Manufacturing

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate Contracting At A Double Digit Rate Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks bca.ems_wr_2019_04_04_s1_c13 bca.ems_wr_2019_04_04_s1_c13 The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads The Korean Won Is At Crossroads The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Property Sector Is Depressed Property Sector Is Depressed Chart II-3Consumer Sector Is Weak Consumer Sector Is Weak Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Corporate Restructuring On The Way? Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

As the world’s second most populous country with an economy projected to grow over 7% annually, India’s potential as a commodity consumer is massive. However, years of distortionary and unfriendly policies have held back the Indian manufacturing sector – the prime consumer of commodities. This has translated into weak “consumption intensity” of industrial commodities. The past four years have witnessed a shift to more business-friendly policies. These policies and an eventual expansion of the manufacturing base will support steeper demand for industrial commodities over the longer term. India’s economic model stands in stark contrast with China’s, which became a voracious consumer of commodities as it industrialized. It is not “the next China” when it comes to metals demand, but it will play an important and growing global role. In terms of agricultural commodities, favorable demographic trends will raise aggregate demand, regardless of the success of India’s industrialization. Highlights Energy: Overweight. Russia’s production was down 42k b/d in January, a trifle compared to the ~ 450k b/d reduction by the Kingdom of Saudi Arabia (KSA) in December. Officials indicate Russia will cut production by 228k b/d in 1Q19. Base Metals/Bulks: Neutral. Indian steelmakers are seeking relief from increasing imports in the form of higher duties, as slowing Asian demand leads to higher shipments from China, Korea, and Japan, according to Reuters.1 Precious Metals: Neutral. Gold markets appear more confident in the Fed’s capitulation on its rates-normalization policy, at least in 1H19, as prices rallied above USD 1,320/oz in end-January. Gold traded slightly lower this week. We remain long as a portfolio hedge. Ags/Softs: Underweight. The USDA releases its WASDE report tomorrow. Feature The impact of China’s rapid industrialization since 2000 on commodity markets is well known. Its share of global consumption of copper and crude oil rose from a modest 10.9% and 6.0% in 2000 to 51.1% and 13.5%, respectively (Chart of the Week). As such, China fueled global demand growth over this period (Chart 2) and, in large part, is responsible for the commodity price boom that ensued. Chart of the WeekChina Now Dominates Industrial Commodity Demand China Now Dominates Industrial Commodity Demand China Now Dominates Industrial Commodity Demand With such a large chunk of demand originating in China, its economic health remains a dominant variable in accurately predicting the path of industrial commodity prices globally. However, with economic priorities shifting from the industrial sector to consumer-driven services, the era of insatiable Chinese commodity demand growth looks to be nearing its end. Chart 2 In search of a replacement to take up the slack, India has often been singled out as a potential leading source of commodity demand growth going forward, and for good reason: India is massive. In terms of population, it is roughly on par with China, boasting a population of 1.3 billion people. And while its share of global wealth is dwarfed by China’s, India’s economy is growing at a rapid pace. According to the most recent IMF projections, its GDP will expand at a 7.5%, and 7.7% clip this year and next – faster than China’s projected 6.2% for both years. Typically, as low income economies develop, their manufacturing sector outpaces economy-wide growth, raising the contribution of industry to overall GDP. Stronger activity in this sector correlates well with industrial commodity demand, which rises accordingly. Meanwhile ag demand is determined by both population and income growth. India, however, has missed the boat (Table 1). Its share of global demand is disproportionate to its current size and its future potential. Table 1India’s Consumption Of Industrial Metals Stands Out As Disproportionately Low India's Commodity Demand, With Or Without Modi India's Commodity Demand, With Or Without Modi In fact, the intensity of commodity usage per dollar of GDP is low even relative to countries at similar income levels (Chart 3). This is most clear in the case of metals. It can be put down to the relatively small role of manufacturing in India’s economy. Chart 3 India did not follow the traditional path of growing its manufacturing base first before re-orienting its economy towards services. Rather, the manufacturing sector has been held back by poor infrastructure and distortionary policies. In fact, services – such as financial services, business services, and telecom – already dominate India’s economy, accounting for 53.9% of GDP, compared to 16.7% in the case of manufacturing (Chart 4). This is in stark contrast with other economies such as China, Korea, and Thailand, in which manufacturing accounts for 29%, 28%, and 27%, respectively (Chart 5). Chart 4 Chart 5No Pickup In Manufacturing Yet No Pickup In Manufacturing Yet No Pickup In Manufacturing Yet Given that the services sector is relatively less metals- and energy-intensive, India’s contribution to global demand for industrial commodities has been disproportionately low. Bottom Line: India’s growth model to date is oriented toward the services sector. As a result, the intensity of industrial commodity demand there – measured as consumption per dollar of GDP – is significantly lower than its peers. This has prevented India from playing a larger role in global commodity markets. The Case For Greater Commodity Demand: Theories And Evidence Economist Walt Whitman Rostow postulated that economies develop through five distinct phases: Traditional society: subsistence agriculture, low level of technology, labor-intensive Preconditions to takeoff: regional trade, the development of manufacturing Take off: the beginning of industrialization Drive to maturity: rising living standards, economic diversification, strong use of technology High mass consumption: mass production and consumerism Along this path, economies in phases (2), (3), and (4) are the most notable in terms of rising appetite for industrial commodities. During these stages, the industrialization and urbanization processes require an expansion of electricity grids, infrastructure and housing. As such, these stages are characterized by high base metals demand. Yet as illustrated by the sigmoid, or S curve, the period of exponential growth in commodity demand eventually slows down and in many cases falls after the country reaches a certain level of GDP per capita (Chart 6). Chart 6 Evidence from metals and oil corroborate this theory. In fact, if we single out the commodity intensity path of DM economies as their incomes were rising, we find that commodity intensity there has already started to decline (Chart 7). Chart 7 This S-curve is also evident in the commodity intensity of emerging economies (Chart 8). China’s path to development stands out as an extreme case of high consumption usage. While not all economies follow China, the paths are similar. Chart 8 In the case of oil, it appears that the consumption intensity of countries that have developed more recently peaked at both a lower income level and a lower oil usage level than countries that developed earlier. This is clearly the case for Korea and Malaysia, and suggests that technology has raised the efficiency of oil. On this basis, we do not expect India’s commodity intensity to reach the same peaks as its more wealthy peers. However, India’s usage has remained stagnant and in some cases fallen. This highlights the relatively muted role of manufacturing in India’s economy. As India’s economy grows and evolves, this should change. We project India’s commodity intensity path as it grows its manufacturing base (Chart 9). Based on this exercise, we find that by the year 2040, India’s consumption of refined copper will account for 12% of global consumption -- up from 2% today.  The impact is more muted in the oil sector -- we expect it will account for almost 12% of global crude oil demand, from the current 5%. Chart 9 This trajectory reveals that the scope for rising demand is greater for metals than for the oil sector, implying that industrial commodities are set to benefit in the case of a boom in Indian manufacturing. Bottom Line: Both theory and evidence suggests that the intensity of India’s commodity usage is set to rise over time as its manufacturing sector expands. This is especially true in the case of metals. Even in our most conservative projection, India’s copper consumption is set to rise more than 10-fold by 2040. The Path Forward: “Make In India” While the Rostow model is instructive in framing our thinking on the path to development, it is a crude theory – not all countries will necessarily follow the same path to development. These are the lessons from economist Alexander Gerschenkron’s theory of economic backwardness, which highlights that countries’ growth paths may not be identical or replicable due to cross-country differences, and differences in the state of technology available at varying points of time. Applying these ideas to India means that while India is able to access current technology, which supports a more rapid industrialization process, its economic model is also very different. The China model rested on a powerful single-party state, with privileged access to the American market, that used its control of the financial system to funnel a swell of national savings into an aggressive industrialization effort. On the other hand, the India model required the government to move forward incrementally. Indian leaders had to pursue industrialization while grappling for democratic consensus in the context of extreme social diversity and a more restrictive trade environment. Thus, India is likely to mimic the circuitous path of emerging markets like Brazil or Mexico. Over the past four years, Indian policymakers have tried to unwind unfavorable business policies and spur growth in the manufacturing sector. The “Make in India” initiative of Prime Minister Narendra Modi seeks to encourage both foreign and domestic investment, and to raise the manufacturing sector’s contribution to GDP to 25% by the year 2025. In the process it aims to create 100 million jobs. This target is unrealistic. In fact, the manufacturing sector’s contribution to GDP has come down slightly, with economists blaming the demonetization drive and the chaotic, complicated and unclear roll out of the new Goods and Services Tax. Modi also faces tough elections this spring, which could put his initiative on ice. Nevertheless, there is a positive omen in the automobile industry. According to figures from the Society of Indian Automobile Manufacturers, roughly 4 million cars were manufactured last year – up from 3.2 million just five years ago (Chart 10). This is in line with India’s Automotive Mission Plan 2026, which aims for the auto industry to become one of the top three, accounting for 40% of the manufacturing sector and contributing 12% to India’s GDP by 2026. Chart 10An Encouraging Trend For Manufacturing An Encouraging Trend For Manufacturing An Encouraging Trend For Manufacturing Moreover, Modi’s impact has been a net positive in making India more welcoming for investment. While poor infrastructure, red tape, and restive labor laws are still constraining industry, measures of institutional performance are improving (Chart 11). This is a prerequisite for a brighter manufacturing future. As for the election, even if India’s opposition Congress Party should come to power, it will have learned from its five years in the political wilderness that Modi’s message of economic development resonates with the public. Their current stance on economic policy calls for import substitution, economic liberalization, and a faster pace of development – consistent with a growing manufacturing sector. Chart 11The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving The Business Environment Is Improving Bottom Line: While the “Make In India” campaign says as much about Modi’s flair for public relations as anything, India’s business environment is now more conducive to growth and investment. This bodes well for commodity demand going forward. Ags In The Age Of Manufacturing While a much-needed push in India’s manufacturing sector would clearly have a direct impact on its demand for industrial metals, the resulting improvement in the economy and employment would also raise incomes. In theory, this would support the consumption of agricultural commodities. Nonetheless, a couple of observations suggest that India is less of an opportunity for ags as it is for metals (Chart 12): Chart 12 In terms of the level of ag consumption per capita, rice usage is actually relatively high in India. While corn intensity levels are still quite low, wheat consumption per capita is near the level at which China plateaued. The differences across these grains likely reflects differences in preferred sources across countries and implies there is not as much room for catch up. Furthermore, ag consumption per capita generally plateaus at fairly low-income levels, in stark contrast to the industrial metals. A clear outlier is corn consumption in the United States, where high-usage patterns can be put down to the rising use of corn for ethanol production on the back of biodiesel mandates. We do not expect growth in ag consumption intensity on the back of rising incomes. Nevertheless, India’s population is projected to continue rising, in turn supporting aggregate food consumption there. That said, policies promoting India’s self-sufficiency in agriculture have generally prevented rising demand from spilling over into global markets. In fact, in terms of the trade balance, India is usually a net exporter of these grains, especially in the case of rice (Chart 13). This is a positive for India – in that it has so far avoided the risk of food shortage that occasionally rears its head – but it is a negative for global ag demand. Chart 13Self-Sufficiency Policies Insulate The Indian Ag Sector Self-Sufficiency Policies Insulate The Indian Ag Sector Self-Sufficiency Policies Insulate The Indian Ag Sector Bottom Line: Unlike industrial commodities, we do not anticipate a rise in per capita ag consumption in India. Nevertheless, a rapidly growing population will mean that aggregate demand for ags will grow briskly.    Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Pavel Bilyk, Research Analyst Commodity & Energy Strategy PavelB@bcaresearch.com Footnotes 1      Please see “Exclusive: Indian steel firms seek higher duties on steel imports as prices drop,” published by Reuters.com on February 5, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 4Q18 Image Commodity Prices and Plays Reference Table Summary of Trades Closed in 2018   Image

Highlights EM equity and credit outperformance versus the U.S. in the past three months was an aberration in the cyclical and structural downtrend. Hence, the recent outperformance of EM assets provides a good entry point for investors to short EM/China assets against their U.S. counterparts. In our opinion, this strategy will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. Feature The fourth quarter of 2018 was marked by a precipitous plunge in global equities, led by the U.S. In the meantime, EM stocks have outperformed the global equity benchmark in the past three months. Will EM and U.S. stocks trade places again, or will EM continue to outperform U.S. and DM equities? By the end of December, global share prices had become extremely oversold, and investor sentiment was downbeat. A trifecta of confidence-boosting developments – the rapprochement between the U.S. and China in trade negotiations, the announcement of more policy stimulus in China and reassurances from Federal Reserve Chairman Jerome Powell that monetary policy tightening is not predetermined – have since led to a rebound in global stocks. A key question for asset allocators heading into 2019 is: Will EM continue to outperform the global equity index in this rebound? We do not think so. The odds are considerable that EM will resume its underperformance versus DM in general and the U.S. in particular. The fundamental rationale for staying bearish on EM is that global trade and manufacturing remain on a downward trajectory. Chart I-1 illustrates that EM risk assets sell off when global trade is slowing, especially when the weakness stems from China. Chart I-1EM Selloff Has Been Due To Slowdown In China EM Selloff Has Been Due To Slowdown In China EM Selloff Has Been Due To Slowdown In China Chinese policymakers are easing both fiscal and monetary policies, but the impact of their efforts on the economy is yet to be seen. Declining interest rates in China do not constitute a sufficient condition to buy EM risk assets. Importantly, EM stocks often drop when Chinese interest rates are falling, as that reflects a deteriorating growth outlook (Chart I-2). Chart I-2Lower Interest Rates In China Is Not A Reason To Buy EM Lower Interest Rates In China Is Not A Reason To Buy EM Lower Interest Rates In China Is Not A Reason To Buy EM In short, monetary and fiscal stimulus in China are not yet sufficient to revive the mainland’s business cycle. The latter is critical to the performance of EM risk assets. We will explore China’s fiscal and credit stimulus efforts in much more detail in the coming weeks. Finally, EM equity valuations are no better than those in the U.S. In particular, our EM/U.S. relative stock valuation indicator based on a 20% trimmed mean is currently neutral (Chart I-3). This valuation measure strips out the top and bottom 10% for EM as well as U.S. sub-sectors and computes an equally weighted average of the other 80%. Hence, it eliminates the outliers that for structural or industry specific reasons trade at much lower or higher multiples. Consequently, contrary to the common narrative in the investment industry, EM equities are not cheap versus U.S. ones. Chart I-3EM Equities Are Not Cheaper Than U.S. Ones bca.ems_wr_2019_01_10_s1_c3 bca.ems_wr_2019_01_10_s1_c3 Given our high conviction on the view that U.S. will outperform EM over the coming several months, we are reiterating a few of our long-standing strategic recommendations/pair trades: Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM high-yield corporate credit / long U.S. high-yield corporate credit; Short Chinese property developers / long U.S. homebuilders. In all four cases, the recent outperformance of EM assets provides a good entry point for investors who do not yet have these positions. In our opinion, these recommendations will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. No Turnaround In Global Trade/Manufacturing Global cyclical equity sectors have plunged significantly and their prices may be recovering/stabilizing due to oversold conditions. Yet there are few signs of improvement in global trade and manufacturing, and no indication of a significant turnaround in financial markets that are most sensitive to global trade and Chinese growth. Our Risk-On-to-Safe-Haven (RSH) currency ratio1 has relapsed again following a failed rebound attempt (Chart I-4, top panel). Interestingly, this ratio seems to be forming a head-and-shoulders pattern, suggesting the next big move could be to the downside. As we have shown in past reports, EM share prices correlate strongly with this indicator, and a major downleg in this indicator would be consistent with a major drop in EM stocks. Chart I-4No Buy Signal For EM From The Global Currency Markets bca.ems_wr_2019_01_10_s1_c4 bca.ems_wr_2019_01_10_s1_c4 Furthermore, the annual rate of change on this currency ratio leads the EM manufacturing PMI, and it presently foreshadows more downside in the latter (Chart I-4, bottom panel). Korean and Taiwanese exports contracted slightly in December from a year ago. As frontloading from U.S. import tariffs wanes, their exports will shrink further. Chips prices are falling, signaling that the slump of the global tech hardware sector is not yet over (Chart I-5). Chart I-5Chip Prices Are Still Plunging Chip Prices Are Still Plunging Chip Prices Are Still Plunging Continued deterioration in global trade and manufacturing is bad news for emerging Asia. The technical profile of Asian stock markets is also poor, raising the odds of a meltdown as cyclical economic conditions in the region deteriorate further. The region’s relative equity performance versus global and Latin American indexes is relapsing, having failed to break above long-term moving averages (Chart I-6). Chart I-6Underweight Emerging Asian Stocks Versus Both World And Latin America Underweight Emerging Asian Stocks Versus Both World And Latin America Underweight Emerging Asian Stocks Versus Both World And Latin America Odds are that emerging Asian stocks will drop in absolute terms, underperforming both the EM and global equity benchmarks. This will drag the EM index down further. We continue to recommend the following strategy: long Latin American stocks / short emerging Asian equities. The U.S. manufacturing leading indicator – the ISM manufacturing new orders-to-inventory ratio – remains in a downtrend (Chart I-7). Chart I-7The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The average of new and backlog orders from the Chinese manufacturing PMI survey has plunged to its previous lows (Chart I-8, top panel). The domestic orders component of the People’s Bank of China’s latest 5000 industrial enterprise survey is also in a free fall (Chart I-8, bottom panel). Chart I-8China: No Sign Of Bottom In Industrial Sectors China: No Sign Of Bottom In Industrial Sectors China: No Sign Of Bottom In Industrial Sectors Meanwhile, the impact of Chinese domestic demand on the rest of the world occurs via mainland imports. The leading indicator for imports – the manufacturing PMI import sub-component – has plunged to 46, well below the 50 boom-bust line (see Chart I-1, bottom panel on page 1). Within the investable Chinese equity universe, cyclical sectors exposed to capital spending are making new lows in absolute terms (Chart I-9, top and middle panels). At the same time property stocks are relapsing again (Chart I-9, bottom panel). Chart I-9China: Not Much Rebound In Cyclical Equity Sectors China: Not Much Rebound In Cyclical Equity Sectors China: Not Much Rebound In Cyclical Equity Sectors While the authorities are once again boosting infrastructure spending by allowing local governments to issue more special bonds, the mainland’s real estate market has ground to a halt. The latter will likely offset the former. Finally, the MSCI China All Shares index – which incorporates all Chinese stocks trading inside and outside the country – has not rebounded much, despite being oversold (Chart I-10, top panel). Chart I-10China All Share Index: Poor Performance Continues China All Share Index: Poor Performance Continues China All Share Index: Poor Performance Continues Notably, this index’s relative performance versus both DM and EM equity indexes has failed to break above its 200-day moving average, despite the announced policy stimulus (Chart I-10, middle and bottom panels). These are negative technical signposts that bode ill for the outlook for Chinese share prices. Bottom Line: Odds are high that the global trade/manufacturing or related equity sectors/segments will continue struggling in the months ahead. What About The U.S. Dollar? The trade-weighted U.S. dollar has been going sideways for several months. While lower U.S. interest rate expectations have weighed on the greenback, the global manufacturing slowdown and risk-off sentiment in financial markets have put a floor under its value. The dollar is a countercyclical currency, and it does well when global growth is weakening, and vice versa (Chart I-11). Chart I-11The U.S. Dollar Is A Counter-Cyclical Currency The U.S. Dollar Is A Counter-Cyclical Currency The U.S. Dollar Is A Counter-Cyclical Currency It is impossible to know how long this standstill phase in the currency markets will last. What we do know is that when it breaks one way or another, the move will be violent and large. We believe risks to the U.S. currency are to the upside. First, U.S. consumer spending growth remains robust, and the labor market is very tight. Unless the rest of the world plunges into a major growth slump, pulling the U.S. down with it, U.S. interest rate expectations should recover, lifting the dollar. Second, a further downshift in U.S. interest rate expectations will likely occur only if the global economic slowdown is so severe that it leads the market to price in Fed rate cuts. In this scenario, the greenback will rally violently as well. The basis is that the dollar tends to appreciate during global slumps and sell off amid global growth recoveries, as illustrated in Chart I-11. Third, the only scenario where the dollar could plunge is where global trade recovers briskly, driven by growth outside the U.S. in general and in China/EM in particular. This is the least-likely scenario at the current juncture, in our opinion. The trend in the dollar is critical to the relative performance between EM and U.S. stocks. Chart I-12 demonstrates that periods of EM equity underperformance versus the U.S. typically coincide with an appreciation in the trade-weighted greenback, and vice versa. Chart I-12When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa Bottom Line: The next big move in the U.S. dollar will likely be up, not down. Investment Considerations Global equity prices are already reflecting a lot of bad news; they are oversold, and investor sentiment on global growth has become downbeat (Chart I-13). This could create a window for global equities to rebound on a tactical basis. Chart I-13U.S./Global Stocks Are Oversold U.S./Global Stocks Are Oversold U.S./Global Stocks Are Oversold The majority of our colleagues at BCA believe global equities are primed for a cyclical rally. We within BCA’s EM team agree with the equity rebound narrative but on a tactical basis and believe that any rebound will be led by U.S. stocks – and that EM will lag. We are not convinced that global equities are in a cyclical bull market yet. The main difference between BCA’s house view and the EM team’s outlook is the risks related to China’s economy and their impact on global cyclical equity sectors. The U.S. is relatively unexposed to Chinese growth, EM economies, commodities producers, Japan and Germany. Therefore, U.S. stocks will outperform and the dollar will do well if Chinese growth continues disappointing. Ongoing trade talks between China and the U.S. may bring about some positive results, and the Fed may continue to sound more dovish. However, we contend that the main culprit behind the global equity selloff in 2018 was neither the trade war nor the Fed, but the slowdown in global trade/manufacturing (please refer to Chart 1 and 7 on pages 1 and 6, respectively). On this front, we do not foresee an imminent reversal, as argued above. The latest underperformance of the U.S. has created a good entry point for our relative strategies/trades to be short EM / long U.S. We reiterate the following strategies/trades (Chart I-14): Chart I-14Reiterating Four EM Vs. U.S. Strategies/Trades Re-iterating Four Strategies/Trades for EM Vs. U.S. Re-iterating Four Strategies/Trades for EM Vs. U.S. Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM HY corporate credit / long U.S. HY corporate credit; Short Chinese property developers / long U.S. homebuilders. Within the EM equity space, we continue to recommend underweighting emerging Asia while overweighting Latin America, Russia and Central Europe. In particular, we are reiterating our long Latin America / short Emerging Asian equities trade initiated on October 11, 2018 (please refer to Chart I-6 on page 5). The complete list of our country equity allocations is presented on page 12. Finally, the path of least resistance for the dollar is up. We continue to recommend shorting a basket of the following EM currencies against the dollar: ZAR, IDR, MYR, KRW, COP and CLP. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The odds of a significant reversal in the current structural downtrend of China's manufacturing productivity growth are low. Meanwhile, the country's manufacturing sector remains highly competitive in the global goods markets. The extent of China's manufacturing productivity growth will largely rely on the scale of its research and development (R&D) investment. China's high-tech sector will likely experience higher productivity growth than other traditional manufacturing sectors, including textiles and metals manufacturing. Feature By definition, increases in productivity1 allow a country to produce greater output for the same level of input, which boosts profits and ultimately improves economic growth and household living standards. In the context of the post-1990 "economic miracle" in China, persistently positive productivity growth has indeed drastically improved the nation's wealth and living standards. Over the past 10 years, however, China's productivity growth has actually decelerated significantly, which carries worrying implications for the future (Chart I-1). Given that productivity is a country's key source of economic growth and competitiveness, two important questions arise: 1. Will there be meaningful improvement in China's productivity growth over the next five years (Chart I-2)? Chart I-1China: Decelerating Productivity Growth China: Decelerating Productivity Growth China: Decelerating Productivity Growth Chart I-2Any Possibility Of A Productivity Boom Ahead? Any Possibility Of A Productivity Boom Ahead? Any Possibility Of A Productivity Boom Ahead? 2. Is China's competitiveness on a declining trajectory (Chart I-3)? In this report we focus on answering these questions as they pertain to China's manufacturing sector, which is still a very important part of the country's economic engine. We conclude that while the odds of a meaningful reversal of the downtrend in China's manufacturing productivity growth are low, Chinese manufacturers are unlikely to experience major losses in global market share. Yet, this underscores the importance of re-orienting China away from the "old economy" model and the difficulty policymakers continue to face in doing so. A long-term shift away from the country's investment-intensive economic sectors is a clear negative for traditional "China plays" such as industrial commodities and emerging market stocks. China's Productivity Growth Downtrend: A Meaningful Reversal Ahead? When examining trends in productivity, measurement issues frequently come into play. For China, we have presented three measures of labor productivity growth (Chart I-1 on the first page). All three exhibit a similar pattern since the early 1990s. However, in the past two years, some divergences have occurred among the three, with the National Bureau Of Statistics (NBS) and Conference Board data showing slight improvement, as opposed to the World Bank data, which declined sharply in 2017. We tend to rely on the Conference Board data over the World Bank, and the recent rebound in the former seems to better reflect both improved manufacturing output and a significant reduction in the number of employees since late 2015 (Chart I-4). Chart I-3Will China's Competitiveness Decline? Will China's Competitiveness Decline? Will China's Competitiveness Decline? Chart I-4Significant Reduction In Manufacturing Workers Significant Reduction In Manufacturing Workers Significant Reduction In Manufacturing Workers In order to understand the outlook for labor productivity, it is first and foremost important to understand what has already occurred. Chart I-1 on page 1 shows that the Conference Board's estimate of Chinese labor productivity growth decelerated significantly from 2008 to 2015, which in our judgement was caused by strong growth in employment, falling manufacturing output growth due to weaker global demand for goods following the 2008 global financial crisis, and, finally, diminishing returns from global technological innovation in the past 30 years. Looking forward over the next five years, several factors point to the conclusion that productivity growth will stay positive but that the odds of a meaningful reversal of the downtrend is low: First, further declines in the number of manufacturing-sector workers are likely to be limited. The manufacturing sector accounts for nearly 90% of total jobs in the industrial sector. Since December 2015, China's supply side reform efforts as well as the increased adoption of automation and technology have already resulted in a 15% decline in the number of manufacturing sector jobs, with employee cuts occurring across all 30 manufacturing sub-sectors covered by the NBS. As such, the lion's share of productivity gains from job cuts has probably occurred already. In fact, since the beginning of this year, the number of employees in the manufacturing sector has actually increased by 0.5%, with positive growth in two-thirds of the 30 manufacturing sub-sectors. Second, overall improvement in manufacturing output volume has been moderate in the past two years, a period when global import volumes have accelerated. Production volumes in nearly half of the 90 major manufacturing product categories contracted during the economic downturn period of 2014-2015. In comparison, about 40% still had negative output growth over the recovery period of 2015-2017 (Chart I-5). Chart I-5Manufacturing Output: Moderate Improvement China's Manufacturing Sector: Don't Bet On A Productivity Boom China's Manufacturing Sector: Don't Bet On A Productivity Boom The likelihood of continued de-leveraging and restructuring will constrain domestic demand growth, while escalating trade wars may even cut external demand for Chinese products. This will create tough headwinds for the Chinese manufacturing sector over the next several years. Third, we examined productivity growth of a sample of nine manufacturing sub-sectors (out of 30) by using key product output volumes divided by the number of employees in each respective sector. The results show that productivity growth for nearly all of the sub-sectors is currently running below 5%, while in some sectors it is actually contracting. The "computers, communication and other electronic equipment" sector is the biggest export sector for China, accounting for over 40% of total export value in U.S. dollars. This is one of the most important high-tech sectors the country is aiming to develop. However, even within this sector, different products show diverging productivity growth. For example, semiconductor integrated circuits are growing at a strong 15% rate, while mobile handsets are contracting at a 13% rate (Chart I-6). Chart I-7 and Chart I-8 drive home the point: productivity growth was positive in four high-value-added manufacturing sectors and four low-value-added commodity process sectors, but most of these sectors' productivity growth was less than 5%. Chart I-6Diverging Productivity Growth Diverging Productivity Growth Diverging Productivity Growth Chart I-7Low Productivity Growth In High-Value-Added ##br##Manufacturing Sectors... Low Productivity Growth In High-Value-Added Manufacturing Sectors... Low Productivity Growth In High-Value-Added Manufacturing Sectors... Chart I-8...And In Low-Value-Added Sectors As Well ...And In Low-Value-Added Sectors As Well ...And In Low-Value-Added Sectors As Well Fourth, we expect Chinese R&D expenditure growth to strengthen, given the government's goal of turning the country into a global leader in digital technology and innovation (Chart I-9, top and middle panels). Chart I-9Rebounding R&D Expenditures Vs. Falling FAIs Rebounding R&D Expenditures Vs. Falling FAIs Rebounding R&D Expenditures Vs. Falling FAIs However, in terms of fixed asset investment (FAI) in the manufacturing sector, which is a much broader investment measure than the R&D investment, its growth already dropped to 3% last year, significantly lower than the compound annual growth rate of 24% over the 2004-2014 period (Chart I-9, bottom panel). Manufacturing FAI growth will likely stay within the range of 0-5% and to some extent will counteract any increases in productivity growth from increased R&D spending. Bottom Line: The recent improvement in China's labor productivity reflects - at least in part - short-term factors that appear to have run their course. China's manufacturing productivity growth will stay low over the coming years, and a meaningful reversal of this downtrend is unlikely. Sustaining Competitiveness Faltering productivity growth, however, does not mean fading competitiveness. For instance, while China's productivity growth plunged from 14.3% in 2007 to 7% in 2017, the country's contribution to global exports climbed from 7.3% to 10.5% during the same period (Chart I-3 on page 2). Meanwhile, Chinese high-tech exports have also gained global market share (Chart I-10). More recently, however, China's exports have lost some global market share both in overall terms and in the high-tech sector over the past two years. Does this herald a declining trajectory in China's manufacturing competitiveness? In our view, the answer is no. We believe China's manufacturing sector will remain highly competitive in the global marketplace: While clearly trending lower, China's productivity growth was the highest among major developed and emerging economies last year (Chart I-11, top panel). It also has always been well above the global average (Chart I-11, bottom panel). Chart I-10Competitive Chinese High-Tech Products Competitive Chinese High-Tech Products Competitive Chinese High-Tech Products Chart I-11China's Productivity Growth: Higher ##br##Than Most Major Economies China's Productivity Growth: Higher Than Most Major Economies China's Productivity Growth: Higher Than Most Major Economies China's manufacturing labor costs are also much lower than many other major exporters (Chart I-12, top panel). In addition, growth of average annual nominal wages in the Chinese manufacturing sector has declined to the lowest since 1997 (Chart I-12, bottom panel). China's R&D investment as a share of GDP is relatively high among major emerging economies (Chart I-13, top panel). With the country allocating more R&D investment into high-tech manufacturing, the pace of technology innovation is set to increase (Chart I-13, middle and bottom panels). Currently, China is already the biggest producer in several high-tech industries, including new energy vehicles, smart phones, communication equipment, solar cells and wind turbines. Chart I-12China's Manufacturing Labor Costs: ##br##Lower Than Most Major Economies China's Manufacturing Labor Costs: Lower Than Most Major Economies China's Manufacturing Labor Costs: Lower Than Most Major Economies Chart I-13China's R&D Spending: ##br##Higher Than Most EM Economies China's R&D Spending: Higher Than Most EM Economies China's R&D Spending: Higher Than Most EM Economies Even in low-value-added export sectors like textiles and metals, China's competitiveness is still strong. This has likely occurred in part due to supply side reforms - which have accelerated the consolidation of domestic industries - reducing costs and increasing production efficiencies. The 8% depreciation in China's currency versus the U.S. dollar over the past three months will also help improve the country's competitiveness. Bottom Line: China's manufacturing sector will remain highly competitive in the global goods market, despite faltering productivity growth. Investment Conclusions BCA's China Investment Strategy service has previously written about how China's export-enabled, catch-up growth phase in the early-2000s came to an abrupt end after the global financial crisis, and how policymakers were subsequently faced with a hard choice: China could either replace exports as a growth driver with debt-fueled domestic demand in order to buy the economy time to move up the value-added chain and transition to a services-led economy, or it could allow the labor market to suffer the consequences of a sharp slowdown in export growth while preserving fiscal and state-owned firepower for some uncertain future opportunity.2 This report highlights the difficulty experienced by China's manufacturing sector at reversing a downtrend in its productivity growth, which can be viewed as a microcosm of China's struggle to reorient itself and move away from its "old economy" towards one that is led by services. For investors, there are two key implications from this: First, the inherent difficulty of transitioning China's economy suggests that it will continue to experience economic mini-cycles around an uncertain primary growth trend, as policymakers periodically shift between aggressive supply-side reforms and demand-side countercyclical policies. In fact, some investors have come to believe that China is about to enter another mini-cycle upswing in response to recent stimulus announcements, but we have noted that the stimulus proposed so far falls short of a "big bang" response that would not only reverse the underlying slowdown and any trade shock but also reaccelerate the growth rate above trend.3 Second, to us the prospect of a potentially long, grinding shift away from China's investment-intensive economic sectors does not present an attractive risk-reward trade-off for traditional "China plays", such as industrial commodities and emerging market equities, over the coming few years. While it is true that periodic mini-cycle upswings may provide tactical opportunities for investors to go long these assets, the China "transition" theme suggests that an investors' strategic allocation to traditional China plays should be below benchmark. Chart I-14Prominence Of Investable ##br##Tech Ex-Internet Stocks Will Rise Prominence Of Investable Tech Ex-Internet Stocks Will Rise Prominence Of Investable Tech Ex-Internet Stocks Will Rise As a final point, periods of economic transition typically create both winners and losers, and China's continued focus on R&D spending suggests that the overlooked elements of China's tech sector may be winners. Chart I-14 highlights that over 90% of China's investable technology sector market capitalization is made up of companies in the internet software and services (ISS) industry, suggesting that investable tech ex-ISS may rise in prominence over time. More generally, identifying potential winners from increased Chinese R&D spending is an area of ongoing research at BCA, and is a theme that we hope to revisit in the future. Stay tuned! Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com 1 The most common productivity measure is labor productivity, typically calculated as a ratio of real gross domestic product (GDP) to hours worked or employed persons. 2 Please see BCA China Investment Strategy Weekly Report, "Legacies Of 2017," dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018, available at cis.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations