Indonesia

Highlights Chart 1European Policy Uncertainty Down European Policy Uncertainty Down European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... What About Emerging Markets? What About Emerging Markets? Chart 3...Brexit And Trump ##br##Should Not Be A Surprise What About Emerging Markets? What About Emerging Markets? Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record What About Emerging Markets? What About Emerging Markets? As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too ...And Commodities Are At Risk Too ...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again China's Growth To Decelerate Again China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? Global Tightening Upon Us? Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead What About Emerging Markets? What About Emerging Markets? Chart 15Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals What About Emerging Markets? What About Emerging Markets? Chart 16Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Keeping Labor Cheap Keeping Labor Cheap Chart 18Fueling The Populist Fire What About Emerging Markets? What About Emerging Markets? Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Society Turning Gray Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency What About Emerging Markets? What About Emerging Markets? Chart 21Constraints On The Sunshine Policy What About Emerging Markets? What About Emerging Markets? In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks South Korea's Twin Trade Risks South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years What About Emerging Markets? What About Emerging Markets? Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Won Strength, Yen Weakness Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Russia Has Undergone Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over ...Which Is Now Over ...Which Is Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized Forex Reserves Have Stabilized Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Russia: Recovery Is At Hand Russia: Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Inventories Remain Far Above Average Levels Inventories Remain Far Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Moscow Will Play Ball With OPEC Moscow Will Play Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Fade Any Spike In Geopolitical Risk Fade Any Spike In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement What About Emerging Markets? What About Emerging Markets? As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote What About Emerging Markets? What About Emerging Markets? Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Turkey Constrained By European Ties Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Money And Credit Growth Strong Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Turkish Stagflation Turkish Stagflation Chart 39Turkey Props Up The Lira Turkey Props Up The Lira Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 What About Emerging Markets? What About Emerging Markets? Table 2Islamist Politics A Real Risk For Jokowi What About Emerging Markets? What About Emerging Markets? He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.

Highlights Tensions are still high between the U.S. and China; China's neighbors are in the line of fire; Korea and Taiwan stand to suffer; We are bullish Thailand, Vietnam, and the Philippines; We are bearish Indonesia and Malaysia. Feature Over the past two weeks we have taken clients on a tour through Europe, where we think political and geopolitical risks are generally overstated in the short term. This provides ample room for European financial assets to outperform this year.1 This week we turn to Asia Pacific, where the situation is quite different. We see this region as the chief source of geopolitical "Black Swans," mainly due to rising U.S.-China tensions, which we have highlighted since 2012.2 While U.S. President Donald Trump and Chinese President Xi Jinping have recently reassured the world that relations will be cooperative and stable, it is far too soon to declare that the two have resolved anything substantial. While we have addressed U.S.-China relations before, it is essential to watch the rest of EM Asia, where proxy battles between the U.S. and China continue to play out.3 If the Philippines shocked the world in 2016 by pivoting away from the U.S. and toward China, South Korea is the country that will do the same in 2017. In this report, we review the opportunities and risks afforded by this regional dynamic. I. Will Trump And Xi Cool Their Heels? Fundamentally, geopolitical risk in Asia Pacific is driven by the "Thucydides Trap," a struggle between the established regional and global power (the United States), and an emerging power that seeks to rewrite the region's geopolitical order (China).4 This dynamic emerged well before President Donald Trump's election.5 Trump is an unpredictable agent thrown into