India

"Tariff Man" Is On Fire "Tariff Man" Is On Fire While the media has zeroed in on the newly announced tariffs on Mexico late last week, tariffs on Indian imports and the narrowly avoided Australia trade war front barely made the news. This heightened policy uncertainty has taken investors aback. Worrisomely, the recent May update of the “Baker, Bloom, and Davis” categorical trade policy uncertainty index surged, which bodes ill for the overall market (trade policy uncertainty shown inverted, top panel). Similarly, we updated the article count that mention “trade war” using Bloomberg data and the message is similar: the opening up of new trade war fronts will continue to weigh on the broad market (trade war article count shown inverted, bottom panel). Bottom Line: Refrain from trying to catch a falling knife, a tactically cautious equity market stance is still warranted.

India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Facing Resistance? Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Business Cycle Is Weak Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Domestic Demand Is Fragile Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Less Provisions = More Paper Profit Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth Very Weak Equity Breadth Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices India Versus EM & Oil Prices India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes 1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand.

Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Reflation Indicator And EM Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Asian Exports To China And To U.S Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities bca.ems_wr_2019_05_30_s1_c12 bca.ems_wr_2019_05_30_s1_c12 Chart I-13Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle bca.ems_wr_2019_05_30_s1_c16 bca.ems_wr_2019_05_30_s1_c16 Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). Chart I-18 This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Facing Resistance? Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Business Cycle Is Weak Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Domestic Demand Is Fragile Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Less Provisions = More Paper Profit Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth Very Weak Equity Breadth Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices India Versus EM & Oil Prices India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes   1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks   Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). Chart I-3Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract   The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel).   Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities Investment Recommendations The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com

Highlights Foreign investors have been rushing into Indian equities in anticipation of a Modi win. While Modi’s chances are reasonable, he may not win an outright majority. Keep tactically underweighting Indian stocks for now. The structural outlook for Vietnam is strong and improving. A bottom in Vietnamese equities is in the making. Investors should overweight Vietnamese stocks within an EM equity portfolio. Feature Indian Equities: A Window Of Risk Remains Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Rural-Exposed Stocks Have Massively Underperformed Urban Stocks   Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Chart I-3Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract Indian EPS Growth Will Likely Contract Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor India's Stock Market Breadth Is Poor   Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel).           Investment Recommendations Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities Higher Oil Prices Are Not Discounted By Indian Equities The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Vietnam: Structural Tailwinds Getting Stronger; Buy On A Dip Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Chart II-1Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-2Accelerating Supply Chain Shift Accelerating Supply Chain Shift Accelerating Supply Chain Shift Chart II-3Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come. In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth. Chart II-4Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China Chart II-5Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration   Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Chart II-8Strong Domestic Demand Strong Domestic Demand Strong Domestic Demand Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors Rising Interest From Foreign Investors Rising Interest From Foreign Investors   Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com Footnotes 1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights So what? EM elections bring opportunities as well as risks. Why?   Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3.  First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Chart 3 Chart 4 Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations ...And Lofty Valuations ...And Lofty Valuations Chart 6 Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy Manipulated Stats Can't Hide Deteriorating Economy   Chart 8 If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle –  which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule Chart A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14.   Chart 9 Chart 10Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Thai Confidence Has Bottomed Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. Chart 14 The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Favorable Economic Conditions Support Incumbent Jokowi Chart 16 Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. Chart 17 There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism Chart 18 The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits... Reflationary Policies Created Twin Deficits...   Chart 20...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso ...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup.   Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2      See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com.  3      The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4      See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com.   Geopolitical Calendar

Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-1Indian Stocks Are Weak Indian Stocks Are Weak Indian Stocks Are Weak Chart II-2Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish   Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating   This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-4Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones   Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-6Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise   Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com

Highlights Please note that analysis on India is published below. Even if the recent upturn in the Chinese credit impulse is sustained, there will likely still be a six- to nine-month lag between the impulse’s trough and the bottom in the mainland’s business cycle. EM corporate earnings cycles typically lag Chinese stimulus efforts by about nine months. Therefore, EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. EM equity valuations are not cheap enough to shield stocks from profit contraction. Feature China’s credit growth was very strong in January. We contend that even if the upturn in the credit impulse proves to be persistent, there will likely be a six- to nine-month lag between its low point and the bottom in the mainland’s business cycle. Chart I-1 demonstrates that the credit impulse leads both nominal manufacturing output growth and the manufacturing PMI’s import subcomponent by roughly nine months. Chinese imports are the most pertinent variable to gauge China’s economic impact on the rest of the world. Chart I-1China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months In the meantime, will financial markets exposed to Chinese growth look through the valley of the ongoing growth deceleration and continue to rally? Or will they experience a major relapse in the coming months? In our opinion, corporate profits will be the key to broader financial market performance. So long as corporate profits do not shrink, investors will likely look beyond weak macro data, and any weakness in stocks will be minor. However, if corporate profits contract in the next nine months, then share prices will plummet anew. EM Profits Are Heading Into Contraction Chart I-2 illustrates that China’s credit impulse leads both EM and Chinese corporate earnings per share (EPS) by at least nine months and that it currently foreshadows EPS contraction in the first three quarters of 2019. Even if the recent upturn in the credit impulse is sustained, EM and Chinese EPS growth will likely bottom only in August – while they are in negative territory. Chart I-2EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM corporate earnings growth has already dropped to zero and will turn negative in 2019. Chart I-3A reveals that EPS in U.S. dollar terms are already contracting in six out of 10 sectors – industrials, consumer staples, consumer discretionary, telecom, utilities and health care. Chart I-3AEM EPS By Sector EM EPS By Sector EM EPS By Sector Chart I-3BEM EPS By Sector EM EPS By Sector EM EPS By Sector EPS growth has not yet turned negative for financials, technology, energy and materials (Chart I-3B). Notably, corporate earnings within these four sectors collectively account for 70% of EM total corporate earnings, as shown in Table I-1. Chart I- Over the course of 2019, these sectors’ EPS are also set to shrink: Technology (accounts for 20% of MSCI EM corporate earnings): NAND semiconductor prices have been plunging for some time, and DRAM prices are also beginning to drop (Chart I-4). This reflects broad-based weakness in global trade – global auto sales are shrinking for the first time since the 2008 global financial crisis, global semiconductor sales are relapsing and global mobile phones shipments are falling (Chart I-5). Chart I-4Semiconductor Prices Are Falling Semiconductor Prices Are Falling Semiconductor Prices Are Falling Chart I-5Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Semiconductors accounted for 77% of Samsung’s operating profits in the first three quarters of 2018, suggesting the potential drop in DRAM prices will be devastating for its profits. Next week we will publish a Special Report on Korea and discuss the outlook for both semiconductors and Korean profits in more detail. In addition, the ongoing contraction in Taiwanese exports of electronics parts confirms downside risks to EM tech earnings (please refer to top panel of Chart I-3B). In brief, the ongoing decline in semiconductor prices will bring about EPS contraction in the EM technology sector. Financials/Banks (financials make up 31% of EM corporate earnings): Banks’ profits often correlate with fluctuations in economic activity, because the latter drive non-performing loan (NPL) cycles (Chart I-6). NPL cycles outside Brazil, Russia and India – where the banking systems have already gone through substantial NPL recognition and provisioning – will deteriorate, and push banks to increase their provisions. The latter will be a major drag on EM banks’ profits. Chart I-6EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity Regarding Chinese banks in particular, if the credit revival in January is sustained, it would strongly suggest that the government is resorting to its old, credit-driven growth playbook. Following 10 years of an enormous credit frenzy and a 20-year capital spending boom, it is currently difficult to find many financially viable projects. Hence, a renewed credit binge will once again be associated with further capital misallocation and more NPLs. Many of these projects will fail to generate sufficient cash flow to service debt. NPLs will thus rise considerably and the need to raise capital will dilute the banks’ existing shareholders. Of course, this will happen with a time lag. Chart I-7 shows that the gap between Chinese banks’ EPS and non-diluted profits has once again widened, and that EPS are beginning to contract. Chart I-7Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese banks could issue perpetual bonds – discussed in great detail in last week’s report – to recapitalize themselves. Nevertheless, this will be negative for existing shareholders. In a nutshell, despite low multiples, share prices of Chinese banks will drop because more credit expansion amid the lingering credit bubble is negative for existing shareholders. The basis is that it will ultimately lead to their dilution. Chinese banks make up 4.5% of the MSCI’s EM equity market cap and 10% of aggregate EM profits. Hence, their EPS contraction will have a non-trivial impact on overall EM EPS. Resource sectors (energy and materials together make 20% of EM corporate earnings): The ongoing slowdown in China will exert renewed selling pressure in commodities markets. As shown in Chart I-9 on page 8, base metals prices lag the turning points in the Chinese credit impulse by several months and are still at risk of renewed price decline. Hence, profits of firms in the materials sector are at risk. Energy companies’ trailing EPS growth is still positive because the late-2018 carnage in oil prices has not yet filtered through to corporate earnings announcements (Chart I-3B on page 3). More importantly, the recent oil price rebound can be attributed to both Saudi Arabia’s output cuts as well as stronger demand – in the form of a surge in Chinese imports of oil and petroleum products. Chart I-8 illustrates that growth rates of China’s intake of oil and related products approached zero when crude prices were rising but has dramatically accelerated following their plunge. This is consistent with China’s pattern of buying commodities on dips. The point is that the upside in oil prices will be capped by China, which will likely moderate its oil purchases going forward, as crude prices have recently rallied. Chart I-8China And Oil bca.ems_wr_2019_02_21_s1_c8 bca.ems_wr_2019_02_21_s1_c8 Bottom Line: EM profit cycles lag Chinese’s stimulus by about nine months. EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. China’s Credit Cycles And Financial Markets What has been the relationship between China’s credit cycle and related financial markets over the past 10 years? The time lag between turning points in China’s credit impulse and relevant financial markets can be anywhere from zero to 18 months. Chart I-9 illustrates historical time lags between the Chinese credit impulse on the one hand and EM share prices, base metals prices and the global manufacturing PMI on the other. The time lag has not been consistent over time. Chart I-9Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags In late 2015-early 2016, the rebound in China’s credit impulse led financial markets by six months. At the recent market peak in January 2018, the credit impulse led financial markets and the global manufacturing PMI by about 18 months. In the meantime, in the 2012-13 mini cycle, EM share prices and commodities markets did not rally much, despite the meaningful upturn in China’s credit impulse. Finally, at the 2010-2011 peak, the credit impulse led EM stocks and base metals prices by 12 months. In short, the credit impulse led those financial markets by a few months to as much as a year and a half. Further, not only do time lags to the stimulus vary, but the impact on both economic activity and financial markets varies as well. This is because both economic activity and financial markets are driven by human psychology and behavior; iterations in stimulus, economic activity and financial markets are chaotic and complex in nature and do not follow well-defined patterns. Given the poor state of sentiment among Chinese consumers, business managers and entrepreneurs, more stimulus and more time may be required to turn the mainland’s business cycle this time around. Besides, unlike in previous episodes, there has not been any stimulus for the property market and no tax reductions on auto sales. Finally, although China and the U.S. may strike a deal on trade, it is unlikely to be a comprehensive agreement that is sustainable in the long run. This would be consistent with our Geopolitical Strategy team’s view that China and the U.S. are in a long-term and broad geopolitical confrontation – not a trade war. The trade war and tariffs are just one dimension of this. Hence, Chinese consumers and businesses, as well as the global business community may well look through this potential deal and not significantly alter their cautious behavior, at least for some time. In other words, the genie of geopolitical confrontation is out of the bottle, and the presidents of the U.S. and China are unlikely to succeed in putting it back. Bottom Line: Turning points in China’s credit impulse generally lead financial markets exposed to Chinese growth by several months. Given that the improvement in the credit impulse is both very recent and modest, odds are that China-related plays including EM risk assets will go through a major selloff before putting in a durable bottom.1 EM Equity Valuations In terms of the ability of EM stocks to withstand profit contraction, would cheap valuations not shield share prices from a considerable drop? We do not think EM equities are cheap; their valuations are neutral. Hence, there is no real valuation cushion in EM stocks to help them endure a period of negative EPS growth. We have written frequently about valuations and will touch on the topic only briefly here. Market cap-based multiples indeed appear very low. However, some segments of the EM universe such as Chinese banks and state-owned companies in Russia, Brazil, China and India have had low multiples for years. In other words, they are a value trap and their multiples are low for a reason. We elaborated above why Chinese banks are chronically “cheap”. For many other companies, low multiples are due to structural issues such as the lack of focus on profitability and shareholder value, or the high cyclicality of profits. Many of these stocks have large market caps, which pull down the EM index’s aggregate multiple. To remove market-cap bias, we have calculated 20% trimmed-mean multiples by ranking 50 MSCI EM industry groups (sub-sectors) and cutting off the top and bottom 10%. Then, we calculate the equal-weighted average of the remaining 80% of the sub-sectors. We did this calculation for the following five ratios: trailing P/E, forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend. Then, we combined them into a composite valuation indicator (Chart I-10, top panel). This indicator shows that EM equity valuations are neutral. Chart I-10EM Equity Valuations In Absolute Terms bca.ems_wr_2019_02_21_s1_c10 bca.ems_wr_2019_02_21_s1_c10 In addition, we calculated the median and equal-weighted composite valuation indicators (Chart I-10, middle and bottom panels). They also remove market cap bias and tell the same message: EM stocks are trading close to their fair value. EM equities are also close to their historical average relative to developed markets (DM). Chart I-11 illustrates relative EM versus DM valuation indicators based on 20%-trimmed mean, median and equal-weighted metrics. Chart I-11EM Equity Valuations Versus DM bca.ems_wr_2019_02_21_s1_c11 bca.ems_wr_2019_02_21_s1_c11 In sum, EM valuations are not cheap neither in absolute terms, nor relative to DM. According to both measures, valuations are neutral. Hence, valuations will not prevent share prices from falling as profits begin to contract. This is why we continue to recommend a defensive strategy for absolute-return investors, and we continue to underweight EM versus DM within a global equity portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Beware Of Rural Growth Lapse Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). Chart II-1Indian Stocks Are Weak Indian Stocks Are Weak Indian Stocks Are Weak The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-2Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. Chart II-4Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Chart II-6Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      This is the view of BCA’s Emerging Markets Strategy team and it is different from BCA’s house view on China-related assets and the global business cycle. The primary source of the difference is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations