China
Highlights The strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. China's PPI inflation will continue to drift lower. Disinflation in PPI is less positive for the economy, but is not outright negative, unless PPI deflates. Odds are low that PPI will deflate anytime soon. Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. Feature China's GDP figures to be released next week will likely show that the economy continued to accelerate in the second quarter, as indicated by recent high-frequency macro indicators (Chart 1). Looking forward, the near-term outlook remains promising, but the strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months, which could lead to softer growth down the road. However, the Chinese economy has regained some self-sustaining momentum, which will allow it to glide at cruising speed without major growth difficulties. For investors, H-shares and onshore corporate bonds should continue to advance, aided by the profit cycle upturn and a largely accommodative policy setting over the next six to nine months. Chart 1Chinese GDP Likely Accelerated In Q2 Chart 2Exports And Monetary Conditions ##br##Drive Chinese Industrial Activity Tailwinds Are Waning... China's seemingly static GDP growth figures disguise much greater volatility in the underlying economy, especially in the industrial sector. The famed Keqiang index, named after China's incumbent premier which incorporates electricity consumption, railway transportation and bank lending, has shown dramatic swings in the past two decades (Chart 2). The index has roared back from rock bottom in late 2015 to currently a one sigma overshoot above its long-term trend, underscoring a sharp recovery in industrial activity. Some have attributed this to a massive dose of fiscal and monetary stimuli - we disagree. In our view, the swings in China's industrial sector performance can be fully explained by the performance of exporters and the country's Monetary Conditions Index (MCI). Our "Reflation Indicator," a combination of export growth and MCI, shows a very tight correlation with the Keqiang Index in the past several cycles. In other words, the rapid recovery in industrial activity since early 2016 was boosted by tailwinds from both accelerating export growth and easing monetary conditions. Currently, the tailwinds are likely passing maximum strength and will wane on both fronts going forward: Global demand appears to be in a synchronized upturn, which bodes well for Chinese exports. The manufacturing PMI new export orders component has been in expansionary territory for eight consecutive months and made a new recovery high in June, pointing to upside surprises in export growth in the near term. Looking further out, our model predicts export growth will likely peak out before the end of the year (Chart 3). After all, it is unrealistic to expect Chinese exports to always grow at double-digit rates - particularly with global trade having downshifted structurally post-global financial crisis. On monetary conditions, the depreciation of the trade-weighted RMB, a major reflationary force for the Chinese economy since late 2015, has stalled in recent weeks. Broad dollar weakness of late has failed to further push down the trade-weighted RMB - either because of the People's Bank of China's intervention, or because bearish bets on the RMB by investors are now off the table (Chart 4). Regardless, a stable RMB exchange rate decreases investors' anxiety on China's macro situation, but also reduces a reflationary source for the overall economy. Overall, recent changes in China's macro environment suggest growth tailwinds are diminishing, but have not yet become headwinds. This on margin is bad news for the economy, but should not lead to a significant growth slowdown. Chart 3Exports: Upside Is Limited Chart 4The RMB Is No Longer Falling ...But Growth Drivers Remain Largely In Place We expect Chinese business activity to remain reasonably buoyant going into the second half of the year. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks to the economy will stay low. Some major growth drivers in the economy remain largely in place. Looking at the consumer sector, the growth recovery and labor market improvement have significantly lifted consumer confidence, which historically is positive for retail sales (Chart 5). Chinese households are under-levered and over-saved, and improving confidence should on margin reduce savings and further boost consumption. Retail sales have already bottomed out and will likely accelerate. The corporate sector's inventory restocking cycle is likely still at an early stage, as the inventory component of the manufacturing Purchasing Managers' Index (PMI) surveys has never moved above 50 since 2012, underscoring increasingly lean stock of finished goods. Industrial firms' inventory levels relative to sales are still standing at close to record low levels (Chart 6). Going forward, inventory re-stocking may supercharge production, should new orders remain elevated. At a minimum, very lean inventory levels limit the downside in industrial production - even if the improvement in new orders stalls. Chart 5Consumer Spending Should Remain Strong Chart 6Inventory Restocking Has Further To Go Furthermore, China's capital spending cycle has likely bottomed out, especially among private enterprises and in the resource sectors. The corporate profit cycle recovery has continued to unfold, and business confidence has improved sharply - both of which are conducive for private sector expansion (Chart 7). There has been dramatic improvement in resource sector profits, which at a minimum will put a floor under the relentless contraction in capex these industries have experienced in recent years. Overall, it is premature to expect a major boom, but the case for a modest upturn in private capital spending continues to strengthen. Finally, the risk of a significant housing growth slowdown due to the government's tightening measures, a major concern among investors earlier this year, has abated. Home sales have cooled off due to local government restrictive policies, but developers' inventories have declined substantially following booming sales in previous years. Therefore, housing starts have continued to improve, which should lift real estate investment going forward (Chart 8). Anecdotal evidence suggests land purchases by developers have been buoyant. Meanwhile, developers' stocks have been outperforming the benchmark, which historically has led housing transactions. All of this means a sharp reduction in real estate investment is highly unlikely, at least from a cyclical point of view. Chart 7Private Sector Capex ##br##Will Likely Accelerate Chart 8Real Estate: Near Term Outlook Improving ##br##The Chain Reactions In Housing In short, we see limited downside risks in the Chinese economy in the near term. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. Will PPI Deflate Again? Chinese producer prices have quickly rolled over in the past several months, falling from a peak of 7.8% in February to 5.5% in June. Rising PPI last year was regarded as a key signpost of China's reflationary trend; in this vein, the latest deterioration in PPI indeed raises a red flag. Our model predicts that PPI inflation will likely drift even lower, reaching 3% before year end (Chart 9). We rely on our models to understand the trend rather than to make number forecasts. It now appears a sure bet that Chinese PPI will continue to surprise to the downside in the coming months. How investors will react to likely increasingly disappointing PPI numbers remains to be seen. Our sense is that disinflation in PPI is less positive, but is not outright negative, unless PPI deflates. For now, we see low odds that PPI will deflate anytime soon. Chart 9PPI Will Continue To Moderate Chart 10Industrial Goods Prices Are Fairly Robust A key reason for the rapid decline in PPI inflation is an increasingly unfavorable "base effect," where the year-over-year growth rate naturally tapers off after a period of rapid acceleration. In terms of levels, overall PPI should remain largely stable, according to our model. The recent softness in Chinese PPI largely reflects weakness in crude oil prices, while prices of most basic industrials prices have been fairly robust, including some products that are widely perceived as suffering chronic overcapacity (Chart 10). This suggests the weakness in PPI is fairly concentrated, and likely reflects the unique supply demand dynamics of the oil market, rather than a demand slowdown in the broader economy. More importantly, China's PPI deflation that lasted between February and June was to a large extent due to policy tightening by the Chinese authorities, which, together with weak global demand amplified strong deflationary pressures in the Chinese economy. This time around, the PBoC is highly unlikely to repeat the policy mistakes of draconian credit and monetary tightening. Even if the central bank intends to tighten policy, it will be a lot more cautious and data-dependent. We will follow up on this issue in the coming weeks. The bottom line is that falling PPI inflation should be closely monitored. For now, we expect continued disinflation rather than outright PPI deflation. Profits And Markets Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. For stocks, net earnings revisions of Chinese companies have been rising, confirming the profit cycle upturn (Chart 11). Even if profit growth rolls over along with other macro numbers, a profit contraction is unlikely. Meanwhile, Chinese stocks are among the cheapest of the major bourses (Chart 12), particularly H shares. Overall, Chinese stocks should continue to do well from a cyclical perspective, and will outperform global and EM peers. For bonds, we went long onshore corporate bonds after the sharp selloff earlier this year - namely because the selloff was entirely triggered by the authorities' liquidity tightening rather than corporate fundamentals. The upturn in the profit cycle should also improve the corporate sector's balance sheet, which should be good news for corporate bonds. This trade has been profitable so far, but we expect further narrowing in corporate bond spreads, as they are still elevated both compared with their global counterparts and their historical norms (Chart 13). Investors should hold. Chart 11Earnings Outlook ##br##Will Continue To Improve Chart 12Chinese Stocks Multiples ##br##Are Among The Lowest Globally Chart 13Chinese Corporate Bond Spreads Set ##br##To Narrow Further Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The G20 summit highlighted our theme of multipolarity, which encourages global instability; U.S.-China tensions have resumed their escalation after a brief pause; The Middle East is still a "red herring" for investors this year, but tail risks are rising; Any negative impact on oil production from these risks should be minor; Iran stands to benefit; Egypt is a buy on the back of cyclical recovery and Saudi support. Feature For the first time in the history of G20 summits, the "sherpas" (emissaries) who prepared the event failed to reach any notable policy agreements. Allegedly, the only policy that the U.S. administration endorsed prior to the summit was women's entrepreneurialism, Ivanka Trump's pet project. Why should investors care? G20 meetings have always been abstract, retroactive (as opposed to proactive), and barely able to move the markets. But they have occasionally mattered. The summits in Washington D.C. (November 2008) and London (April 2009) set the agenda for economic stimulus and global financial regulatory reform that brought the world back from the brink of abyss. The London summit, in particular, set the stage for coordinated, global, fiscal policy that reflated the economy. At the September 2009 Pittsburgh summit, the G20 replaced the Western-dominated G8 as the premier economic governance platform. (The latter is now the G7 because of Russia's exclusion after annexing Crimea.) The idea behind the expanded forum was to give emerging markets like China, India, and Brazil a say in the global economic architecture. It was the forum's expansion that ultimately doomed its effectiveness. To our knowledge, no multilateral framework has ever successfully coordinated global affairs. Global stability has always been underpinned by hegemony, which is why we have warned our readers since 2011 that emerging global multipolarity - caused by America's relative geopolitical decline - would lead to instability.1 The press will inevitably blame President Trump's "America First" for the failures of the G20. We do not disagree, but there is more to it than just politics. "America First" is a natural political reaction to the reality of American geopolitical decline. It is also a reaction to nearly two decades of foreign policy decisions to commit massive amounts of U.S. hard and soft power to pursuing nation-building policies in the Middle East. As such, "America First" is a symptom, not the cause, of global multipolarity. The "Trump Doctrine" could indeed be highly destabilizing, if followed through to its logical conclusion.2 Ostensibly, President Trump seeks to renegotiate global security and economic arrangements that have taken advantage of American magnanimity. But it was America that initially designed these arrangements, at the height of its power in the immediate aftermath of the Second World War, to secure its own interests. Institutions like NATO, the IMF, and the World Bank underpin, they do not undermine, American hegemony. Without these institutions, American allies will seek their own negotiated arrangements more freely and frequently with U.S. adversaries, slowly eroding Washington's global influence. Over the long term, the Trump Doctrine could also undermine the U.S. dollar's status as the global reserve currency. The dollar's reserve currency status is a privilege that monetizes American geopolitical hegemony. America's allies are essentially already paying for American hegemony: through their investments in U.S. dollar assets.3 Chart 1 illustrates this so-called "exorbitant privilege."4 Foreigners hold U.S. assets because of the size of the economy, the sustainability of the market, and its deep liquidity, but also because the U.S. provides them with assurances of peace through security. If Washington raises barriers to its markets and becomes a doubtful provider of security, states may gradually see less of a payoff in holding U.S. assets and thus diversify more rapidly. They could also be forced to diversify by new security guarantors, regional hegemons, and geopolitical bullies. Chart 1Exorbitant Privilege The concept of exorbitant privilege - and its economic benefits - cannot easily be explained to voters. What voters understand is that China's rapid industrialization has been accomplished at the cost of American manufacturing jobs. Candidate Trump successfully tapped into this angst during the campaign. President Trump, however, initially shied away from seriously applying the "America First" doctrine. The April Trump-Xi summit at Mar-a-Lago was hailed as evidence that fears of global protectionism were overblown and that the "globalist" camp of advisers in the White House were prevailing over the nationalists. As we expected, however, the détente did not last long. Over the past several weeks, China and the U.S. have clashed over several key issues: Taiwan: On June 29, the U.S. announced that it will sell $1.42 billion worth of arms to the island nation.5 Secondary sanctions: At the end of June, the Trump administration sanctioned a Chinese shipping company, bank, and two citizens for their ties to North Korea. Human rights: Also at the end of June, the U.S. State Department announced it would list China among the worst human trafficking offenders, which could trigger punitive actions and complicate trade negotiations in the future. Steel tariffs: President Trump asked the Department of Commerce back in April to study whether steel imports were harming national security, under the authority of the Trade Expansion Act of 1962, and a potential decision by Trump on tariffs is due within days. While China only accounts for 2% of U.S. steel imports, new tariffs could set in motion more protectionist measures that target additional industries. Sovereignty claims: The U.S. Navy and Air Force have made sojourns into disputed maritime areas. The navy conducted a "freedom of navigation" operation in the South China Sea in July, with USS Stethem steaming within 12 nautical miles of Triton Island. The air force also conducted separate missions sending B-1 bombers over the South China Sea, and over the Korean peninsula and East China Sea along with Japanese and South Korean F-15 fighter jets. This flurry of brinkmanship has largely emanated from Washington, not Beijing. As Trump's domestic political agenda stalled - with both health care and tax reform now in doubt - the administration has set its sights on the policy realm where the U.S. president has few constraints: foreign and trade policy. That is not to say that Beijing has not invited these actions. It has continued to militarize its artificial islands in the South China Sea and has failed to impose meaningful sanctions on North Korea. The Trump administration is clearly disappointed that its Mar-a-Lago summit failed to produce any tangible effect on these fronts, particularly with North Korea having launched a purported intercontinental ballistic missile for the first time. It is the Trump administration itself, however, that is to be blamed for China's lack of enthusiasm. One of the first acts of the Trump administration was to bring into question Washington's "One China" policy. As we remarked at the time, this would have serious implications for Sino-American policies. Defending sovereignty is a core pillar of the Chinese Communist Party; it is part of its "creation myth," and this is nowhere truer than in regard to Taiwan. When Trump brought into question the "One China" principle, he signaled to Beijing policymakers that Washington is not to be trusted. North Korea is both formally and in practical terms a Chinese ally. Though the Xi administration evidently wishes that the North was not providing the U.S. with excuses to enhance the American position on the Korean Peninsula, nevertheless it is longstanding Chinese policy to avoid destabilizing the North Korean regime. A collapse, possibly followed by a unified Korean Peninsula, could benefit the U.S. in the region. In other words, China will pressure the North enough to encourage a new round of talks but not enough to risk fracturing the regime. Chart 2Mar-A-Lago Summit Is Over What investors are seeing today is the impact of words - "signaling" to be technical - in geopolitics. To be fair to President Trump, he has not pursued a revolutionary foreign policy yet. However, his mere words - literally dithering on NATO's Article V and calling into question the "One China" policy - have pushed other global powers into realignment. The rest of the world takes Trump very seriously because he may one day act on his unorthodox policies, or because American voters may elect someone in the future who will. The likely result is further erosion of U.S. global influence. Notably, the U.S. president stood alone on several crucial global issues at the G20 summit in Germany, making it look more like a "G19" summit. American isolation makes sense from Trump's short-term, domestic-political vantage. In the long term, however, it accelerates the drift toward geopolitical multipolarity and thus encourages global instability. Over the near term, we are particularly concerned that Sino-American tensions could escalate and spill over into a trade war. Since Donald Trump's election, and particularly since the Mar-a-Lago summit, the market has largely priced out economic tensions between the two superpowers, with China-exposed S&P 500 equities outperforming the market (Chart 2). We would bet against the continuation of this trend. Lack of cooperation over North Korea is a sign that the Sino-American relationship is systematically broken. Middle East Update: Watch Power Vacuums In Iraq And Syria At the beginning of this year, we made a forecast that geopolitics in the Middle East would not be investment relevant.6 So far we are correct. However, we continue to worry that vacuums in Iraq and Syria - in the Sunni-dominated territories formerly occupied by the now-collapsing Islamic State - could become greater sources of instability in the region. We are particularly concerned about three potential flash points: North Iraq, North Syria, and East Syria. East Syria In East Syria, the Syrian Arab Army (SAA) loyal to President Bashar al-Assad - as well as its Lebanese Shia ally Hezbollah - has aggressively moved to establish control over the Syrian-Iraqi border. As indicated on Map 1, SAA forces have created a land-bridge through Islamic State territory to Tayyara on the Iraqi border. This has put SAA troops in close proximity to "Free Syrian Army" (FSA) forces operating in the southeast of the country. Map 1Syria's Army Has Created A Land-Bridge To Iraq The FSA was created by the U.S. and its allies. Its forces are trained by the U.S., and the U.S. Air Force provides cover for its territory. The recent downing of Syrian fighter jets and Iranian drones have occurred near the U.S. FSA base, which is based in the proximity of the FSA stronghold at Al Tanf. Without committing land troops, however, the best the U.S. can hope for is to limit SAA incursions into FSA-held territory. The push by SAA and Hezbollah to the Iraqi border creates an all-important land-bridge from Iran to the Mediterranean. It allows Tehran to reinforce Assad's SAA and Hezbollah by land, rather than relying on sea routes - which can be intercepted by the U.S. and Israel's superior naval capabilities in the Mediterranean - or through air. Not only will Iran and Shia-dominated Iraq be able to supply Assad with weapons, but also with troops. After a five-year war of attrition, the main resource that has been depleted on all sides is manpower. A significant influx of "fresh blood" means that the power balance will shift more easily in favor of Assad. Following the collapse of the Islamic State in Mosul, Iraq will be able to deploy significant resources from its Shia militias to Syria. This could be the game changer that ends the conflict in Syria in Assad's favor over the next 12 months. The SAA penetration to Tayyara has now set up the next target: Al Bukamal to the north and also on the Iraqi border. From there, the SAA will be able to round back deep into Islamic State territory and capture Deir ez-Zor. This will give Assad control over most of Syria's border with Iraq as well as the country's highway infrastructure. It will also pin the U.S.-backed FSA to a largely irrelevant corner of Syria. The success of Iranian and Russian-backed SAA in Eastern Syria is very important for the geopolitics of the region. By creating a land-bridge between Iran and the Mediterranean, Syrian forces have now opened up the possibility of one day hosting massive natural gas and oil pipeline infrastructure that would link natural gas from the Persian Gulf, developed jointly by Qatar and Iran, and oil from Iran and Iraq to European markets (Map 2). Map 2The Path Is Opening For Iranian Pipelines Through Syria Such an alternative route to Iranian energy exports would give Tehran an upper hand over Saudi Arabia and its GCC allies. In a hypothetical conflict scenario between Iran and Saudi Arabia, for example, Tehran would be more willing to try to close shipping in the Straits of Hormuz if it possessed an alternative route for energy exports. This is clear to Saudi Arabia, which is why it has lashed out against Qatar in recent weeks. The main Saudi demand of Qatar is that it abandon its pro-Iranian foreign policy. It is becoming clear to Saudi Arabia that Iran's power is set to grow in the wake of the Islamic State's defeat in Iraq and Syria. As such, Saudi Arabia is trying to tie loose ends in its own coalition, starting with Qatar. Despite the reported Trump-Putin ceasefire agreed at the G19, U.S. and Russian forces could still become entangled as their proxies battle in the strategic regions near the Syrian-Iraqi border. SAA troops have also begun to operate near Raqqa, where the Kurdish forces supported by the U.S. are currently encircling the Islamic State capital. Final stages of wars tend to be erratic and even more violent. As belligerents glimpse the end of conflict they rush to seize as much territory as possible before negotiations begin. This is effectively what is happening in East Syria and around Raqqa today. Northern Syria In the Kurdish dominated northern Syria, the People's Protection Units (YPG) have massively increased the territory under their control. Supported by the U.S., YPG have encircled Raqqa and will soon defeat the Islamic State in the North. Assad's SAA will concede Raqqa in order to move onto the more strategic Resafa and Deir ez-Zor, effectively abandoning northern Syria to the Kurds to focus on establishing the land-bridge with Iraq. Turkey, however, is not interested in conceding northern Syria to YPG. The latter are allied to the Kurdistan Workers' Party (PKK) that Ankara considers a terrorist organization. With SAA focused on controlling population centers and the Syrian-Iraqi border, northern Syria will descend further into Kurdish domination. This would give PKK militants a large territory from which to regroup and resupply operations in Turkey. It is therefore a real possibility that Turkey will invade YPG-controlled northern Syria as soon as the operations against the Islamic State end. This will put the U.S. into a difficult position. On one hand, Turkey is a NATO ally. On the other, the Kurds are informal U.S. allies. The YPG have fought valiantly against the Islamic State and are perhaps the group most deserving of thanks for the defeat of its so-called Caliphate. Northern Iraq In northern Iraq, a similar dynamic has emerged where the Kurds have benefited the most from the rise of the Islamic State (Map 3). Operations in Mosul will soon end the Islamic State's dominion over parts of Iraq, which will allow Iraqi forces to focus on two tasks. First, resupplying Assad's SAA with weapons and troops. Second, turning to Kurdish gains in the north, particularly in the city of Kirkuk. Map 3Kurdish Gains Threaten Conflicts With Iraqi Government ... And Turkey Iraqi Kurds, for their part, have called an independence referendum for September 25, 2017. President Masoud Barzani will not necessarily proclaim an independent Kurdistan following the referendum. The exercise could be a bid to negotiate more autonomy with Baghdad or a pre-election ploy to secure a majority in upcoming general elections and bolster the eventual presidential bid of his nephew, Nechirvan Barzani (current Prime Minister of Iraqi Kurdistan). Iraqi Kurds may be able to find some sort of an arrangement with Baghdad for greater autonomy. The problem is that both sides claim parts of the region. Kirkuk, for example, is not officially part of Iraqi Kurdistan. However, Kurds see it as their ancient capital and thus seized it in June 2014 as a preventative move to ensure that it did not fall into the hands of the Islamic State. Not only is Kirkuk a major Iraqi population center, but it is also a significant oil-producing region. Investment Implications Over the next several months, we would expect tensions in these three geographies to increase. Given the proximity of Russian, Iranian, Turkish, and American forces, we would expect the probability of accidents to rise significantly. This could temporarily move the markets and assign some geopolitical risk premium to oil prices. However, investors should realize that the regions involved are not major producers of oil, aside from Iraqi Kurdistan where we do not expect large-scale warfare. As such, any effect on oil production would be a minor blip in the global supply. Over the long term, the clear winner in the region remains Iran. Bashar al-Assad, Iran's ally in Syria, will stay in power. It is also clear that the Sunni Islamic State Caliphate will disappear, giving back the Shia-dominated Iraqi government control over its territory. For Saudi Arabia, this is a reality that cannot be changed at the moment. As we have pointed out before, low oil prices are a constraint to war.7 They reduce government revenue and force leaders to focus on domestic stability. A major conflict between Saudi Arabia and Iran is therefore unlikely. However, Saudi Arabia will respond by building a Sunni alliance against Iran. With Syria and Iraq now in the Iranian sphere, the imperative for Saudi Arabia is to counter Iranian regional hegemony through alliances. Egypt will remain a clear beneficiary of this strategy. The country is already the Middle East's candidate for the "too big to fail" moniker. Its population, economy, demographics, and security challenges all make it the main candidate for chief regional security risk. As such, it will continue to receive support from the international community. For Saudi Arabia, Egypt is a way to diversify its security portfolio away from the aloof United States. As such, we would expect the Saudis to continue to prop up the Egyptian economy with loans and grants in return for being able to call on the Egyptian military in time of need. Given a cyclical recovery in Egypt, which BCA's Frontier Markets Strategy has recently elucidated, this creates a structural buying opportunity in the country's equity market.8 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Oleg Babanov, Editor/Strategist EM Equity Sector Strategy obabanov@bcaresearch.co.uk 1 The closest the world ever got to a powerful and effective multilateral structure was the nineteenth-century "Concert of Europe," which kept general peace in Europe for a century (1814-1914), but at the cost of dividing up the rest of the planet into imperial spheres of influence where European states could play out their mercantilist rivalries. Ultimately, even that architecture crumbled as the British hegemony that underpinned it weakened after the 1870s. 2 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," dated February 1, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 4 While the U.S. runs a massively negative net international investment position, its net international income remains positive. In other words, foreigners receive almost nothing for holding U.S. assets, while the U.S. benefits from risk premia in foreign markets. 5 The deal is not particularly significant in a military sense, and it is smaller in value than the last deal in December 2015, but it still sends a signal that angers Beijing, which also expects more controversial deals to be forthcoming given the Trump administration's signals that it plans to strengthen the Taiwan alliance. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust?" dated May 11, 2016, available at gps.bcaresearch.com. 8 Please see BCA Frontier Markets Strategy Special Report, "Egypt: A Cyclical Recovery Amid Lingering Structural Challenges," dated June 20, 2017, available at fms.bcaresearch.com.
Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights The long-term interests of both Chinese policymakers and foreign investors are aligned regarding the Chinese onshore bonds. There is a strong case for higher demand for Chinese bonds going forward. The Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market, but it holds the promise of improving the efficiency of China's financial system over the long run, making the economy less dependent on the banking sector for financial intermediation. Chinese domestic bonds will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. This week we review some basics of this asset class. Feature The Bond Connect program, which launched early this week, has established another channel for foreign investors to tap into China's massive onshore bond markets. Like Chinese A shares' inclusion in the MSCI indices announced last month, the Bond Connect scheme offers little near term impact but marks yet another milestone in China's financial market liberalization. Together with some existing channels, the new program opens up China's vast fixed-income assets to world financial markets, which have yet to be explored by global investors. There is a clear case for rising interest among global investors in Chinese onshore bonds going forward. This also holds the promise of improving the efficiency of China's financial system over the long run. It Takes Two To Tango For Chinese regulators, the benefits of opening up the bond market to foreigners are straightforward. First, it helps develop a deep and more efficient bond market, which is instrumental in allowing market forces to set interest rates for the overall economy.1 Although already one of the largest in the world, the Chinese bond market is primarily for the government and government-related entities. Corporate issuers also tend to be state-owned enterprises, which overwhelmingly carry investment-grade ratings from local rating agencies - i.e. little differentiation in credit quality (Chart 1). The primitive state of the corporate bond market (and financial markets in general) is a key reason why China's financial resources are predominantly channeled by the banking sector. A key target of China's financial sector reforms is to improve the efficiency of financial markets and reduce the reliance on the banking sector. Along with the Bond Connect initiative, Chinese regulators also granted access to overseas rating agencies to its domestic bond market, which should also help Chinese investors properly price credit risks. Chart 1Outstanding Corporate Bonds##br## By Credit Ratings Second, it also facilitates further internalization of the RMB, as it offers a vast asset class for foreign investors to park their RMB exposure. A major consideration for the Chinese authorities to internationalize the RMB has been to reduce exchange rate risk for domestic entities both for trade and financing. Governments and companies in the developed world mostly issue bonds in their respective local currencies, while developing countries typically issue bonds in foreign "hard currencies" such as the dollar and the euro, which makes them vulnerable to exchange rate volatility. By joining the IMF Special Drawing Right (SDR) basket, the Chinese authorities aim to foster the RMB to be an international "hard currency." This, together with a sufficiently deep and efficient RMB bond market, allows Chinese corporate borrowers to issue local currency bonds that are immune to exchange rate fluctuations. Finally, there is clearly a short-term intention to support the RMB exchange rate. The newly established Connect program only allows for "northbound" flows, meaning foreigners are only able to purchase onshore bonds through Hong Kong. This is designed to offset domestic capital outflows and mitigate any downward pressure on the RMB exchange rate. A reciprocal "southbound" channel that allows domestic investors to purchase foreign bonds will inevitably be established. However, the timing will be contingent on conditions of cross-border capital flows and exchange rate performance. For foreign investors, the Connect program and onshore RMB bonds will also prove attractive. Unlike existing programs facilitating foreign bond purchases such as Qualified Foreign Institutional Investors (QFII), RMB QFII (RQFII) and foreign eligible institutions' direct participation in the onshore interbank bond market, the Bond Connect program bypasses China's often lengthy and complicated regulatory procedures, making it easier and more flexible for foreign investors to directly hold Chinese onshore bonds. Holding RMB fixed income assets offers diversification benefits. Foreigners' exposure to Chinese bonds is practically nonexistent, which will inevitably increase. It is worth noting that foreign holdings in most emerging countries' bonds have been rising over time, despite exchange rate fluctuations (Chart 2). The volatility of the RMB exchange rate against the dollar is the smallest among SDR currencies, and Chinese onshore bonds offer the highest yields - both of which will prove attractive for foreign bond investors over the long run (Chart 3). China's structurally higher economic growth should also deliver higher returns for investors over the long run. Chart 4 shows that total returns of Chinese stocks and bonds have been almost identical since 2004 (when Chinese bond data became available) - both of which significantly outperformed global benchmarks. However, the volatility of Chinese stocks has been much greater than bonds. In other words, Chinese bonds offer an attractive risk-return trade off for investors to capitalize on China's growth outlook. Chart 2Foreign Holdings Of Chinese Bonds ##br##Are Set To Grow Chart 3China's Yield Advantage Chart 4Chinese Bonds: A Long Term Play ##br##To Capitalize On Chinese Growth All in all, the Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market. However, it is clear that the long-term interests of both Chinese policymakers and foreign investors are aligned, which builds a strong case for higher demand for Chinese bonds going forward. A Synopsis Of The Chinese Onshore Bond Market Regardless of any near-term considerations, Chinese domestic bonds, and onshore assets in general, will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. It is useful to review some basics of this asset class. At the onset, China's total outstanding bonds currently stand at RMB 69 trillion, or US$10.2 trillion, the majority of which are issued by government and related entities (Table 1). Treasurys and bonds issued by policy banks are backed by the central government. Municipal bonds issued by local governments are not explicitly backed by Beijing, but in reality the odds of a local government defaulting on its bonds are very low. Bonds issued by the corporate sector account for about 20% of the market, but corporate issuers also tend to be state-owned enterprises. Bonds and Certificates of Deposits (CDs) issued by banks are also state-owned. The Bond Connect program allows foreigners to tap into Chinese onshore bonds traded in the interbank market (CIBM), where the majority of Chinese bond transactions take place. CIBM hosts about 70% of total Chinese onshore bonds, while the rest are listed on securities exchanges and over-the-counter (OTC) markets (Chart 5). Chinese bonds are primarily held by commercial banks (and credit co-ops), accounting for about 65% of total outstanding bonds. In recent years, investment funds have become increasingly active, currently holding 15% of the market, compared with 10% three years ago. This, together with increasing foreign participation, will over time help improve the efficiency of the onshore bond market. Table 1Chinese Bond Market Breakdown Chart 5Where Are The Bonds Traded? Bond issuance increased sharply in previous years, mostly boosted by municipal bonds and more recently by banks' CDs (Chart 6). The Chinese authorities' regulatory tightening to rein in financial excesses has led to a notable slowdown in overall bond issuance, which is likely to be temporary.2 Overall, the country's financial reforms will continue to encourage bond issuance and reduce the economy's overreliance on the banking sector for financial intermediation. Chart 6The Growing Importance Of Bond Market The importance of bond issuance for the corporate sector to raise capital has been increasing in recent years, but is still marginal. Currently, corporate bond issuance accounts for over 10% of total social financing (TSF), up from practically zero in the early 2000s (Chart 7). As stated earlier, corporate bonds are primarily issued by state-owned enterprises or listed firms, while small and private enterprises' access to bond issuance is still very restrictive. Maturities of the majority of Chinese corporate bonds are less than five years, while long-dated corporate bonds are rare. Corporate bonds with over 10-year maturities account for about 1% of total outstanding bonds (Chart 8). Chart 7The Growing Importance Of Corporate Bonds Chart 8Maturity Profile China's bond market liberalization measures have allowed some ETFs to be established to track the onshore bond market - a trend that is set to accelerate going forward with the latest Bond Connect scheme (Table 2). Onshore bonds will likely follow A shares to progressively enter major international bond indexes over time, which will further stoke global investors' interest. Table 2ETFs For Chinese Onshore Bonds An Update On The Chinese Economy Chart 9The Economy Will Remain Resilient Recent growth numbers from China confirm that the economy has remained resilient amid the regulatory crackdown by Chinese regulators. Both official and privately sourced manufacturing PMI numbers have improved, and both have moved above the 50 threshold. The regained momentum is also reflected in the rebound in raw materials prices in the global market (Chart 9, top panel). The regained strength in the Chinese economy, in our view, is probably due to easing in monetary conditions, primarily through the exchange rate. Although the RMB has stopped depreciating against the dollar of late, it has relapsed in trade-weighted terms, thanks to weakness in the greenback. This has led to a period of easing in monetary conditions, which in turn has helped the economy reflate (Chart 9, bottom panel). Looking forward, we maintain the view that China's business activity will remain reasonably buoyant. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks in the economy will remain low. China's growth improvement since early last year was primarily due to easing in monetary conditions rather than a massive dose of fiscal and monetary stimuli,3 and it is highly unlikely that the authorities will tighten their overall policy stance significantly, causing major growth problems. As such, we remain positive on both the economy and Chinese H shares. Overall, China's growth performance has been largely in line with our expectations outlined in our 2017 outlook report published in January.4 We will offer a mid-year revisit on the cyclical trends of the economy and financial markets next week. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, “A Chinese Slowdown: How Much Downside?” dated June 08, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Chart 22Message From Our U.S. Stock Market ##br##Timing Model Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights While the yield curve is a critical indicator for developed economies, its significance in China should be put in proper perspective, as the country's market-based financial intermediation is much less important compared with the West. The inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. The near term impact of MSCI's A Share inclusion should be negligible for the broader market. Valuation indicators of the select 222 large-cap names are much more attractive compared with their domestic peers, which may well provide a catalyst for some catch-up rally. Feature Chart 1China's Inverted Yield Curve The Chinese authorities' tightening measures on the financial sector have significantly pushed up interest rates across the curve, particularly in the short end, leading to rapid yield-curve flattening. By some measures, long-dated interest rates are currently lower than short rates, generating an inverted yield curve (Chart 1). Some have viewed an inverted Chinese yield curve as a harbinger of an impending material growth slowdown. While the yield curve is undoubtedly a critical indicator for developed economies, its significance in China should be put in proper perspective. In short, bank loans still play a dominant role in financial intermediation, the interest rates on which are still largely determined by the policy lending rate. Therefore, a simple comparison of the Chinese yield curve to its counterparts in the West misreads the situation and is overly alarmist. Moreover, we suspect that the phase of maximum strength of policy tightening is over, at least in the near term. Therefore, Chinese interest rates are likely to fall in the coming three to six months. This week we recommend a long position in Chinese onshore corporate bonds. Why The Yield Curve Matters Less For China To be sure, the yield curve is among the most relevant and watched indicators in some developed economies. In the U.S., for example, an inverted yield curve, defined as U.S. 10-year Treasury yields resting below three-month Treasury yields, has historically been a reliable indicator in predicting economic recessions (Chart 2). Evidence from other developed economies such as Japan and Europe is less compelling, but a flat/inverted yield curve is still generally regarded as a market signal for growth problems. Chart 2U.S. Yield Curve Inversion Predicts Economic Recession The reasons for the linkage between yield curve inversion and economic recessions have been the subject of lengthy debates among academia, policymakers and investors. From a financial market perspective, it is generally accepted that an inverted yield curve occurs when the bond market anticipates a significant slowdown in growth and/or decline in inflation, which bids down long-term yields, while policymakers fail to respond in a timely manner, which holds short-term rates at elevated levels. Yield curve inversion is typically followed by aggressive monetary easing as central banks wake up to the economic reality predicted by the bond market. Economically, the costs of funding in most developed countries are tightly linked with interest rates in the bond markets. One of banks' key functions as financial intermediaries is to transform maturity - i.e. to "borrow short and lend long," and therefore interest rates of bank loans are tied to government bond yields at the longer end, while their costs of funding are linked to the shorter end. Therefore, an inverted yield curve typically compresses banks' interest margins, which tends to hinder credit origination and slow down business activity. For example, Chart 3 shows that U.S. mortgage interest rates historically have been tightly linked with 10-year Treasury yields, while interest rates of banks' deposit base and interbank rates for "wholesale" funding are both determined by short-term Treasury yields, which is in turn determined by the fed funds rate. In China, the yield curve plays a much smaller role than in the developed world, simply because the country's market-based financial intermediation is much less important. Traditionally both lending rates and deposit rates of commercial banks were rigidly set by the People's Bank of China, and there was little lending/borrowing activity outside the formal commercial banking system. The situation has been gradually changing in recent years as a result of financial reforms. Banks are given flexibility to set their own interest rates, and non-bank lending, or shadow banking activity that is more driven by market interest rates, has expanded. However, commercial banks still play a dominant role. Chart 3U.S. Bank Loan Rates Follow Treasury Yields Closely Chart 4China: Bank Loans Still Dominate Bank loans currently account for over 70% of China's total non-equity social financing, both in terms of flow and total outstanding stock (Chart 4). Commercial banks' average lending rate still closely tracks the PBoC policy benchmark. Banks' prime lending rate moves in lock step with PBoC interest rate adjustments, and average interest rates on new mortgages are also primarily determined by the policy rate (Chart 5). Banks' cost of funding is also primarily determined by retail deposit interest rates, which are in turn set by the PBoC. Retail deposits account for about 80% of total loanable funds for large banks, or 70% for smaller banks (Chart 6). Repo and interbank transactions, which are subject to the central bank's liquidity tightening, only account for 14% of smaller lenders' source of funds, or a mere 2% for large lenders. Chart 5Chinese Bank Loan Rates ##br##Still Track PBoC Benchmarks Chart 6Retail Deposits Are Still The Dominant Funding Source ##br##For Commercial Banks The important point is that market signals from China's juvenile and volatile financial markets should be taken with a healthy dose of skepticism, and a simple comparison with the West is often misleading. For example, a significant decline in stock prices in developed economies may well herald a growth recession in their respective economies. In China, however, domestic stock prices have routinely gone through massive boom and bust cycles without any tangible impact on the broader economy, as the equity markets play a marginal role for both the corporate sector in terms of raising capital and for households in managing their wealth. In recent years, China's financial sector reforms have been gradually introducing market forces in setting interest rates, but the process is far from advanced enough to have a meaningful and direct impact on the cost of funding for both the corporate sector and banks. Overall, the inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. PBoC Tightening: Passing The Phase Of Maximum Strength Moreover, it is noteworthy that yield-curve flattening has been a global phenomenon rather than a China-specific development (Chart 7). What's different is that in other countries the flatter yield curve has been mostly due to falling yields of longer-dated bonds, while in China it has been entirely driven by a sharp increase in short-term yields due to the PBoC's liquidity tightening.1 Looking forward, the PBoC will maintain close scrutiny on the financial sector to keep financial excesses in check. However, we believe the phase of maximum strength of liquidity tightening is likely over, at least in the near term. There is no case for genuine monetary tightening, as inflation is extremely low and growth momentum is already softening. It is very unlikely that the PBoC will tighten monetary conditions further, amplifying deflationary pressures in the process.2 The PBoC's tightening measures have already significantly reduced the pace of leverage buildup and excesses in the financial system. Banks' exposure to non-bank financial institutions has tumbled, net issuance of commercial banks' negotiable certificates of deposits has turned negative of late, and overall off-balance-sheet lending by financial institutions, or shadow banking activity, has slowed sharply in recent months (Chart 8). In other words, the tightening campaign has achieved the intended consequences, diminishing the odds of further escalation. Chart 7Synchronized Yield Curve Flattening Chart 8Financial Excesses Are Being Reined In Global developments are also conducive for some loosening by the PBoC. Last week's rate hike by the Federal Reserve has further pushed down both U.S. interest rates and the dollar. The spread between Chinese 10-year government bond yields and U.S. Treasurys has widened sharply of late, which is helping stabilize the RMB (Chart 9). All of this has reduced pressure on the PBoC to follow the Fed with additional domestic tightening. Already, the PBoC has stepped in to ease liquidity pressure in the interbank system in recent weeks. After massive liquidity withdrawals early this year, the PBoC has been injecting liquidity into the interbank market through various open market operations in the past two months, according to our calculations - likely a key reason why interbank rates have stopped rising of late (Chart 10). Chart 9China - U.S. Interest Rate Spread Versus##br## Exchange Rate Chart 10The PBoC Is Stepping In ##br##To Ease Interbank Liquidity Pressure Chart 11Onshore Corporate Bonds ##br##Are Attractive Chinese corporate bonds will benefit the most, should the authorities stop further tightening (Chart 11). Onshore corporate spreads have widened sharply since late last year amid the PBoC crackdown, and are now substantially higher than in other countries. Chinese corporate spreads should recover without further escalation in liquidity tightening, and will also benefit from the ongoing profit recovery in the corporate sector. We expect both quality spreads and government bond yields to drop in the next three to six months, lifting corporate bond prices. Bottom Line: The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. A Word On The MSCI A-Share Inclusion MSCI Inc. announced this week its decision to include Chinese A shares in its widely followed emerging market and world equities indexes. The company will add 222 China A large-cap stocks to its EM benchmark at a 5% partial inclusion factor, which will account for about 0.73% of EM market cap. This marks a major milestone in China's capital market development and financial sector liberalization. Increasing participation of foreign institutional investors will also over the long run help improve China's corporate governance and regulatory practices - all of which are instrumental for improving the efficiency of domestic capital market as well as the efficiency of capital allocation. Table 1Valuation Of China A-Share Universe The near-term market impact, however, should be negligible. After all, the inclusion will take effect June next year. In addition, foreign investors already have access to these A share companies through the existing Stock Connect channels between Chinese domestic exchanges and Hong Kong. Moreover, potential capital inflows from global managed assets benchmarked to MSCI indexes in the initial step will be marginal. It is estimated that a total of US$18 billion, or RMB 125 billion, foreign capital may follow the MSCI decision into the A share market, a tiny fraction of A-shares' almost RMB 40 trillion market cap. That said, the valuation indicators of the select 222 large-cap names look attractive compared with their domestic peers, with median trailing P/E and P/B ratios at 23 and 2 times, substantially lower than other major domestic indexes (Table 1). MSCI inclusion may well provide a catalyst for some catch-up rally. We will follow up on this issue in the following weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "A Chinese Slowdown: How Much Downside?," dated June 8, 2017, and "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Our "fair value" models incorporate prevailing domestic risk-free interest rates and long-term earnings, which provide an assessment on market valuation levels from a historical perspective. Hong Kong and Chinese A shares are substantially "undervalued" compared with their respective "fair values," while Taiwanese and Chinese investable stocks are roughly "fairly valued" according to our models. The PBoC will continue to enforce deleveraging in the financial sector through liquidity tightening. However, without genuine inflation pressures and any sign of economic overheating, the "deleveraging" process is likely to remain gradual, and its impact on growth will continue to be closely monitored by the authorities. Feature Investors have become increasingly concerned about the rapid expansion of U.S. equity multiples. By some measures, the market appears frothy by historical standards. The forward price-to-earnings ratio for U.S. stocks currently stands at about 18 times, and the cyclically adjusted PE (CAPE), or the Shiller PE for U.S. stocks, is over 26 times - both of which are substantially higher than historical norms (Chart 1). The red-hot performance and elevated valuation levels of the U.S. tech sector has brought back memories of the Internet mania of the late 1990s, which in part triggered a mini-meltdown in the NASDAQ last Friday. Beyond Valuation Indicators Compared with American bourses, other major markets are more reasonably valued, particularly emerging markets, including stocks in the greater China region. EM stocks are trading at about 13 times forward earnings, compared with 18 times for the U.S. (Chart 2). Similarly, forward PE ratios for Taiwan, Chinese A shares and Chinese investable stocks are all at around 13 times, and 16 times for Hong Kong. In addition, our calculations show that CAPEs for Taiwan and Chinese domestic A shares are both about 18 times, 12 times for Hong Kong stocks and a mere 8 times for investable Chinese shares, compared with over 26 times for the U.S. market. Chart 1U.S. Stocks: Valuation Looks Stretched Chart 2Greater China Markets Are Much Cheaper While these valuation indicators are useful to identify potential value plays globally, they do have limitations from a historical perspective. Stocks, as an asset class, compete with other assets, and therefore, the valuation levels of competing asset classes need to be taken into consideration. More specifically, inflation, monetary policy and interest rates determine the "risk free" discount factor for valuing equities. Historically the fed funds rate has been a defining factor for U.S. stock multiples. The famed "Fed model" argues that forward earnings yields should track 10-year Treasury yields (Chart 3). On both accounts, U.S. stocks do not look exceptionally expensive, considering exceedingly low interest rates. In fact, U.S. stocks' earnings yields have diverged with "risk free" rates since the Global Financial Crisis. This offers a glimmer of hope that U.S. stocks are not immediately vulnerable, even if interest rates continue to rise, unless higher rates tilt the U.S. economy into recession, which in turn leads to a major contraction in equity earnings. A Fair Value Assessment This week we incorporate interest rates into the valuation matrix for Greater China markets. Our "fair value" models incorporate prevailing domestic risk-free interest rates and long-term earnings, providing an assessment on market valuation levels from a historical perspective. Our models suggest that Hong Kong and Chinese A shares are substantially "undervalued" compared with their respective "fair values," while Taiwan and Chinese investable stocks are roughly "fairly valued." Hong Kong The Hong Kong market is currently standing at one standard deviation below its long-term "fair value," underscoring more upside potential in prices (Chart 4). In fact, the current reading matches that of the early 1980s, which marked the beginning of a dramatic bull market that lasted several decades, despite some sharp pullbacks. This comparison of course does not take into consideration that the Hong Kong market graduated from an electrifying developing market with excessive gains and risks into a developed one, and therefore a "fair-value" assessment based on historical norms could be misleading. Overall, Hong Kong stocks appear cheap, but a replay of a mega bull market is not realistic. Chart 3U.S. Stocks Do Not Appear Expensive ##br##Considering Interest Rate Chart 4Hong Kong Stocks Are Deeply Undervalued ##br##Compared With 'Fair Value' Taiwan Taiwanese stocks currently are almost exactly "fairly valued," according to our model (Chart 5). Our indicator has been hovering around current levels in recent years, despite price gains, due to improved earnings and more importantly, lower interest rates. Taiwanese local government bond yields are the lowest among the Greater China economies, and therefore our fair-value assessment of Taiwanese stocks' can change quickly if interest rates rise. Overall, Taiwanese stocks do not appear particularly appealing from a valuation perspective, especially compared with other bourses in the region. Chinese Investable Shares Chinese investable shares, although still deeply undervalued by most conventional valuation yardsticks, are now roughly "fairly valued" according to our model (Chart 6). In fact, this asset class was deeply undervalued in the early 2000s, followed by parabolic price moves that transformed into a feverish mania in 2007, but they have not been unduly cheap by this matrix in recent years. We suspect this is likely due to the high earnings volatility of this asset class, attributable to its heavy concentration in highly cyclical sectors such as energy and materials. Furthermore, investor sentiment on Chinese investable stocks swings dramatically, pushing their valuation indicators routinely to overshoot or undershoot extremes. Currently, investors are still skeptical on China's macro profile, and Chinese investable shares are likely under-owned by investors. We continue to expect this asset class to be positively re-rated, but the current situation does not appear too extreme compared with historical episodes. Chart 5Taiwanese Stocks Are Roughly 'Fairly Valued' Chart 6Chinese Investable Shares Are No Longer 'Undervalued' Chinese A shares Chart 7Chinese A Shares Appear Deeply Undervalued The Chinese domestic market, however, scores surprisingly high on our "fair value" assessment. The broad A-share index is well below its historical "fair value" level, and has in fact continued to improve (i.e. fall deeper into undervalued territory) since last year along with rising stock prices and a sharp spike in local bond yields (Chart 7). Although A shares historically have rarely been cheap in a global comparison, this asset class is now well below its historical average valuation levels, underscoring room for mean reversion. Moreover, Chinese local government bond yields are the highest among the Greater China economies. Any decline in bond yields will make A shares more attractive to local investors. In short, Taiwanese stocks appear to be the least attractive in our "fair value" assessment, both compared with other bourses in the region and from their own historical perspective. Hong Kong stock valuations look appealing. We continue to favor H shares over A shares to play the Chinese reflation cycle, but the tide could soon shift. A shares are still trading at a premium compared to their H-share counterparts, but the A-H premium has shrunk to 25% from 45% early last year. We will be looking for an opportunity to lift our bullish rating on A shares at the expense of H shares in the coming weeks. Stay tuned. A Word On Macro Numbers And The PBoC Most of China's macro numbers for May released on Wednesday have come in largely as expected. Taken together, the macro data confirm that the economic momentum has softened, but growth remains stable, as growth rates of capital spending, industrial production and retail sales have remained largely unchanged. A more disconcerting development is the continued decline in broad money growth, which decelerated from 10.5% in April to 9.6% in May, a new record low, underscoring continued pressure from the authorities to enforce financial deleveraging, which could further inflict downward pressure on the economy. The saving grace, however, is that bank loan growth remains stable, which means that the slowdown is mainly due to a contraction in off-balance sheet "shadow banking" activity. Meanwhile, broad money growth currently is well below the official target, which reduces the odds of further escalation in tightening measures. Furthermore, inflationary pressure is muted. While headline consumer price inflation (CPI) did pick up slightly to 1.5% in May compared with 1.2% in April, it is still exceedingly low (Chart 8). Moreover, the recent sharp decline in food prices in the wholesale market suggests that food CPI will come in much weaker next month, which will lead to a further decline in headline CPI, likely to below 1%, a further departure from the official CPI estimate (Chart 9). Chart 8Chinese Food Inflation Will Drop Sharply Chart 9Headline Inflation Is Chronically Below Official Estimate As this report goes to press, the Fed has just announced a 25 basis point rate hike, a widely anticipated move. As far as China is concerned, domestic factors are the top priority for the PBoC's decision-making considerations. On this front, there is no reason for the central bank to hasten its tightening. For now, we expect the PBoC will continue to enforce deleveraging in the financial sector through liquidity tightening. However, without genuine inflation pressures and any sign of economic overheating, the "deleveraging" process is likely to remain gradual, and its impact on growth will continue to be closely monitored by the authorities. As such, there is no case at the moment for monetary overkill that could risk major growth disappointments. We will follow up on these issues in the coming weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations