India

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Our net assessment of India is bullish over the long run, but this year is full of risks. Prime Minister Modi will struggle to reboot the economy and maintain social stability in his second term. If unemployment, social unrest, and communal tensions spiral out of control, Modi could lose political capital. A foreign policy blunder with China and Pakistan would also weaken Modi’s strongman image. Losses for Modi and the BJP would weigh on India’s potential growth and earnings outlook. Buy Indian stocks on dips, but monitor risks. Go long Indian pharma and local currency government bonds. Feature The Indo-Chinese conflict on the Himalayan border is unlikely to have a significant impact on global financial markets. A major escalation could cause short-term volatility. But most likely an escalation will have a regional impact and present a buying opportunity for Indian, Chinese, or Pakistani equities. There is a potential problem for India, however, in the combination of internal and external political risks. Prime Minister Narendra Modi faces a threat to his popular support because of the economic shock of the COVID-19 pandemic. Insufficient fiscal stimulus will lead to a faltering recovery. Lingering large-scale unemployment will motivate social unrest. Thus Modi will struggle to ensure economic recovery and law and order in his second term. Our base case is that he has the political capital and enough time on the political clock to stabilize the country and his rule. However, a failure to handle domestic challenges poses a risk to our view. And a foreign policy defeat at the hands of the Chinese would further undermine our view. Over the past two months we have written about the risk of social unrest and political instability in emerging markets due to the global pandemic. In this report we extend that analysis to India. We are strategically bullish on India. But a fundamental loss of control by Modi’s administration would skew the risk to the downside over the near and medium term. India’s Domestic Risks India is neither the worst nor the best off among emerging markets. It ranks right in the middle of our COVID-19 Social Unrest Index, mostly because of the status of the economy (Table 1). Table 1Our COVID-19 Social Unrest Index For Emerging Markets Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 1India's Economic Pain A Challenge For Modi India's Economic Pain A Challenge For Modi India's Economic Pain A Challenge For Modi Given that Chile, Russia, and China rank at the top our list, and yet face challenges to their stability, India’s middling position should not be interpreted optimistically. The economic hit has been massive. Manufacturing and especially services PMIs collapsed in April and May, pulling down the composite index to 7.2 and 14.8 respectively, from 50.6 in March – just a hair above the 50 boom-bust line (Chart 1). The breakdown in manufacturing is one of the worst among India’s emerging market peers (Chart 2). This is a problem for a country that is trying to upgrade its manufacturing sector. The domestic economy was frail even prior to COVID. Growth slowed to 4.2% in 2019 from 6.1% in 2018. Discretionary spending by households, reflected in passenger car sales, and capital expenditure by companies were already extremely weak (Chart 3). Chart 2India's Manufacturing Hit Harder Than Other EMs India's Manufacturing Hit Harder Than Other EMs India's Manufacturing Hit Harder Than Other EMs Chart 3India's Consumers And Businesses In Freefall India's Consumers And Businesses In Freefall India's Consumers And Businesses In Freefall Exports have slowed since 2018 due to the Chinese slowdown and trade war (Chart 4). COVID-19 dashed the small signs of a rebound in early 2020. India runs a twin deficit and its fiscal position is especially precarious. At 7.4% of GDP in 2019, the general government deficit was among the largest going into the pandemic. Coupled with a high debt-to-GDP ratio, fiscal policy is a risk to India’s long run sustainability and foreign investors’ returns (Chart 5). This marks a major limitation on India’s ability to stimulate aggregate demand. Chart 4Consumer-Led, But Not Immune To Global Shock Consumer-Led, But Not Immune To Global Shock Consumer-Led, But Not Immune To Global Shock Chart 5Debt Constraint On Stimulus Debt Constraint On Stimulus Debt Constraint On Stimulus On the positive side, India’s foreign currency reserves are sufficient, and it is capable of repaying the foreign debt obligations coming due in the near term, according to our Emerging Markets Strategy (Chart 6). Thus while it has less fiscal space than some other emerging markets, it is not as exposed to a foreign funding squeeze. Chart 6AIndia Can Cover Foreign Debt Payments Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 6BIndia Not Over-Reliant On Foreign Capital Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? How large is India’s stimulus package? The headline-grabbing INR 20 trillion stimulus package – equivalent to 10% of GDP – overstates the direct stimulus to the economy (Table 2). Only about 1.3% of GDP consists of genuinely new on-budget spending. This is much bigger than the 0.5% of GDP fiscal stimulus in 2008-10 but smaller than what other major countries have done in the pandemic thus far (Chart 7). Table 2India’s Fiscal And Monetary Stimulus Amid Coronavirus Crisis Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 7India’s Stimulus: Larger Than GFC, But Smaller Than Many Peers Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Modi will likely need to unleash more stimulus, but his response thus far indicates that he recognizes the country’s fiscal constraints and is not throwing everything at the economy all at once. The COVID-19 crisis hit not long after Modi reconsolidated power in parliament. He has the political capital to make tough decisions – he is not forced to stimulate the economy frantically for the sake of general elections.1 Thus the administration is unlikely to take the path of fiscal profligacy. This is positive for the debt outlook, although it is negative for the demand outlook and recovery. Structural reform is a cornerstone of Modi’s stimulus package. Finance minister Nirmala Sitharaman has highlighted changes to land, labor, and law as parts of the stimulus package, as well as more typical measures to stimulate demand. For Modi the COVID-19 crisis and stimulus measures provide an opportunity to get reforms back on track after several initiatives, such as land reform, were put on hold in order to concentrate on the single biggest reform initiative of his first term (the goods and services tax). This reform agenda cannot go too far as Modi will be forced to sacrifice painful reforms for the sake of maintaining stability. But as long as India snaps back from its lockdown period like other economies, its decision to keep a lid on spending will enable it to manage inflation and generate savings and capital investment over the long run. This is what India needs to reform its moribund economy. Modi can also cut red tape and bureaucracy to speed the recovery. Bottom Line: Indian policymakers recognize the constraints of large deficits and debt and have thus far shown a reluctance to deploy massive fiscal stimulus. The upside is that India will avoid crowding out private investment that is essential to maintain its economic rise. The downside is a slower recovery. India Re-Opening, But Pandemic Yet To Peak On the pandemic, the good news is that India is experiencing a relatively low number of COVID-19 cases and deaths compared to Brazil and South Africa (Chart 8). This may be due to the early and stringent lockdown, the relatively small elderly share of the population, or other epidemiological factors. India also lags in terms of testing (Chart 9). Chart 8COVID-19 Still Poses A Risk Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 9India’s COVID Testing Has Lagged Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? However, any surge would devastate India’s weak health care system. The fact that the economy is reopening without having already experienced a peak in new cases bodes ill. What’s more, India does not appear to be in control of the virus’s spread. By contrast, the number of new cases is still rising in India three months after the nationwide lockdown was first imposed. Indians are vulnerable to the virus as they are more susceptible to die from major diseases than many other countries. India spends notoriously little on health. The health care infrastructure is in no shape to withstand a surge in infections. Reports indicate that even at current low COVID-19 infection rates, hospitals are already turning down patients due to a shortage of beds and ventilators. The implication is that India is not prepared to handle an outbreak that reaches levels seen in say Brazil, South Africa, or Turkey. Given that it is already loosening the lockdown without having witnessed a peak in cases, there is a risk that India has yet to experience the worst of the pandemic. Bottom Line: The pandemic has so far been relatively manageable in India. However, cases are still on the rise and are at risk of surging as the nationwide lockdown is eased. India’s poor health infrastructure puts the nation in a weak situation in handling the virus. Even if the virus itself proves overblown, Prime Minister Modi’s political capital could suffer from the health care crisis. The Risk Of Social Unrest Assuming that India muddles through the pandemic, Modi’s next big challenge is large-scale unemployment. Official unemployment figures – which are not published regularly – understate the impact of the deteriorating economic situation on households, as does our COVID-19 Unrest Index. Our index shows that Indian households, relative to EM peers, are not particularly distressed as measured by a combination of the Gini index of inequality and the “misery index” of unemployment and inflation (see Table 1). However, these are real problems for Indians themselves. Especially unemployment. The massive informal sector makes it hard to measure the real employment situation (Chart 10). Informal workers are the most vulnerable and face the greatest uncertainty. Chart 10India’s Informal Sector Masks Real Unemployment Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 11Household Income Shock Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 12Job Rolls Shrink For Traders And Workers Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Data from April, before reopening, show that nearly half of households saw a drop in income, according to the Centre for Monitoring Indian Economy (CMIE) (Chart 11). But the lifting of lockdowns is starting to bring down unemployment which peaked in May at nearly 25%, with small traders and laborers suffering the brunt of the layoffs (Chart 12). Individuals working in this category, along with farmers, are the most likely to be considered part of the informal sector. The improvement in unemployment also overlooks the decline in labor force participation, which fell to 38.7% in May from 43.2% before the pandemic. Therefore while economic reopening is undoubtedly positive for the labor market, the data do not capture the full extent of the impact of the pandemic and recession on household incomes. Moreover, the labor market may not revert to its pre-pandemic status quickly. Despite record unemployment, construction companies – a cornerstone of the Indian economy – were reporting difficulty in accessing labor in late-April when unemployment was at its peak, weighing on their ability to resume work.2 This is because migrants – which account for 20% of the labor force – are reluctant to return to work as they have been traumatized by the lockdown experience during which restrictions on travel left them stranded far away from their families and hometowns. Even though the restrictions have since been eased, many of the migrant workers are choosing to return home rather than take up work in the construction sector. Moreover, on June 9 the Supreme Court ordered states to transport all stranded migrant workers home within 15 days. The court’s request that federal and state governments ensure they are providing employment to migrants will help reduce unemployment among migrants. However, the unemployment rate is likely to stay high due to transitional unemployment. A lesser challenge comes from the collapse of oil-dependent Persian Gulf economies. Overall, remittances account for 3% of India’s GDP, which is substantial. Many of these workers are now jobless and India is repatriating its citizens that are stranded in the Gulf. An estimated 8.5 million Indians work there, which is small relative to the ~519 million strong domestic labor force. But the return of laborers may have an impact in certain regions. For example, the finance minister of Kerala noted they expect 500,000 Indians to return to his state, which could prove destabilizing. Modi’s biggest challenge is unemployment. Bottom Line: The easing of lockdowns has been positive for the jobs market. However, unemployment will be slow to recover to pre-COVID levels. India will face greater household grievances, threatening social unrest. This is a risk to Modi’s political capital over his second term. Communal Tensions Will Worsen Another risk to Modi’s political capital is the rise of communal tensions. These could potentially mobilize the political opposition against Modi, beginning at the state level. They could also lead to a secular rise in domestic insecurity, which would deter foreign investment. Religious polarization is picking up. India’s COVID lockdown brought a halt to anti-government demonstrations which started in December 2019 in protest of the Citizenship Amendment Act. Prior to the lockdown, many Indians had taken to the streets arguing that this act discriminated against the Muslim minority, violated the country’s foundational secular values, and was unconstitutional. Indian views on the law differ according to religion, with 63.5% of Muslims opposing the Act vs. 32.3% of non-Muslims (Chart 13). Chart 13Muslim Minority Opposes Citizenship Law Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? By granting citizenship to illegal migrants who entered India prior to 2014 from Afghanistan, Bangladesh and Pakistan, and who are Hindu, Sikh, Jain, Parsi, Buddhist, or Christian, Modi’s act used religion as a basis for citizenship, discriminating against the Muslim minority – which makes up almost 15% of India’s population. Although the demonstrations have paused, protesters’ grievances and the Citizenship Law itself remain unresolved. If anything, religious tensions intensified during the lockdown period, as police have been arresting high-profile activists. Right-wing groups have accused the Muslim community of being “super spreaders,” and pro-government media highlighted that regions with large populations of Muslims following the Tablighi Jamaat group have more COVID-19 cases.3 For example, these groups spread rumors that Muslim food vendors were intentionally spitting on fruits to spread the virus. They distributed flags to Hindu food vendors to make them more identifiable. Religious polarization and Modi’s suppression of the Muslim community will continue to be a source of instability throughout Modi’s second term. The prime minister’s stance regarding the minority group will not change. Rather, the weak economy will force Modi to seek success elsewhere, including through sectarian rhetoric to fire up his Hindu nationalist political base. Widespread unemployment will stoke these animosities. Thus religious and ideological tensions are likely to pick up rather than die down, resulting in communal violence and even radicalization and terrorism. This point is especially relevant in Muslim-majority Jammu and Kashmir, which is seeing a spike in communal tensions as well as an escalating struggle over the central government’s authority. Modi’s August 2019 decision to revoke the constitutional autonomy of Jammu and Kashmir also increases security risks. While the Indian government justified the move by the need to stop militancy in Kashmir, it is perceived by many Kashmiri Muslims as an attempt to tighten the government’s grip on the region and suppress their interests. The government’s moves in late 2019, which included a lockdown on the citizens of Kashmir, an internet blackout, and the arrest of local politicians and public figures, will provoke dissent, resistance, separatism, and radicalization. Fresh anti-India protests have already arisen in Indian Kashmir after the killing of nine rebels at the hands of Indian forces. The killings followed intelligence received by the Indian government that some of the rebels either wanted Kashmir to be independent or to merge with Muslim-majority Pakistan. According to a tally by the police, 73 rebels have been killed in Indian-administered Kashmir so far this year. New tensions could arise if India encroaches on Pakistan-administered Kashmir or if Pakistan-backed proxy groups strike out against India’s change of Kashmir’s status. This could lead to a more open-ended military confrontation between India and Pakistan than the tit-for-tat attacks in early 2019. The latter incident could be contained due to a novice government in Pakistan and the approaching general election in India, whereas a new round of hostilities might not so easily be dampened. Tensions with Pakistan are already high – two Pakistani embassy officials were expelled by New Delhi on May 31 due to allegations of spying. An India-Pakistan standoff could easily mingle with Sino-Indian tensions given China’s strengthening alliance with Pakistan. India accuses the People’s Liberation Army of assisting Pakistan on its side of Kashmir. A major escalation with China over Ladakh could entangle Pakistan and widen the conflict. Bottom Line: Religious polarization is picking up amid the lockdown and could explode as containment efforts are eased. India is likely to experience an intensification of unrest from the Muslim minority. In addition to being frustrated by the economy, this group is being politically marginalized, and thus will become more restless and radicalized over time. Will Modi’s Popularity Persist? Modi remains extremely popular, but he has seen his pandemic popularity “bounce” come and go (Chart 14). He is credited for the early and aggressive response to the outbreak, but his approval rating may have trouble in the coming months and years as the economic aftermath unfolds. The positives for Modi are very clear. India’s economic woes this year will be blamed on the shock brought on by the pandemic even though the economy was in bad shape prior to that, washing away any bad memories from the country’s de-monetization and implementation of the new goods and services tax. Another positive for Modi: while states led by his Bharatiya Janata Party (BJP) were previously worse off in terms of unemployment rates, this situation reversed in April and May. Now states led by the opposition Indian National Congress (INC) are suffering the greatest in terms of job losses (Chart 15). In fact, the average unemployment rate for states led by the BJP fell in May. Chart 14Modi’s Popularity High, But COVID Bounce Gone Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? Chart 15Opposition States Bear Brunt Of Unemployment Can Modi Handle India’s Crisis? Can Modi Handle India’s Crisis? The dichotomy in state unemployment is due to the heavier presence of industry in BJP-led states such as Gujarat, Karnataka, and Haryana. The exodus of migrants from these states reduced the size of the labor force, bringing down unemployment rates. By contrast, unemployment spiked in migrant workers’ home states such as Jharkhand, and Punjab, which are opposition-led. Moreover there’s been little effective political opposition to Modi’s handling of the pandemic. True, as with all federal systems, Modi faces pushback from the state governments, which argue that their funding is drying up. A major source of state funding comes from alcohol sales, fuel, and real estate. The latter two have collapsed amid the recession, while the federal government’s decision to ban alcohol sales during the lockdown weighed on state financing and catalyzed the political clash. Yet Modi has used the occasion to centralize control and make his case for stronger federal government. For instance, he has mandated that only the central government can produce, procure, import, or distribute COVID-combating materials and equipment, from personal protective equipment (PPE) to masks to ventilators, thus clipping states’ powers. From a structural point of view, India needs a stronger central government to pursue economic and strategic objectives. Since the pandemic is a challenge that requires a strong central response, Modi’s centralizing approach continues to receive a tailwind from public support. India has a relatively strong score on our COVID-19 Unrest Index when it comes to governance, especially in terms of voice and accountability and control of corruption. Modi’s centralization of power could weaken governance over time, but it is not an immediate concern for investors since the overriding problem in India is a lack of national coordination.4 Clearly, then, the risk to Modi is that unemployment, unrest, communal tensions, and conflict with Pakistan and China lead to political defeats that deplete his political capital in his second term and make him vulnerable to electoral losses at the state level and ultimately in the general election in 2024. At the moment he has sufficient political capital, but political risks are much higher for him than they were prior to COVID-19. If these risks mount, Indian equities will suffer, as the clear implication is a loss of Modi’s and the BJP’s high level of control over both federal and state governments. This would reduce India’s ability to execute policy. The lack of coherence would shake investors’ faith in India’s ability to accelerate reforms and economic development. Bottom Line: Modi’s popularity enjoyed a solid bounce from the crisis and remains very high. He is concentrating power into the federal government, demonstrating that it is capable of rising to India’s modern challenges. The risk is that governance could suffer as a result of the massive challenges to the economy and social stability in the wake of COVID-19. Investment Takeaways Chart 16Indian Equities Breaking Down Indian Equities Breaking Down Indian Equities Breaking Down Indian equities relative to emerging markets are hovering at the 12-year moving average, a critical technical point. If they break beneath this level then there is further downside. Indian equities have broken down relative to global equities (Chart 16). The breakdown occurred despite the collapse in oil prices, which normally would help Indian stocks since the country’s import bill runs to 5% of GDP (Chart 17). Oil prices will strengthen in the second half of the year as global supply-demand balances tighten on the back of OPEC 2.0 supply restraints. Our Commodity & Energy Strategy expects cartel discipline to persist this year. A spike in oil prices driven by production cuts will penalize Indian stocks relative to EM peers. However, we maintain a bullish outlook on India over the long run and tend to view major selloffs, from today’s levels, as an opportunity to buy on the dip. Major selloffs from today are a buying opportunity. Specifically, we see a buying opportunity in Indian pharmaceutical equities (Chart 18). India is one of China’s top competitors in producing both active pharmaceutical ingredients and finished drugs for the United States. While India’s fiscal stimulus will incentivize foreign companies to move supply chains out of China, the United States’ upcoming rounds of stimulus will offer incentives for companies to move out of China, particularly health care companies. While the US rhetoric will emphasize “Buy American, Hire American” onshoring, economic constraints will still motivate companies to work abroad. It is China that will bear the brunt of US protectionist impulses, not the world as a whole. Therefore India stands to benefit, particularly when it comes to pharma. Chart 17Oil Price Drop Brought Cold Comfort This Time Oil Price Drop Brought Cold Comfort This Time Oil Price Drop Brought Cold Comfort This Time Chart 18Go Long India Pharma Versus EM Pharma Go Long India Pharma Versus EM Pharma Go Long India Pharma Versus EM Pharma We also recommend investors go long Indian local currency bonds relative to emerging markets. These bonds are protected by the fact that foreign ownership and capital outflows are limited, as Ayman Kawtharani of our Emerging Markets Strategy observes (Chart 19). Chart 19Go Long Indian Local Currency Government Bonds Go Long Indian Local Currency Government Bonds Go Long Indian Local Currency Government Bonds Chart 20Rupee Will Trend Sideways From Here Rupee Will Trend Sideways From Here Rupee Will Trend Sideways From Here Easier monetary policy will weigh on the rupee, but it is already near the floor of the narrowing band in which its been trading against the dollar since 2018 (Chart 20). Thus odds are that the currency will move sideways over the near term. The primary risk to our view is Modi’s political survival. A collapse of Modi’s political capital and momentum – for any reason – would not deliver a new prime minister or ruling party with the same degree of capital and momentum. Rather it would produce either a weak Modi and BJP, or a challenger that will likely lack Modi’s single-party federal majority and state-assembly majority. If unemployment, social unrest, and communal tensions evolve in a way that fundamentally undermines the Modi regime – if Modi and the BJP suffered permanent damage from this year’s crises – then India’s overall economic policy uncertainty would rise on a long-term basis. The market would have to downgrade India’s economic outlook and earnings expectations to adjust. We remain bullish India on a secular basis, however, because there would remain an underlying national consensus on the need to prioritize economic development. That will not change anytime soon, as Modi has demonstrated to the public and the opposition that it is a winning formula.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1 Upcoming state elections are a different story, but any stimulus will be local. 2 Pandya, Dhwani “Biggest Job Creator Short of Labor Amid Vast India Unemployment,” Bloomberg, May 6, 2020. 3 Muhammad Saad Khandalvi, leader of Tablighi Jamaat, has been charged with manslaughter after ignoring two notices to put a stop to an event hosted by the group at a mosque in New Delhi which started on March 3. The group claims to have ended the event prematurely upon learning of a national curfew on March 22, arguing that other non-Muslim religious gatherings are not facing the same charges. 4 The risk of centralization is that India’s governance could suffer over time. For example, the Prime Minister’s Citizen Assistance and Relief in Emergency Situations Fund, chaired by Modi, has been criticized for its lack of transparency and for diverting resources from other efforts. Modi created a new fund when an older fund, the Prime Minister’s National Relief Fund, already existed. Political patronage is clearly at work. Modi’s fund enjoys benefits that are unavailable to other relief funds, allowing overseas contributions and corporate donations to count toward the mandatory 2% of profits spent on corporate social responsibility.

Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 5India Attracts Investment As Supply Chains Diversify From China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform The China-India Skirmish: Buy India On Weakness The China-India Skirmish: Buy India On Weakness In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.

Feature In this report, we determine which South and Southeast Asian countries are better equipped to endure the COVID-19 pandemic. Answers to this question combined with our macro fundamental analysis lead us to recommend which countries to favor or avoid. We assess several factors in regard to the COVID-19 shock: (1) the healthcare capacity in each country, (2) the COVID-19 containment measures that have been implemented, and (3) the magnitude of fiscal and monetary stimulus packages that have been announced. We conclude that EM equity investors should keep an overweight position in Thai equities and a neutral one in the Malaysian stock market. Indian, Indonesian and Philippine stock markets, on the other hand, warrant an underweight stance. Healthcare System Capacity The COVID-19 virus can cause individuals with underlying medical conditions and already in poor health, as well as those above a certain age, to become seriously ill when infected. These patients will require the kind of special medical attention  – such as ventilation – that is only provided in a hospital’s intensive care unit (ICU). A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks overburdening the health care system. This would be a social catastrophe. A country that currently lacks sufficient ICU capacity relative to the number of patients requiring it, risks over¬burdening the health care system. Therefore, a key measure of the current coronavirus crisis is the relation between a population’s risk of developing critical illness from COVID-19 infections and a country’s intensive care unit (ICU) availability. We assess the risk of COVID-19 infections developing into critical illnesses in ASEAN countries and in India by gauging (1) the prevalence of diabetes in the population and (2) the share in population of people above the age of 60. Chart I-1 and Chart I-2 illustrate these factors separately. Chart I-1ASEAN & India: Population With Diabetes COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-2Population Above 60 Years Old COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities In addition, we combine these two risk variables to calculate the risk of critical illness. This measure is shown in Chart I-3. The measure shows that the population of both Malaysia and Thailand carry the highest risk of developing critical illnesses from COVID-19, owing to Malaysia’s high prevalence of diabetes and to Thailand’s rapidly aging population. Meanwhile, that risk is somewhat lower in India and dramatically lower in both the Philippines and Indonesia.  The next thing to look at is each country’s ICU capacity. Chart I-4 shows the number of ICU beds available per 100,000 people. Thailand has the highest number and Malaysia the second highest. On the other hand, India, Indonesia and the Philippines all have lower rates of ICU capacity. Chart i-3The Risk Of Critical Illness From COVID-19 COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-4Intensive Care Unit (ICU) Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Finally, we compare the risk of critical illness in each country to its available ICU capacity. Chart I-5 shows a scatter plot between these two variables. The risk of critical illness is shown on the Y-axis and the availability of ICU beds per 100,000 people is plotted on the X-axis. Thailand and Malaysia both have the highest risk of critical illness but also a large number of available ICU beds. India, Indonesia and the Philippines have lower average risk of critical illness but also far fewer ICU bed availabilities. Chart I-5The Risk Of Critical Illness Versus ICU Capacity COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities It is also important to note that Malaysia has the highest relative number of medical doctors per 10,000 people in the region (15 versus an average of 8). Furthermore, both Malaysia and Thailand appear to be performing many more COVID-19 tests. That in turn should help slow the spread of the virus and avoid overwhelming health care systems of Malaysia and Thailand. Bottom Line: Thailand and Malaysia have decent healthcare care capabilities relative to the threat of critical illness among their populations. India, Indonesia and the Philippines, on the other hand, seem relatively unprepared to weather this outbreak. Containment Response The magnitude and effectiveness of social distancing measures implemented is a critical means of protecting a country’s health care system. Indeed, the sooner such measures are put into place, the earlier the threat of the pandemic is likely to subside. This will then allow a country to normalize its economic activities sooner.  It appears that the Philippines and India have enacted the most stringent social distancing measures. Both announced complete lockdowns and called in their respective national armies to intervene. Malaysia has also announced extremely inhibitive measures and their enforcement has been quite successful. In Thailand, while the authorities have not imposed a complete lockdown, they have placed curfews and checkpoints that are subject to extension. Thai authorities have also warned that more restrictive measures could be imposed if residents do not comply. Indonesia, on the other hand, has been much softer on enforcement and is reluctant to introduce additional measures due to its economic concerns. Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Remarkably, the effectiveness of the measures can be quantitatively assessed via Google’s COVID-19 mobility tool and TomTom’s traffic congestion data. The average of all Google’s mobility variables, as of April 5, has declined most significantly in the Philippines, Malaysia, and India, relative to baseline values (Chart I-6).1 Likewise, TomTom’s traffic congestion data for the major cities in these same countries’ shows a similar decline during average peak hours over the first two weeks of April 2020, relative to the same period in 2019 (Chart I-7). Chart I-6How Effective Are Social Distancing Measures? COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Chart I-7Decline In Traffic From ##br##A Year Ago COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities Bottom Line: The Philippines, India, and Malaysia have imposed the most effective and successful social distancing measures. This is then followed by Thailand. Indonesia on the other hand has not been as effective in this aspect. Fiscal And Monetary Stimulus Table I-1Stimulus Packages So Far Announced COVID-19 Battle: Assessing ASEAN And Indian Capabilities COVID-19 Battle: Assessing ASEAN And Indian Capabilities The magnitude of the stimulus plans announced by each country is also important. Once the pandemic subsides and social distancing measures are relaxed, countries with a larger stimulus package in place should experience a faster economic recovery. Table I-1 shows the size of the overall stimulus packages announced so far. Malaysia and Thailand have the largest overall stimulus packages to the tune of 16% and 14% of GDP, respectively. India, Indonesia and the Philippines fall well short of these levels. Regarding monetary policy, central banks in all these countries have been cutting policy rates and injecting local currency liquidity. However, some of the programs announced by some of the central banks stand out: The Bank Of Thailand will inject 400 billion baht ($13 billion or 2% of GDP) into the corporate bond market. The central bank is also allocating 500 billion baht ($15 billion or 3% of GDP) of soft loans to small-and mid-sized companies.2 The central bank of the Philippines will be purchasing 300 billion pesos worth of government bonds ($6 billion or 1.6% of GDP) under a 3- to 6-month repurchase agreement to aid government efforts in countering the pandemic. Bank Indonesia may also begin buying government bonds (recovery/pandemic bonds) directly from the primary market. Details are not yet clear but the Indonesian government plans to issue $27 billion worth of these bonds and the central bank might emerge as the largest buyer. Similarly, the Reserve Bank of India has been injecting liquidity and purchasing government bonds for some time now. For instance, it announced a 1 trillion rupees injection in February – or $13 billion – via the long-term repo operation channel. It is now infusing an additional 1 trillion rupees through the same channel. It will also continue purchasing government bonds and securities to keep liquidity aflush and suppress market interest rates. Crucially, Governor Shaktikanta Das indicated that the RBI might even be forced to purchase government bonds directly from the primary market and that all options – including non-conventional ones – are on the table. Bottom Line: Both Thailand and Malaysia have so far announced larger overall stimulus packages than Indonesia, the Philippines and India have. This combined with their better health care capacities, suggests that the Thai and Malaysian economies will recover more quickly than they will in India, Indonesia and the Philippines. Conclusions Having considered risk of critical illness, the ICU availability and general medical capacities, the effectiveness of social distancing measures, and the stimulus packages each country has announced, Malaysia and Thailand emerge as the most likely to win the battle against COVID-19 in the region. Despite their elevated risk of critical illness, both countries have decent healthcare system capacities. Additionally, Malaysia has put in place very effective social distancing measures. Meanwhile, Thailand is placing curfews and monitoring developments very closely. Finally, both countries have enacted massive stimulus packages that will aid in the recovery of their economies later this year.  Notably, Thailand and Malaysia have been running current account surpluses for a long period of time whereas India, Indonesia and the Philippines generally run current account deficits. This, in turn, will allow the former to implement much larger overall stimulus packages than the latter, without risking major currency depreciation. Despite strong and successful social distancing efforts, India and the Philippines are hampered by a weakness in their health care infrastructures. They also are unlikely to be able to provide a large enough stimulus without subjecting themselves to significant currency depreciation. Additionally, India also has an elevated critical illness risk. Finally, Indonesia is likely to emerge from the crisis in the weakest position. Its healthcare system capacity is weak, the social distancing measures it implemented are insufficient and its enforcement has been lax. Indonesia is likely to emerge from the crisis in the weakest position. The government has also been timid about enacting significant stimulus given that it runs a large current account deficit. Moreover, it is unwilling to tolerate any further large currency depreciation due to the elevated foreign currency debt that Indonesian companies and banks carry. The latter stands at  $124 billion in the form of both bonds and loans. Investment Strategy Chart I-8Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets Thai Stock Prices Vs. Emerging Markets The following is our strategy recommendations for each country: Thailand: Our equity overweight stance on this bourse has been significantly challenged since early this year (Chart I-8). However, Thai stocks seem to be holding up at an important technical support level in relative terms.       Furthermore, as of December 2019, the ownership of the country’s local currency bonds was low at 17% (i.e. even before the global sell-off commenced). Further selling by foreigners should therefore be limited, which should reduce renewed depreciation pressures on the Thai currency. We recommend that respective EM portfolios keep an overweight position on Thai equities, sovereign US dollar and local currency bonds. Malaysia: On the one hand, Malaysian stocks have been underperforming EM benchmarks since 2014. Also, foreign ownership of Malaysian local currency bonds has declined from 34% in 2016 to 25% as of December 2019. This limits the possibility of future foreign selling. On the other hand, the economy was facing severe deflationary pressures even before the COVID-19 shock occurred. The latter will only reinforce these deflationary dynamics. Considering the positives and the negatives together, we recommend a neutral allocation to Malaysia within an EM equity portfolio. The Philippines:  Philippine stock prices relative to EM seem to have broken below a critical support level that will now act as resistance (Chart I-9). Moreover, local currency government bond yields have risen sharply (Chart I-10 and Chart I-11). This does not bode well for real estate and bank stocks that account for a very large market-cap chunk of the Philippine MSCI Index (46%). Critically, government expenditures were strong even before the COVID-19 pandemic occurred and it was only a matter of time before that contributed to higher imports. Now that exports are crashing - due to collapsing global demand - and imports are likely to remain high because of even higher government spending/fiscal stimulus, the current account deficit will widen substantially. This will cause the peso – which has been holding up so far – to depreciate significantly. Stay underweight on this bourse and local currency government bonds relative to their respective EM benchmarks. We also recommend keeping a short position on the Philippine peso versus the US dollar. Chart I-9Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Philippine Stock Prices Vs. Emerging Markets Chart I-10Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Philippine Yields In Absolute Terms... Chart I-11...And Relative To Their EM Peers ...And Relative To Their EM Peers ...And Relative To Their EM Peers India: We discussed India in detail in a recent report. We recommend an underweight position amid the pandemic. In previous years, private banks lent enormous amounts to consumers via mortgages and consumer loans/credit cards. Therefore, the performance of both sectors has been contingent on the health of the Indian consumer sector. However, the outlook for the Indian consumer has worsened dramatically because of the unprecedented income hit households will suffer from the lockdown. Moreover, social safety nets and health care capacities (as mentioned above) are very weak in India. Indonesia: We also discussed Indonesia in detail in a report published on April 2. In recent years, the Indonesian bourse benefited from lower US interest rates and ignored deteriorating domestic fundamentals and lower commodities prices. Global investors’ increased sensitivity to individual EM fundamentals amid this pandemic will only make Indonesia’s weakest spots – like its exposure to commodities and its anemic domestic demand – more apparent. With global growth being very weak, commodities prices will remain low – reinforcing currency depreciation and pushing corporate bond yields higher. Combined with relapsing domestic growth, the Indonesian bourse will likely continue underperforming. Bottom Line:  Within an EM equity portfolio, we are keeping an overweight position on the Thai stock market. We also recommend keeping Malaysian equities on neutral. Our equity underweights are India, Indonesia, and the Philippines. In terms of fixed income markets, we recommend overweighting Thai, Malaysian and Indian local currency bonds and US dollar sovereign bonds. We recommend underweighting Indonesian and Philippine local and US dollar sovereign bonds.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1 The baseline is the median value between January 3 and February 6. Our average calculation includes retail & recreation, grocery & pharmacy, parks, transit stations, and workplaces. It excludes the residential variable. 2 Note that this is part of the stimulus shown in Table 1.

India’s relative equity performance versus the EM benchmark is breaking down, and we recommend downgrading this bourse from neutral to underweight. Chart II-1 illustrates that Indian stock prices relative to EM in US dollars are breaking below a critical support line. As this technical support fails to hold, Indian equities will likely relapse further versus their EM peers. In absolute terms, Indian stock prices have also plunged below their long-term moving average that in the past proved to be a major defense line (Chart II-2). Chart II-1Breakdown In India Versus EM Equity Performance Breakdown In India Versus EM Equity Performance Breakdown In India Versus EM Equity Performance Chart II-2Indian Stocks In USD Terms: Where Is The Next Support? Indian Stocks In USD Terms: Where Is The Next Support? Indian Stocks In USD Terms: Where Is The Next Support?   The total lockdown announced by Prime Minster Narendra Modi last week will create significant adverse ripple effects on household incomes, consumption and banks. Chart II-3India Monetary Transmission Mechanism Has Been Broken India Monetary Transmission Mechanism Has Been Broken India Monetary Transmission Mechanism Has Been Broken Critically, India lacks the social safety nets available in advanced economies as well as the mechanism for the government to deliver rapid financial assistance to individuals and companies. Along with extremely underdeveloped medical infrastructure, this creates significant complexities and challenges for the government in channeling meaningful humanitarian and financial support through the coronavirus pandemic. The fiscal stimulus which was announced on March 26 to counter COVID-19 amounts to only about 0.9% of GDP and is too small to move the economic needle. Furthermore, with economic activity frozen due to the lockdown, consumption and investment will plunge before any stimulus gains traction. In term of monetary policy, liquidity injections into the system will alleviate liquidity stress but will not help borrowers in the real economy, who are suffering from shrinking income. Real lending rates (deflated by the average of core CPI and the GDP deflator) remain high at around 5% (Chart II-3). Finally, even though the moratorium provided by some banks to debtors on loan servicing is significant, odds are that there will be mushrooming defaults after the moratorium ends. Debtors that are in the process of losing incomes will also face uncertainty about the pace of the recovery and will be reluctant to pay their debts in full after the moratorium is over. Consumer spending accounts for 66% of GDP and has been the cornerstone of Indian economic growth over the past 10 years. The drop in household income will produce an unprecedented decline in consumer spending. This will devastate many businesses large and small.  We wrote in our August 8, 2019 report that banking/credit woes in India were not over. We contended that private banks would be the last shoe to drop in the deleveraging cycle that India has been experiencing since around 2012. In our January 23 report, we also warned that stock prices of consumer staples and private banks were extremely expensive and overbought, and therefore vulnerable to a correction. Private banks have been lending enormously to consumers, but household incomes are beginning to shrink. As a result, the outlook for private banks and consumer staples – especially – has worsened even more (Chart II-4 & 5). Chart II-4Indian Private Banks Valuation Indian Private Banks Valuation Indian Private Banks Valuation Chart II-5Indian Consumer Staples’ Trailing P/E Ratio Indian Consumer Staples Trailing P/E Ratio Indian Consumer Staples Trailing P/E Ratio   Investment Recommendations We are downgrading Indian stocks from neutral to underweight within an EM equity benchmark portfolio. Notably, this bourse has lately underperformed despite collapsing oil prices. This is a manifestation of a worsening backdrop. We are closing our relative trade of being long Indian software stocks / short the EM benchmark. This position has produced a 16.5% gain since December 21, 2016. Fixed-income investors should continue overweighting Indian local currency bonds within an EM local currency bond portfolio. Foreigners hold a very small portion of Indian local currency government bonds and capital outflows are not a major risk compared with other developing countries. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Indian Private Bank Stocks Are Expensive Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey Indian Consumer Staple Stocks Are Very Pricey Indian Consumer Staple Stocks Are Very Pricey   Chart II-3A Credit Boom Among Indian Private Banks A Credit Boom Among Indian Private Banks A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).1 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book.  Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums India's Labor Market Is In Doldrums India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate India: Household Nominal Income And Lending Rate India: Household Nominal Income And Lending Rate Chart II-6India: Housing Market Is Feeble India: Housing Market Is Feeble India: Housing Market Is Feeble Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-7India: Companies Are Not Investing India: Companies Are Not Investing India: Companies Are Not Investing Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Lending Rates Have Not Declined Despite Monetary Easing Lending Rates Have Not Declined Despite Monetary Easing   Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil India Vs. EM Relative Equity Performance Is Often About Oil India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,2 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1   The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 2   This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil.

Highlights An analysis on India is available on page 12. There is extreme complacency in global financial markets. With currency markets’ implied volatility at a record low, we recommend going long EM currency volatility. The latter will rise in the next six month regardless the direction of global risk assets. For now, we remain long the EM MSCI equity index with a stop point at 1050. In India, nominal income growth has fallen below lending rates. The latter have not declined despite monetary easing. The authorities will force banks to reduce their lending rates, which will hurt bank stocks. Feature “…we have probably seen the end of the boom-bust cycle.” Bob Prince, Co-CIO of Bridgewater World Economic Forum, Davos January 22, 2020 Low Volatility = Complacency Chart I-1Go Long Currency Volatility Go Long Currency Volatility Go Long Currency Volatility The comment above by co-CIO of the largest hedge fund declaring the end of boom-bust cycle is consistent with lingering complacency in global financial markets. Any time an influential person made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets. It does not mean that the world economy will crash but financial markets volatility in general and currency market volatility in particular are bound to rise considerably in the months ahead. The risk-reward profile of going long EM currency or US dollar volatility appears very attractive. Today we recommend investors to go long EM currency volatility. The latter will rise regardless the direction of global risk assets. Concerning overall strategy, EM financial markets are entering a testing period. How broader EM risk assets and currencies perform in the coming weeks will signal how durable and long-lasting the current EM rally will be. Given global risk assets are overbought, a correction or consolidation phase is overdue. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. If during budding market turbulence EM risk assets and currencies underperform their DM peers, it will signal their vulnerability in 2020.Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. For now, we remain long the EM MSCI equity index with a stop point at 1050. We will upgrade our EM equity and credit market allocations versus DM if the EM universe generally exhibits relative resilience in the coming weeks, and more of our indicators confirm China’s growth recovery. Hints Of Recovery… December economic data out of China were strong, and it seems that the credit and fiscal stimulus are finally beginning to lift growth: Chinese imports and nominal industrial output – among the most reliable measures of the Chinese business cycle – posted very robust growth numbers in December (Chart I-2). DRAM and NAND semiconductor prices are climbing, and China’s container freight index is also in revival mode (Chart I-3). These high-frequency (daily and weekly) data confirm improving business activity in both the global semiconductor sector and in overall world trade. Chart I-2China's December Economic Data Were Strong China's December Economic Data Were Strong China's December Economic Data Were Strong Chart I-3Asia's Trade Is Recovering Asia's Trade Is Recovering Asia's Trade Is Recovering   There are tentative signs of amelioration in our proxies for marginal propensity to spend by households and enterprises in China (Chart I-4). A more decisive improvement in these indicators is needed to reinforce the positive outlook for China’s growth. …But Doubts Still Linger Despite the recent improvement in Chinese economic data and the rebound in China-related plays, there are a number of financial market indicators that are not yet confirming a sustainable business cycle recovery in China and global trade. In particular: First, apart from semiconductor stocks, global cyclical equity sectors and sub-sectors – industrials, materials, and freight and logistics – have begun, once again, underperforming defensive sectors (Chart I-5). Outperformance by these cyclical sectors against defensives is essential in confirming that global and Chinese capital spending – which were the primary sources of the most recent slowdown – are picking up again. Chart I-4China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend Chart I-5Global Equities: Cyclicals Are Again Underperforming Defensives Global Equities: Cyclicals Are Again Underperforming Defensives Global Equities: Cyclicals Are Again Underperforming Defensives   Notably, the relative performance of EM share prices to the global equity benchmark historically tracks the relative performance of global materials versus the global overall stock index.1 However, the two have recently diverged (Chart I-6). In short, global materials are not corroborating sustainability in the recent EM outperformance. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. Second, the rebound in Chinese and EM shares prices is not corroborated by Chinese onshore government bond yields, which are dipping to new cyclical lows (Chart I-7). In other words, interest rate expectations in China are falling – i.e., they are not confirming a robust recovery. Chart I-6Unsustainable Decoupling Unsustainable Decoupling Unsustainable Decoupling Chart I-7A Message From The Chinese Fixed-Income Market A Message From The Chinese Fixed-Income Market A Message From The Chinese Fixed-Income Market   Third, EM ex-China currencies have not yet broken out versus the US dollar (Chart I-8). Consistently, the broad trade-weighted US dollar has not yet broken down. Chart I-9 illustrates that the greenback’s advance-decline line has not yet fallen below its 200-day moving average, a condition that has historically been required to confirm the dollar’s cyclical bear market. Chart I-8EM Currencies: No Breakout Yet EM Currencies: No Breakout Yet EM Currencies: No Breakout Yet Chart I-9The US Dollar Is At A Critical Juncture The US Dollar Is At A Critical Juncture The US Dollar Is At A Critical Juncture   We view these exchange rate patterns as a litmus test to validate turning points in the global business cycle. Finally, the technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive (Chart I-10). These markets have rebounded but seem to be confronting a critical technical test. If they decisively break above these technical levels, it will be a sign that the EM bull market will be lasting and durable. Otherwise, caution is still warranted. Bottom Line: There is a good amount of complacency among global investors at a time when there are several market signals that are still challenging the view of enduring revival in China/EM growth. Corporate Profits Will Be The Arbiter Ultimately, economic growth and corporate profits will determine the direction of not only share prices but also EM sovereign and corporate credit spreads as well as their currencies. So far, the EM equity rebound of the past 12 months has been solely due to multiples expansion amid a deepening EM profit recession: Earnings per share in US dollar terms has been contracting by 10% from a year ago, and the rate of change has so far not turned around (Chart I-11). Chart I-10The KOSPI And Copper Are Facing A Resilience Test The KOSPI And Copper Are Facing A Resilience Test The KOSPI And Copper Are Facing A Resilience Test Chart I-11EM Equities: A Profitless Rally? EM Equities: A Profitless Rally? EM Equities: A Profitless Rally?   Going forward, however, EM corporate profits growth is set to improve. Our indicator for semiconductor companies’ revenues is heralding a revival in semi sector profits (Chart I-12, top panel). The rate-of-change improvement in commodities prices is also foreshadowing potential amelioration in corporate earnings growth among energy producers and materials (Chart I-12, middle and bottom panels). Chart I-12EPS Growth In EM Technology, Energy And Materials EPS Growth In EM Technology, Energy And Materials EPS Growth In EM Technology, Energy And Materials We are negative on EM bank profits due to their need to recognize and provision for non-performing loans as well as the authorities’ mounting pressures on them to reduce lending rates. The latter will shrink banks’ elevated net interest rate margins. The profit profile of other EM equity sectors is illustrated in Chart I-13A and I-13B. Chart I-13AEM EPS Growth By Sectors EM EPS Growth By Sectors EM EPS Growth By Sectors Chart I-13BEM EPS Growth By Sectors EM EPS Growth By Sectors EM EPS Growth By Sectors   Provided technology, materials and energy stocks account for 33% of the MSCI EM aggregate equity index’s earnings (banks account for another 28% of total profits), it is safe to assume that the growth rate of EM EPS will move from -10% currently to zero or mildly positive territory by mid-2020. Nevertheless, beyond the next several months, our leading indicators on the EM profit outlook are not positive. China’s narrow money growth leads EM EPS by 12 months, and currently suggests the EPS recovery will be both muted and short-lived (Chart I-14). The technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive. Further, China’s broad money impulse points to a peak in the credit impulse in the first half of the year (Chart I-15). Given that EM share prices bottomed a year ago, simultaneously with China’s credit impulse, odds are that EM equities could slump with a rollover in the latter. Chart I-14EM EPS: Marginal Improvement Ahead But No Robust Recovery EM EPS: Marginal Improvement Ahead But No Robust Recovery EM EPS: Marginal Improvement Ahead But No Robust Recovery Chart I-15China: A Signpost Of A Potential Top In The Credit Impulse China: A Signpost Of A Potential Top In The Credit Impulse China: A Signpost Of A Potential Top In The Credit Impulse   Chart I-16DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation What if the current liquidity-driven rally continues? In our report last week titled A Primer On Liquidity, we elaborated at great length about the different liquidity measures and how they influence financial asset prices. Empirically, changes in DM central banks’ balance sheets have had no stable correlation with either EM share prices or EM local currency bonds, as demonstrated in Chart I-16. There have been periods over the past 10 years when EM risk assets and currencies have performed poorly, despite an accelerating pace of QE programs worldwide (Chart I-16). The true and critical driver for EM equity and currency performance has been EM’s own domestic fundamentals and China’s business cycle (please refer to Chart I-11 on page 7). To be sure, we are not suggesting that DM central bank policies have not affected global and EM financial markets at all. They have done so in spades. By purchasing and withdrawing about $9 trillion in high-quality securities from the marketplace, the monetary authorities have shrunk the stock of available financial assets. Consequently, even though QE programs have expanded broad money supply only modestly,2 the upshot has been that more money has been chasing fewer financial assets. Also, low interest rates reduce the opportunity cost of owning risk assets. These two phenomena have led investors to bid up prices of various securities, including EM ones. Nevertheless, despite the ongoing and indiscriminate global search for yield, EM share prices in US dollar terms and EM ex-China currencies (including carry, i.e. on a total-return basis) are still below their 2010 levels. Such poor performance of EM risk assets has been a corollary of just how bad EM fundamentals have been. Bottom Line: EM corporate profits will improve on a rate-of-change basis in the coming months. However, forward-looking indicators do not yet point to a robust recovery in EM corporate profits as occurred in 2017. Investment Conclusions We are maintaining our long EM equities position with a stop point at 1050 for the MSCI EM stock index (7% below the current level). If EM share prices, credit markets and currencies outperform their DM peers during a correction/consolidation phase, we will upgrade EM allocations to overweight in global equity and credit portfolios. At the moment, EM is confronting a resilience test. Within the EM equity universe, our overweights are Russia, Korea, Thailand, Mexico, UAE, Pakistan and central Europe. Our recommended equity underweights include Indonesia, the Philippines, Hong Kong domestic stocks, South Africa, Turkey and Colombia. In sovereign credit and local bond markets, our overweights are Mexico, Russia, Thailand, Malaysia, Pakistan and Ukraine. In turn, South Africa, Turkey, Philippines and Indonesia warrant an underweight stance. Today we are upgrading Indian bonds from neutral to overweight (see page 17).  In the currency space, we continue holding a short position versus the US dollar in the following basket of currencies: BRL, ZAR, CLP, COP, IDR, PHP and KRW. As always, the full list of our positions is presented at the end of report (please refer to pages 18-19 and on our website).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: Beware Of Private Banks And Consumer Perils Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Indian Private Bank Stocks Are Expensive Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey Indian Consumer Staple Stocks Are Very Pricey Indian Consumer Staple Stocks Are Very Pricey   Chart II-3A Credit Boom Among Indian Private Banks A Credit Boom Among Indian Private Banks A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).3 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book.  Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums India's Labor Market Is In Doldrums India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate India: Household Nominal Income And Lending Rate India: Household Nominal Income And Lending Rate Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Chart II-6India: Housing Market Is Feeble India: Housing Market Is Feeble India: Housing Market Is Feeble Chart II-7India: Companies Are Not Investing India: Companies Are Not Investing India: Companies Are Not Investing   Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Lending Rates Have Not Declined Despite Monetary Easing Lending Rates Have Not Declined Despite Monetary Easing Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil India Vs. EM Relative Equity Performance Is Often About Oil India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,4 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1  Please click on the link to access EM: Perception versus Reality report. 2  Commercial banks’ reserves at central banks do not constitute and are not a part of narrow or broad money supply. 3  The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 4   This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations