Money/Credit/Debt
Highlights The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. Our negative outlook for China's capital spending and imports will be wrong if the money velocity or the money multiplier or productivity growth rise materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity would be highly speculative and unreasonable. With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Feature Chart I-1EM Share Prices Are ##br##Facing A Technical Hurdle In this week's report we elaborate on the following interrelated questions: Where do EM economies stand in terms of their respective business cycles? What are the key drivers and risks to our view? EM share prices in U.S. dollar terms are facing another technical hurdle (Chart I-1). Even though EM risk assets have been trading well, we still find their risk-reward profile unattractive, and below we elaborate why. The EM Business Cycle EM economic data have differed greatly over the course of the current rally, and various economic parameters presently exhibit very different phases of the business cycle in developing economies. For example, Asian export growth has rolled over having expanded at a double-digit pace early this year (Chart I-2). In general, EM exports have posted a broad-based recovery: the recovery in Chinese, U.S. and European imports has helped Asian exports, while higher commodities prices have boosted export revenues of commodities producers. On the flip side, domestic demand in EM ex-China has been rather mediocre. In fact, there has been very little domestic demand recovery, as evidenced by retail sales and auto sales (Chart I-3). Importantly, bank loan growth has not recovered at all (Chart I-3, bottom panel). Based on the above, we can summarize the above divergences as follows: the global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Chart I-2Asian Export Growth ##br##Has Rolled Over Chart I-3EM ex-China: Domestic ##br##Demand Has Not Yet Recovered In turn, China's imports surge has been due to the revival in new money/credit origination that has been in play since the middle of 2015. China's commercial banks have originated about RMB 43 trillion of new money/credit in the past two years. This has greatly helped many developing countries selling to China, boosted commodities prices, creating fertile ground for capital flows to EM financial markets. Going forward, the pertinent question for the EM business cycle is which of the following two scenarios will likely play out: (1) China's imports relapse materially soon, weighing on commodities and other EMs and capping the recovery in their domestic demand; or (2) Chinese import growth holds and the recovery in EM ex-China domestic demand gains momentum. The first scenario entails a bearish outcome for EM share prices, while the second would imply a continuation of the EM rally. BCA's Emerging Markets Strategy team envisages the first scenario. The basis of our argument is that the deceleration that has already occurred in Chinese money growth combined with ongoing monetary tightening are about to cause a considerable slowdown in China's real economy and imports (Chart I-4). What about the other two pillars of global imports - the U.S. and Europe? U.S. imports have in the past year outpaced final sales to domestic purchasers (Chart I-5). As can be seen in this chart, imports are more volatile than domestic demand and this discrepancy is reflective of inventory cycles. After outpacing final domestic demand for the past seven months, odds are U.S. imports growth will moderate in the next 12 months. That said, we do not expect a contraction in U.S. imports. Even if European imports remain robust, a material slowdown in China and some moderation in U.S. imports will be sufficient to produce a slump in EM aggregate exports. The rationale is twofold: First, for many developing countries, China as a destination for shipments is larger than or as large as the U.S. and Europe combined. Chart I-4China: Money Growth And Business Cycle Chart I-5U.S. Import Growth to Moderate Second, mainland demand for raw materials is critical for their prices. In turn, the trend in commodities prices often defines EM financial markets dynamics. This is why we focus so much on China's credit/money cycle, which in turn drives China's capital spending and an overwhelming majority of its imports. Notably, the reason why Chinese imports are much more sensitive to credit compared to other EM and DM economies is because the mainland's imports consist of 42% of commodities and raw materials and 55% of capital goods. Hence, 97% of imports is for investment spending, with the latter financed and driven by money/credit. Bottom Line: The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. The Key Pillar Of Our View The key area where we differ from the bullish consensus on EM/China is our expectation that Chinese growth will slow before year-end due to a combination of ongoing policy tightening and lingering credit excesses. Regardless of which broad money measure we use - official M2, money calculated using commercial banks' liabilities (we refer to it as deposit-money or M3 hereafter) or banks' assets (we refer to this as credit-money) - the current message is the same: broad money growth has fallen to historic lows (Chart I-6). An imperative question is: what does the recent gap between broad money (our calculation of M3) and private (corporate and household) credit growth, as evidenced by the top panel of Chart I-7A, mean for investors? Chart I-6China: Various Versions Of Broad Money Chart I-7Comparing Broad Money And Credit Growth From the perspective of the outlook for growth, it is the aggregate of private and public credit that matters. When we substitute private credit with the aggregate of private and public credit, there does not appear to be much decoupling (Chart I-7, bottom panel). Readers should note that the historical time series for aggregate private and public credit is from BIS and the data for 2017 are our estimates based on general government fiscal deficit and total social financing. If past correlations between money, credit and economic growth and their respective time lags hold, the cyclical parts of the Chinese economy should slow down before year-end (Chart I-8). This differs from the consensus view on the street that a slowdown is not in the cards until well into next year (or later). China's currently flat yield curve also supports our view on imminent growth deceleration (Chart I-9). In fact, Chinese money market rates and onshore corporate bond yields have begun drifting higher following two to three months of consolidation. Chart I-8China: A Slowdown Before Year-End? Chart I-9China: Yield Curve And PMI Finally, we believe the depth of the impending slowdown will be material because ongoing liquidity tightening is occurring amid lingering credit excesses/credit bubble. While policymakers do not plan to push the economy into a vicious downturn, they may be open to the idea of attempting mild short-term deleveraging to contain risks in the long run. Furthermore, the Chinese authorities - like in any other country - may not have perfect foresight about the magnitude of a potential slowdown. Hence, their reversal of tightening policies is likely to be late, resulting in a rough spot in growth. Bottom Line: The key difference between our stance and the bullish view on EM is on China's growth trajectory and commodities prices. Risks To Our View Given that the main pillar of our view is that China's credit and money growth is driving mainland capital spending and imports, our recommended investment strategy will be wrong if the already transpiring slowdown in money growth does not translate into investment spending deceleration. This could happen because of the following: Strong nominal growth can coincide with slower money growth only if the velocity of money accelerates. In short, our view will be wrong if China's nominal output growth holds up or quickens, despite the slowdown in broad money growth that has already occurred. This could happen if the velocity of money suddenly shoots up - i.e., the same amount of money simply turns faster facilitating faster expansion of nominal output. There is no way to forecast changes in money velocity in any country in any period with any precision. As a rule, we (and the vast majority of other market participants) simply assume money velocity will be constant over our forecast horizons. Money velocity is calculated as nominal GDP divided by broad money supply. From a historical perspective, Chart I-10 demonstrates that China's money velocity has actually drifted lower in the past 10 years or so. Therefore, a material rise in China's money velocity would be an exception from the trend of past decade. Consequently, before assuming a rising money velocity, one needs to prove why it will escalate going forward. This does not mean it is impossible or could not happen, but it is reasonable to challenge the nature and timing of it. Our view will be wrong if money growth accelerates sharply from current levels without more liquidity (banks' excess reserves) provisioning by the People's Bank of China (PBoC). In such a scenario, broad money growth acceleration amid low levels of banks' excess reserves would signify a spike in the money multiplier. However, the money multiplier for China - measured as broad money divided by commercial banks' excess reserves at the central bank - is already at the second highest of the past ten years (Chart I-11, top panel). In level terms, there is currently about RMB 212 trillion of broad money - measured by commercial banks' liabilities/deposits (our measure of M3) versus RMB 2 trillion of commercial banks' excess reserves at the end of June. Chart I-10China: Velocity Of Money ##br##Has Been Drifting Lower Chart I-11China: Money Multiplier ##br##Is Already Elevated We assume the money multiplier will be flat to down in China over the next 12-18 months. Banks have already become overextended with respect to the money multiplier, and are operating on thin liquidity/excess reserves (Chart I-11, bottom panel). With interest rates rising and regulatory tightening forcing banks to bring off-balance-sheet assets onto their balance sheets, it is reasonable to assume a flat-to-down money multiplier. Finally, another risk to our view stems from productivity. If productivity growth is set to accelerate considerably in China, it will boost real output growth despite the slump in money/credit. Chart I-12China: Structural Slowdown ##br##In Productivity Growth It is hard to measure productivity ex-post, let alone to forecast it. This is especially true for developing economies. This is why we assume that productivity growth in China will be stable in the medium term but will decelerate in the long run if structural reforms are not implemented and the economy's reliance on abundant money/credit is not reduced. Simply put, when money/credit are plentiful, people and companies make a lot of money without working hard and innovating. This is why money/credit deluges and asset bubbles often lead to a considerable productivity slowdown in any country. Provided that China's economy has been primarily fueled by copious amounts of money and credit since early 2009, it is reasonable to assume that productivity growth has slowed (Chart I-12). Without structural reforms, the quality of capital allocation will not improve. Therefore, productivity growth is bound to slow rather than accelerate. We will discuss the structural outlook for China including productivity and economic rebalancing toward the service sector in a special report to be published in the coming weeks. Bottom Line: Our negative outlook for China's capital spending and imports will be wrong if the money velocity rises considerably or the money multiplier shoots up or productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity from current levels would be highly speculative and unreasonable. Risk Off And Fund Flows Into EM Last week we downgraded Korean stocks due to expectations that geopolitical tensions are set to rise in the near term. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.1 And that process could take more time, which means more volatility in the markets.2 The risk-off dynamics in EM due to tensions in the Korean Peninsula is a near-term risk and might become a trigger for a rollover in EM risk assets via reversal of portfolio flows. One of the narratives supporting the EM rally has been the changing composition of foreign capital flows into EM. This narrative argues3 that international flows to EM have been dominated by foreign direct investment (FDI) rather than portfolio inflows. This presages that EM risk assets are much less exposed to portfolio outflows than before. However, this is factually wrong. The composition of international capital flows into EM has been dominated by portfolio flows rather than FDI. In fact, FDI inflows have not yet recovered (Chart I-13). For the calculation of this aggregate we exclude not only China, Korea and Taiwan - which have large current account surpluses and do not require FDI inflows - but also Brazil. We exclude Brazil because its FDI and portfolio flows data have been distorted due to disadvantageous tax treatment of portfolio flows relative to FDIs. Chart I-14 illustrates that FDIs inflows have been robust and net portfolio inflows have been negative in the past 18 months. The latter does not pass our smell test because Brazil's financial markets have rallied tremendously since early 2016. This appears simply non-credible and confirms lingering speculation that a lot of foreign capital inflows have been registered in Brazil as FDI inflows to get preferential tax treatment - and were subsequently invested in financial markets, specifically in domestic bonds, not the real economy. Chart I-13EM ex-China, Korea, Taiwan And Brazil: ##br##FDI Inflows Have Not Recovered Chart I-14Brazil: The Puzzle of FDI ##br##Inflows And Portfolio Flows Chart I-15Brazil: Strong FDI Inflows ##br##And Collapsing Capital Spending Consistently, capital spending has not recovered at all, despite the preceding collapse (Chart I-15). All in all, excluding Brazilian data, there has been little recovery in EM FDI inflows (Chart 16A and Chart I-16B). Chart I-16AFDI Inflows Into Various EM Countries Chart I-16BFDI Inflows Into Various EM Countries Bottom Line: With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. 3 Please see, "Globalisation in retreat: capital flows decline since crisis", August 21, 2017, available at https://www.ft.com/content/ade8ada8-83f6-11e7-94e2-c5b903247afd Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Despite a tightening in Chinese monetary conditions, dollar bloc currencies have continued to rally. Rising global reserves and strong carry inflows into EM prompted by low global financial volatility have created plentiful liquidity conditions in EM, supporting dollar-bloc currencies. The beginning of the Fed's balance-sheet runoff could reverse these dynamics, hurting the AUD, CAD and NZD in the process. Monitor U.S. inflation, cross-currency basis swap spreads, gold, EM currencies and Chinese monetary conditions to judge when a break in dollar-bloc currencies will materialize. Feature The rally in the dollar-bloc currencies since July 2016 has been nothing short of stunning. We did highlight in April last year that commodity currencies had room to appreciate, but we did not anticipate such a prolonged move.1 In fact, the up leg that began in April 2017 caught us by surprise. At this juncture, it is essential to analyze whether or not the bull move in commodity currencies has further to run, or whether it is in its final innings. A principal component analysis of the returns of the AUD, the CAD, and the NZD shows that despite differing central bank postures in the three countries, a simple common factor explains 86% of their variability against the USD since 2010 (Chart I-1). Because of this result, our focus in this week's report are the global forces that may be driving this factor. Today, the key risk to the dollar-bloc currencies is global liquidity tightening. Behind this danger lies the removal of policy accommodation in the U.S., and the risks to carry trades created by the already-very-low volatility of risk assets. A China-Fueled Rebound, But Something Is Amiss... The key reason behind the rally in commodity currencies has been improvement in EM growth relative to DM economies since 2016 (Chart I-2). This growth outperformance has been underpinned by a few factors. Chart I-1One Factor To Drive Them All Chart I-2Commodity Currencies And EM Growth China has played an essential role. As the Chinese economy decelerated in 2015, Beijing implemented a large amount of fiscal stimulus, which saw government spending grow at a 25% annual rate in November 2015. Due to the lags of stimulus on the economy, the full force of that stimulus was felt in 2016. Direct fiscal goosing was not the only road taken by Beijing. The Chinese authorities also applied a considerable amount of monetary pressure on China. After tightening massively through 2015, Chinese monetary conditions eased greatly in 2016 as real borrowing costs collapsed from a peak of 10.5% in the fall of 2015 to a trough of -3.5% earlier this year (Chart I-3). Directed expansion of credit through banking channels was also used to support the economy, resulting in a surge in the Chinese credit impulse. However, in recent months these positives have dissipated. Chinese money growth has slowed, and the combined credit and fiscal impulse has been lessened. Yet EM equity prices, copper prices and commodity currencies are all continuing their rally, and are now re-testing their May 2015 levels - levels last experienced right before EM assets and related plays entered a vicious tailspin that lasted all the way until January 2016 (Chart I-4). Chart I-3China: From Tailwind ##br##To Headwind Chart I-4EM, Copper, Dollar Bloc: ##br##Back To May 2015 Levels Bottom Line: The rally in dollar-bloc currencies that begun in January 2016 was powered by improving growth performance within EM economies. The original driver behind this move was Chinese monetary and fiscal stimulus. However, even once the easing faded, EM plays, including the AUD, the CAD and the NZD continued to appreciate. Another factor is currently at play. ...And This Something Is Global Liquidity Our view is that global liquidity is now the key factor supporting EM plays in general and dollar-bloc currencies in particular. Since the end of 2016, we have seen a rebound in the Federal Reserve's custody holdings - one that has happened as foreign central banks resumed their purchases of Treasury securities (Chart I-5). Fed custodial holdings for other monetary authorities are a key component of our dollar-based liquidity indicator. A rebound in this indicator tends to be associated with a surge in high-powered money globally. The capital outflows from China have dissipated, helping high-powered money find its way into EM plays and the commodity-currency complex. Private FX settlements - a proxy for the Chinese private sector's selling of yuan - was CNY -43 billion in July, a massive improvement compared to the CNY 800 billion in outflows experienced in August 2015 (Chart I-6). Through stringent administrative controls and a lessening of deflation, China gained the upper hand over its capital account. This development has two implications: it means that China does not need to sell reserves anymore, and in fact has been accumulating Treasurys since February 2017. It also means that investors are now less afraid of a sudden devaluation in the CNY, which has heartened risk-taking globally - especially in assets most exposed to China, which includes EM, commodities and dollar-bloc currencies. Chart I-5Easing Global Liquidty In 2017 Chart I-6Chinese Capital Account Under Control The collapse in the volatility of risk assets has been an additional element helping global liquidity make its way into EM plays and commodity currencies. As Chart I-7 illustrates, there is a relationship between the realized volatility of the U.S. stock market and the performance of dollar-bloc currencies. The first hunch is to dismiss the relationship as an artifact of the fact that both stock prices and commodity currencies are "risk-on" instruments. But there is an economic underpinning behind this relationship. As we argued in a Special Report on carry trades last year, the main reason carry trades have been able generate high Sharpe ratios since the 1980s is because they offer investors a risk premium for taking on exposure to unforeseen spikes in volatility.2 As a result, when the volatility of risk assets collapses, as has been the case recently, carry currencies outperform. The opposite holds true when volatility spikes back up. Chart I-7Dollar Bloc Currencies Like Low Vol When carry trades do well, investors end up aggressively buying EM currencies. As a result of these purchases, they inject funds - i.e. liquidity - into these economies. These injections of liquidity end up boosting money growth and supporting their economic activity, which stimulates global trade, commodity prices, and thus commodity currencies - even if these are not currently "high-yielders." Bottom Line: Chinese monetary conditions have deteriorated, creating a handicap for EM assets and the dollar-bloc currencies. Nonetheless, an increase in high-powered money growth, a decline in the risk premium to compensate investors for the risk of sudden new Chinese devaluation, and a collapse in global financial volatility have reinforced each other to create the ideal breeding ground for a rally in the AUD, the CAD and the NZD. The Sweet Spot Is Passing At the current juncture, the sweet spot for the dollar-bloc currencies may be passing. To begin with, commodity currencies are trading at a significant premium to underlying commodity prices, suggesting they are expensive and vulnerable to a decrease in global liquidity (Chart I-8). The AUD and the NZD stand out as especially expensive, while the CAD is only trading at a small premium to its long-term fair value (Chart I-9). This suggests that the Canadian dollar is likely to continue to outperform the Australian and New Zealand currencies, as it has been doing in choppy fashion since November 2016. Chart I-8Dollar Bloc Currencies Are Expensive Chart I-9AUD And NZD Are Expensive Another problem for dollar-bloc currencies is that they have greatly overshot global liquidity metrics. Historically, the commodity currencies have moved in lockstep with the evolution of global central bank reserves - a key measure of global liquidity (Chart I-10). While global reserves have improved, the average of the AUD, the CAD and the NZD has over-discounted this positive, pointing to potential vulnerability once liquidity ebbs. The problem with this overshoot is that liquidity is likely to decline with the imminent reduction in the Fed's balance sheet size. As Chart I-11 shows, the USD has been closely linked to changes in the reserves of commercial banks held at the Fed. As commercial banks accumulate excess reserves, this provides fuel for the repo market and the Eurodollar market, creating a supply of globally available USD for offshore markets. However, mechanically, once the Fed lets the assets on its balance sheet run off (its holdings of Treasurys), a liability will also have to decrease. This liability is most likely to be excess reserves as banks buy the Treasurys sold by the Fed. A fall in the accumulation of reserves of commercial banks in the U.S. is also directly linked with weaker dollar-bloc currencies (Chart I-12). This is because falling reserves push up the dollar and hurt commodity prices - a negative terms-of-trade shock for the AUD, the CAD and the NZD. Moreover, less reserves point to less liquidity making its way into EM economies. This also hurts the expected returns of holding assets in dollar-bloc economies. This therefore means that not only is there less liquidity available to move into these markets, the rationale to do so also dissipates. Without this dollar-based liquidity support, the tightening in Chinese monetary conditions could finally show its true impact on commodity currencies. Chart I-10Commodity Currencies Have##br## Overshot Global Liquidity Chart I-11Falling Excess Bank Reserves##br## Equals Strong Greenback Chart I-12Falling Excess Reserves Equals##br## Falling Commodity Currencies The last worrisome development for the dollar-bloc currencies is the volatility of financial assets. When volatility falls, it creates a wonderful environment for these currencies. But today, historical volatility is near the bottom of its distribution of the past 28 years. Being a highly mean-reverting series, it is thus more likely to rise than fall further going forward. There are three fundamental factors pointing to a potential reversal. First, share buyback activity has been declining, which historically points to rising volatility. Second, the U.S. yield curve slope also points toward a higher level of volatility. Volatility tends to bottom before the stock market peaks, and the stock market tends to peak before the economy enters recession. The yield curve itself tends to invert a year or so before a recession emerges. As a result, the yield curve begins to flatten around two years before volatility picks up (Chart I-13). Third, the anticipated decline in bank reserves - an important factor that has supported risk-taking around the globe - is likely to be the key catalyst supporting the relationship between the yield curve and volatility. If volatility increases, carry trades are likely to perform poorly, which will hurt EM currencies and result in outflows from these markets. This will cause liquidity conditions in EM economies to dry out, hurting their growth outlook. EM M1 growth has already weakened considerably, and is currently pointing to problems for commodity currencies (Chart I-14). The dry out in liquidity resulting from a reversal in carry trades will only amplify this phenomenon. Chart I-13Listen To The Yield Curve: ##br##Volatility Will Pick Up Chart I-14EM M1 Growth Is Becoming ##br##A Headwind For The Dollar Bloc Bottom Line: Global liquidity conditions are set to begin to tighten. While it is probably not enough to cause the bull market in stock prices to end now, it could be enough to affect the area of the global economy most exposed to this risk factor: carry trades and the dollar-bloc currencies. Specifically, commodity currencies are likely to be negatively affected by their elevated valuations, their strong sensitivity to excess bank reserves, and their high responsiveness to changes in financial market volatility. Key Indicators To Monitor After the surge that the dollar-bloc currencies have experienced since the spring and the large increase in the long exposure of speculators to these currencies, they are naturally at risk of experiencing a period of weakness. However, what worries us is not a retracement of 3-4%, but rather a 10-15% move. We suggest monitoring the following: First, watch U.S. inflation closely. The U.S. dollar is only likely to genuinely rally once the market believes the Fed can actually increase rates. So long as inflation remains tepid, investors will continue to second-guess the Fed. The market's response to this week's release of the most recent Federal Open Market Committee minutes only confirmed this. Mentions of debate on inflation within the FOMC was enough to send bond yields and the dollar reeling. However, based on the dynamics in the U.S. velocity of money, we continue to expect inflation to pick up in the second half of 2017 (Chart I-15).3 Second, follow cross-currency basis swap spreads. The cost of hedging U.S. assets back into euro or yen has normalized somewhat after hitting record levels in early 2016 (Chart I-16). If the removal of excess bank reserves in the U.S. system does affect global liquidity conditions, this market will be one of the first to be affected. Third, scrutinize the price of gold. The yellow metal remains a key gauge of global liquidity. Moreover, it is extremely sensitive to real rates and the dollar - two major determinants of the cost of global liquidity. In the summer of 2015, EM and dollar-bloc currencies severely suffered once gold broke below 1150. Today, a break below 1200 would be a sign of danger ahead. Fourth, watch EM currencies. A breakdown in EM currencies would be a key indication that carry trades are being reversed, and that global liquidity is no longer making its way into EM and EM-related plays. Commodity currencies are currently trading at a premium to their historical relationship with EM currencies, suggesting they would be highly vulnerable to such an event (Chart I-17). Chart I-15Watch U.S. Inflation Chart I-16Monitor Cross-Currency Basis Swap Spreads Chart I-17Dollar-Bloc Currencies At The Mercy Of EM FX Finally, keep an eye on Chinese monetary conditions. If Chinese monetary conditions improve from here, it would alleviate some of the negative pressure exercised on dollar-bloc currencies by the upcoming deterioration in global liquidity. However, if Chinese monetary conditions deteriorate further, this would negatively affect commodity prices, EM returns and the commodity currency complex. It would also hurt expected returns on Chinese assets, re-kindling outflows out of China and thus raising the risk premium associated with what would become a growing risk of CNY depreciation. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Pyrrhic Victories", dated April 29, 2016, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report titled, "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report titled, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been mixed this week: The Empire State Manufacturing Index increased to 25.2, a significant jump and beat Retail Sales increased at a 0.5% monthly pace, with the ex. Autos measure increasing at 0.5%, both beating expectations; The Import Price Index increased by 1.5% since last year; Initial jobless claims dropped to 232,000, beating expectations significantly; However, housing starts and building permits both underperformed expectations. While the DXY has rebounded, the FOMC's July minutes discussed the recent shortfall of inflation, which was interpreted bearishly by markets. The Fed is likely to begin normalizing its balance sheet very soon, as well as raising rates again by the end of this year. The greenback will likely continue its ascent when firmer inflation data emerges. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Improving euro area growth prospects have propelled the euro 12% higher since the beginning of the year. However, the market seems to begin questioning the ECB's hawkishness. In its minutes, the ECB expressed worries about a potential euro overshoot. Additionally, rumors emerged that Mario Draghi will not give much guidance in Jackson Hole. Together, these stories have reversed some of the euphoria that had engulfed the euro. The tightening in euro area financial conditions relative to the U.S. has prompted a roll over in relative economic and inflation surprises, justifying these budding doubts. Furthermore, U.S. inflation should begin to meaningfully accelerate in the fall. This is likely to add to the euro's weakness, as the greenback will resume its upward trend. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Data in Japan was mixed this week: Annualized gross domestic product growth grew by 4% on an annualized basis, crushing expectations. Additionally the month-to-month growth of industrial production came in at 2.2%, also beating expectations. However both export and import growth underperformed, coming in at 13.4% and 16.3% respectively. On cue, after we placed a long USD/JPY trade last week, USD/JPY rallied half percentage point, even if it gave up some of the gain now. We continue to be bearish on the yen as we expect U.S. yields to start picking up, in an environment where market expectations are very depressed. But could a correction in EM caused by the rise in the dollar help the yen? Not in the short term, given that historically the yen only gains in very sharp EM selloffs that themselves weigh on bond yields. Report Links: Fade North Korea, And Sell The Yen - August 11, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Data in the U.K. was mixed this week: Retail sales prices increased by 3.6% year-on-year, outperforming expectations. However, The trade balance not only worsened since last month but also came in below expectations, at -4.564 Billion pounds Crucially, most inflation metrics came in below expectations, with headline inflation coming in at 2.6% while PPI core output inflation came in at 2.4%. Overall, we continue to believe that the market's rate expectations for the BoE remain too hawkish. As the pass through from the currency dissipates, inflation should also start to come down. Furthermore, one has to remember that the BoE has a higher hurdle for raising rates than other central banks due to the unique situation in which the U.K. is currently in. Lowered rate expectations will be negative for cable in the short term. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Despite initially weak data, a risk-on environment and increasing copper prices have fueled a rally in the AUD. Data from China has been soft, and Australian data has been neutral: Chinese retail sales increased annually by 10.4%, less than expected; Chinese industrial production also underperformed at 6.4%; Australian wages increased at a 1.9% annual pace, in line with expectations; Australian unemployment dropped to 5.6%; participation rate increased to 65.1%; and a net of 27,900 jobs were filled. However, full-time employment went down by 20,300 while part-time employment increased by 48,200, so hours worked contracted. This development is likely to comfort the RBA in its dovish stance. In its minutes, the RBA discussed its worries concerning the housing market, and that "borrowers investing in residential property had been facing higher interest rates". This further worries the RBA regarding the impact of higher interest rates, limiting the room for more hawkish speeches. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: Retail sales and retail sales ex-autos Quarter-on-quarter growth strengthened relatively to the previous quarter, coming in at 2% and 2.1% respectively. Moreover quarter-on-quarter inflation both for producer prices in outputs and inputs outperformed expectations, coming in at 1.3% and 1.4%. Currently, differences in perception adjustment between the dovishness of the RBNZ and the RBA have pushed Australian rate expectations to the point that the market is now pricing a hike in Australia before New Zealand. Overall, this seems like a mispricing, as the kiwi economy is on a stronger footing than the aussie one. Moreover, a slowdown in China would be more harmful for Australia as iron ore is more sensitive to the Chinese industrial cycle than dairy products. Thus we remain bearish on AUD/NZD. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD has regained some composure despite weak oil prices. Even with the U.S. dollar weakening and inventories drawing massively, oil dropped. This dynamic is particularly worrying for oil, as the markets are doubting the durability of the curtailment in global oil production. While this could be worrying for the CAD, we still believe the USD 40-60/bbl equilibrium price level, as postulated by the BoC, will have a limiting effect on the oil-based currency, which has been driven by interest rate differentials. Both central banks are now hiking, but we believe that markets are underpricing Fed hikes. Thus, the CAD should weaken against USD. However, it will outperform other G10 currencies. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data has continued to show a mixed picture for the Swiss economy: Consumer prices inflation, increased slightly from the previous month, coming in at 0.3%, in line with expectations. The unemployment rate also came in in line of expectations at 3.2%, unchanged from the previous month. However, producer prices contracted by 0.1%, underperforming expectations. EUR/CHF has been weakening since its August second overbought extreme. For the moment, we expect the SNB to stand pat in its ultra-dovish monetary policy, at least until inflation and other economic indicators start to strengthen considerably. USD/CHF however might appreciate, given that the euro might fall the ECB minutes this week showed that the ECB is concerned by a potential euro overshoot. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Data in Norway this week was mixed: Headline inflation came in at 1.5% in July, outperforming expectations. However, it softened from June's 1.9% reading. Core inflation came at 1.2% in July, in line with expectations, decreasing from 1.6% in June. Moreover, manufacturing output contracted by 0.6% year-on-year. We continue to be bullish on USD/NOK, as the increasing gap in real rate differentials between the United States and Norway should outweigh any oil rally. Indeed, the recent numbers in Norway illustrate the lack of inflationary pressures in this Scandinavian country. This should keep a lid on rates, and thus help USD/NOK. On the other hand EUR/NOK should follow the path of oil. Thus, the OPEC supply cuts will ultimately support oil prices and thus, weigh on this cross. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has had a particularly strong week, as inflation surprised to the upside on both a monthly and a yearly basis, coming in at 0.5% and 2.2% respectively. While it initially appreciated against all currencies, the uptick in commodity currencies on Wednesday made it lose its gains against AUD, CAD, NZD and NOK. As inflationary pressures grow, the SEK is likely to appreciate further, especially against the EUR and GBP. Additionally, with current Riskbank governor Stefan Ingves' term coming to an end by the end of this year, the hawkish rhetoric is likely to only increase. Report Links: Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights A number forward-looking indicators for EM corporate profits point to a major deceleration in the next several months, and potentially a contraction early next year. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth and they herald a bearish outlook for EM EPS. We continue deciphering the differences between China's various money and credit aggregates. Irrespective of which money measure we use, and regardless of their past track record, all of them are currently extremely weak and point to a major and imminent slump in China's growth in the next six to 12 months. We recommend shifting the underweight EM corporate and sovereign credit position versus U.S. high-yield to underweight versus U.S. investment-grade corporate credit. Feature Chart I-1Asian Exports And EM EPS The recovery in EM earnings per share (EPS) has been instrumental to the EM stock rally this year. As such, the equity strategy at the moment hinges on the outlook for corporate profits. In this report, we revisit coincident and leading indicators for EM profits. At the moment, EM corporate profit growth still appears robust, though several forward-looking indicators point to a major deceleration in the next several months, and potentially a contraction early next year. Korean and Taiwanese exports can be used as proxy for global trade. The latest data for July reveal that the sum of Taiwanese exports and Korean total exports excluding vessels has rolled over (Chart I-1). Historically, the U.S. dollar values of both economies' exports have correlated with EM EPS, and Chart I-1 entails that EM EPS growth will roll over very soon. The reason why we exclude vessel exports in the case of Korea is because vessel shipments are one-off occurrences and when they take place, they distort export growth. This was the case in the last several months - vessel (shipbuilding) exports surged by 75% from a year ago, distorting the annual growth rate of total exports. Overall, Korea's and Taiwan's overseas shipments in the past three months have averaged about 10%, which is lower than the mid-teen growth rates recorded earlier this year. In China, export growth is close to 9% in the past three months, and it is also rolling over. On a similar note, Korea's and Taiwanese shipments-to-inventory ratios lead EM EPS cycles, and they are presently sending a downbeat message (Chart I-2). China's import growth has relapsed, as suggested by both Chinese trade data and their counterparties export data to China (Chart I-3). Chart I-2Asia's Shipment-To-Inventory Ratios And EM EPS Chart I-3Exports To China And Chinese Imports The recovery in Chinese imports has been responsible for a considerable part of the recovery in global trade. Importantly, Chinese import cycles correlate very well with EM EPS growth (Chart I-4). The key pillar of our view remains that Chinese imports will contract going forward, which will depress both advanced and developing countries' shipments to China. Exports to China are much more important for EM than DM economies, and deteriorating sales to China will weigh considerably on EM profits and currencies. The most reliable forward-looking indicators for EM EPS have been EM/China narrow and broad money growth. Chart I-5A and Chart I-5B demonstrate that both EM narrow (M1) growth and China's broad money impulse (the second derivative) - herald a major slump in EM EPS. This is the main reason behind our negative stance on EM share prices and other risk assets. Chart I-4Chinese Imports And EM EPS Chart I-5AChina Broad Money Impulse And EM EPS Chart I-5BEM Narrow Money And EM EPS Both narrow and broad money growth in China have already relapsed, and it is a matter of time until economic growth and imports downshift enough to produce a major selloff in EM risk assets. We discuss China's monetary aggregates in the section below. Finally, if Chinese imports and commodities prices relapse, any reasonable strength in DM domestic demand will not be sufficient to preclude a meaningful EM slowdown. The basis is that exports to the U.S. and EU only make up 7% of GDP for China, 8% for Korea and 11% for Taiwan. While exports to China account for 10% of Korean GDP and 15% of Taiwanese GDP. The same holds true for most East Asian countries. With the exceptions of India and Turkey, non-Asian EM countries are primarily commodities producers. These two have their own idiosyncratic problems. Most of our analysis is not applicable to smaller central European economies that are leveraged to the EU business cycle. That said, neither Turkey, India, nor central European markets have large enough financial markets to make a difference in the EM benchmarks. The above is the primary reason behind our bearish view on EM growth and profits. That said, there are a few other interesting considerations regarding EM corporate profits dynamics. First, EM share prices lead EM EPS by six to nine months. Therefore, to be bullish on EM stocks, it is not sufficient to expect EM EPS growth to be robust over the next three months. Rather, to be bullish on EM stocks at the current juncture, one should have a bullish view on EM EPS by the end of this year and into the early part of 2018. Consistently, we believe that EM EPS growth will decelerate materially by the end of this year and shrink in the early part of 2018. Second, the top-line shrinkage in 2015 and the consequent recovery for EM exporters has been mostly driven by prices rather than volumes. Chart I-6A illustrate that Korean, Taiwanese and Chinese manufacturing production growth is rather muted. Chart I-6ACorporate Pricing Power Chart I-6BAsian Manufacturing Production Price fluctuations affect profits much more than output volume changes. Therefore, if global tradable goods prices deflate - at the moment they have rolled over (Chart I-6B) - EM EPS will contract materially. Third, in EM excluding China, Korea and Taiwan, there has been little economic recovery, as evidenced by Chart I-7. Along the same lines, the latest (July) manufacturing PMI for EM ex-China, Korea and Taiwan has dropped below the crucial 50 line (Chart I-7, bottom panel). This and the majority of other economic aggregates we use are equity market-cap weighted averages, so they are relevant to investors. This corroborates the fact that outside China, Korea and Taiwan there has been little genuine growth improvement in EM domestic demand - despite the decent recovery in global trade. This challenges the prevailing widespread consensus of a synchronized global economic recovery/expansion. This is also consistent with the fact that the overwhelming EM profit recovery has occurred in technology and resource sectors while domestic sectors have not seen much of corporate earnings recovery (Chart I-8). Chart I-7EM Ex-China, Korea And Taiwan: ##br##No Strong Recovery Chart I-8EM Sectors' EPS: Exporters ##br##Have Outperformed Domestic Finally, bottom-up equity analysts have recently downgraded their EPS estimates for listed EM companies (Chart I-9). Typically, analysts alter their forecasts simultaneously with swings in share prices. Hence, the latest decoupling is puzzling. Chart I-9EM EPS And Analysts' Net Revisions Notably, EM net EPS revisions have failed to move into positive territory in the past 7 years. This entails that analysts' expectations have been chronically high in recent years, and/or that companies have failed to deliver profits that match these projections. Bottom Line: The EM EPS outlook is downbeat, and listed companies profits will likely contract early next year. Deciphering China's Money Puzzle Based on our assessment of multiple measures, our conclusion with respect to Chinese broad money growth is as follows: Irrespective of which measure we use, and regardless of their individual past track records, all Chinese monetary growth aggregates are currently weak (Chart 10), and point to a major and imminent slump in China's growth in the next six to 12 months. In recent weeks, we have been working to understand differences among various measures of money growth in China. Our motivation is because neither M2 nor total social financing and fiscal spending - variables that we relied on last year - did a good job of forecasting the duration and magnitude of China's economic and profit revival in the past 12 months. In our July 26 report,1 we introduced the concept of broad money calculated using commercial banks' assets. We called it credit-money. This week, we discuss a different broad money calculation based on commercial banks' liabilities, and refer to it as deposit-money. Deposit-money is an aggregate of non-financial companies' time and demand deposits, household deposits, transferable and other deposits, other liabilities, bonds issued and liabilities to non-depository financial corporations. This measure is broader than official broad money (M2) because the latter includes only non-financial companies' time and demand deposits, household deposits and some of liabilities to non-depository financial corporations. In brief, our deposit-money calculation is more comprehensive than the official broad money figures (M2). In turn, banks' credit-money is the sum of commercial banks' claims on companies, households, non-bank financial institutions and all levels of government, as well as banks' foreign assets. Also, we deduct government deposits at the central bank (see July 26 Emerging Markets Strategy report1 for more details). Chart I-10 illustrates the differences between credit-money, deposit-money, total social financing and M2. Based on our calculations, deposit-money grew faster in 2015-'16 than both M2 and total social financing. Yet its current and ongoing slowdown is as bad as that of credit-money or M2. Chart I-10Dichotomy Among Various Money And Credit Aggregates In China The reason why M2 growth has lagged behind deposit-money growth since the middle of 2015 until now is the fact that the latter's components that are not included in the official M2 measure have outpaced M2 growth by a wide margin since late 2015. The main components of deposit-money are shown in Chart I-11. This is one of the main reasons why we missed the latest China-play rally - we relied on the official measure of money and credit published by the PBoC that has been much tamer than the broader money and credit, as banks have originated credit and hence money in a way that official monetary aggregates have not captured. In addition, banks' credit-money and deposit-money measures should theoretically be identical, but this has not been the case in China in recent years. Deposit-money is larger and it may well be more comprehensive than credit-money (Chart I-12). Chart I-11China: Components Of Deposit-Money Aggregate Chart I-12The Outstanding Stock And Flow Of Money Understanding these discrepancies is an ongoing work-in-progress for us, and we will be refining these measures going forward. For now, we would say that these differences are probably due to banks' efforts to misrepresent/hide their assets and liabilities to meet the regulatory ratios and avoid penalties, as well as maximize short-term profits. All that said, the gaps between M2 and deposit-money has recently narrowed: both deposit-money and M2 growth and their impulses are at all-time lows (Chart I-13). Furthermore, we expect deposit-money to slow further because of the lagged impact of higher interest rates and regulatory tightening that is intended to curb commercial banks' ability to originate more money via shadow banking activities. Finally, as can be seen from Chart I-14A, Chart I-14B and Chart I-15, deposit-money's impulse - its second derivative - leads many cyclical economic variables such as nominal GDP, producer prices, freight index, and imports. Chart I-13China: Two Measures Of Broad Money Chart I-14ADeposit-Money Leads Real Business Cycle Chart I-14BDeposit-Money Leads Real Business Cycle There are several other data points from China's real economy that portend developing weakness. Specifically, car sales growth has almost ground to a halt, real estate floor space sold and started are decelerating (Chart I-16). Chart I-15Deposit-Money Leads Metals Prices And Construction Chart I-16China: More Signs Of Slowdown Bottom Line: Regardless of which money measure we use, and regardless of their past track record, all of them are currently weak and point to a major and imminent slump in China's growth in the next six to 12 months. This gives us confidence in reiterating our negative view on China plays (including commodities) and EM. Credit Markets Strategy We have been recommending a strategy of shorting/underweighting EM sovereign and corporate credit versus U.S. high-yield (HY) credit and this strategy has shown strong performance, producing 15% gains with low volatility since August 2011 (Chart I-17). However, today we recommend shifting the underweight EM corporate and sovereign credit position from U.S. HY to U.S. investment grade (IG) corporate credit. The primary reason is that credit spreads are extremely tight and odds favor credit spreads widening in both U.S. and EM. Chart I-18 shows that when U.S. TIPS yields rise U.S. IG usually outperforms U.S. HY on an excess return basis. We expect U.S. Treasurys and TIPS yields to grind higher in the near term because U.S. growth and inflation are much stronger than the bond market is currently pricing in. Chart I-17Book Gains On This Strategy Chart I-18Higher U.S. Bond (TIPS) Yields Warrant Rotation Rising U.S. bond yields also warrants EM credit underperformance versus U.S. IG because the EM credit benchmark is riskier than U.S. IG. While the two segments have similar durations, the duration times spread measure of risk is greater for EM credit. Furthermore, U.S. HY spreads have narrowed versus both EM sovereign and corporate spreads since early 2016 (Chart I-19, top panel). Hence, there is little value favoring the former versus EM credit. In contrast, U.S. IG spreads versus both EM sovereign and corporate credit are appealing historically (Chart I-19, bottom panel). Therefore, there is a valuation aspect to this strategy change. Relative spread differences have historically correlated quite well with the subsequent 12-month return. Given where relative spreads are, the subsequent 12-month return for investing in U.S. IG relative EM credit is positive (Chart I-20, top panel) but it is negative for investing in U.S. HY versus EM credit (Chart I-20, bottom panel). Chart I-19EM Credit Offers Value Relative ##br##To U.S. HY But Not Versus U.S. IG Chart I-20Projected Returns Of EM Credit ##br##To Both U.S. IG And HY As to the rationale of favoring U.S. credit to EM credit, this is consistent with our theme that the growth outlook, corporate leverage, and health of the banking system are in much better shape in the U.S. than in EM. Bottom Line: Book profits on the short EM sovereign and corporate credit / long U.S. HY credit position. Institute a new position: short EM sovereign and corporate credit / long U.S. IG corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Follow The Money, Not The Crowd", dated July 26, 2017, link available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Chart I-4BWidening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Chart I-1The Economy Has Stabilized##br## But Has Not Recovered Brazil desperately needs to boost nominal growth to avoid public debt spiraling out of control1. We do not think it is possible without resorting to meaningful currency depreciation and much lower interest rates. The Brazilian economy has stabilized, but it has not yet recovered (Chart I-1). To stage a sustainable recovery, much easier monetary conditions and fiscal stance are required. However, monetary conditions remain tight and fiscal policy is tightening: Feature Real interest rates are about 5.5-6% - as high as they were before the current rate-cut cycle commenced (Chart I-2). The Brazilian central bank's aggressive rate cuts have largely matched the drop in the inflation rate, keeping real borrowing costs elevated. Besides, household debt servicing costs (interest payments and principal) are high, above 20% of disposable income (Chart I-3) and employment conditions remain extremely poor. In this environment, households will not be inclined to expand leverage considerably. The Brazilian real is not cheap. In fact, the real effective exchange rate is slightly above its fair value (Chart I-4). Nominal GDP growth is currently running close to 4%, while the government's budget assumption for nominal GDP growth in 2017 is 5-5.5%. Not surprisingly, government revenues are disappointing and the budget deficit is above its target (Chart I-5). Furthermore, the improvement in government revenues in the past 12 months has been due to one-off measures such as non-recurring privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL and tax amnesty/capital repatriation programs that will not be repeated. In brief, more tax hikes are needed to achieve revenue targets but higher taxes will in turn jeopardize the economic revival. Taxes on fuel have been raised in recent weeks. Chart I-2Interest Rates Are##br## Still Very High Chart I-3Household Debt Servicing##br## Ratio Has Not Yet Declined Chart I-4The Real Is Not Cheap Chart I-5Brazil: No Improvement In Fiscal Accounts Given that fiscal policy is straightjacketed by high and rapidly rising public debt levels, the onus of boosting nominal growth is squarely on the central bank. Not only have the monetary authorities cut interest rates, they have also been monetizing government debt. Chart I-6 shows that the central bank's holdings of government securities have skyrocketed, i.e., the central bank has bought BRL531 billion of government paper since January 2015. While it has partially sterilized its debt monetization by using these securities as reverse repos with banks, the amount of high-powered money/liquidity withdrawal via repos has been much smaller than the central bank's liquidity injections. Chart I-6aBrazil: Central Bank Has##br## Been Monetizing Public Debt... Chart I-6b...And Sterilizing It ##br##Only Partially This has helped liquidity in the banking system considerably, and smoothed the banking system adjustment at a time of surging non-performing loans. However, it has not generated enough purchasing power in the economy to boost nominal growth. Notably, broad money growth is slowing (Chart I-7). Even though bank loan growth may have troughed (Chart I-7, bottom panel), it is unlikely to recover strongly due to high real rates. Broad money captures the stance of credit and fiscal policies because broad money reflects purchasing power created by commercial banks and central bank when lending to and buying government bonds from non-banks. Remarkably, the broad money impulse - which is the second derivative of outstanding broad money - points to weakness in nominal GDP growth (Chart I-8). Chart I-7Brazil: Broad Money##br## And Bank Loans Chart I-8Broad Money And Terms Of Trade Point ##br## To Weaker Nominal Growth In addition, nominal GDP growth correlates with terms of trade, and the latter has also relapsed (Chart I-8, bottom panel). Furthermore, high-frequency data reveal that manufacturing PMI and consumer confidence have also rolled over lately, pointing to stalling improvement in both the manufacturing sector and consumer spending (Chart I-9). All in all, policymakers are behind the curve. The central bank could continue cutting interest rates, increase its purchases of government bonds, and also use other measures to inject more money – both high-powered money and broad money – into circulation. If they do so, it will eventually help the economy recover and boost inflation, yet it is bearish for the exchange rate. However, if the exchange rate relapses on its own (due to other factors), that will limit the authorities' ability to reduce interest rates further. This is on top of heightened political uncertainty that does not bode well for Brazilian financial markets. In a nutshell, Brazil needs to engineer currency depreciation to boost nominal growth and make public debt sustainable. This is true especially as Argentina is opting to keep its currency competitive, and it will be even more critical if commodities prices relapse, as we expect (Chart I-10). Provided the share of foreign currency public debt is low, reflating via currency depreciation is the least painful way out for Brazil. Bottom Line: Policymakers are desperate to boost nominal growth to stabilize public debt. Yet, in our opinion, nominal growth will not improve without further sizable rate cuts and meaningful currency depreciation. Eventually, policymakers will allow the BRL to depreciate 20%-plus, which will hurt foreign investments in local asset markets. We remain negative on/underweight Brazil equities, currency and sovereign debt. That said, we recommend fixed-income investors to bet on the 3/1-year yield curve flattening: receive 3-year / pay 1-year swap rate (Chart I-11). Chart I-9High-Frequency Indicators:##br## Improvement Has Stalled Chart I-10Other Headwinds##br## For BRL Chart I-11A New Trade: ##br## Bet On 3/1-Year Yield Curve Flattening Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 11 - we argued that Brazil's public debt dynamics is unsustainable without strong nominal growth and/or social security reforms. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Chart II-3Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Chart II-5Mexico: Exports Are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Chart II-7Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights EM equity breadth has moved into negative territory, DM-based excess liquidity measures are set to roll-over, and China-based liquidity measures are also weak. Individually, each of these factors are not enough to raise alarm bells, but together they point to a period of heightened risks for EM assets and commodity currencies. AUD/CAD and NZD/JPY are set to suffer in this environment. EUR/USD will rise to 1.15-1.16, but unlike in 2015, it should not receive much of a fillip from EM volatility. Feature Chart I-1Technical Risk In EM An interesting development has unfolded in emerging markets. While the pause in the EM rally has hit investors' radar screens, the more puzzling event concerns breadth. Not only has the advanced/decline line rolled over, but more worrisomely, it has recently moved into negative territory. Historically, when more stocks are declining rather than advancing, EM equities tend to experience sharp selloffs (Chart I-1). This development is important when put into a global context. EM stocks and related assets like commodity currencies have been buoyed by plentiful global liquidity conditions. However, global liquidity is set to deteriorate. A rocky second half may emerge in EM assets. Global Liquidity Is Slowing Following in the Federal Reserve's footsteps, DM central banks are moving away from monetary accommodation. Last week, European Central Bank President Mario Draghi made a speech that was interpreted as representing an abandonment of the ECB's dovish bias. With the anticipation that its bond-buying program will be tapered early in 2018 and reports that the ECB is having problems buying its quota of German and Finnish bonds, global bonds suffered, with Bund and T-Note yields moving up 33 and 23 basis points since June 27, respectively. The ECB is not the only central bank to have changed its tack. The Bank of Canada's communications have been crystal clear that it intends to increase rates this summer, or early fall at the latest. Even the perennially dovish Riksbank is moving away from its easy bias, as Sweden's resource utilization points to a continued acceleration in core inflation. But does this even matter? The global economy is strong, and beginning to remove accommodation is not quite the same thing as pushing rates into tight territory. The advanced economies are unlikely to suffer much from this development. However, the picture for EM is more concerning. Some key leading indicators of EM activity have already begun to roll over. For example, Taiwanese IP, a key bellwether of overall EM strength, is now contracting on a year-on-year basis (Chart I-2, top panel). Meanwhile EM PMIs rolled over three months ago and EM narrow money growth, a key forecaster of EM profits, is slowing sharply (Chart I-2, bottom panel). Despite these negative developments, EM stocks have remained resilient. The factor underpinning this impressive performance has been the rise in global liquidity. More technically, the rise in the global Marshallian K - the ratio of money to nominal GDP - over the past six months. Excess money has had to go somewhere. Among the many refuges, EM has been a key pole of attraction, with massive inflows supporting assets prices. The 8% appreciation in EM currencies versus the dollar since their January 2016 trough has been a vivid illustration of this phenomenon. The driver of the rise in excess money has been the ratio's numerator, dollar-based liquidity. The Fed's various QE programs were key determinants of dollar-based liquidity (Chart I-3). However, its tapering in late 2014 was enough to prompt a contraction of the measure. Now that the Fed is intent on decreasing its balance sheet while the ECB tapers and other smaller DM central banks begin increasing rates, the small improvement witnessed in the past three months is likely to end. The recent weakness in gold prices, despite the softness in the dollar, could be a sign that markets are beginning to sniff out the imminent tightening of global liquidity conditions. Chart I-2EM/China Profits Growth To Roll Over (I) EM Growth ##br##Has Deteriorated, Profits Will Suffer Chart I-3The Fed Balance Sheet Runoff ##br##Will Hurt Global Liquidity Additionally, not only are global central banks, led by the Fed, tightening or looking to tighten policy, they are doing so despite an absence of actual inflation. As a result, this means DM real yields are set to rise. As Chart I-4 illustrates, rising real DM yields have historically been a harbinger of poor EM bond performance. In fact, the action in DM real yields since mid-2016 already points to a problematic second half for EM bonds. As a result, EM bond investors are likely to suffer some losses in the coming months. Such losses would not only tighten EM financial conditions, but would also be symptomatic of capital leaving the region. Less money in those markets simply means less liquidity. With EM corporate spreads near historical lows, a repricing of credit risk on the back of softening global and EM liquidity is likely to prompt both a selloff in EM stocks and in EM currencies (Chart I-5). As a result, DM commodity currencies, the NZD and AUD in particular, could suffer. Chart I-4EM Financial Conditions##br## Are Set To Deteriorate Chart I-5If Liquidity Dries, Spreads Widen ##br##And EM Stocks Fall Bottom Line: In November 2016, a new leg of the EM rally began - a move driven by an expansion in global liquidity, even as a key bellwether of EM economic activity rolled over in the interim. Global excess liquidity is set to roll over as DM central banks abandon their dovish biases and the Fed begins to let its balance sheet run off. With EM weaker from a technical perspective, the second half of 2017 could be a tough environment for EM plays. Chinese Liquidity Joins The Fray In May 2015, EM equities in U.S.-dollar terms peaked just before global liquidity began to roll over. Compounding the risks, back then Chinese economic conditions were also problematic. Excess capacity and massive deflationary forces were wearing down on profits and investment. China is thus another key factor to watch. In this optic, beyond DM liquidity, a key driver of the rebound in EM last year was actually Chinese liquidity conditions. In the second half of 2015, China's own Marshallian K - based on M2 relative to nominal GDP growth - was rebounding sharply, as the PBoC was easing policy and the fiscal authorities were pressing on the gas pedal, expanding both public expenditures and pushing credit growth through the economy. However, that was then. Today, China has joined the tightening party. The quarterly moving average of Chinese interbank rates has increased by 100 basis points over the past year. Crackdowns on real estate and excess leverage have also resumed. Most importantly, the issuance of bonds by small and medium banks - a key source of grease to total social financing - has also massively decelerated, which points to a sharp slowdown and even a contraction in the Chinese credit impulse (Chart I-6). Thanks to this development, the Chinese Marshallian K is now in negative territory. The global impact of tighter Chinese monetary conditions is also flashing a red flag. Our indicator is based on the relative performance of Chinese bank stocks and USD/HKD. Underperformance of Chinese banks tends to send warning signs that tightening policy is beginning to negatively affect the outlook for Chinese credit growth. Additionally, USD/HKD is at an 18-month high because Hong Kong interest rates have not been able to follow U.S. ones, as loan demand by mainland-China entities has been poor. Most of the time, this indicator tends to move with EM stock prices, providing very little information. However, as Chart I-7 illustrates, this gauge is at its most useful when it diverges from EM equity prices. In each case, such as in 2007, 2011, and 2014, the divergences between the falling price-based Chinese liquidity indicator and rising EM stock prices was resolved by a correction in the latter. Today, the indicator points to a large amount of downside risk for EM stocks. Chart I-6Chinese Credit Impulse Will Slow Chart I-7A Worrying Divergence Again, it is important to reiterate that in and of itself, such a divergence is not enough to prompt investors to run for the hills and ditch EM stocks and related plays. However, when this happens as DM liquidity is also set to deteriorate, and most crucially, when EM breadth turns negative, decreasing EM exposure makes sense. Bottom Line: Chinese liquidity conditions are also deteriorating. The People's Bank of China may not want to push the economy into another slowdown cycle, which will most likely limit how far the Chinese central bank will tighten policy. However, this tightening has not been priced in by EM equities, and is happening as DM central banks are also reducing accommodation and as EM breadth has greatly deteriorated. A sizeable correction in EM plays is becoming increasingly likely. Investment Implications Chart I-8Global Liquidity Leads EM ##br##By More Than A Year A tightening of dollar-based liquidity and Chinese-based liquidity is a big problem for non-China EM economies. EM economies outside of China and OPEC nations still run an annual current account deficit of more than US$200 billion. They need liquidity. Moreover, they still have at least US$3.6 trillion in foreign-currency debt. With liquidity conditions deteriorating, we should expect a widening of EM spreads, falling EM stock prices and falling commodity currencies. In fact, we are today in the window of maximum risk. Chart I-8 shows the combined G7 and Chinese Marshallian K, standardized. This indicator tends to have long leads over EM equity prices. It turned negative in the summer of 2006, though EM stock prices did not peak until the fourth quarter of 2007. It turned negative again in the early days of 2010, but EM equity prices did not peak until April 2011. The indicator moved below zero in mid-2014, yet EM equities only sold off in the second quarter of 2015. This time around, the combined liquidity indicator became negative in early 2016, suggesting great risks for EM assets and related plays in the second half of 2017. High carry EM currencies like the BRL or the TRY are at risk. The ZAR looks especially poorly positioned as well but the RUB seems better cushioned against these risks. The MXN could suffer too as Mexico has a lot of U.S. dollar-denominated debt. Nonetheless, MXN remains much cheaper than the BRL and could still outperform its Brazilian brethren. The SGD is very sensitive to global liquidity conditions, as Singapore is a key banking center for EM, and could also suffer substantially against the USD. In terms of timing for the G10 currency markets, the deterioration of EM breadth has historically been a dangerous sign for commodity currencies (Chart I-9). This combination of deteriorating liquidity and breadth is often associated with a sharp selloff in NZD/JPY (Chart I-10). Investors should short this cross, and we are re-opening this trade this week. Chart I-9Commodity Currencies##br## Prefer A Fresh Breadth... Chart I-10...So Does ##br##NZD/JPY The dynamics highlighted above also explain why despite our positive stance on Canada and the CAD, we are not willing to chase the selloff in USD/CAD further, and prefer to play the CAD's strength through its crosses. The risk-reward ratio seems better this way, as we are not as negatively exposed to an EM selloff as we would be buying the CAD against the USD. Indeed, a cleaner way to play the BoC's change of tone while gaining exposure to an EM-risk off theme, is to short AUD/CAD, a trade that is already on our book. On the domestic front, this week the Reserve Bank of Australia disappointed markets and did not try to indicate a change in stance away from its dovish bias. Markets have taken notice, with the AUD incapable of rallying against a weak USD, despite very strong trade data yesterday. Meanwhile, the BoC is telegraphing a rate hike in the very near future. Additionally, an abnormal gap has emerged between AUD/CAD and AUD/USD. As Chart I-11 shows, historically, AUD/CAD and AUD/USD have tracked one another. This makes sense. The Australian economy is very levered to Asian growth and liquidity dynamics, while Canada is a crucial link in the North American supply chain. With the U.S. and Canadian business cycles so tightly integrated, the CAD tends to mimic the greenback when compared to non-USD currencies. Chart I-11AUD/CAD Is A Short The points in time when AUD/CAD has been much stronger than the AUD/USD deserve closer attention. They are periods of booms in EM Asia, such as the middle of the 1990s, or 2004 to 2005. Today, AUD/CAD is again out of line with AUD/USD, reflecting the boom in EM assets prices in 2016 and in the first half of 2017. However, if our view is correct that EM is entering a dangerous zone, AUD/CAD should weaken further. Chart I-12When Investors Are Short, ##br##EUR/USD Likes EM Selloffs Last but certainly not least the euro. EUR/USD has much momentum and could continue to rally into the 1.15-1.16 zone. In fact, historically, EM shocks have been able to lift the euro, albeit temporarily. This definitely was the case in 2015 when EM sold off: in April 2015, when EM began to weaken, in August 2015, when a temporary selling climax emerged after the Chinese floated the CNY, and in December 2015, after the Fed hiked. The euro spiked in all three instances. However, investors were very short EUR/USD entering each of these periods, and the ensuing rallies were short-covering rallies (Chart I-12). This time around, investors are very long the euro, suggesting that the euro has not been used as a funding vehicle to the same extent as it was in 2015. Additionally, in all these previous episodes, EUR/USD traded at a small discount to the fair value implied by real rate differentials, today it is trading at a premium. Thus, the same kind of short-covering rally is unlikely. As a result, we do not anticipate EUR/USD to break out of its range on the back of an EM risk-off event. That being said, EUR could outperform GBP in this type of environment. The pound remains very dependent on global liquidity conditions to finance its current account deficit of more than 4% of GDP. With big financial institutions announcing more divesture from the U.K., these hot-money flows could prove even more crucial. As a result, we are removing our call to short EUR/GBP if it moves above 0.88, and expect a move in EUR/GBP toward 0.92-0.93 in the second half of 2017. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback slipped on weak as the ADP employment, the ISM-non manufacturing employment component, and continuing as well as initial jobless claims all underperformed expectations. While the dollar reacted negatively to this news, the Fed's hawkish stance should ultimately help the USD. Supplementing the increases in interest rates, are plans to reverse the multi-year quantitative easing program.The FOMC is also increasingly worried about the "quite high" stock valuations which, could lead to financial instability. U.S. 10-year yields have gone up 4 basis points following the release of the minutes, after the 20 bps spike following initial Fed comments on June 27. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro's strength extends as the union experienced strong services and composite PMI measures this Wednesday. While it is true that the ECB may be looking to draw back its excessively easy monetary policy, Draghi and Praet have highlighted that accommodative policy is still needed as inflationary pressures are not yet entrenched. The euro's recent appreciation and weak producer price numbers could vindicate this view. The euro's strength has also weighed on manufacturing activity, as PMIs underperformed expectations. This is likely to weigh on EUR/USD going forward, especially as European stocks have been underperofming U.S. ones in recent weeks. EUR/SEK can face considerable pressure ahead due to the Riksbank's change in rhetoric. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Europe's Divine Comedy Part II: Italy In Purgatorio - June 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: National inflation came in at 0.4%, while Tokyo ex fresh food and energy inflation contracted by 0.2%. Both of these measures underperformed expectations. On the other hand, Japan's job-to-applicant ratio continues to climb, coming in at 1.49, and outperforming expectations. This last data point is key, as it highlights that the Japanese labor market is very tight, and that the stage is set for inflation to come back to Japan. However, as evidenced by the recent disappointments in data, the currency holds the key to unleash inflation in Japan. Thus, not only is a selloff in the yen needed for inflation to remerge, but this selloff would feed on itself, as a falling currency and a tight labor market would raise inflation (and thus lower real rates, as Japanese 10-year rates are anchored at 0), which would push the yen down further. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Markit manufacturing PMI declined from last month's reading and also came in below expectations at 54.3. Construction PMI also declined and came in below expectations at 53.4 However credit had a strong showing as net lending to individuals, consumer credit and mortgage approvals all came in above expectations at 5.3 billion pounds, 1.73 billion pounds and 65 thousand respectively. Various BoE members have stated that rising interest rates might be necessary to keep a lid on the island's high inflation. Although there are still some voices within the BoE who are more cautious, given the uncertainty that Brexit poses, overall the BoE has shown a much more hawkish tone in recent weeks. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has experienced considerable weakness this week, following a drawback in inflation estimates for June by the TD Securities measure, of 2.3% from 2.8% and a less hawkish than anticipated RBA. While retail sales beat expectations of 0.2% - coming in at 0.6% - the pace of appreciation in the RBA Commodity Index in SDR terms continues to slow Nevertheless, these factors were not the only contributors to the recent AUD weakness. Australia remains highly levered to emerging markets, and the Fed tightening remains a major risk for the AUD. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The annual trade balance underperformed expectations, coming in at a deficit of 3.75 billion U.S. dollars. However the ANZ business confidence index continued climbing, and now stands at the highest level in 8 months Overall the New Zealand economy continues to be one of the best performing in the G10. If one were to be guided merely by domestic factors, the RBNZ should be the next central bank to hike after the Fed. However the picture is slightly more nuanced, as the RBNZ is still worried about foreign developments, particularly EM weakness. This justifies why they continue to state that "monetary policy will remain accommodative for a considerable period". Thus, we continue to be bullish on the NZD against the AUD, while we are shorting it against the JPY, as a mean to benefit from a potential EM dislocation. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 USD/CAD has broken down from a crucial technical level following Poloz's statements about the Canadian economy. He states that the "cuts have done their job". When asked about oil, the reply was reassuring, declaring that the expected level of WTI is at USD 40-50 bbl, which implies that fluctuations within that band should not influence movements the BoC path, helping the CAD in the process. He also suggested that "the adjustment we've been talking about... is largely complete now". While inflation is weak, the BoC governor highlighted that forward looking indicators for inflation should be monitored instead of current inflation. These variables are pointing to stronger growth, and are in line with the bank's expectations of a closing output gap in the first half of 2018. While this may be true, a strengthening CAD will remain a risk for inflation. Report Links: Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Although real retail sales yearly growth came in negative at -0.3%, it outperformed expectations and was better than last month. Additionally, the SVME PMI came also blew away expectations, increasing from last month's 55.6 reading to 60.1. However Consumer price inflation came in at -0.1%, underperforming expectations. The Swiss economy continues to be haunted by the ghost of deflation. Nonetheless, some economic indicators appear to be ticking up, most likely as a result of the sharp rally in EUR/CHF. We continue to believe that a rally of EUR/CHF beyond 1.1 is unlikely, as most of the good news in the euro area are already priced into the euro. Furthermore, any disappointments, particularly in EM could trigger a selloff in this cross. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Labor Force survey, which measures the number of unemployed people as a percentage of the total civilian labor force came in at 4.6%, increased since last month. This measure shows that despite the increase in oil prices the Norwegian labour market continues to be tepid. The Norges Bank agrees with our assessment, as it lowered its projected near term policy rate path. Furthermore, they projected that rates in Norway will not rise until the beginning of 2019. The reasons for this are two fold: first, inflation should continue to remain weak, as the pass through from the collapse in the currency has faded. Additionally, bubbly real estate prices, which were the only factor, which could incite the Norges Bank to become more hawkish, have gone down, following reform in lending standards. Thus, despite its good value, the NOK will continue to underperform amongst commodity currencies. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 It is true that the Riksbank recently hinted towards a more neutral stance, acknowledging "that inflation has recently been slightly higher than expected", which has made it "less likely than before that the Riksbank will cut the repo rate in the near term". However, the Riksbank also highlighted the fact that the bank is "prepared to implement further monetary policy easing if necessary to stabilize inflation". A very nuanced statement referred to the exchange rate, which "is important that [it] does not appreciate too rapidly", further stating that "this could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." This conclusively highlights that the bank is wary of diverging rates lifting undesirably on the krona, which is a limiting factor for substantial krona strength in the near term. However, the change of guard at the helm of this central bank in early 2018 could change all this caution. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades