the fiscal debt trap. The exchange rate depreciation is an important relieve valve. Given that only 4% of government debt is denominated in foreign currency, a deprecation of the Brazilian real is the least painful solution. Bottom Line: Going forward, the only way for Brazil to stabilize the public debt-to-GDP ratio is to boost nominal GDP growth. This can be achieved by reducing interest rates aggressively, injecting large amounts of liquidity into the wounded banking system and devaluing the currency. Unless financial markets in Brazil sell off, there is a non-trivial probability that the authorities will embark on outright or covered public debt monetization. This would allow the country to avoid fiscal stress/crisis. Yet, the price will be large exchange rate depreciation. Chart I-13Stay Underweight Brazil ##br##Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Investment Implications We have been wrong on Brazilian markets in the past 12 months, but we do not see a reason to alter our view. The currency will plunge due to the ongoing debt monetization, and foreigners will not make money in Brazilian financial markets in U.S. dollar terms. We reiterate our short positions in the BRL versus the U.S. dollar, ARS and MXN. Stay long CDS and underweight Brazilian credit within EM sovereign and corporate credit portfolios. Continue underweighting this bourse within an EM equity portfolio (Chart I-13). Interest rate cuts will continue, but with the BRL set to depreciate considerably versus the U.S. dollar in the next 12 months - as we expect - buying local bonds for the U.S. dollar based investors is not the best strategy. Santiago E. Gomez, Associate Vice President santiago@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These figures come from the appendix on page 9 of the Deutsche Bank report titled, "Brazil at a Debt Crossroad - Again", dated January 23, 2017. 2 Please refer to the following IMF report on Brazil, available at http://www.imf.org/external/pubs/ft/scr/2016/cr16349.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed bca.ems_wr_2016_12_21_s1_c3 bca.ems_wr_2016_12_21_s1_c3 Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices bca.ems_wr_2016_12_21_s1_c4a bca.ems_wr_2016_12_21_s1_c4a Chart I-4BGold Led Oil Prices Gold Led Oil Prices Gold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6a bca.ems_wr_2016_12_21_s1_c6a Chart I-6BGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6b bca.ems_wr_2016_12_21_s1_c6b In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies bca.ems_wr_2016_12_21_s1_c7 bca.ems_wr_2016_12_21_s1_c7 The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement bca.ems_wr_2016_12_21_s1_c9 bca.ems_wr_2016_12_21_s1_c9 The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Brazil's Economy: No Improvement At All Brazil's Economy: No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Rand, AUD And Precious Metals Rand, AUD And Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Very Weak Employment Outlook Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Indian PMIs Are Sinking Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Indian Capex Is Anemic Indian Capex Is Anemic Chart II-4Banks Prefer Consumers bca.ems_wr_2016_12_21_s2_c4 bca.ems_wr_2016_12_21_s2_c4 We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

The U.S. dollar's corrective/consolidation phase is over, and it is about to rally. The risk-reward for EM stocks and currencies is extremely unattractive. We are reiterating our recommendation to short a basket of ZAR, BRL, TRY, MYR, IDR and CLP versus the U.S. dollar. There is a value opportunity in the Mexican peso. Go long MXN versus ZAR. Also, double down on the long MXN / short BRL trade.

India's agricultural output per capita has not increased at all. Thus, food and headline inflation will remain structurally high, which will negatively impact savings and investment dynamics in the years ahead. With respect to cyclical growth, household spending is very strong, but investment expenditures are stagnant. Fixed-income traders should bet on yield curve steepening in India. A section <i>Brazil's Business Cycle Illustrated</i> highlights the cyclical profile of this economy.

In a February <i>Special Report</i> titled "Assessing Fair Value In FX Markets" we introduced a set of long-term valuation models based on various fundamentals. We have updated the results and added KRW, INR, PHP, HKD, CLP and COP to our analysis. The dollar still remains expensive, albeit with no signs of a dangerous overvaluation. The yuan is now at its cheapest level since 2009.

The median voter moving to the left has spurred paradigm shifts. These new regimes are giving way to transformational leaders who seek change by breaking convention. As they test their constraints and pursue their preferences, a cautious stance towards risk assets is warranted. In this Monthly Report, BCA's Geopolitical Strategy discusses Trump's recent comeback, rising EM political risk, and Italy's upcoming constitutional referendum.

Conditions are falling into place for inflation to plunge and monetary easing to progress rapidly. This in combination with structural reforms creates a bullish backdrop for Argentine financial markets. The current economic, structural and political configurations look more promising for Argentina than Brazil. Go long Argentina/ short Brazilian sovereign credit, overweight the Argentine bourse versus the Frontier Markets benchmark and, go long the Argentine Peso versus the Brazilian <i>real</i>.

Brazilian risk assets have rallied on the back of investor optimism about the impeachment of President Dilma Rousseff. But the political games have just begun. With all politicians looking to the October municipal elections and 2018 general elections, the Michel Temer administration is unlikely to impose fiscal and structural reforms. Debt dynamics are set to worsen, and we continue to short Brazilian equities.

The current risk premium embedded into Brazilian financial markets is too low and will widen as investors come to realize Brazil's unsustainable public debt dynamics. The government is planning a major shift in its fiscal policy framework that will ease pressure to cut budget expenditures, but is bearish for the nation's public debt trajectory. Although the economy could stabilize going forward, financial markets are already discounting a lot of good news. Stay put.