a structural dynamic. His election on an avowed platform of protectionism, his comments singling out China as a U.S. threat, and his break with the U.S. foreign policy establishment all suggest that the secular rise in Sino-U.S. tensions is about to get worse.6 Yet, since taking office, Trump has sent mixed signals. On the one hand, he threatens a policy of isolationism that would see the U.S. withdraw from its global security commitments. On the other hand, he has threatened to escalate geopolitical conflicts in order to get what he wants on business and trade. Table 1Market Implications Of ##br##Trump's Options Toward China How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia As Table 1 illustrates, it is extremely important for investors which of these foreign policies Trump ultimately pursues - nationalist or isolationist - and whether he combines it with the trade protectionism (or mercantilism) that he has threatened. In the short term, the most bullish combination would be the economic status quo with a scaled-down U.S. presence. The most bearish would be mercantilism combined with nationalist foreign policy. Trump's recent interchanges with Xi were notable because for once he adhered to diplomatic protocol. He and Xi gave some initial - and we would add tentative - assurances to the world that Sino-U.S. relations will not explode in a ball of flames this year: Taiwan - Trump reaffirmed the One China Policy, i.e., that Taiwan has no claim to independence from the mainland. Trump's phone call with the Taiwanese President Tsai Ing-wen in December, and subsequent comments, had put this principle in doubt, raising the prospect of a new Cold War or actual war. North Korea - China has offered to enforce a stringent new set of economic sanctions on North Korea, namely barring coal imports for 2017. This is significant, given the short duration of China's previous punitive measures against the North and the hit that North Korean exports have already suffered from China's slowing economic growth (Chart 1). The Obama administration had begun sanctioning China as a result of its unwillingness to enforce, so with enforcement may come the Trump administration's deactivation of such threats for a time. The RMB - Trump did not accuse China of currency manipulation on "day one" of his administration as he had promised during his campaign, though he has informally called the Chinese the "grand champions" of manipulation.7 This strongly suggests that he will allow the Treasury Department's semi-annual foreign exchange review process to run its course (Diagram 1). On that time frame, the U.S. would issue a warning in the April report and then begin negotiations that legally should take a year. Of course, China does not qualify by the usual measures. Since 2015 it has been propping up its currency rather than suppressing it (Chart 2), and its current account surplus has dropped sharply from 10% to 2% of GDP over the past ten years (though still massive in absolute terms). Diagram 1Calling China A Currency Manipulator: The Process How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia The Trans-Pacific Partnership (TPP) - Trump yanked the U.S. out of the major multilateral trade initiative of the Obama administration, which was an advanced trade deal that excluded China and primarily benefited smaller Chinese competitors like Vietnam and Malaysia. Though Trump acted unilaterally - and therefore cannot have gotten any real concessions from China in exchange for killing an "anti-China" trade deal - he avoided the frictions with China that would have resulted over the coming years from implementing the deal. Chart 1Will China Cut Imports From Here? Will China Cut Imports From Here? Will China Cut Imports From Here? Chart 2The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation The 'Grand Champions' Of Currency Manipulation In addition, the Trump administration is already embroiled in domestic politics with a number of its early actions. Thus it would not surprise us if Trump - exactly like Ronald Reagan, Bill Clinton, Barack Obama, and George W. Bush - needed to pacify relations with China despite his early tough talk. Meanwhile President Xi wants stability even more than usual this year as the Communist Party holds its "midterm" five-year National Party Congress. We will return to the party congress in an upcoming report, but for now we will simply reiterate that stability means neither excessive stimulus nor excessive reform (Chart 3). Chinese policymakers could trigger unintended consequences with their financial tightening, but that's why we think they will be exceedingly cautious.8 If Trump does not try to sabotage this politically sensitive year, China should be relatively stable. Chart 3China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress So have U.S.-China ties become bullish all of a sudden? No. At least, not yet. Consider the following: South China Sea still a powder keg - On both sides, the idea of excluding "access" to the sea is being openly discussed, if disavowed.9 While there is conceivably a path for both sides to de-escalate, it will take very tough negotiations, and we are not there yet. Trade fight hasn't even begun - Though previous presidents got sidetracked, Trump was the first to campaign aggressively on a protectionist, anti-China platform, and to put a team in place to pursue that platform.10 We think he will get tough. We also think he will endorse the House Republicans' plan of a Border Adjustment Tax - a tax on imports - which would hurt China most of all as the country with the biggest trade surplus with the U.S.11 Japan is proactive - Japan has virtually no domestic political constraints and has an incentive to play up security threats. Why? Because Prime Minister Abe wants a nationwide popular referendum on revising the constitution to legitimize the Japanese Self-Defense Forces.12 And this is not even to mention that Taiwan and the Koreas are still major risks. Structurally, we still see Sino-U.S. tensions as the chief source of geopolitical risk and "Black Swan" events this year that could rattle markets in a very big way. Bottom Line: A modus vivendi between Trump and Xi is conceivable, but the U.S. and China are not out of the woods yet. II. What About The Neighbors? Short of the formidable "left-tail" risk of direct U.S.-China conflict, China's periphery is the chief battlefield and source of risk for investors. Asian EM economies have the most to risk from the reversal of the past decade's trade globalization (Chart 4). Investors also tend to underrate the fact that they are in the thick of the geopolitical risk arising from Sino-U.S. tensions and global "multipolarity" more broadly.13 A look across the region suggests that most Asian EM economies are shifting their policy to become more accommodative with China. This should reduce their geopolitical risk in the short term, though it is too soon to sound the "all clear." We remain strategically short EM stocks relative to DM. Within the EM space, we are bullish on Thailand, less so on the Philippines and Vietnam, and neutral-to-bearish on Taiwan, South Korea, Malaysia, and Indonesia. Chart 4De-Globalization Hurts Asia Pacific Most Of All How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Koreas - Here Comes The Sunshine Policy South Korea is at the center of the U.S.-China struggle as it faces a domestic political crisis, economic pressure from China, rising North Korean nuclear and missile capabilities, and a likely clash with the new U.S. administration. First, the Constitutional Court must decide the fate of impeached President Park Geun-hye. The market has rallied since the ruling Saenuri Party turned against her in early December, paving the way for her December 9 impeachment in the assembly. However, the politics of the court makes her removal from office less likely than the market expects, especially if the court does not rule by March 13, when a second judge this year retires from the bench.14 If the impeachment falters, it will lock South Korea into greater political instability throughout the year, at least until the scheduled election on December 20. Chart 5Leftward Policy Shift In South Korea ... How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia However, it is virtually impossible for the Saenuri Party candidate, Acting President Hwang Kyo-Anh, to win the election, despite his fairly strong polling (Chart 5). His party has been discredited and split, and there are now calls for his impeachment as he defends Park from further investigation. The leading contenders are all left-of-center. They are contending in a primary election over how to redistribute wealth, crack down on the Chaebol (corporate conglomerates), engage North Korea, and improve relations with China. These policies are receiving a tailwind because Korean society has seen the economic system shocked by the end of the debt supercycle in the United States and the slowdown in China. Moreover, inequality has been rising in Korea (Chart 6). As in neighboring Taiwanese elections last year, the election is shaping up to be a backlash against the pro-trade and globalization policies of the preceding decade. Korea's share of global exports has increased, and its tech companies are profitable, but the government has engaged in conservative fiscal policies, its workers are overworked and underpaid, and its social safety net is non-existent (Chart 7). Redistribution and reforming the Chaebol could bring serious benefits over the long run, but both will negatively affect corporate profits on the margin. Internationally, improving relations with North Korea and China will mean that the new South Korean government, in H2 of this year or H1 of next, could be on a collision course with the United States and especially Japan. We expect Korea to go its own way for a time, giving the impression globally that another American ally is "pivoting to China" (after the Philippines in 2016).15 While this may seem bullish for Korea, as it did for the Philippines due to the fact that China is a growing economy, Korean exports to the U.S. and Japan are still a significant portion of its total exports (Chart 8). Korea is also constrained by the fact that China is increasingly a trade competitor, and Korea's exports to China mainly consist of goods that China wants to make itself: high-end electronic manufacturing, cars, and car parts. Thus, China will welcome greater ties as it looks for substitutes for the increasingly protectionist West in acquiring technology and expertise, but Korea's new government will see rising fears of economic "absorption" as it attempts to improve access to Chinese markets. Chart 6... As Inequality Has Risen Sharply How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Chart 7Workers Want More Largesse Workers Want More Largesse Workers Want More Largesse Chart 8Korea's Balancing Act Korea's Balancing Act Korea's Balancing Act What are the market implications? South Korea is in a decent place in the short run. Global growth, exports, and corporate earnings are improving, and stock valuations have come down, especially relative to EM. Over the long run, however, we are turning bearish. Korean labor productivity is in a downtrend (Chart 9), its population is not growing, and there is no reservoir of young people left to tap. There are three basic options for securing future growth. First, Korea could become a net investor nation like Japan (Chart 10). However, it is not yet wealthy enough to do so, and needs to build the aforementioned social safety net. Second, South Korea could reunify with the North, which would alleviate its labor force problems, though the costs of reunification would be extreme (Chart 11). Chart 9Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Reforms On Hold Until New Government Sits Chart 10Korea's Japanese Dream Korea's Japanese Dream Korea's Japanese Dream Chart 11Reunification Would Increase Labor Force How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Third, it could continue on its current path of trying to secure large markets like the U.S. and China, while conducting a balancing act between them as geopolitical tensions rise. The problem right now is that the first two options are not ready and the balancing act is getting too hard, too soon. The South stands to suffer from both protectionism and multipolarity, i.e., being sandwiched between resurgent Sino-U.S. and Sino-Japanese tensions. Furthermore, the Trump administration has not yet decided whether its North Korea policy will be one of engagement, aggression, or continued neglect. Yet the U.S. defense and intelligence establishment's threat assessment is reaching a level that will cause greater public concern and more demand for action. Until Trump's policy is clear, South Korea's attempts to launch a new "Sunshine Policy" toward eventual reunification will be extremely vulnerable. Over time, North Korea is likely to become more of a black swan than the red herring it has been in the past (Chart 12). Chart 12North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings North Korean Incidents: Mostly Red Herrings Bottom Line: Now is ostensibly a good entry point for Korean stocks relative to EM stocks, but we remain reluctant due to the political and geopolitical factors. Also, the path of least resistance for the Korean won is down, so we recommend going long THB/KRW, discussed further below. Taiwan - "One China" Or More? Our prediction that China-Taiwan relations would deteriorate dramatically, and that Taiwan could be one of five "Black Swans" of 2016, has essentially played out.16 The two sides cut off formal contact, Trump accepted a phone call from the Taiwanese president in a sharp break with U.S.-China convention, and the Taiwanese navy accidentally fired a missile toward the mainland during a drill on the Chinese Communist Party's 95th birthday on July 1. Despite the tensions, hard data coming out of Taiwan have been strong. Its export-oriented economy is buoyed by strong global growth. Both its equities and currency are the few bright spots in the EM universe and investors have been responding positively to the strong data (Chart 13). Yet Taiwan remains highly vulnerable to geopolitical tensions, as its economy is "too open," especially to China. China has imposed discrete economic sanctions, as we expected. The number of mainland tourists to Taiwan have dropped by 50% (Chart 14). This trend will continue, hurting consumer sentiment. While Trump has backed away from his threat to break the One China Policy, a move markets view as very reassuring, he cannot unsay his words and China will not forget them. Moreover, his administration will attempt to shore up the U.S.-Taiwan alliance in traditional ways, including with new arms sales that will provoke angrier responses than in the past from Beijing (Chart 15). Chart 13Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Investors Do Not Fear Independence Talk Yet Chart 14China's Silent Sanctions China's Silent Sanctions China's Silent Sanctions Chart 15Plenty More To Come How To Play The Proxy Battles In Asia How To Play The Proxy Battles In Asia Crucially, Taiwan's domestic politics are not a major constraint on its actions, which heightens the risks of a cross-strait "incident." The Democratic Progressive Party (DPP) is in control at almost every level of government on the island. President Tsai Ing-wen and the DPP swept to power on a popular mandate to stall and roll back trade liberalization with China, which the public felt had gone too far under the previous Kuomintang government. Perhaps if Trump had never entered the picture, Taiwan and China would have found a new equilibrium in which Taiwan distanced itself while assuring the mainland it did not seek independence. Now, however, the odds of that solution are declining. Taipei may become overly aggressive if it believes Trump has its back, and this dynamic will ensure continuous Chinese pressures and sanctions, all negative for Taiwanese assets. Bottom Line: Despite the fact that Taiwan's economy has some bright spots (exports, capital formation), we are sticking with our "One China Policy" trade of going long Chinese equities / short Taiwanese and Hong Kong equities. BCA's China Investment Strategy agrees with this call and is shorting Taiwanese stocks relative to its mainland counterparts.17 We expect China to penalize these territories for expressing the desire for greater autonomy. We also suggest going short the Taiwanese dollar versus the Philippine peso, to be discussed further below. Thailand - The Junta's Persistence Is Bullish For most of the past fifteen years, the death of Thailand's King Bhumibol Adulyadej, which occurred on October 13 of last year, was feared as a catalyst for a total breakdown of law and order due to the deep socio-political and regional division in Thai politics that has pitted an urban royalist faction against a rural populist faction. But the 2014 coup was intended to preempt the king's death and ensure that the royalist, pro-military faction held firm control over the country during the risky succession period. The market responded positively during the coup in 2014 and upon the king's death last year (Chart 16). We recommended going long Thai stocks and THB last October, in a joint report with BCA's Emerging Markets Strategy, and both trades are in the black.18 Chart 16Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis Thailand: Investors Cheered The Succession Crisis The junta's strategy has been to root out the leaders of the populist movement and rewrite the constitution to legitimize its ability to intervene in the future. The new monarch has cooperated with the military so far, upholding the status quo, but if at any point he favors the populists to the detriment of the military, political uncertainty will spike from its current historically low levels (Chart 17). The junta is fully in charge for the time being. It has pushed back elections to February 2018 or later, delaying the re-introduction of political instability into the Thai market. It is also surging public spending and transfers to the rural poor to ensure social stability. Historically, strong public capital investment and global exports coincide with strong Thai manufacturing output (Chart 18). Favorable domestic and external macro environments should be bullish for Thai equities, creating a near-term buying opportunity in the Thai market. Chart 17Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Junta Keeps A Lid On Politics... Chart 18... And Buys Friends With Public Money ... And Buys Friends With Public Money ... And Buys Friends With Public Money Thailand is distant from China's quarrels with its neighbors over the South China Sea. It was the first of the U.S. allies to hedge against President Obama's pivot and seek better relations with China instead, a strategy that has paid off. Thailand, like many regional actors, may be forced to choose between China and U.S. at some point, but for now it enjoys the best of both worlds. With a fundamentally strong macro-backdrop, including a large current account surplus of 12% of GDP, we are bullish on Thai assets relative to EM. Bottom Line: Thailand is the most attractive Asian EM economy right now from an investment-oriented geopolitical point of view. It is not too late to go long THB/KRW or long Thai stocks relative to EM. Philippines - The War On Drugs Is A Headwind The Philippines continues to display strong macro-fundamentals and market momentum in the EM universe. However, domestic political risks are significant and prevent us from returning to an overweight stance relative to EM.19 The inauguration of populist southerner Rodrigo Duterte as president of the Philippines in July of last year led the country into a bloodbath that has since claimed over 7,000 lives in a "war on drugs." Only recently has it shown any sign of abating, and it is not clear that it will. The political backlash is gradually building. Duterte's policy preferences are left-leaning and mark a partial reversal of the pro-market, reform orientation of the preceding Aquino government.20 As a result, foreign investment has dropped off from its sharp rise, though it remains elevated (Chart 19). The Philippines may also fall victim to its own success. Due to the booming economy under the Aquino presidency, bank loans and deposits have enjoyed strong growth in recent years. However, the loan-to-deposit ratio is getting overextended and the economy is showing signs of heating up with inflation creeping above 2% in 2016 (Chart 20). Populist policies and the advanced cyclical expansion may add more heat. Thus, it is becoming more likely that monetary policy will tighten as the economy moves into the advanced stage of its cyclical expansion. Duterte could create a problem if at any point he decides to interfere with the central bank or technocratic management of the economy more broadly. In terms of geopolitical risk, Duterte is engineering a pivot away from the United States toward Russia and China, aggravating relations with the former, its chief ally (Chart 21). As relations with China improve, they will bring some investment in infrastructure and a calming of the near seas. Chart 19Duterte Marked The Top Duterte Marked The Top Duterte Marked The Top Chart 20Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Credit Is Strong, Inflation Creeping Back Chart 21Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Duterte's 'Pivot' To Asia Ultimately, however, we view this calming as temporary, since China's assertiveness is a long-term phenomenon. We also think that the fundamental U.S.-Philippine alliance will survive any major disagreements of the Duterte era. Duterte is constrained by his weakness in the Philippine Senate and the popularity of the United States among Filipinos, which is among the highest in the world. In essence, the public is not anti-American but "anti-colonialist" - many feared that the U.S. "Pivot to Asia" of the Obama and Aquino administrations would put the Philippines into a subordinate "colonial" role highly vulnerable to Chinese aggression. Like other U.S. allies in the region, the Philippines wants to be a partner of the U.S. and not just a naval base. Thus, for now, we see the Philippines in a gray area of frictions with the U.S. yet disappointing hopes with regard to China. Until Duterte removes the headline risk to internal stability from his belligerent law and order policies - and compromises on his more anti-market economic stances - we are at best open to tactical possibilities. Bottom Line: Considering its strong macro-fundamentals, advanced cyclical expansion, and politically driven uncertainty, we are only willing to entertain short-term, tactical opportunities in the Philippines. Now is a decent entry point for equities relative to EM. Also, our colleagues at BCA's Foreign Exchange Strategy point out that the peso is currently trading at a 10% discount.21 We recommend going long the peso versus the Taiwanese dollar to capitalize on the dynamics outlined for both countries above. Indonesia - A Dream Deferred Indonesia outperformed our expectations throughout 2016.22 President Joko Widodo ("Jokowi") managed to corral his party behind him despite an internal leadership struggle. And the large bureaucratic party, Golkar, joined his coalition in parliament, creating a strong legislative majority. These were our two preconditions for a more effective government; Jokowi has also found allies within the military, as we surmised. As a result, he managed to make some progress on his tax-raising, union-restraining, and infrastructure-building initiatives. Nevertheless, the market has sniffed out the difference between a pro-reform government and the enormous difficulties of pulling off reform in Indonesia. Long-term investment has fallen even as short-term portfolio investment has rallied on the back of the EM reflation trade (Chart 22). While Jokowi reduced the size of costly domestic fuel subsidies in his first year, it was easy to do so amid the oil-price collapse in 2014. Since then, Indonesian retail gasoline prices have remained subdued, indicating that subsidies are still significant. As the global oil prices continue increasing, so will the subsidy (Chart 23), adding to the country's budget deficit. Jokowi also put forth minimum-wage reforms in 2015, introducing a formula which requires the minimum wage to be adjusted every year based on inflation and economic growth (rather than ad hoc negotiations with local unions and governments). Predictably, wages have skyrocketed since the indexing policy was implemented, which is negative for profit margins (Chart 24). Chart 22Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Investors Skeptical Of Jokowi's Reforms Chart 23Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Fuel Subsidies Still In Effect Chart 24No Wage Rationalization Yet No Wage Rationalization Yet No Wage Rationalization Yet Indonesia is on the outskirts of China's claims in the South China Sea and has a domestically driven economy that should suffer less than that of its neighbors in a context of de-globalization. In that sense, we are inclined to view it favorably. However, its currency is at risk from twin deficits - current account and budgetary reforms have stalled, and the credit impulse is weakening. If Jokowi's favored candidate wins the heavily contested gubernatorial run-off in Jakarta in April, it will not be very bullish, but a loss would be bearish for Jokowi's reform agenda ahead of the 2019 elections. Bottom Line: We are still short Indonesia within the EM space - its underperformance since the second half of last year can persist. Vietnam - No American Guarantee Vietnam is highly vulnerable to a geopolitical conflict with China which would impact markets. Unlike the Philippines and Thailand, it cannot count on an underlying bedrock of American defense to anchor its pivot toward China - and yet, it has the greatest historical and territorial conflicts with China of all the Southeast Asian states. Chart 25Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Fighting In The Teeth Of The Dragon Nevertheless, in the short term, geopolitical risks are abating. Relations have improved since a recent low point in 2014.23 And Vietnamese leaders, having invested heavily in the TPP as the trade pact's biggest potential beneficiaries, are trying to make amends with China now that it is canceled. Thus, we remain long Vietnamese equities relative to EM. This is mostly due to the country's strong domestic demand and export competitiveness (Chart 25), attractive environment for foreign investment, and ability to capitalize on diversification away from China. The country's reforms are not perfect, but it has at least recognized NPLs and begun privatizing some SOEs. Bottom Line: We are sticking with long Vietnamese equities versus EM, though downgrading it to a tactical trade due to our wariness of a turn for the worse in China relations or the broader trade environment. Malaysia - Going To The Pawnshop Malaysia, with Vietnam, was to be the top beneficiary of the TPP. It, too, has lost greater access to the U.S. market that the deal would have provided and must now make amends with China. The latter process has already begun, as Malaysia's government has turned to China for a $33 billion deal in exchange for energy assets and valuable land in the state of Johor. The general election of 2013 and the economic slowdown have catalyzed domestic political divisions, especially ethnic and religious ones, igniting a drastic push over the past two years to have Prime Minister Najib Razak ousted for his alleged embezzlement of funds from the state-owned 1MDB corporation. Najib chose to crack down on the opposition and ride out the storm, which he has managed so far, causing unprecedented political instability. Najib's decision to sell land to the Chinese will not sit well with much of the Malay population. Many will see it as undignified; and historically, there is much animosity toward the local Chinese. Najib already faces an intense political struggle due to the exodus of high-ranking politicians from his ruling United Malay National Organization (UMNO). Former strongman leader Mahathir Mohammad and ex-Deputy Prime Minister Muhyiddin Yassin are leading the defectors to form a new Malay party that will pose a serious challenge in the 2018 elections. Recent flirtation between the ruling UMNO and the Islamist Pan-Malaysia Islamic Party (PAS) also injected new uncertainty into the already turbulent domestic political environment. In essence, the one-party state that investors once knew (and loved) is forming new factions that will contest the upcoming elections with abandon. Chart 26Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up Growth Slowing, Credit Drying Up This struggle over the 2018 election promises to be emphatically unfriendly to investors. And until Najib gets a new mandate, he can do very little to arrest the economic breakdown. As long as the support and continuity of Najib's policies are in question, it is difficult to take a directional view of Malaysian assets. A victorious UMNO does not mean that investors should be bullish, but it will resolve the question of "Who is in charge?" At that point, we can reassess the market attractiveness based on the higher "certainty" of the policy preferences of the country. Meanwhile the constraints to Malaysia's economy are clear from a host of weak data, from domestic trade to the property market to the current account and the currency, along with a rise in NPLs that will undermine the inadequately provisioned banks' willingness to lend (Chart 26). While palm oil and petroleum prices have recovered, which is positive for Malaysian markets, this is not enough to outweigh the negative factors. Bottom Line: We are bearish on Malaysian assets and currency. Matt Gertken, Associate Editor mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, and BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Special Report, "The Looming Conflict In The South China Sea," dated May 29, 2012, available at gis.bcaresearch.com, and BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see BCA China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 9 In the short time since Trump's and Xi's phone call, the U.S. has announced that it intends to intensify the Freedom of Navigation Operations around the rocks in the South China Sea to assert its rights of navigation and overflight. Meanwhile Chinese lawmakers have revealed that they want to pass a new maritime law by 2020 that would encourage maritime security forces to bar foreign ships from passing through Chinese "sovereign" waters if they are ill-intentioned. 10 Trump's Treasury Secretary Steve Mnuchin was only just confirmed by the Senate and could not have taken any significant action yet. His appointees, notably Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer, are China hawks. If not currency, Trump's team will rotate the negotiations to focus on China's capital controls and failure to liberalize the capital account, its lackadaisical cuts to industrial overcapacity, and the negative business environment for U.S. firms. 11 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com, and Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 12 The first nationwide evacuation drill in the event of a North Korean missile attack will take place sometime in March of this year. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 Bringing the total number of judges from nine to seven, and thus reducing the threshold for a vote in favor of retaining Park in office from four to two, for constitutional reasons. All but one of the judges were appointed by Park or her party's predecessor. 15 For instance, if the new administration reverses the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) system, it will provoke a crisis with the U.S., but if it does not, China will continue its underhanded economic sanctions on the South, and the new South Korean president's North Korean policy will be stillborn. 16 Please see BCA Geopolitical Strategy Special Reports, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Taiwan's 'Trump' Risk," dated February 2, 2017, available at cis.bcaresearch.com. 18 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW," in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 For instance, he is imposing controls on the mining sector that will scare away investors, in an echo of Indonesia's mining fiasco implemented since 2013, and he is working on eliminating a "contract worker" system that enables employers to avoid the costs of full-time hiring. Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 21 Please see BCA Foreign Exchange Strategy Special Report, "Updating Our Long-Term FX Value Models," dated February 17, 2017, available at fes.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Stick To Long Modi / Short Jokowi," dated November 23, 2015, available at gps.bcaresearch.com. 23 Vietnam has moved toward better crisis management with China since the HYSY-981 incident in 2014, when a clash broke out over a mobile Chinese oil rig in the South China Sea. Significantly, the Vietnamese Communist Party's leaders removed former Prime Minister Nguyen Tan Dung, the highest-ranked China hawk and pro-market reformer on the Politburo, in the January 2016 leadership reshuffle.

There is a considerable dichotomy between the EM equity universe and EM corporate credit markets. EM credit markets remain mispriced. EM currencies are at risk of renewed depreciation. This will push sovereign and corporate spreads, as well as high-yielding domestic bond yields, higher. Continue underweighting Indonesian stocks, sovereign credit and domestic bonds within their respective benchmarks.

The near-term (next month or two) market dynamics in EM risk assets remain a coin toss. Beyond that the outlook for EM risk assets remains downbeat. EM financial markets are complacent and there are many potential negative EM/China developments that could derail the current EM rally. A new trade: go long the KOSPI / short EM overall equity index.

Indonesia has been fighting the Impossible Trinity, a battle that cannot be won. The central bank will continue printing rupiahs and the currency will depreciate further. Eventually rupiah depreciation will push up interbank rates, and Indonesia's credit cycle and economic growth will stumble. Continue shorting the rupiah, underweighting Indonesian stocks and sovereign credit, and shorting long-term (5-year) local government bonds.