Singapore

Highlights The Singapore dollar has come full circle and has cheapened massively in real terms. This has boosted the economy’s competitiveness. The country is attracting record amounts of FDI inflows. This should benefit manufacturing and new economy sectors, boosting productivity and income growth. A very large weight of value stocks in the Singapore bourse and rising global interest rates have set this market on a course to outperform the EM and global markets. Asset allocators should overweight this market in an EM or Asian equity portfolio. Absolute return investors should go long Singaporean stocks outright. Feature Chart 1Singapore Stocks Underperformance Is Over Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Singapore stocks have been underperforming their emerging markets peers since 2015. The pandemic deepened this further - leading this bourse to all-time lows vis-à-vis their EM counterparts (Chart 1). The question is, can Singapore stocks begin outperforming the EM benchmark on a sustainable basis? We believe that the tide has turned; and are upgrading Singapore from neutral to overweight for EM and Asian equity portfolios. In this report we will explain the regime shifts that the country’s macro backdrop underwent over the past several years, and how that could benefit Singaporean stocks going forward. A Form Of Dutch Disease?  Singapore has undergone some profound macro shifts over the past 15 years in its currency competitiveness. Beginning in 2005, the Singapore dollar went on to become a very expensive currency in the decade that followed. That changed the structure of its economy. Since 2015, the currency has embarked on a secular downtrend in real effective exchange rate terms – practically giving up all the gains of the previous decade (Chart 2). And this has begun to change the economy again – in a different direction. Chart 2The Singapore Dollar Has Come Full Circle Since 2005 Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight To recognize the likely implications of it all, we need to understand what led to such regime shifts in the first place. The answer lies partly in the manner in which monetary policy is conducted in Singapore. The Monetary Authority of Singapore (MAS) uses the Singapore dollar,1 rather than interest rates to achieve its monetary policy objective: to maintain price stability. By doing this, it lets the domestic interest rates find their own equilibrium. To give an example of MAS’s framework, when inflation rises, it guides the trade-weighted Singapore dollar to appreciate. They do the opposite when inflation falls. While this method (a rising inflation to be tackled by a stronger currency) can work to rein in inflation, the combination of higher inflation and an appreciating currency can make the latter expensive in real terms vis-à-vis other currencies. In fact, this is what happened to the Singapore dollar between 2005 and 2015 – a period when inflationary pressures were higher. Attempts to counter rising inflation by pushing up the Singapore dollar led to a very overvalued currency, especially in real terms. In other words, the inflation-adjusted “real effective exchange rate” rose significantly (Chart 2). A strong currency in nominal terms can help rein in inflation, but a strong currency in real terms hurts a country’s competitiveness. There was another issue. While MAS’s framework was able to somewhat contain the general inflationary pressures in the economy (i.e. goods and services inflation), it could not contain the rising labor costs (wages). Compounding the problem, Singapore’s productivity growth rate dropped a notch in the mid-2000s as the country veered towards the services sector at the expense of industries (Chart 3). The reason for the drop is that productivity gains are much harder to achieve in services sectors than in industrial sectors. Indeed, Singapore’s productivity levels began to fall relative to its ASEAN neighbors around 2005 (Chart 4). Chart 3When Singapore Veered Towards The Service Sector In The Mid-2000s... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 4...Its' Productivity Growth Rate Dropped A Notch... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight   Rising wages in conjunction with lower productivity gains led to a steep increase in the unit labor cost (ULC) of the firms. Since employee compensation is a major component of any company’s overall cost structure, the ULC matter for a company much more directly than consumer prices. Hence, real exchange rates measured using the ULC are more representative of currency competitiveness than consumer prices. Measured as such, the Singapore dollar had become extremely pricey in real terms by 2015 (Chart 5). An expensive currency can chip away at the external competitiveness of firms. Singaporean exports made a secular peak (as a % of GDP) in 2005 – coinciding with the bottom in the real exchange rates (Chart 6). Chart 5...Leading To Higher Unit Labor Costs, And A Very Expensive Currency... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 6...That Weighed On The Country's Exports Competitiveness... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 7...As Well As On Its Manufacturing Sectors Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Closer to home, the expensive currency weighed much more on the country’s goods-producing industries than it did on services-producing ones. Not surprisingly, the manufacturing sector also reached a secular high at 28% of GDP in 2005 – when the real exchange rate had begun to climb (Chart 7). Over the following decade, goods-producing firms experienced eroding profitability. As a result, the manufacturing and exports sectors lost prominence in Singapore stock indexes. From a high of 28% of market cap in 2011, the industrial sector is down to 8% today on the MSCI Singapore index. The share of consumer durables and staples is down from 20% back then to 6% now.  The Tides Have Turned Singapore’s real exchange rate eventually peaked in 2015 as global macro backdrop changed. Growth in China and the rest of the ASEAN slowed. Global trade and commodity prices fell. The growth slump in Asia and global trade reduced inflationary pressures in this very open economy (Chart 8). Core CPI, that is monitored by MAS, has averaged 1% since 2014 – compared to 2% between 2005 and 2014 – and is well below MAS’s implicit target of 2%. So are the wages: unit labor costs in level terms have been flat to down during the same period. With inflation now firmly under control, MAS has had no reason to push up its currency anymore. Tame inflation and a nominal currency depreciation led to a steep decline in Singapore’s real exchange rate since 2015. Indeed, in level terms, the real exchange rate has now cheapened to 20-year lows (Chart 5, above).  This is a bullish development for the country’s external competitiveness: As the currency became more competitive, it encouraged more FDI inflows. At 16% of GDP, net FDI is now at an all-time high. Recent political turmoil in Hong Kong has also diverted some FDI to Singapore. These tailwinds are likely to persist.  A cheaper currency can rejuvenate Singapore’s manufacturing sector. Large FDI inflows will boost productivity and, hence, long-term income growth. The income growth that it will generate will in turn benefit services sectors like banking and real estate (Chart 9).    Chart 8Muted Goods And Wage Inflation Have Again Made The Currency Very Competitive... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 9...Attracting Record Amounts Of FDI Inflows Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight   What Drives Singapore Stocks? Chart 10Bank And Real Estate Share Prices Are Linked To The Domestic Economy In General... Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight The MSCI Singapore index is now dominated by banks and real estate companies – who together make up 75% of the market cap. The city state is also a global financial and trading hub. Yet its stock market is driven by the growth in domestic non-financial sectors – just like most other economies: Domestic borrowers make up a major chunk of the loan books of listed Singaporean banks, even after their geographic diversification over the years. The ebbs and flows of the domestic economy therefore dictate the profits and share prices of the banks. The top panel of Chart 10 shows that manufacturing growth, or the absence thereof, has a strong bearing on bank stocks’ absolute performance. The other major stock market sector, real estate, is also leveraged to domestic economy. This is evident in stock performance vis-à-vis several non-financial activities such as industrial production and domestic2 exports. When the latter do well, so do real estate firms’ share prices (Chart 10, bottom panel) Notably, even though manufacturing has fallen over the past 15 years, at 22%, it is still the Singapore economy’s largest sector. By comparison, finance and insurance make up 14%, and real estate 3% of the output. As such, what happens in the manufacturing sector has a meaningful impact on the tertiary sectors like banking and real estate. Singapore is also a very open economy where exports of goods make up 110% of GDP, while exports of services make up 55% of GDP. Therefore, manufacturing and export growth drive income for the overall economy and, in turn, stock market cycles. Chart 11provides evidence of how rising new orders boosts the overall stock market, while the lack thereof hurts it. One reason Singapore markets sharply underperformed since late 2019 was due to the dominance of banking and other “old economy” stocks in the index and a lack of new economy ones (such as Alibaba, Tencent, Samsung, TSMC etc.). A substantial drop in global interest rates had benefitted the latter immensely, until very recently. Going forward, as global value stocks begin to outperform global growth ones, Singaporean stocks are well placed to outperform the EM and global equity indexes. While the pandemic has hit Singapore’s banking sector hard, the negative fallouts are mostly priced in. Banks have already set aside a large amount for loan loss provisions – which caused a 30% year-over-year contraction in their earnings. In the months ahead, as the local and global economies gradually re-open, credit demand will resume – benefiting bank stocks. The Singapore banking sector is facing another tailwind. A rising share of the gross value added in the country’s finance and insurance sectors has been accruing to the capital owners (as opposed to providers of labor, i.e. employees) (Chart 12). This is beneficial for this sector’s stock prices. The ongoing automation and digitalization of finance will continue benefiting shareholders more than employees. Hence, the share of bank income going to shareholders will continue rising versus labor compensation.  Chart 11...And The Manufacturing Sector In Particular Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 12A Rising Share Of Output Going To Owners Is Bullish For Bank Stocks Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight   Finally, stronger economic activity will also boost the real estate stocks. A lot of bad news is already priced in this sector – in which saw a massive 80% contraction in earnings. Investment Conclusion Interest rates are already rising around the world. Chart 13 shows that rising interest rates from low levels benefit Singapore stocks. The reason for that is it indicates growth is firming up. In that sense, Singaporean banks are more akin to Developed Market (DM) banks – which benefit from rising interest rates, rather than EM banks – which usually do not. This is because of the inflationary backdrop, and therefore interest rate levels in Singapore resemble more a DM economy rather than a typical EM economy. Singaporean banks are considered among the most efficient and with the cleanest balance sheets among banking sectors across the EM. This is also borne out by their steady outperformance relative to EM banks over the past 15 years (Chart 14). Chart 13Rising Interest Rates From Low Levels Foreshadow Higher Stock Prices Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Chart 14Bank And Real Estate Firms Have Long Outperformed Their EM Counterparts Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight   Singapore real estate stocks have also displayed steady outperformance versus their EM counterparts (Chart 14: bottom panel). All of this is unlikely to change anytime soon. A competitive currency should help manufacturing and attract more FDI, including in new economy sectors. This will support productivity and income growth – benefitting the overall economy and the stock market. The fact that Singapore index is heavily weighted in banks and old economy stocks that are slated to outperform; and that its banks have been among the best performers in EM – makes this bourse a strong candidate for overweighting. Chart 15Rising US Treasury Yields Are A Good Omen For Singapore Stocks' Relative Performance Singapore Stocks: Upgrade To Overweight Singapore Stocks: Upgrade To Overweight Investors therefore should upgrade this market to overweight in an Asian or EM equity portfolio. Absolute return investors should go long Singapore stocks outright. Singapore will also likely outperform other Developed Markets such as the US. Chart 15 shows that periods of rising US interest rates usually coincide with Singapore stocks outperforming their global counterparts. Moreover, the dominance of value stocks in the Singapore index and the extremely expensive new economy stocks in US indexes means Singapore’s long period of underperformance is coming to an end. The Singapore dollar cross versus the US dollar is likely to stay flattish. The absence of local inflation precludes any attempt from MAS to guide it upwards. At the same time, a strong balance of payment will put a floor under the currency. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 Against a trade-weighted basket of currencies. 2 Domestic exports are the ones that originate in Singapore, as opposed to re-exports which originate from a foreign country for onward exporting to another country.

Risk Of Debt Deflation… Chart II-1Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Singaporean businesses and consumers have been deleveraging in the past six years. That, along with the ongoing export slump1  and collapse in tourism revenues – 50% and 5% of GDP, respectively – have likely pushed real and nominal GDP into contraction in Q1 2020. Negative income growth risks turning this gradual deleveraging into debt deflation. Debt deflation occurs when prices fall and the real value of debt rises. Given the private sector is still heavily leveraged, deflation will trigger defaults. This scenario would be disastrous for Singapore’s credit sensitive property and banking sectors – the two key pillars of this economy. Singapore is not far from this tipping point as core and trimmed-mean consumer prices inflation measures as well as GDP deflator are flirting with deflation (Chart II-1). In order to ensure that this ongoing deleveraging does not enter a debt deflation spiral, both monetary and fiscal authorities need to stimulate more aggressively than they already have. Specifically, they should reduce interest rates to zero and provide substantial fiscal stimulus. … Warrants Zero Interest Rates Even though Singapore households and companies have been deleveraging, they remain highly indebted - total non-financial private sector credit stands at 173% of GDP (Chart II-2, top panel). The middle and bottom panels on Chart II-2 illustrate company and household leverage, defined as the ratio of Singaporean banks domestic loans to non-financial businesses and households relative to corporate profits and employee compensation, respectively. Corporate profits and employee compensation are better measures because they are incomes available to corporates and households, while nominal GDP is not.  In brief, these measures gauge companies and households liabilities relative to their proper income. Critically, nominal GDP growth has dropped well below prime lending rates which stand at 5.25%. Besides, the prime lending rate in real (in inflation-adjusted) terms has risen as inflation dropped (Chart II-3). Chart II-2Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging Chart II-3Singapore: Interest Payments Are Elevated Singapore: Interest Payments Are Elevated Singapore: Interest Payments Are Elevated   This is dangerous and nominal income growth is falling below the nominal interest rate, worsening borrowers’ ability to service their debt. Chart II-4 shows that the private sector’s interest rate payments on debt are elevated relative to GDP. This risks pushing the level of non-performing loans (NPLs) at commercial banks much higher. The non-performing loan (NPL) ratio at Singaporean commercials banks is bound to rise from the low NPL ratio of 2%. Moreover, the ratio of special-mention loans - loans that are stressed but are not yet officially recognized as non-preforming - are also set to climb meaningfully from 2%. Furthermore, Singaporean banks have extended a non-negligible amount of loans to Chinese and ASEAN businesses. With the indebted mainland economy struggling following the COVID-19 epidemics and ASEAN companies strained by weakness in their domestic demand, Singaporean banks will have to deal with rising NPLs emanating from China and ASEAN. Singapore’s commercial banks will be forced to raise their provisioning levels significantly, which will hurt their profits. Provisions of the three large MSCI-listed commercial banks  have been already rising. This has been historically negative for bank share prices2 (Chart II-5). Chart II-4Singapore: NPL Provisions And Bank Stocks Singapore: NPL Provisions And Bank Stocks Singapore: NPL Provisions And Bank Stocks Chart II-5Singapore: Rates Are Heading To New Lows Singapore: Rates Are Heading To New Lows Singapore: Rates Are Heading To New Lows As banks boost their provisioning, shareholders will push them to curtail credit origination to control risks. This will dampen economic and income growth. Without bold actions by the authorities, the banking sector and the real economy are facing a dire outlook. Interest Rates Are Heading To Zero Although the monetary and fiscal authorities have provided stimulus, it remains inadequate to fend off rising risks of debt deflation. The MAS (Monetary Authority of Singapore) conducts monetary policy by guiding the trade-weighted exchange rate. The MAS depreciates the trade-weighted SGD when it wants to ease and vice versa. Given the economy has become much more leveraged and, thereby, more sensitive to credit and interest rates, depreciating currency is not always sufficient to create a swift turnaround in domestic demand. This is especially true when global trade is shrinking, as it is today. In brief, currency depreciation will only augment the market share of exporters in world trade even though their exports will continue shrinking in absolute terms. Hence, currency depreciation will not promptly boost income and employment in the export industries amid the ongoing global trade contraction. At the current juncture, currency depreciation without a substantial decline in borrowing costs will have little spillover to domestic demand. Chart II-6 illustrates that Singapore’s central bank has already been injecting liquidity in the banking system in order to bring interbank/money market rates lower. However, interest rates remain relatively elevated compared with the US, the euro area and Japan (Chart II-7), as well as relative to what this indebted economy needs. Chart II-6Singapore: Real Lending Rates Are High Singapore: Real Lending Rates Are High Singapore: Real Lending Rates Are High Chart II-7Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3     On the fiscal side, the government budget will barely turn expansionary this year: expenditures will rise from 3% currently to just 7%, which translates to a 1% rise relative to GDP. This will not do much to boost overall growth. If the pace of domestic loan growth drops from 2.4% to 1.4% (by 100 basis points), that would generate a negative 1.8% credit impulse of GDP, more than offsetting the rise in the fiscal spending impulse. Chart II-8Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Confirming the lingering growth downtrend, economic conditions were dire even before the COVID-19 outbreak. Manufacturing production volume is shrinking and sea cargo handled has been dropping (Chart II-8). Electronic exports are contracting from a year ago (Chart II-8, bottom panel). Finally, corporate profits are not growing. Consumer spending is extremely weak. Retail volume sales excluding vehicle sales are contracting 2% from last year (Chart II-9). The excess-mired property sector is slowing down anew. Housing loans are contracting which will trigger a material drop in residential property sales (Chart II-10, top panel). As the latter transpires, construction activity will also shrink (Chart II-10, bottom panel). Chart II-9Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Chart II-10Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Bottom Line: The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. Investment Recommendations The MAS will continue injecting more liquidity into the banking system to bring down interest rates further and devalue the currency. Exactly for these reasons, since June 8, 2018 we have been recommending shorting the SGD versus the JPY. This trade has so far produced a 7.3% gain with very low volatility (Chart II-11). Our target for this SGDJPY position is 70. Today we are booking profits on the short Hong Kong property developers / long Singapore property developers position because the Fed is about to cut rates to zero, which will reduce downside potential in Hong Kong real estate stocks. This recommendation has produced 21.5% profit since March 22, 2017 (Chart II-12). Chart II-11Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Chart II-12Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position   As to the overall stock market, we continue recommending a neutral allocation to Singapore within an EM dedicated equity portfolio. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Feature An analysis on Singapore is available below. The plunge in global risk assets is occurring at such a breathtaking pace that any economic analysis is pointless at this time. Economic growth forecasts have been reduced to moving targets. In our latest report published two days ago, we argued that we are witnessing the unravelling of the policy put. For now, monetary stimulus – both rate cuts and QE programs – are unlikely to halt the market riot. Fiscal stimulus is forthcoming but its actual impact on the real economy will not materialize until another several months. The only thing that investors can use to gauge market downside as of now are valuations and market technicals. This report presents the most important technical and valuations indicators that we are currently monitoring. All market prices are updated as of the close of Thursday, March 12, 2020. We are in a liquidation phase where fundamentals do not matter and markets often undershoot. Such indiscriminate liquidation also leads to major buying opportunities. We will book profits on the short EM stocks position when the MSCI EM equity index in USD hits 800. On Thursday March 12, the MSCI EM equity index closed at 880. Possibly, we will recommend accumulating EM stocks and will reverse our bearish bias on EM currencies and fixed-income markets if the EM MSCI Index reaches this level. Remarkably, the top chart on page 2 shows that major EM bear markets – in 1998, 2002, 2008 and 2015-16 – all bottomed when EM share prices hit their 24-year exponential moving average. This technical support for the MSCI EM stock index is currently 780, about 10% below yesterday’s close. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com EM Stocks Are Approaching A Major Defense Line EM Stocks Are Approaching A Major Defense Line EM Stocks Are Approaching A Major Defense Line Global Material Stocks Are At A Long-Term Technical Support Line Global Material Stocks Are At A Long-Term Technical Support Line Global Material Stocks Are At A Long-Term Technical Support Line A Long-Term Perspective On Brazilian Stocks Technical And Valuation Charts That Matter Technical And Valuation Charts That Matter The Brazilian Real Is Not Yet Very Cheap The Brazilian Real Is Not Yet Very Cheap The Brazilian Real Is Not Yet Very Cheap Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E Ratio For EM Equities Cyclically-Adjusted P/E (CAPE) Ratio For US Stocks Cyclically-Adjusted P/E Ratio For US Stocks Cyclically-Adjusted P/E Ratio For US Stocks Three Technical Support Levels For S&P 500 Three Technical Support Levels For S&P 500 Three Technical Support Levels For S&P 500 An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft An Equal-Weighted Aggregate Stock Price Of Facebook, Apple, Amazon, Netflix, Google And Microsoft Is FAANGM A Bubble That Has Reached A Top? Is FAANGM A Bubble That Has Reached A Top? Is FAANGM A Bubble That Has Reached A Top? US Market Cap As % Of GDP Was Record High Last Month US Market Cap As % Of GDP Was Record High Last Month US Market Cap As % Of GDP Was Record High Last Month Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies Global Stock-To-Bond Ratio, Commodities And EM Currencies   Singapore: Zero Interest Rates Ahead   Risk Of Debt Deflation… Singaporean businesses and consumers have been deleveraging in the past six years. That, along with the ongoing export slump1  and collapse in tourism revenues – 50% and 5% of GDP, respectively – have likely pushed real and nominal GDP into contraction in Q1 2020. Negative income growth risks turning this gradual deleveraging into debt deflation. Debt deflation occurs when prices fall and the real value of debt rises. Given the private sector is still heavily leveraged, deflation will trigger defaults. This scenario would be disastrous for Singapore’s credit sensitive property and banking sectors – the two key pillars of this economy. Singapore is not far from this tipping point as core and trimmed-mean consumer prices inflation measures as well as GDP deflator are flirting with deflation (Chart II-1). In order to ensure that this ongoing deleveraging does not enter a debt deflation spiral, both monetary and fiscal authorities need to stimulate more aggressively than they already have. Specifically, they should reduce interest rates to zero and provide substantial fiscal stimulus. … Warrants Zero Interest Rates Even though Singapore households and companies have been deleveraging, they remain highly indebted - total non-financial private sector credit stands at 173% of GDP (Chart II-2, top panel). Chart II-1Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Singapore: Deflation Is At The Door Chart II-2Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging Singapore: Companies & Households Are Deleveraging   The middle and bottom panels on Chart II-2 illustrate company and household leverage, defined as the ratio of Singaporean banks domestic loans to non-financial businesses and households relative to corporate profits and employee compensation, respectively. Corporate profits and employee compensation are better measures because they are incomes available to corporates and households, while nominal GDP is not.  In brief, these measures gauge companies and households liabilities relative to their proper income. Critically, nominal GDP growth has dropped well below prime lending rates which stand at 5.25%. Besides, the prime lending rate in real (in inflation-adjusted) terms has risen as inflation dropped (Chart II-3). This is dangerous and nominal income growth is falling below the nominal interest rate, worsening borrowers’ ability to service their debt. Chart II-4 shows that the private sector’s interest rate payments on debt are elevated relative to GDP. This risks pushing the level of non-performing loans (NPLs) at commercial banks much higher. Chart II-3Singapore: Real Lending Rates Are High Singapore: Interest Payments Are Elevated Singapore: Interest Payments Are Elevated Chart II-4Singapore: Interest Payments Are Elevated Singapore: NPL Provisions And Bank Stocks Singapore: NPL Provisions And Bank Stocks   The non-performing loan (NPL) ratio at Singaporean commercials banks is bound to rise from the low NPL ratio of 2%. Moreover, the ratio of special-mention loans - loans that are stressed but are not yet officially recognized as non-preforming - are also set to climb meaningfully from 2%. Chart II-5Singapore: NPL Provisions And Bank Stocks Singapore: Rates Are Heading To New Lows Singapore: Rates Are Heading To New Lows Furthermore, Singaporean banks have extended a non-negligible amount of loans to Chinese and ASEAN businesses. With the indebted mainland economy struggling following the COVID-19 epidemics and ASEAN companies strained by weakness in their domestic demand, Singaporean banks will have to deal with rising NPLs emanating from China and ASEAN. Singapore’s commercial banks will be forced to raise their provisioning levels significantly, which will hurt their profits. Provisions of the three large MSCI-listed commercial banks  have been already rising. This has been historically negative for bank share prices2 (Chart II-5). As banks boost their provisioning, shareholders will push them to curtail credit origination to control risks. This will dampen economic and income growth. Without bold actions by the authorities, the banking sector and the real economy are facing a dire outlook. Interest Rates Are Heading To Zero Although the monetary and fiscal authorities have provided stimulus, it remains inadequate to fend off rising risks of debt deflation. The MAS (Monetary Authority of Singapore) conducts monetary policy by guiding the trade-weighted exchange rate. The MAS depreciates the trade-weighted SGD when it wants to ease and vice versa. Given the economy has become much more leveraged and, thereby, more sensitive to credit and interest rates, depreciating currency is not always sufficient to create a swift turnaround in domestic demand. This is especially true when global trade is shrinking, as it is today. The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. In brief, currency depreciation will only augment the market share of exporters in world trade even though their exports will continue shrinking in absolute terms. Hence, currency depreciation will not promptly boost income and employment in the export industries amid the ongoing global trade contraction. At the current juncture, currency depreciation without a substantial decline in borrowing costs will have little spillover to domestic demand. Chart II-6 illustrates that Singapore’s central bank has already been injecting liquidity in the banking system in order to bring interbank/money market rates lower. However, interest rates remain relatively elevated compared with the US, the euro area and Japan (Chart II-7), as well as relative to what this indebted economy needs. Chart II-6Singapore: Rates Are Heading To New Lows Singapore: Real Lending Rates Are High Singapore: Real Lending Rates Are High Chart II-7Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3 Singapore Interest Rates Are Above G3     On the fiscal side, the government budget will barely turn expansionary this year: expenditures will rise from 3% currently to just 7%, which translates to a 1% rise relative to GDP. This will not do much to boost overall growth. If the pace of domestic loan growth drops from 2.4% to 1.4% (by 100 basis points), that would generate a negative 1.8% credit impulse of GDP, more than offsetting the rise in the fiscal spending impulse. Chart II-8Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Singapore: Cyclical Sectors Are Contracting Confirming the lingering growth downtrend, economic conditions were dire even before the COVID-19 outbreak. Manufacturing production volume is shrinking and sea cargo handled has been dropping (Chart II-8). Electronic exports are contracting from a year ago (Chart II-8, bottom panel). Finally, corporate profits are not growing. Consumer spending is extremely weak. Retail volume sales excluding vehicle sales are contracting 2% from last year (Chart II-9). The excess-mired property sector is slowing down anew. Housing loans are contracting which will trigger a material drop in residential property sales (Chart II-10, top panel). As the latter transpires, construction activity will also shrink (Chart II-10, bottom panel). Chart II-9Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Singapore: Consumer Are Not Spending Chart II-10Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Singapore Property Sector Is Struggling Bottom Line: The Singaporean economy needs much lower lending rates and a significant fiscal boost to avoid entering painful debt deflation. The odds are high that Singaporean bond yields and swap rates are heading to zero. Investment Recommendations The MAS will continue injecting more liquidity into the banking system to bring down interest rates further and devalue the currency. Exactly for these reasons, since June 8, 2018 we have been recommending shorting the SGD versus the JPY. This trade has so far produced a 7.3% gain with very low volatility (Chart II-11). Our target for this SGDJPY position is 70. Today we are booking profits on the short Hong Kong property developers / long Singapore property developers position because the Fed is about to cut rates to zero, which will reduce downside potential in Hong Kong real estate stocks. This recommendation has produced 21.5% profit since March 22, 2017 (Chart II-12). Chart II-11Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Stay With Short SGD / Long JPY Trade Chart II-12Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position Book Profits On Our Long Singapore / Short Hong Kong Property Stocks Position   As to the overall stock market, we continue recommending a neutral allocation to Singapore within an EM dedicated equity portfolio. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1   Domestic exports, excluding re-exports. 2   DBS Bank, Overseas-Chinese Banking, United Overseas Bank.

Singapore: Monetary Easing Is Imminent Singapore’s stock market is at risk of selling off in absolute terms. However, the monetary authorities (MAS) will soon commence policy easing. This will differentiate Singapore from Hong Kong. While both Singapore and Hong Kong suffer from property and credit excesses and are facing a cyclical downtrend, the former – unlike the latter – can and will lower interest rates and allow its currency to depreciate to reflate the system. As a result, we are reiterating our short Hong Kong / long Singaporean property stocks strategy. Cyclical Headwinds Persist Singapore’s cyclical growth outlook is worsening: Chart II-1 shows that the narrow money impulse is in deep contraction and the private domestic banks loans impulse is dipping into negative territory anew. The property sector – which is an important driver of Singapore’s economy – is depressed. Residential units sold has dipped, the high-end condominium market is virtually frozen and housing mortgage growth has stalled. These create formidable risks for Singapore’s real estate stocks’ absolute performance (Chart II-2). The latter account for 15% of the Singaporean stock market. Chart II-1Singapore: Money / Credit Impulses Singapore: Money / Credit Impulses Singapore: Money / Credit Impulses Chart II-2Singapore: Real Estate Stocks Are At Risk Singapore: Real Estate Stocks Are At Risk Singapore: Real Estate Stocks Are At Risk Meanwhile, there has been no signs of improvement in both domestic demand and exports. The top panel of Chart II-3 shows that the marginal propensity to spend among both consumers and non-financial businesses is diminishing. Specifically, the impulse for overall consumer loans is negative, while retail sales are contracting (Chart II-3, bottom panel). As for the business sector, it is also slowing down. Manufacturing PMI and new orders are in a contraction zone (Chart II-4). Chart II-3Private Consumption Is Weakening Private Consumption Is Weakening Private Consumption Is Weakening Chart II-4Business Sector Is Hit Hard Business Sector is Hit Hard Business Sector is Hit Hard Finally, corporate profitability of listed non-financial and non-property firms has massively deteriorated in the last decade. Chart II-5 illustrates that both return on assets (ROA) and return-on-equity (ROE) have been in a downward trend and have lately plunged. Shrinking profit margins have been the result of escalating unit labor costs (Chart II-6). In other words, productivity gains among listed non-financial companies have lagged behind wage increases. Chart II-5Corporate Profitability Is At 20-Year Low Corporate Profitability Is At 20-Year Low Corporate Profitability Is At 20-Year Low Chart II-6Rising Unit Labor Costs = Shrinking Profit Margins Rising Unit Labor Costs = Shrinking Profit Margins Rising Unit Labor Costs = Shrinking Profit Margins Monetary Policy Will Be Relaxed Chart II-7The Central Bank Has Been Withdrawing Liquidity The Central Bank Has Been Withdrawing Liquidity The Central Bank Has Been Withdrawing Liquidity The Monetary Authority of Singapore (MAS) conducts monetary policy by controlling the currency and by default allowing domestic interest rates to find their own equilibrium. Currently, the MAS’s monetary policy setting is restrictive – i.e. it is aiming to gradually appreciate the trade-weighted Singaporean dollar by withdrawing excess reserve from the banking system (Chart II-7, top panel). This in turn, is causing commercial banks to bid interbank rates higher (Chart II-7, bottom panel). Nevertheless, with the domestic growth deceleration intensifying and the private sector highly leveraged, the MAS will soon opt for policy easing. It will guide the trade-weighted exchange rate lower by injecting liquidity into the banking system and lowering interest rates. Bottom Line: The Singaporean economy needs lower rates and the MAS is not constrained by the currency peg as the HKMA is. Consequently, interest rates in Singapore will decline both in absolute terms and relative to Hong Kong ones. Investment Conclusion The cyclical downturn will deepen and Singapore share prices will drop in absolute U.S. dollar terms. Relative to the EM or the Asian benchmarks, we continue to recommend a neutral position on overall Singaporean equities for now. Importantly, Singapore is better positioned than Hong Kong because the former’s monetary authorities can lower interest rates and allow the currency to depreciate. Hong Kong monetary authorities cannot tolerate lower interest rates due to their peg to the U.S. dollar and budding capital outflows. Interest rates in Singapore will drop relative to Hong Kong. We are therefore reiterating our short Hong Kong / long Singaporean property stocks strategy (Chart I-11 on page 10).   Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com

Highlights Like in any currency board, Hong Kong dollar money supply is not fully backed by foreign currency (FX) reserves. Yet, the Hong Kong authorities have large FX reserves to defend the currency peg for now. Regardless, mounting capital outflows and the ensuing currency defense will lead to higher interest rates. Contrary to Hong Kong, Singapore has a flexible exchange rate regime and will begin easing monetary policy soon. Interest rates in Singapore will drop relative to Hong Kong. We are therefore reiterating our short Hong Kong / long Singaporean property stocks strategy. Feature The recent popular protests in Hong Kong against the extradition bill will likely mark a regime shift – not only in the territory’s socio-political dynamics but also in its financial outlook. It seems the local authorities are still considering an adoption of the extradition bill. For now, the bill has been suspended, but it has not been withdrawn outright. In light of elevated political uncertainty over the one-country, two-systems model, it is reasonable to assume that capital outflows from Hong Kong will rise in the coming year or so.  In light of elevated political uncertainty over the one-country, two-systems model, it is reasonable to assume that capital outflows from Hong Kong will rise in the coming year or so. The question therefore becomes whether or not the Hong Kong Monetary Authority (HKMA) has sufficient foreign currency (FX) reserves to defend the Hong Kong dollar’s peg. Even though Hong Kong's broad money supply is not fully backed by FX reserves, we see no major risk to the currency peg at the moment. That said, mounting capital outflows will necessitate higher interest rates, as least relative to U.S. ones, to defend the peg. This is negative for Hong Kong’s property market and share prices. Are Hong Kong Dollars Fully Backed By FX Reserves? Hong Kong operates a linked-exchange rate system, which stipulates that its monetary base must be fully backed by FX reserves. The monetary base includes (Table I-1): The balance of the clearing accounts of banks kept with the HKMA (called the Aggregate Balance, which represents commercial banks’ excess reserves). Exchange Fund bills and notes – securities issued by the Exchange Fund to manage excess reserves/liquidity in the interbank market. Certificates of Indebtedness which are equivalent to currency in circulation. These certificates are held by note-issuing banks in exchange for their FX deposits at the Exchange Fund. The Exchange Fund is a balance sheet vehicle of the HKMA. Government-issued coins in circulation. Chart I- Presently, Hong Kong’s FX reserves-to-monetary base ratio is 2.2 (Chart I-1on page 1). This ratio is well above the stipulated currency board rule of one: a unit of monetary base can be issued only when it is backed by an equivalent foreign currency asset. Chart I-1HK: FX Coverage Of Monetary Base Is Well Above 1 HK: FX Coverage Of Monetary Base Is Well Above 1 HK: FX Coverage Of Monetary Base Is Well Above 1 The reason the ratio is currently more than double where it technically should be is because the HKMA’s foreign exchange reserves also include the fiscal authorities’ foreign currency deposits at the Exchange Fund. Hence, the large pool of fiscal assets converted into foreign currency and sitting in the Exchange Fund has pushed the monetary base’s coverage ratio above two. As of December 31, 2018, the Exchange Fund’s foreign currency assets consisted of HK$743 billion of its own foreign currency reserves (net FX reserves), HK$1.17 trillion of the fiscal authorities’ foreign currency deposits, and HK$485 billion of foreign currency deposits by money issuing commercial banks (Table I-1). However, broad money supply in Hong Kong is not fully backed by foreign currency reserves (Chart I-2). At 0.45, this coverage ratio entails that each HK dollar of broad money supply is backed by 0.45 USD foreign currency reserves within the Exchange Fund. Broad money supply includes currency in circulation, demand, savings and time deposits, and negotiable certificates of deposits (NCDs) issued by licensed banks. Chart I-2HK: FX Coverage Of HK Dollars Is Only 0.45 HK: FX Coverage Of HK Dollars Is Only 0.45 HK: FX Coverage Of HK Dollars Is Only 0.45 Crucially, broad money supply does not include commercial banks’ reserves at the central bank in any economy, including Hong Kong. The pertinent measure of any exchange rate backing is the ratio of FX reserves to broad money supply (all local currency deposits plus cash in circulation). The motive is that households and companies can use not only cash in circulation but also their deposits to acquire foreign currency. With the ratio standing at 0.45, the Hong Kong monetary authorities do not have sufficient amounts of U.S. dollars to guarantee the exchange of each unit of local currency (cash in circulation and all deposits) into U.S. dollars in the event of a full-blown flight out of HK dollars. It is essential to clarify that the monetary authorities in Hong Kong have not deviated from the original framework of the currency board. This exchange rate mechanism was devised in 1983 in such a way that only the monetary base – not broad money supply – was supposed to be backed by foreign currency. In short, any currency board entails that only the monetary base – not broad money supply - is backed by FX reserves. Hong Kong is not an exception. Nevertheless, there is widespread perception in the financial community and among economists that all Hong Kong dollars are backed by foreign currency reserves, which is incorrect. Like in any banking system, when commercial banks in Hong Kong grant loans or buy assets from non-banks, they create local currency deposits “out of thin air.” These deposits are not backed by foreign currency, and commercial banks that create these deposits are not obliged to deposit FX reserves at the Exchange Fund. The credit boom in Hong Kong has accelerated since 2009 (Chart I-3, top panel). Consistently, since that time, the amount of local currency deposits has mushroomed – these deposits are not backed by foreign currency (Chart I-3, bottom panel).  Chart I-3Banks' Loans And Deposit Growth Go Hand-In-Hand Banks' Loans And Deposit Growth Go Hand-In-Hand Banks' Loans And Deposit Growth Go Hand-In-Hand On the whole, the currency board system in Hong Kong and elsewhere cannot guarantee full convertibility of broad money supply (all types of deposits). Therefore, these currency regimes are ultimately based on confidence. If and when confidence in the exchange rate plummets and economic agents rush to exchange a large share of their local currency cash in circulation and deposits into foreign currency, the monetary authorities’ FX reserves will not be sufficient. That said, there is presently no basis to argue that close to 45% of Hong Kong broad money supply (cash and coins in circulation and deposits of all types) is poised to panic-flood the currency market. Hence, we do not foresee a de-pegging of the HKD exchange rate for now. The currency will continue to trade within its HKD/USD 7.75-7.85 band. Bottom Line: Like in any currency board, the Hong Kong dollars are not fully backed by its FX reserves. However, the Hong Kong authorities have large FX reserves to defend the currency peg for some time. Liquidity Strains? According to the Impossible Trinity thesis, in an economy with an open capital account, the monetary authorities can control either interest rates or the exchange rate, but not both simultaneously. Provided Hong Kong has both an open capital account and a fixed exchange rate, the monetary authorities have little control over interest rates. Balance-of-payment (BoP) dynamics determine whether the HKMA has to buy or sell foreign currency to preserve the exchange rate peg. When the BoP is in surplus, the HKMA accumulates FX reserves, and vice versa.  The odds are rising that Hong Kong will begin experiencing capital outflows due to heightening political uncertainty over the one-country, two-systems model. Consistently, the BoP will swing from recurring surpluses to deficits and the HKMA will have to finance them by selling FX reserves (Chart I-4). By doing so, the monetary authorities will drain banks’ excess reserves, thereby tightening interbank liquidity. Chart I-4Balance Of Payments And FX Reserves Balance Of Payments And FX Reserves Balance Of Payments And FX Reserves Chart I-5Falling Excess Reserves = Higher Interbank Rates Falling Excess Reserves = Higher Interbank Rates Falling Excess Reserves = Higher Interbank Rates Notably, the HKMA’s FX reserves have plateaued, commercial banks’ excess reserves (the Aggregate Balance at the HKMA) have shrunk and money market rates have risen since 2016 (Chart I-5). Importantly, the latter has continued, even as U.S. interest rates have dropped over the past six months (Chart I-5, bottom panel). These dynamics are set to continue. To defend the HKD’s fixed exchange rate, interest rates in Hong Kong should rise and stay above those in the U.S. This will be the equivalent of pricing in a risk premium in Hong Kong rates due to higher political uncertainty in domestic politics as well as the ongoing U.S.-China trade confrontation. To defend the HKD’s fixed exchange rate, interest rates in Hong Kong should rise and stay above those in the U.S. On a positive note, the HKMA has ample room to mitigate liquidity strains resulting from FX interventions. In years when the BoP was in surplus, to prevent HKD appreciation the authorities purchased substantial amounts of U.S. dollars. As a result, the aggregate balance/excess reserves swelled, and Exchange Fund bills and notes were issued to absorb excess reserves (Chart I-6). Chart I-6HK Authorities Have Large Liquidity Firepower HK Authorities Have Large Liquidity Firepower HK Authorities Have Large Liquidity Firepower Going forward, with capital outflows causing tightening liquidity, the HKMA can redeem its own bills and notes to replenish the Aggregate Balance. This will ease interbank liquidity and preclude interest rates from shooting up dramatically. The HKMA’s liquidity firepower is sizable: the amount of Exchange Fund bills and notes is more than HK$1 trillion. This compares with aggregate balance (excess reserves) of HK$55 billion. Hence, potential interbank liquidity is HK$1.1 trillion (the Aggregate Balance plus the Exchange Fund’s bills and notes) (Chart I-6, top panel). There is no way to guesstimate potential capital outflows from Hong Kong. Hence, it is difficult to know what the equilibrium level of the interest rate spread over U.S. rates will be. The market will be re-balancing continuously, and the interest rate differential will fluctuate – i.e., it will be a moving target that ensures the fixed value of the currency. Bottom Line: Odds are that market-based interest rates in Hong Kong have to rise and stay above the U.S. ones for now. Heading Into Recession? With non-financial private sector debt close to 300% of GDP (Chart I-7) and property/construction and financial services sectors accounting for a large share of the economy, the Hong Kong economy is extremely sensitive to interest rates. Chart I-7Hong Kong: Leverage And Debt Servicing Hong Kong: Leverage And Debt Servicing Hong Kong: Leverage And Debt Servicing Chart I-8HK Economy Is In A Cyclical Downtrend HK Economy Is In A Cyclical Downtrend HK Economy Is In A Cyclical Downtrend Economic conditions have already been worsening, and any further rise in interest rates will escalate the economic downtrend: Private credit growth has decelerated and is probably heading into contraction (Chart I-8, top panel). The property market is one of the most expensive in the world. Property transactions have plunged and real estate prices will likely deflate (Chart I-8, middle panels). China’s weakening economy and subsiding Hong Kong business and investor confidence will hurt domestic demand. Retail sales volumes are already contracting (Chart I-8, bottom panel). Investment Implications The interest rate differential between Hong Kong and the U.S. has recently become positive after two and a half years of lingering below zero (Chart I-9). Odds are that it will remain positive at least over the next couple years. Therefore, even if U.S. interest rates decline further, Hong Kong rates will not. This has major investment ramifications: Hong Kong stocks will likely underperform U.S. and EM equity benchmarks, as its interest rate differential with the U.S. stays on the positive side and widens further (Chart I-10).  Chart I-9HK Interest Rate Spread Over U.S. Will Rise And Stay Positive HK Interest Rate Spread Over U.S. Will Rise And Stay Positive HK Interest Rate Spread Over U.S. Will Rise And Stay Positive Chart I-10Higher HK Interest Rates Herald HK Equity Underperformance Higher HK Interest Rates Herald HK Equity Underperformance Higher HK Interest Rates Herald HK Equity Underperformance The MSCI Hong Kong stock index is composed of financials (36% of market cap) and property stocks (26% of market cap). Therefore, domestic stocks are very sensitive to interest rates. Hong Kong companies are also very exposed to mainland growth. A recovery in the latter is not yet imminent. As a market neutral trade, we are reiterating our short Hong Kong property / long Singapore property stocks strategy. Chart I-11Favor Singapore Stocks Versus Hong Kong Ones Favor Singapore Stocks Versus Hong Kong Ones Favor Singapore Stocks Versus Hong Kong Ones All of this leads us to maintain our underweight stance on Hong Kong domestic stocks versus U.S. and EM equity indexes (Chart I-10). As a market neutral trade, we are reiterating our short Hong Kong property / long Singapore property stocks strategy. Hong Kong interest rates will rise above Singapore’s, leading to the former’s equity underperformance versus the latter across property, banks and probably the overall stock index (Chart I-11). For a more detailed discussion of Singapore, please see below.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com           Singapore: Monetary Easing Is Imminent Singapore’s stock market is at risk of selling off in absolute terms. However, the monetary authorities (MAS) will soon commence policy easing. This will differentiate Singapore from Hong Kong. While both Singapore and Hong Kong suffer from property and credit excesses and are facing a cyclical downtrend, the former – unlike the latter – can and will lower interest rates and allow its currency to depreciate to reflate the system. As a result, we are reiterating our short Hong Kong / long Singaporean property stocks strategy. Cyclical Headwinds Persist While both Singapore and Hong Kong suffer from property and credit excesses and are facing a cyclical downtrend, the former – unlike the latter – can and will lower interest rates and allow its currency to depreciate to reflate the system. Singapore’s cyclical growth outlook is worsening: Chart II-1 shows that the narrow money impulse is in deep contraction and the private domestic banks loans impulse is dipping into negative territory anew. The property sector – which is an important driver of Singapore’s economy – is depressed. Residential units sold has dipped, the high-end condominium market is virtually frozen and housing mortgage growth has stalled. These create formidable risks for Singapore’s real estate stocks’ absolute performance (Chart II-2). The latter account for 15% of the Singaporean stock market. Chart II-1Singapore: Money / Credit Impulses Singapore: Money / Credit Impulses Singapore: Money / Credit Impulses Chart II-2Singapore: Real Estate Stocks Are At Risk Singapore: Real Estate Stocks Are At Risk Singapore: Real Estate Stocks Are At Risk Meanwhile, there has been no signs of improvement in both domestic demand and exports. The top panel of Chart II-3 shows that the marginal propensity to spend among both consumers and non-financial businesses is diminishing. Specifically, the impulse for overall consumer loans is negative, while retail sales are contracting (Chart II-3, bottom panel). As for the business sector, it is also slowing down. Manufacturing PMI and new orders are in a contraction zone (Chart II-4). Chart II-3Private Consumption Is Weakening Private Consumption Is Weakening Private Consumption Is Weakening Chart II-4Business Sector Is Hit Hard Business Sector is Hit Hard Business Sector is Hit Hard Finally, corporate profitability of listed non-financial and non-property firms has massively deteriorated in the last decade. Chart II-5 illustrates that both return on assets (ROA) and return-on-equity (ROE) have been in a downward trend and have lately plunged. Shrinking profit margins have been the result of escalating unit labor costs (Chart II-6). In other words, productivity gains among listed non-financial companies have lagged behind wage increases. Chart II-5Corporate Profitability Is At 20-Year Low Corporate Profitability Is At 20-Year Low Corporate Profitability Is At 20-Year Low Chart II-6Rising Unit Labor Costs = Shrinking Profit Margins Rising Unit Labor Costs = Shrinking Profit Margins Rising Unit Labor Costs = Shrinking Profit Margins Monetary Policy Will Be Relaxed Chart II-7The Central Bank Has Been Withdrawing Liquidity The Central Bank Has Been Withdrawing Liquidity The Central Bank Has Been Withdrawing Liquidity The Monetary Authority of Singapore (MAS) conducts monetary policy by controlling the currency and by default allowing domestic interest rates to find their own equilibrium. Currently, the MAS’s monetary policy setting is restrictive – i.e. it is aiming to gradually appreciate the trade-weighted Singaporean dollar by withdrawing excess reserve from the banking system (Chart II-7, top panel). This in turn, is causing commercial banks to bid interbank rates higher (Chart II-7, bottom panel). Nevertheless, with the domestic growth deceleration intensifying and the private sector highly leveraged, the MAS will soon opt for policy easing. It will guide the trade-weighted exchange rate lower by injecting liquidity into the banking system and lowering interest rates. Bottom Line: The Singaporean economy needs lower rates and the MAS is not constrained by the currency peg as the HKMA is. Consequently, interest rates in Singapore will decline both in absolute terms and relative to Hong Kong ones. Investment Conclusion The cyclical downturn will deepen and Singapore share prices will drop in absolute U.S. dollar terms. Relative to the EM or the Asian benchmarks, we continue to recommend a neutral position on overall Singaporean equities for now. Importantly, Singapore is better positioned than Hong Kong because the former’s monetary authorities can lower interest rates and allow the currency to depreciate. Hong Kong monetary authorities cannot tolerate lower interest rates due to their peg to the U.S. dollar and budding capital outflows. Interest rates in Singapore will drop relative to Hong Kong. We are therefore reiterating our short Hong Kong / long Singaporean property stocks strategy (Chart I-11 on page 10).   Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes Fixed-Income, Credit And Currency Recommendations Image Image Equity Recommendations  

Please note that a Special Alert titled "Brazil: A Regime Shift?" discussing investment implications of the weekend elections was published on Tuesday. Highlights The combination of rising U.S. bond yields and slumping growth in EM/China heralds further downside in EM risk assets and currencies. Watch for a breakdown in Asian risk assets and currencies. As a market-neutral trade for the next several months, we recommend going long Latin American and short emerging Asian stocks in common currency terms. We are downgrading Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. Feature U.S. bond prices have broken down, and yields have broken out (Chart I-1). The bond selloff will continue as U.S. growth is very strong and inflationary pressures are accumulating. Chart I-1U.S. Bond Yields Have Broken Out, More Upside U.S. Bond Yields Have Broken Out, More Upside U.S. Bond Yields Have Broken Out, More Upside How will EM financial markets react to a further rise in U.S. bond yields? If EM growth were robust and fundamentals healthy, financial markets in developing countries would have no problem digesting higher U.S. interest rates. However, the fact is that EM fundamentals are poor and growth is weakening. Consequently, financial markets in the developing world are very vulnerable to higher U.S. bond yields. For now, U.S. bond yields will continue to rise, the U.S. dollar will strengthen further, and the EM bear market will endure. Stay short/underweight EM risk assets. Understanding The Nexus Between EM Assets And U.S. Bonds Rising U.S. bond yields pose a threat to EM risk assets if the former leads to a stronger U.S. dollar and by extension weaker EM currencies. Notably, risks to EM share prices will magnify if dollar borrowing costs for EM (corporate and sovereign bond yields) increase further (Chart I-2). In short, if rising U.S. bond yields are not offset by narrowing EM credit spreads, EM dollar bond yields will climb. This in turn will weigh on EM share prices. Chart I-2Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Rising Dollar Borrowing Costs: A Bad Omen For EM Stocks Chart I-3 highlights that the divergence between U.S. and EM share prices this year can be attributed to the decoupling in their credit spreads. Chart I-3Diverging Credit Spreads Between EM & U.S Diverging Credit Spreads Between EM & U.S Diverging Credit Spreads Between EM & U.S Credit spreads, meanwhile, are steered by EM exchange rates (Chart I-4). When EM currencies depreciate, debtors' ability to service U.S. dollar debt worsens, and credit spreads widen to reflect higher risk. The opposite also holds true. Chart I-4EM Credit Spreads Are A Function Of EM Currencies EM Credit Spreads Are A Function Of EM Currencies EM Credit Spreads Are A Function Of EM Currencies Overall, getting EM exchange rates right is of paramount importance. Hence, a vital question: Do EM currencies always depreciate when U.S. bond yields are rising or the Federal Reserve is tightening? Chart I-5 suggests not. Before 2013, EM currencies appreciated with rising U.S. bond yields. Since 2013, the correlation has been mixed. Chart I-5No Stable Relationship Between U.S. Bond Yields & EM Currencies No Stable Relationship Between U.S. Bond Yields & EM Currencies No Stable Relationship Between U.S. Bond Yields & EM Currencies The key difference between these periods is the performance of EM/Chinese economies. When EM/China growth is robust or accelerating, financial markets in developing economies have no trouble digesting higher U.S. interest rates and their currencies tend to appreciate. By contrast, when EM/China growth is weak or slumping, EM asset prices and currencies tumble regardless of the trajectory of U.S. interest rates. A pertinent question at the moment is why robust U.S. growth is not helping EM weather higher U.S. interest rates. The caveat is that EM as a whole is more exposed to the Chinese economy than the American one. Hence, barring a meaningful improvement in Chinese growth, higher U.S. bond yields will be overwhelming for EM financial markets. This is why we have been focusing on China's growth dynamics. Bottom Line: Desynchronization between the U.S. and Chinese economies will persist. The resulting combination of rising U.S. bond yields, a stronger greenback and depreciating EM currencies foreshadows further downside in EM risk assets. Emerging Asia: Do Not Catch A Falling Knife The latest export data from Korea and Taiwan point to a continued slowdown in their exports (Chart I-6). Corroborating the deepening slump in Asian growth and global trade, emerging Asian equity and credit markets are plunging. In particular: Chart I-6Global Trade Is Slowing Global Trade Is Slowing Global Trade Is Slowing The relative performance of emerging Asian stocks versus the global equity benchmark failed to break above important technical long-term resistance lines earlier this year, and will likely breach below their early 2016 lows (Chart I-7). Chart I-7Emerging Asian Equities Vs. Global: Further Underperformance Ahead Emerging Asian Equities Vs. Global: Further Underperformance Ahead Emerging Asian Equities Vs. Global: Further Underperformance Ahead Both high-yield and investment-grade emerging Asian corporate dollar-denominated bond yields continue to climb - a worrisome development for emerging Asian share prices (high-yield corporate bond yields are shown inverted in Chart I-8). Chart I-8Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices Rising Corporate Bond Yields In Emerging Asia = Lower Stock Prices The equity selloff in emerging Asia is broad-based. Chart I-9 shows that the emerging Asian small-cap equity index is in freefall. Chart I-9Emerging Asian Small Caps Are In Freefall Emerging Asian Small Caps Are In Freefall Emerging Asian Small Caps Are In Freefall Net earnings revisions in China, Korea and Taiwan have dropped into negative territory (Chart I-10). Chart I-10Net Earnings Revisions Are Negative In China, Korea And Taiwan Net Earnings Revisions Are Negative In China, Korea And Taiwan Net Earnings Revisions Are Negative In China, Korea And Taiwan The Chinese MSCI All-Share Index - all stocks listed on the mainland and offshore (worldwide) - has plunged close to its early 2016 lows (Chart I-11). Chart I-11Chinese Broad Equity Index Is Back To Its 2016 Lows Chinese Broad Equity Index Is Back To Its 2016 Lows Chinese Broad Equity Index Is Back To Its 2016 Lows In China, the property market and construction remain at substantial risk. The budding slump in the real estate market will likely offset the government spending stimulus on infrastructure investment. Plunging share prices of property developers listed in both onshore and in Hong Kong point to a looming major downtrend in real estate market (Chart I-12). Chart I-12An Imminent Slump In Chinese Real Estate? An Imminent Slump In Chinese Real Estate? An Imminent Slump In Chinese Real Estate? For Asian equity portfolio managers whose mandate is to make a decision on Hong Kong and Singapore stocks, we recommend downgrading Hong Kong equities from neutral to underweight while maintaining Singapore at neutral within an Asian and overall EM equity portfolio. Our basis is that rising interest rates in the U.S. will translate into higher borrowing costs in Hong Kong due to the currency peg (Chart I-13). Simultaneously, Hong Kong's economy will suffer from a slowdown in China. Hence, a combination of weaker growth and rising borrowing costs will spell trouble for this interest rate-sensitive bourse. Chart I-13Higher U.S. Rates = Higher Hong Kong Rates Higher U.S. Rates = Higher Hong Kong Rates Higher U.S. Rates = Higher Hong Kong Rates Bottom Line: Equity and credit markets in emerging Asia are trading extremely poorly, and further downside is very likely. This week, we are downgrading allocations to Hong Kong stocks from neutral to underweight within an Asian or EM equity portfolio. A Relative Equity Trade: Short Asia / Long Latin America Common currency relative performance of emerging Asian versus Latin American stocks has broken down (Chart I-14). We reckon emerging Asian equities are set to underperform their Latin American peers for the next several months. Chart I-14Long Latin American / Short Emerging Asian Stocks Long Latin American / Short Emerging Asian Stocks Long Latin American / Short Emerging Asian Stocks The main culprit will likely be further depreciation in the RMB and an intensifying economic downturn in Asia, which will propel emerging Asian currencies and share prices lower. In regard to Latin America, elections in Mexico and Colombia have produced governments that will on the margin be positive for their respective economies. In Brazil too, first round election results are pointing to a market friendly result. We have been shifting our country equity allocation in favor of Latin America at the expense of Asia since late last year. In particular, we downgraded Chinese stocks in December 2017, Indonesian equities this past May and the Indian bourse last week. At the same time, we have been raising our equity allocation to Latin America by upgrading Mexico to overweight in April 2018, Colombia last week and Brazil earlier this week.1 Given we are also overweight Chilean stocks, our fully invested EM equity model portfolio noticeably overweights Latin America versus Asia. Notwithstanding our broad underweight in emerging Asia, we are still overweight Korea, Taiwan and Thailand within an EM equity portfolio. However, these overweights are paltry relative to both the size of the Asian equity universe and our overweights in Latin America. Bottom Line: Go long Latin American and short emerging Asian stocks in common currency terms as a trade for the next several months. Our Fully-Invested Equity Model Portfolio Chart I-15 demonstrates the performance of our fully invested EM equity portfolio versus the EM MSCI benchmark. This portfolio is constructed based on our country recommendations. Hence, it is a measure of alpha that clients could derive from our country calls and geographical equity allocations. Chart I-15EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance EMS's Fully-Invested Model Equity Portfolio Performance We make explicit country equity recommendations (overweight, underweight and neutral) based on qualitative assessments of all relevant variables - the business cycle, liquidity, currency risks, policy, politics, valuations, and the structural backdrop among other things - for each country. This model portfolio is not a quantitative black box, but rather a combination of several factors: macro themes on the overall EM space, in-depth research on each individual country and various quantitative indicators. The table with our recommended country equity allocation is published at the end of our weekly reports (please refer to page 11). This fully invested equity model portfolio has outperformed the MSCI EM equity benchmark by about 65% with very low volatility since its initiation in May 2008. This translates into 500-basis-points of compounded outperformance per year. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Staring At A Grey Swan?" dated October 4, 2018 and Emerging Markets Strategy Special Alert "Brazil: A Regime Shift?" dated October 9, 2018; links are available on page 11. Equity Recommendations Fixed-Income, Credit And Currency Recommendations