Thailand

No, the secular rise in geopolitical risk has not peaked. EU-China trade ties underscore the multipolar context, but this multipolarity is unbalanced, as the US has not reached a new equilibrium with its rivals. While the second quarter is murky, investors should stay defensive this year on the whole.

Great Power Rivalry is taking another leg up as Russia and China further align their geopolitical interests. Investors should stay long USD-CNY, favor defensives over cyclicals, and markets like North America and DM Europe that have less exposure to geopolitical risk. 

Thai stocks and currency will weaken over the short term. And yet EM equity portfolios should overweight Thailand as tourism revivals will rejuvenate this economy.

Executive Summary Thai stocks’ recent outperformance had more to do with investors forsaking Chinese and Russian markets to rotate elsewhere, rather than Thailand’s bullish outlook. Thai domestic demand is still shaky as households are struggling with meagre income growth amid high indebtedness. Tight fiscal policy is another headwind. All this will delay the recovery in Thai corporate profits, without which a sustainable equity bull market is unlikely. On the positive side, the baht is much more competitive now, which is a boon for an economy where trade makes up 100% of GDP. The country’s travel and tourism revenues are also set to rise. Keep An Eye On Order Books For A Hint On A Sustainable Stock Rally Keep An Eye On Order Books For A Hint On A Suatainable Stock Rally Keep An Eye On Order Books For A Hint On A Suatainable Stock Rally Bottom Line: Equity investors should stay neutral for now; but put this bourse on an upgrade watchlist. Domestic bond investors should upgrade Thai local currency bonds from neutral to overweight in EM portfolios, and from underweight to neutral in Emerging Asian portfolios.   Chart 1Thai Stocks' Recent Outperformance Will Not Linger Thai stocks's Recent Outperformance Will Not Linger Thai stocks's Recent Outperformance Will Not Linger Thai stocks have held up relatively well during the market turbulence of the past two months or so. Can this be a sign that the end of the Thai bear market is near (Chart 1, top panel)? We believe that this bourse is not about to experience a major breakout in absolute or in relative terms. Thai domestic demand is still shaky, and might take some more time to recover. This is because households’ real income growth remains lackluster, and they are saddled with high debts. This will hinder consumer demand from rising strongly even after the pandemic subsides. That, in turn, will also discourage capital investments. Notably, Thai stocks’ recent relative breakout is more due to a meltdown in Chinese and Russian markets following the Ukraine crisis rather than any major improvements in Thailand’s domestic fundamentals. Thai relative performance looks much less impressive versus the EM equity index excluding Chinese and Russian stocks (Chart 1, middle and bottom panels). That said, two major macro headwinds that had hamstrung this market over the past several years have eased. The baht is no longer expensive, and the country’s decimated travel and tourism revenues – which fell from 12% of the GDP before the pandemic to nearly naught – are also set to recoup some of the losses. All this warrants that investors maintain a neutral allocation to this bourse in EM and emerging Asian portfolios for now, but put it on an upgrade watchlist. As for domestic bonds, investors should upgrade Thai bonds to overweight in an EM local currency bond portfolio, and to neutral in Emerging Asian portfolios. The Economy: An Extended Bottoming Phase  Chart 2Thai Private Consumption Is Struggling Thai Private Consumption Is Stuggling Thai Private Consumption Is Stuggling The Thai economy is still in an extended bottoming phase. Top panel of Chart 2 shows that private consumption is barely at 2019 levels, and is still about 10% lower than what would be the pre-pandemic trend. Consumption clearly slows as new COVID-19 cases go up are. The latter have been on the rise again lately, and it could slow the pace of recovery again. This is at a time when durable goods sales have not recovered to even their pre-pandemic levels (Chart 2, bottom panel). More importantly, what could hinder the economic recovery beyond the pandemic is the fact that Thai households are quite depleted in terms of their purchasing power: Household incomes are severely impaired as average wage growth has been very poor. In fact, both private and government sector jobs have barely seen any rise in their real wages in the past six years (Chart 3, top panel). Given the current higher energy and transportation prices, that leaves households with little discretionary income to spend elsewhere.   Lack of employment opportunities is exacerbating the poor wages issue. Non-farm jobs have not grown at all since 2016. The number of manufacturing jobs has actually fallen by 10% during this period (Chart 3, bottom panel). All this has been a headwind to household income. Prospects of a strong job/wage recovery in the near future is also not high. One reason for this is that Thai banks have substantially retrenched their loans to the SME sector in the past couple of years. From a high of 30% of GDP in 2019, these loans are now down to 21% (Chart 4). Credit retrenchment of this order in the job-intensive SME sector has driven many companies out of business, shrinking job opportunities. It will take a considerable time to recoup all these jobs even when the pandemic subsides.  Chart 3Real Wages Have Stagnated For Years As Employment Stopped Growing Real Wages Have Stagnated For Years As Employment Stopped Growing Real Wages Have Stagnated For Years As Employment Stopped Growing Chart 4Massive Credit Retrenchment To SMEs Will Cost Jobs Massive Credit Retrenchment To SME Sectors Will Cost Jobs Massive Credit Retrenchment To SME Sectors Will Cost Jobs Notably, Thai households were already highly leveraged going into the pandemic. Household borrowing from banks and other financial institutions taken together now amount to a very high 90% of GDP. The top panel of Chart 5 shows that for almost a decade until 2015, Thai households were leveraging up incessantly. Those loans did help boost consumer demand during all those years. But now, when jobs are scarce and wage growth is paltry, households are shy to add more leverage to their balance sheets. This means a debt-fueled recovery in consumer demand is not in the cards. Notably, total domestic credit (including households and corporates)  had also surged in a similar fashion, and is now very high at 170% of GDP (Chart 5, bottom panel). Facing subdued demand, Thai manufacturing and shipments are also struggling. Weak sales mean businesses are struck with high inventories. Order books do not appear to be strong either (Chart 6). Chart 5High Household Debt Entails No Debt-Fueled Consumer Demand Recovery Already High Household Debts Means No Debt Fueled Consumer Demand Recovery Already High Household Debts Means No Debt Fueled Consumer Demand Recovery Chart 6Mediocre Orders Amid High Inventory Does Not Entail Strong Manufacturing Recovery Mediocre Orders Amid High Investory Does Not Entail Strong Manufacturing Recovery Mediocre Orders Amid High Investory Does Not Entail Strong Manufacturing Recovery The combination of rather high finished goods inventories and mediocre order books entail that a strong manufacturing recovery is not around the corner. If so, that could be a problem as only a sustained recovery in manufacturing can lead to a major breakout in Thai stock performance. Indeed, the first hints of an improving economy often come from the status of order books. At present, middling order book figures do not imply that Thai stocks are on the cusp of a major rally (Chart 7). Chart 7Keep An Eye On Order Books For A Hint On A Sustainable Stock Rally Keep An Eye On Order Books For A Hint On A Suatainable Stock Rally Keep An Eye On Order Books For A Hint On A Suatainable Stock Rally Chart 8Thai Profits Are Far Too Low Compared To Stock Prices Thai Profits Are Far Too Low Compared To Stock Prices Thai Profits Are Far Too Low Compared To Stock Prices Notably, Thai share prices have outpaced corporate profits since 2012. The listed companies’ EPS in US dollar terms are still languishing at around the same level as they were a decade back. As such, multiples have steadily risen over the past 10 years, and stocks are not cheap (Chart 8). Provided that the policy rate is already close to zero (with little room to fall), any multiple expansion-based rally in Thai equities is also unlikely. In sum, for a new bull market to develop, this bourse needs a sustained rise in corporate profits. But given the macro backdrop, that kind of sustained earnings expansion will take more time to materialize. What About Policy Support? Fiscal policy in Thailand will remain tight. In its fiscal budget, the government plans to spend about 5.5% less this year (October 2021 – September 2022) than the year before. Actual fiscal expenditure is indeed contracting in nominal terms. The IMF estimates that the fiscal thrust in 2022 will be a significantly negative 3% of GDP (Chart 9). As for monetary policy, the policy rate is already very low at 0.5% since early 2020. Yet, it hasn’t helped much in terms of credit growth. Meanwhile, thanks to a sharp rise in commodity prices, headline CPI has surged past the central bank’s upper inflation target band. CPI-excluding sectors affected by energy and food prices, however, are still very low (Chart 10). The lingering softness in domestic demand, weak employment and muted wages also indicate that deflationary pressures are more dominant in the Thai economy than are inflationary pressures. As such, the central bank is unlikely to raise interest rates in the foreseeable future. Chart 9Thai Fiscal Policy Is Very Restrictive Thai Fiscal Policy Is Very Restrictive Thai Fiscal Policy Is Very Restrictive Chart 10There Is No Genuine Inflation There Is No Genuine Inflation There Is No Genuine Inflation In sum, fiscal policy will tighten considerably this year and there will be little change in monetary policy. Altogether, these factors do not herald a strong recovery.  External Outlook Thailand’s external outlook has improved. One reason for that is the currency is now more competitive as it has cheapened significantly in real terms (Chart 11, top panel). For a small, open economy where external trade (exports + imports) makes up 100% of GDP, a competitive currency is a major positive. Right on cue, Thai export volumes, which have been falling for a decade relative to global and EM exports, appears to have bottomed (Chart 11, bottom panel). The country’s travel and tourism revenues are set to rise as well. Thailand has already relaxed various travel restrictions for foreign tourists and further relaxation will be in effect from April 1. The country hosted 40 million foreign tourists in 2019, earning about $60 billion in revenues. All this disappeared during the pandemic in the past two years, leading to a massive drop in the country’s services sector balance. In fact, those losses also pushed the Thai current account balance into deficit – even though the country’s goods balance held up well (Chart 12). Chart 11The Baht Has Cheapened Significantly In Real Terms, Improving Competitiveness The Baht Has Cheapened Significantly In Real Terms, Improving Competitiveness The Baht Has Cheapened Significantly In Real Terms, Improving Competitiveness Chart 12With Easing Travel Restrictions, The Current Account Balance Will Improve With Easing Travel Restrictions Current Account Balance Will Improve With Easing Travel Restrictions Current Account Balance Will Improve Going forward, even if a quarter of those lost revenues come back over the next year, that should be enough to push the current account and the balance of payments back into surplus. An improving balance of payments is a bullish development for the currency. Chart 13The Depreciation In The Baht Is Likely Over The Depreciation In Baht Is Likely Over The Depreciation In Baht Is Likely Over All this means that the baht depreciation is likely over. It has fallen about 10% against the US dollar since February last year when we first recommended that investors short the baht (Chart 13). We sent a special alert on February 18 this year announcing the closing of this trade. Upgrade Domestic Bonds Chart 14Thai Domestic Bond Returns Are Highly Dependent On The Baht Thai Domestic Bond Returns Are Highly Dependent On The Baht Thai Domestic Bond Returns Are Highly Dependent On The Baht Thai domestic bond returns in US dollar terms are highly contingent on the baht’s performance. Chart 14 shows that both have fallen materially over the past year. However, given that the baht has likely bottomed, Thai bonds’ total return in USD terms will get a boost from now on. The Thai currency could also be one of the more resilient currencies in EM going forward. Historically, the baht had tended to perform better than most other EM currencies during periods of global uncertainty. We are witnessing such a period in view of the rapidly rising US bond yields and the Ukraine crisis. A better-performing baht compared to other currencies would help boost Thai bonds’ total returns relative to other EM bonds. Notably, Thai bond yields have been falling relative to that of the GBI-EM (excluding Russia) index. This is reflecting the difference in the inflationary backdrop between Thailand and many other EM countries, especially in Latin America and EMEA. The relative yields, therefore, might fall further. Considering the above, we recommend that investors upgrade Thai domestic bonds from neutral to overweight in EM domestic bond portfolios (Chart 15). Relative to their Emerging Asian peers, we recommend a neutral allocation to Thai bonds. This is because inflationary pressures in Asia are very similar to those in Thailand. Meanwhile, Thai relative bond yields have already risen significantly versus their Emerging Asian counterparts since the height of the pandemic scare in early 2020. As such, the relative yield compression move is likely late (Chart 16, top panel). Considering that Thai bonds have already had a steep underperformance, and that the baht is also cheaper now, we recommend that investors upgrade Thai bonds to a neutral allocation in Emerging Asian portfolios (Chart 16, bottom panel).    Chart 15Upgrade Thai Domestic Bonds To Overweight In An EM Bond Portfolio Upgrade Thai Domestic Bonds To Overweight In An EM Bond Portfolio Upgrade Thai Domestic Bonds To Overweight In An EM Bond Portfolio Chart 16Upgrade Thai Domestic Bonds To Neutral In An Emerging Asian Portfolio Upgrade Thai Domestic Bonds To Neutral In An Emerrging Asian Portfolio Upgrade Thai Domestic Bonds To Neutral In An Emerrging Asian Portfolio Investment Recommendations Currency: The baht has fallen about 10% in nominal terms over the past year or so. It has cheapened significantly in real terms also – which has enhanced the economy’s competitiveness. Going forward, prospects of an improving balance of payments means the Thai currency will be one of the more resilient ones in the EM. Stocks: A sustainable rise in Thai corporate profits is still some way off. But a much cheaper currency and an improving balance of payments will help. One should not chase the recent Thai outperformance. It had more to do with investors forsaking Chinese stocks en masse to pile on elsewhere in EM, including Thai equities. Chart 17 shows that the Thai bourse saw an unusual amount of foreign net purchases over the past month. Some of these inflows are at risk of unwinding in the months ahead. Instead, equity managers should put this market on an upgrade watchlist to move its allocation from the current neutral to overweight in EM and Emerging Asian portfolios. Chart 17Some Of The Recent Foreign Equity Inflows Are At Risk Of Unwinding Some Of The Recent Foreign Equity Inflows Are At Risk Of Unwinding Some Of The Recent Foreign Equity Inflows Are At Risk Of Unwinding Domestic Bonds: Investors should upgrade Thai bonds from neutral to overweight in an EM basket, and from underweight to neutral in an Emerging Asian basket.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

We are booking profits on our short Baht/ long U.S. dollar trade instituted on March 25, 2021. The position has generated a 1.6% profit, including carry. We recommended to short the baht against the US dollar a year ago due to a shortfall in Thai tourism revenues. The baht was also too expensive in real terms given the macro-outlook back then. The currency has since weakened vis-à-vis the US dollar and is no longer expensive. In addition, Thai firms have been receiving a sizeable amount of foreign trade credit in recent months, which indicates higher exports in the medium term. The recent announcement of Thai authorities, following a remission in Omicron cases, to allow vaccinated international travelers from all countries to enter without quarantine measures has raised the probability of a considerable revival in tourism revenues. This is also positive for the currency. As such, the risk-reward benefit for staying short the baht is no longer there.     Bottom Line: Take profit on the short THB / long USD trade. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Highlights The baht will depreciate further, given the state of the economy and external accounts. Domestic demand was already relapsing, even before the latest surge in COVID-19 cases. Now, the recovery will be delayed more. The authorities have little to offer by way of fiscal or monetary support. Credit to the job-intensive SME sector has collapsed. The balance of payment dynamics remains negative for the currency. Investors should stay short the baht. Dedicated EM asset allocators should continue to be neutral on Thailand within respective equity and domestic bond portfolios. Feature Chart 1Thai Stocks Are Facing Several Headwinds Thailand: Stay Short The Baht Thailand: Stay Short The Baht Our negative view on the baht has played out as expected.1 The Thai currency is down 10% versus the dollar since its peak in February of this year. It has also been the worst performer in Asia. The country’s stock market is struggling and going down in both absolute terms and relative to their EM counterparts (Chart 1). Going forward, odds are that the baht will remain weak. A weak currency will continue to stifle both Thai stocks’ and local currency bonds’ relative performance. Investors should stay short the baht and remain neutral Thai equity and local currency bonds within their respective EM portfolios. Relapsing Growth Chart 2Surging New COVID-19 Cases... Thailand: Stay Short The Baht Thailand: Stay Short The Baht The latest spike in new COVID-19 cases has dashed hopes for any early recovery of the Thai economy (Chart 2). Earlier this month, the central bank revised down their GDP forecast for 2021 from 1.8% to 0.7%. We concur with this bearish outlook: Private consumption in real terms was languishing as of June this year at 10% below 2019 levels. Car sales, both personal and commercial, are even more downbeat (Chart 3). After the latest surge in new COVID-19 cases, those numbers must have weakened further. Incidentally, the country’s vaccination rate, at 26% of total population (7.5% fully vaccinated), remains low. It could be, therefore, several months before any meaningful recovery in consumer demand takes place. Faced with low demand, the country’s manufacturing and shipment volumes are also weak. They are both breaking down anew from well below the 2019 levels (Chart 4, top panel). Chart 3...Will Further Delay Domestic Demand Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 4Manufacturers Are Saddled With High Inventory Amid Weak Orders... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Weak demand also means that businesses are stuck with high inventories. Indeed, there is a widening disparity between inventory levels and shipments (Chart 4, middle panel). Furthermore, order books have slipped back to levels not seen since the height of the COVID-19 scare early last year. The combination of high inventories and tumbling orders does not portend a manufacturing recovery anytime soon (Chart 4, bottom panel). Notably, jobs and wages are also weak. Employment in the manufacturing sector is well below pre-pandemic levels (Chart 5). This trend, in turn, is hurting household income and consumer demand, completing a vicious cycle of depressed demand, weak production, falling employment and household income, and further reduced demand. The softness of the economy is accentuating the disinflationary pressure that was already entrenched. Headline and core CPI in Thailand have stayed mostly below 1% over the past five years — the lower band of the central bank’s inflation target. Now, they are flirting with outright deflation. In fact, if the impact of food and oil prices is excluded, the prices are actually deflating (Chart 6). Chart 5...Which Is Hurting Jobs And Wage Growth Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 6Thailand Is Flirting With Outright Deflation... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Outright deflation makes it harder for borrowers to service their debts, which then discourages both borrowing and spending — making the recovery much harder. Notably, the banks’ prime lending rates remain high at 5.4%, which means real prime lending rates are quite steep at 5% (deflated by core CPI). This is at a time of very low household income and business revenue growth expectations. This trend is a strong disincentive for borrowing and consuming /capital spending. Little Policy Support What is more concerning for the economy is that policymakers can offer little to boost the economy. Fiscal stimulus has waned: government expenditure, after a surge last year, is now contracting (Chart 7). The budget proposal for the next fiscal year (October 2021 - September 2022) that was passed by the parliament in June 2021 (first reading)2 stipulates a 5.7% cut in nominal spending. Part of the reason is that fiscal deficits have already ballooned to a staggering 8% of GDP — from an average of 2.5% in the past ten years. The IMF estimates that the fiscal thrust will be zero this year, and a negative 2.4% of GDP in 2022 (Chart 7, bottom panel). The monetary policy transmission is also paralyzed. Despite easing by the Bank of Thailand — the policy rate is at an all-time low of 0.5% since May last year — credit growth is dismal. Lenders are wary of rising NPLs and are holding back new credit: The share of impaired loans (NPLs plus Special Mention Loans) of total bank loans has dramatically increased to 10%. In the case of small and medium enterprises (SMEs), that ratio is 20%. By comparison, loss provisions are much lower, at just 5.2% as of June of this year (Chart 8, top panel). Chart 7...Yet, The Government Is Planning To Cut Fiscal Spending Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 8Sharp Rise In Banks' Stressed Loans Amid Tanking Profits... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   Notably, both operating and net profits of banks had already halved (as a % of assets) by June 2021 — as both interest and non-interest incomes dropped. Profits are slated to contract further, since banks will have to make greater provisions in the future as the recent surge in new cases will produce more loan delinquencies (Chart 8, bottom panel). The specter of rising NPLs has prompted banks to retrench loans. In particular, bank credit to SMEs has plunged by a massive 34% from 2019 levels (Chart 9). Before the pandemic, banks’ SME loans made up a significant 30% of GDP. Now, they are down to 21%. Credit retrenchment of this order to the job-intensive SME sector is going to have a significant negative ripple effect. Employment will shrink further as small businesses go bust. Shrinking jobs will dent household income, and, in turn, consumer demand. Incidentally, loans to other business segments are also not rising much. Bank loans to all non-financial corporates are growing rather minimally, at 1.5% year-over-year. Going into the pandemic, the Thai household sector was already highly leveraged. Over the past two decades, banks and other financial institutions have been lending ever more to households, shunning non-financial corporates. Households’ borrowing from banks have now risen to 40% of GDP; and those from other institutions another 50%. These loans had helped boost consumer demand all those years, but now, at a time when incomes are uncertain, households have very limited appetite to borrow more to spend. This means a consumer debt-fueled demand recovery is not in the cards (Chart 10). Chart 9...Induced Banks To Massively Reduce Credit To The Job-Intensive SME Sector Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 10Thai Households Are Too Indebted To Borrow More And Spend Thailand: Stay Short The Baht Thailand: Stay Short The Baht   In brief, Thai businesses are in the middle of a toxic combination of contracting sales, absent fiscal support, slashed credit facilities, and rather high borrowing costs in real terms. Chart 11 shows that corporate profit margins of non-financial firms are struggling at a low level. It is no wonder that businesses are reluctant to invest, expand, and hire. The message is similar when we examined all companies included in the MSCI Thailand stock index. On the one hand, their EPS has fallen to 10-year lows. Thai stock prices, on the other hand, have not yet fallen as much as the shrinking EPS would imply (Chart 12, top panel). The consequence is that the valuations are remarkably stretched—near a 20-year high (Chart 12, bottom panel). Chart 11Low Margins Are Discouraging Thai Firms To Borrow, Invest, Or Hire Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 12Thai Profits, At A Decade-Low, Are Also A Headwind For Stock Prices Thailand: Stay Short The Baht Thailand: Stay Short The Baht   All in all, for Thai share prices to stage a sustainable rally, an economic recovery is essential. The first indications of that usually come from an improving order book. The latter currently shows little glimmer of hope. But investors should keep an eye on this indicator, as Thai stocks’ performance is geared to the ebbs and flows of the business order book (Chart 13). Thailand Needs A Weaker Currency The state of the Thai economy not only warrants exchange rate depreciation, but also needs a much weaker currency to help an economic recovery. The country’s balance of payment is in deficit — for the first time since 2014. A crucial reason is that the baht is still expensive, which continues to weigh on exports. Of all the export-oriented Asian economies, Thai exports recovery has been the weakest (Chart 14). Chart 13Keep An Eye On The Order Book For A Sign In Stock Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 14An Expensive Baht Held Back Thai Exports Recovery Thailand: Stay Short The Baht Thailand: Stay Short The Baht   The fact that a quarter of Thai exports go to other ASEAN countries — where demand has been and remains weak due to the lingering pandemic — doesn’t help either. As a result, the Thai trade surplus has narrowed significantly, and the current account has slipped into deficit (Chart 15, top and middle panels). The other main external revenue source of Thailand, tourism, continues to be near absent at 0.6% of GDP — a far cry from a high of 12% before the pandemic (Chart 15, bottom panel). What’s more, there is little hope of any recovery in the near future. The government now expects the number of foreign tourists this year to be as low as 0.3 million versus 40 million in 2019. On the capital account front, Thailand continues to hemorrhage both FDI and portfolio capital — just as it did the past several years. Despite that, the baht had remained strong until early this year, as a result of a substantial repatriation of bank deposits by Thai residents and, to a lesser extent, foreign borrowings. Those inflows prevented the Thai baht from depreciating. But such panic-stricken, one-off savings/deposit repatriations by Thai residents will certainly slow materially going forward (Chart 16). Chart 15The Thai Current Account Balance Will Struggle To Stay In Surplus... Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 16...While The Capital Account Balance Will Slip Deeper Into Deficit... Thailand: Stay Short The Baht Thailand: Stay Short The Baht   There’s also little hope that FDI and portfolio inflows will pick up the slack. The reason is that the Thai economy is very weak and the return on capital is low. The latter discourages capital inflows. The fact that the baht continues to be an expensive currency in real terms, and therefore not as competitive as some of its neighbors’, doesn’t help either. The multi-nationals who are planning to re-locate out of China might find some other countries — where the currency is more competitive (such as in India, Malaysia, or the Philippines) — more attractive. Overall, the Thai capital account balance will likely slide deeper into deficit, at a time when the current account will also struggle to stay in surplus. The result will be a further deterioration in the country’s balance of payment, hurting the baht (Chart 17). Considered from another angle, if the return on capital on Thai assets is any guide, the baht could drop much more from its current levels (Chart 18). Chart 17...Putting Downward Pressure On The Baht Thailand: Stay Short The Baht Thailand: Stay Short The Baht Chart 18Thai Firms' Low Rates Of Return Point To More Baht Depreciation Thailand: Stay Short The Baht Thailand: Stay Short The Baht     The reality is that, given Thailand’s current macro backdrop, a cheaper currency is what the nation needs. That will help boost growth significantly by aiding exports and promoting import substitution. Since foreign trade makes up an impressive 90% of GDP, a boost therein could kickstart the entire economy. Another result of a weaker currency will be higher inflation, something the economy seriously needs. Higher inflation will contribute to lower real interest rates which, in turn, will encourage borrowing and spending. Higher spending and inflation will help achieve higher nominal sales, boost firms’ profits, employment, and eventually, household incomes. All in all, it could allow a productive cycle to unfold. Given all these possible benefits and given that policymakers have few other tools at their disposal at this juncture, chances are the central bank will let the baht depreciate more, albeit in an orderly fashion, in the months to come. What About Bonds? Chart 19Mantain A Neutral Allocation To Thai Domestic Bonds In An EM Basket Thailand: Stay Short The Baht Thailand: Stay Short The Baht Thai local currency bonds’ absolute return in US dollar terms, as expected, is highly dependent on the exchange rate (Chart 19, top panel). Given the weak currency outlook, foreign investors should refrain from holding Thai domestic bonds outright. For foreign asset allocators, however, the matter is more nuanced. Thai domestic bonds’ relative return versus that of overall EM did not depend on the baht movement alone. This is because Thailand has been a defensive market owing to the following: a traditionally strong current account, a manageable public debt (now 47% of GDP), and a relatively low holding of bonds by foreign investors (now 12% of total). A robust current account surplus for years meant that during periods of negative growth shocks, the baht often fell less than many other EM currencies — that is, in periods of distress, the baht helped boost the relative performance of Thai bonds vis-à-vis overall EM bonds in US dollar terms. Those periods of distress also saw Thai bond yields fall as the central bank was able to cut rates due to low inflation. In addition, during those periods, local investors moved from equities to government bonds. Since the holdings of local bond investors far outweighed those of foreign investors, Thai bond yields managed to go down, even when some foreign investors dumped EM and Thai domestic bonds. As a result of these factors, Thai bonds outperformed their EM counterparts during the commodity/EM slowdown in 2014-15, and again at the height of the COVID-19-scare in early 2020 — even though the baht fell versus the US dollar during those periods (Chart 19, middle panel). All that said, the reality in the ground has changed somewhat since early last year. The Thai current account is no longer in surplus, and, given the dismal tourism outlook and slowing trade surplus, it will probably stay that way for the foreseeable future. That will keep the baht relatively weak weighing on Thai bonds’ relative performance versus their EM peers. On the other hand, the grim outlook of the Thai economy and looming deflation risk means that Thai bond yields could fall going forward relative to their EM counterparts. That will be a tailwind for Thai domestic bonds’ relative outperformance versus their EM counterparts. There is, therefore, a good chance that the headwind from a relatively weaker baht could be somewhat compensated for by a drop in Thai local yields versus their EM peers. Indeed, the periods of the baht’s weakness usually coincided with Thai bonds’ relative yield compression (Chart 19, bottom panel). This calls for a neutral outlook for relative bond performance going forward. Investment Conclusions Currency: The baht outlook remains precarious. Investors would do well to remain short the baht versus the US dollar. Domestic Bonds: Thai bond yields will go down. The Bank of Thailand will have no choice but to cut rates further. Local investors should stay long bonds. For international dedicated EM fixed-income portfolios, we downgraded Thai bonds in February of this year, from overweight to neutral in an EM bond portfolio, in view of the impending baht weakness. That turned out to be a good decision. Going forward, investors should continue to have a neutral allocation on Thai bonds, as the headwind from the baht will be mitigated by the tailwind from relative bond yield compression. Foreign absolute-return investors, however, should avoid Thai bonds in view of expected currency depreciation. Chart 20A Vulnerable Baht Will Keep Foreign Equity Investors Away Thailand: Stay Short The Baht Thailand: Stay Short The Baht Stocks: A struggling economy offers little hope for corporate margins or profits recovery soon. A vulnerable currency makes Thai stocks even less appealing to foreign investors. Without their participation, it will be hard for this market to rise sustainably in absolute terms or outperform their EM counterparts (Chart 20). Thai equities are not cheap either: the P/Book ratio is at par with EM. That said, given the Thai market’s already very steep underperformance versus the EM equity benchmark, from a portfolio strategy point of view, we recommend investors stay neutral this market within an EM equity portfolio. Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Footnotes 1 Please refer to the EMS report “Thailand: Beset By A Vulnerable Baht,” dated February 24, 2021. 2 The budget bill has to pass the second and third readings expected in August before it goes for senate and royal approval.

Highlights Years of capital outflows have turned Thailand a net creditor to the world – a rarity among developing nations. The Thai currency is too strong given the state of the economy. The baht is slated to depreciate this year; investors will do well to short it. Equity portfolios should stay neutral this market. Fixed income investors should book profits by downgrading Thai bonds from overweight to neutral in an EM bond portfolio. Feature Chart 1Thai Stocks Steep Underperformance Has Been In Works Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Thai stocks’ recent underperformance versus the EM benchmark has been one of the steepest among EM bourses (Chart 1). What caused such a fall after almost a decade of outperformance? More importantly, does this market offer a good risk-reward now? Our research indicates that the seeds of the underperformance were sown over the past several years. In fact, the underperformance could have been worse had it not been for the Thai currency – which held up rather well. That said, the baht is now vulnerable; and going forward it will likely be the one which will weigh on this market’s relative performance. Currency investors should consider shorting the Thai baht; and for dedicated EM equity portfolios a neutral allocation to Thailand is currently appropriate. Thai Assets Have Long Lost Their Sheen One reason for the potential downward pressure on the baht is investor apathy towards Thai assets. Due partly to over a decade of socio-political upheavals, foreign investors have long lost interest in them. This is evident in the incessant capital outflows: Chart 2As Investors And Corporates Have Long Shunned Thailand Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The country has witnessed steady portfolio outflows on a net basis - driven mostly by equity portfolio outflows (Chart 2, top panel). Although there have been minor net debt portfolio inflows, they have paled in comparison to equity outflows.   There have been more FDI outflows from Thailand to elsewhere in the world than inflows into the country. Put differently, not only financial investors, but also foreign and domestic corporates, have been shunning Thailand for several years (Chart 2, bottom panel).  Finally, Thai residents have also been consistently sending their savings abroad - primarily in the form of bank deposits - until Covid19 hit (Chart 3). This tendency reveals that it’s not just the foreigners but also the residents who have long been nurturing a negative outlook on Thai assets. While these sustained capital outflows indicate investor apathy towards Thai assets, it has also fundamentally changed Thailand’s international investment position. The country has now become a net creditor to the world – a rarity among the developing economies (Chart 4). Chart 3And Thai Residents Funneled Their Deposits Abroad For Years Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 4Turning Thailand Into A Rare EM Country Who Is Net Creditor To The World Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   This regime shift has important implications. For instance, currencies of net creditor countries typically fare better than those of debtor countries during global risk-off periods. This is because residents tend to repatriate their money back to the home country during uncertain times. It’s one reason why the baht held up relatively well last year. However, by that same logic, the baht is now likely to underperform debtor nations’ – the majority of EM – currencies during the ongoing global risk-on phase and/or the US dollar decline. Currency Strength Is Transitory Despite steady capital outflows over the years, the Thai currency had held up remarkably well until late 2019. The reason for that was a robust current account surplus, aided by tourism and export revenues (Chart 5, top panel). Mid-pandemic, however, tourism revenues have been decimated. In 2021, the government expects only 5 million tourists compared to 40 million in 2019 (Chart 5, middle panel). Exports are struggling to recover as well. Indeed, despite the massive reflation unleashed by the global central banks and fiscal authorities, Thai exports have failed to take advantage of it – in stark contrast to previous reflation cycles. Of all the export-oriented Asian economies, Thai export revival is the most tepid; and is the only one which is still contracting year-over-year (Chart 6). The reasons are twofold: Chart 5Baht Is Vulnerable As Tourism Got Decimated And Exports Remain Weak Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 6And A Currency That Has Become Expensive Vis-à-Vis Its Competitors Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   A considerable share of Thai exports (24%) goes to other ASEAN countries. Exports to this region have been subpar as these economies are still reeling from the negative ramifications of Covid19 and their domestic demand recovery is very muted (Chart 7). Chart 7Due To A Large Exposure To ASEAN Where Domestic Demand Recovery Is Muted Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   That said, Thai exports to China, Japan and Korea have not accelerated much either – even though Covid19-related negative impacts had been rather limited in those countries. Exports to developed markets like the US and Europe have fared somewhat better – thanks mostly to the massive stimulus in the US and the solid recovery in European demand (Chart 7, bottom panel). The other reason for the poor export performance is that the baht has become rather expensive, especially relative to its other Asian competitors. Chart 8 shows that in real effective terms, the baht has been one of the most expensive currencies for a while among its’ regional peers. This is weighing on Thai competitiveness, and therefore on exports. To be sure, loss of competitiveness is not a new phenomenon for Thailand. The country has been losing export market share for a while now – both relative to emerging markets and to the world (Chart 9). Chart 8And A Currency That Has Become Expensive Vis-à-Vis Its Competitors Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 9Thailand Has Been Steadily Losing Exports Market Share Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   What’s new however is that mid-pandemic with current account balance turning negative by the end of 2020 (for the first time in several years), a strong currency is simply unsustainable. As such, given that the ebbs and flows in exports and tourism revenues have long dictated the baht’s trajectory, they now point to a much weaker currency ahead (Chart 5, bottom panel).  Despite negative net portfolio and FDI flows as well as deteriorating current account, the baht remained well-bid last year, largely due to the substantial repatriation of bank deposits by Thai residents (Chart 3, above). The advent of the pandemic prompted Thai residents to bring back a significant amount of bank deposits that they had been funneling abroad in preceding years. Those inflows prevented the Thai balance of payment from sinking and bid up the baht. That said, this kind of panic-stricken repatriation of capital/deposits happens rarely; the only other instance being during the global financial crisis in 2008, as illustrated in Chart 3. Hence, odds are that going forward such repatriation will slow meaningfully as the Covid19-related panic subsides. In fact, bank deposits might even resume their outward flows, as was the case from 2011 to 2019.  A reversal in deposit repatriation will drastically worsen Thailand’s balance of payments this year and beyond, causing the baht to depreciate. Growth Remains Subpar In the World Economic Forum at Davos last month, the Thai finance minister projected a growth of just 2.8% in 2021, after a contraction of 6.1% in 2020. Clearly, the pandemic-related fiscal and monetary stimulus efforts have proved inadequate to kickstart the economy: Chart 10A Strong Currency Has Added To The Deflationary Forces Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Despite the promise of a substantial Covid19 fiscal stimulus package last year (14% of GDP), actual spending so far has been less than spectacular. Fiscal expenditure has risen a modest 11% year-over-year as of December 2020 (a rise of barely 3% on its 2019 GDP) - not an outlier in the context of recent history. As such, the surge in fiscal deficit to over 6% of GDP is mainly due to collapsed fiscal revenues. Notably, the fiscal authorities have not announced any new meaningful stimulus measures in recent months. On the monetary front, the central bank has little room to cut rates further as policy rates are already approaching the zero-bound (now at 0.5%). Yet, consumer price inflation has slid to a negative territory, dramatically undershooting the central bank target of 1% to 3%. Producer prices are also deflating (Chart 10). Part of the reason for the outright deflation is a strong currency amid depressed economic activity. The deflationary pressures are making the borrowers struggle with high real borrowing cost (i.e., inflation-adjusted borrowing cost). This is because banks’ primes lending rates remain elevated at 5.4%, making real prime lending rates quite steep at 5.7% at a time when the economy is expected to grow at 2.8%. Deflation makes it harder for firms to service their debts. The outcome is usually a shrinkage in margins, loan defaults, or a combination of the two. Indeed, Chart 11 (top panel) shows that corporate profit margins are shrinking as the borrowing costs for non-financial firms are now much higher than their sales growth rate. Low and falling margins do not portend a stock market recovery. Falling return on capital typically discourages capital inflows too. That, in turn, has a negative impact on the currency. This has indeed been the case for Thailand in the past (Chart 12). Last year, the pandemic-induced massive, but one-off, bank deposit repatriation supported the baht. But sooner rather than later the baht will depreciate meaningfully. Chart 11High Real Rates Are Weighing On Profits, And Will Dampen New Capital Expenditure Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 12Falling Return On Capital Discourages Foreign Investors, And Are Bearish For Currency Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   Falling profits also discourage firms from making capital expenditures. Since a new capex cycle is often instrumental to a post-recession recovery, the absence of it means subdued growth ahead (Chart 11, bottom panel). Another issue clouding the chances of an imminent economic recovery is a significant inventory overhang. Chart 13 shows that finished good inventory levels are too high vis-à-vis shipments. At the same time, Thai manufacturing order books are relapsing anew (Chart 13, middle panel). Chart 13Elevated Inventory Amid Falling Orders Means Lower Manufacturing Output Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The combination of surplus finished goods inventory and falling orders will discourage manufacturing activity. Slowing manufacturing is usually a bad omen for Thai stocks’ relative performance versus EM (Chart 13, bottom panel). Seen from a different angle, the struggling export sector and the anemic domestic demand needs a weaker currency – which could help stimulate output and income. On the other hand, if the baht stays expensive, real variables such as output growth and employment will be hurt. That, in turn, will add further fuel to the ongoing political turmoil. As detailed in our previous Thailand report, the country has entered a precarious time socio-politically, which might last a while. A weaker currency can at least help ameliorate the economic situation to some degree.  Bank NPLs Are Poised To Rise Domestic credit1 in Thailand had risen sharply for several years before peaking at 150% of GDP in 2015. Commercial bank loans peaked at 100% of GDP around the same time.  Credit growth has been meagre in recent years. In fact, most depository corporations have been busy ramping up their securities portfolios instead, since 2018. Part of the indifference towards lending stems from the fact that banks are likely still saddled with bad loans from their previous credit surge: The speed and extent of credit expansion from 2009 to 2016 indicate a high likelihood of capital misallocations. Yet, banks have not made enough NPL provisions, i.e., they have not yet taken enough of a hit on their income statements by way of making provisions. The cumulative amount of ‘impairment loss’ on their income statements since Q1 2011 turns out to be 1300 billion baht. This is just 12% of their average loan book from Q1 2011 to Q1 2015 – a figure that appears to be grossly inadequate compared with other banking systems (Chart 14). By comparison, India’s private sector banks have, in the past 10 years, made a loan loss provision of over 50% of their outstanding average loans from 2010 to 2014. This indicates that Thai banks’ reported gross and net NPL ratios of 3.1% and minus 2% (after adjusting for the current stock of provisions) respectively, are understated. Complicating things further, the pandemic is set to cause another surge in bad debts. Combined NPLs and SMLs (Special Mention Loans) have risen to 11% of the loan book as of June 2020 (latest data available). In case of small and medium enterprise loans, that figure has risen to 19% (Chart 15). Odds are that they will rise further as economic activity has remained constrained since last June. Chart 14Thai Banks Have Barely Cleansed Their Balance Sheets Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Chart 15And Pandemic Is Causing Another Surge In Stressed Loans Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht   The bottom line is that Thailand is unlikely to witness a credit-fueled recovery anytime soon. This is because rising bad loans will discourage banks from lending. On the other end, prohibitively high real borrowing costs will discourage demand for loans. The absence of meaningful fiscal or monetary solutions makes the case for a weaker currency even more pertinent, if the country were to experience a decent recovery. Investment Conclusions Chart 16Thai Stock Performance Is Hinged On Foreigners Appetite Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht The outlook for the Thai baht is poor. Given that it is too risky to short it against a falling US dollar, we recommend shorting the baht versus a basket of euro, Swiss franc and Japanese yen. We also recommend a trade of shorting baht versus the Indian rupee. The baht has appreciated significantly against rupee in the past 3 years. The trade should be instituted as a stop sale order at THB/INR at 2.50 (THB/INR is currently at 2.42). On the equity front, foreign investors are likely to stay away from this market as the corporate profitability will remain subpar and currency vulnerable. Notably, it’s the foreign investors who continue to be the marginal buyer of Thai equity; and their abstinence will not go down well with this bourse (Chart 16). Incidentally, energy and financial stocks in Thailand make up 30% of the market cap and 40% of total earnings. As explained above, financial stocks are unlikely to do well. Chart 17Despite The Steep Underperformance Thai Equity Relative Valuations Are Not Attractive Thailand: Beset By A Vulnerable Baht Thailand: Beset By A Vulnerable Baht Even energy stocks (mostly oil refineries) will face strong headwinds in future. The reason is massive refinery capacity expansion by China. The country has added a 1 million barrels/day new capacity since 2019; and another 4 projects worth 1.4 million barrels/day are under construction. China is increasing its exports of refined petroleum products at low prices to grab a market share from the competition. This puts Thai refineries at risk of losing market share to Chinese refineries. Valuation-wise, Thai stocks are not that attractive either. On trailing price/earnings basis, they are 10% more expensive than the EM benchmark. In terms of price/book, they are 10% cheaper (Chart 17). Despite all the negatives, Thai stocks’ underperformance has been far too steep and is already at a 10-year low. Dedicated EM equity asset allocators therefore should stay neutral on this bourse relative to the EM benchmark. In the fixed-income arena, Thai local currency government bond yields are not as appealing anymore as they have fallen relative to other Asian peers. Besides, the baht is also vulnerable. On the flip side, given the subdued growth outlook, bonds will likely remain well-bid. Hence, while local asset allocators should stick with them; foreign asset allocators should book profits by downgrading them from overweight to neutral in an EM bond portfolio.  Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Footnotes 1 In Thailand, commercial bank credit makes up about two-thirds of total domestic credit accorded by all depository corporations. Other credit providers include various finance companies, specialized banks such as Government savings banks, Government housing banks, Bank of agriculture and agricultural co-operatives, Export-Import bank, Small and medium enterprise development bank, Savings Cooperatives/ Thrifts and Credit cooperatives and some others.

Highlights A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. The US is the most susceptible to social unrest of all the developed markets. Europe is stable relative to the US, but political risks are rising as new lockdowns go into effect. Emerging markets are also susceptible to social unrest – even those that look best on paper. Chile and Thailand have more downside due to politics, despite underlying advantages. Turkey and Nigeria are among those at risk of major unrest in a post-COVID world. Book gains on EUR-GBP volatility, Indian pharma, and rare earths. Cut losses. Feature This week saw a long-awaited risk-off move in global financial markets. A new wave of COVID lockdowns plus the US failure to pass a fiscal package finally registered with investors. Over the past two months we have argued that rising COVID cases without stimulus would produce a pre-election selloff that would drive the final nail in President Trump’s re-election bid. That should still be the case (Chart 1).  While we are sticking with our view that Biden will win, we have upgraded Trump’s odds from 35% to 45%. We are focused on Trump’s momentum – not alleged polling errors – in Florida and Pennsylvania, and Biden’s loss of altitude in Arizona, as these trends open a clear Electoral College path to another Trump victory (Chart 2). Nevertheless Biden is tied with Trump among men and leads by 17 percentage points among women. He is also in a statistical tie among the elderly.  Chart 1COVID Rising + Stimulus Falling = Red Ink COVID Rising + Stimulus Falling = Red Ink COVID Rising + Stimulus Falling = Red Ink Chart 2Trump's Momentum In Swing States Trump's Momentum In Swing States Trump's Momentum In Swing States   Even assuming Trump’s comeback proves too little, too late, it could produce a contested election in which Trump has constitutional advantages, or a Republican Senate. Either of these two scenarios would extend the election season volatility for one-to-three months. Our updated US election probabilities are shown in Table 1 alongside the odds from the popular online betting site PredictIt.org. Table 1There Is A 72% Chance The Post-Election Policy Setting Will Favor Reflation Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update A Biden victory with a Republican Senate (28% odds) is the only deflationary scenario in the near term, since fiscal stimulus will be reduced in size and uncertain in timing. However, assuming financial market pressure forces senators to agree, this is actually the best outcome over the full two-year Senate election period, since neither tariffs nor corporate taxes would rise. Notably Treasury yields have risen regardless of election scenario, but there is little doubt that this scenario poses the greatest risk to the global reflation trade (Chart 3). Why does this election matter? Trump’s re-election would prolong US political polarization and “maximum pressure” foreign and trade policy. Trump must win through the constitutional system, not the popular vote, so a win would push polarization up. Polarization at home, including Democratic opposition in the House of Representatives, would drive him abroad. By contrast, a Biden win would include a popular majority and might include a united Democratic Congress, which would result in a clear popular mandate and would concentrate Biden's administration on an ambitious domestic agenda.   A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. Hence Trump’s election would bolster the USD and US equity outperformance, along with global policy uncertainty relative to the United States (Chart 4). Whereas Biden’s election, if it also brings a Democratic Senate, would bolster global equity outperformance, cyclical equities, and US policy uncertainty relative to global. Chart 3Republican Senate Less Reflationary Republican Senate Less Reflationary Republican Senate Less Reflationary Chart 4Trump Would Boost US Equity Outperformance Trump Would Boost US Equity Outperformance Trump Would Boost US Equity Outperformance   The election will have a geopolitical fallout. First, Trump is still president through January 20 regardless of outcome and could take aggressive actions to seal his legacy and lock the Biden administration into conflict with China or Iran. Second, a contested election would create a power vacuum in which other nations could seek to take advantage of American distraction. Third, a Trump victory spells strategic conflict with Iran and China, and either could try to seize the advantage by acting first. Fourth, a Biden win spells confrontation with Russia and ultimately China, and both countries would test his resolve early in his administration. Diagram 1 summarizes these key market takeaways of the US election scenarios. This week we provide our monthly GeoRisk Update with a special focus on our COVID-19 Social Unrest Index and implications for select developed, emerging, and frontier markets. Diagram 1Scenarios For US Election Outcomes And Market Impacts Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The United States The market can get hit by negative surprises after the US election just as easily as before.1 The US is a powder keg of social and political angst, ranking the worst among developed markets in our COVID-19 Social Unrest Index (Table 2). The lower a country ranks on the list, the less stable it is and the more susceptible to unrest. Social unrest becomes market-relevant if it weighs on consumer or business sentiment, or if it causes a major change in government or policy. Table 2The US Is The Developed Market Most Susceptible To Social Unrest Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The first US risk is a contested election. By rallying in the swing states in the final weeks of the election, Trump has increased the likelihood of a disputed outcome. Armies of lawyers will descend upon the swing state election boards. The Supreme Court’s intervention in Florida in 2000 has incentivized political parties to seek a judicial intervention, especially if they think they are losing the popular vote narrowly. Mail-in counts, recounts, and other disputes could push up against the December 14 Electoral College voting date. Worse, if the Electoral College is hung, the House of Representatives would have to decide the outcome in January. Volatility and risk-off sentiment would predominate. Emerging markets are showing the first signs of upheaval in the wake of this year’s crisis. The second risk is resistance to the election results. If Trump wins on a constitutional technicality, the country faces widespread unrest. This would be relevant to investors if it paralyzes major cities, exacerbates the COVID outbreak, or snowballs into something big enough to suppress consumer confidence. If Biden wins on a technicality, the country faces not widespread unrest but isolated pockets of potentially armed resistance or domestic terrorist attacks. The FBI, DHS, and recent news events have confirmed the presence of armed or violent extremist groups of various ideological stripes that pose a rising threat in the current climate of pandemic, unemployment, and polarization.2 They could strike any time after the election.     Europe And Brexit Chart 5European Lockdowns Push Up Political Risk European Lockdowns Push Up Political Risk European Lockdowns Push Up Political Risk Europe and Canada have reinstated lockdowns in response to their rise in COVID-19 cases. The surge in political risk is evident from our GeoRisk Indicators (Chart 5). These lockdowns will not be as draconian as earlier this year as the death rate has been found to be lower than once feared. While most governments have time on the political clock to take a hardline approach today, at the start of what could be a nasty winter season, they do not have so much leeway in 2021. Greece, Spain, Italy, the UK, and France are next in line for social unrest, after the US, in our index, Table 2 above. These countries are also vulnerable because fiscal support is not as robust as elsewhere, as can be seen by our global fiscal stimulus tracker (Chart 6). France is in better shape than the others and marks the dividing line – the 2017 election was a turning point in which the political establishment unified to defeat a right-wing populist challenge. President Emmanuel Macron’s popularity is holding up decently and it will now be buttressed by his tough stance against a spate of radical Islamist terrorist attacks. Extremist incidents will continue to be a problem, given the lockdowns and economic slump. Macron will focus on economic reflation in 2021 leading up to an election for which he is clearly favored in spring of 2022. Anything that derails his political trajectory before that time is of great importance for Europe’s political future, since Macron will be the de facto leader once Angela Merkel steps down in October 2022. Italy and Spain will be ongoing sources of political risk. Italy was the first major European hotspot of the pandemic, and euroskeptic attitudes are quietly ticking back up, but the ruling coalition and especially Prime Minister Giuseppe Conte have received popular backing for their handling of the crisis. Spain, on the other hand, has seen Prime Minister Pedro Sánchez lose support, while conservative parties tick up in popular opinion. These two countries are candidates for early elections when the hens come home to roost for the pandemic and recession (Chart 7). Chart 6More Stimulus Needed In Europe Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update Chart 7Europe’s Leaders Fare Better Than Others Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update   The other major countries with looming elections in 2021-22 are seeing relatively positive outcomes in popular opinion (e.g. the Netherlands, Germany). The exception is the UK, which is on the lower end of the social unrest index and is in the midst of internal disruption due to Brexit. Our assessment remains that Prime Minister Boris Johnson and the Tories will have to accept a trade deal with the EU over the next month (Chart 8). They can afford to leave on paper, but the economy would suffer and Scotland’s nationalists would be empowered to attempt secession. Our European Strategist Dhaval Joshi believes a Biden win in the US will hasten Johnson’s capitulation. We don’t expect much more upside in our GBP-EUR volatility trade after the US election result is known (Chart 9).  Chart 8Go Long Sterling Go Long Sterling Go Long Sterling Chart 9Close EUR-GBP Volatility Trade Close EUR-GBP Volatility Trade Close EUR-GBP Volatility Trade Chart 10Trump Would Weigh On Euro Trump Would Weigh On Euro Trump Would Weigh On Euro Trump’s re-election would be negative for the European Union’s economic and political stability (Chart 10). It would portend a greater trade war, Middle Eastern instability and refugees, Russian aggression, or European populism. By contrast, Biden will not use sweeping tariffs to resolve trade tensions, will seek to restore the 2015 nuclear deal with Iran, will suppress anti-establishment politics, will seek a multilateral approach to China trade tensions, and will only substantially aggravate the Europeans by being too aggressive on Russia. EM: Chile And Thailand Emerging markets are showing the first inevitable signs of upheaval in the wake of this year’s global crisis. What is critical to note about our Social Unrest Index for EM is that even if a country ranks high on the list overall, it could still face significant sociopolitical upheaval. This is manifest in the top-ranked countries of our list – Chile, Malaysia, Thailand, Russia, Indonesia – all of which have already seen some degree of social and/or political unrest in this crisis year (Table 3).  Table 3Even Emerging Markets That Look Good On Paper Are Susceptible To Unrest Election Trades And Global Social Unrest: A GeoRisk Update Election Trades And Global Social Unrest: A GeoRisk Update The best example is Chile, which is top-ranked in the index but ranks ninth in the “Household Grievances” column, which measures inequality, inflation, and unemployment. The latter measure helps explain how Chile erupted last fall and again this fall in mass protests. Chart 11Political Risk Weighs On Chile Political Risk Weighs On Chile Political Risk Weighs On Chile Over the past week Chileans voted overwhelmingly in a referendum to revise their constitution with a constitutional convention that will be elected, i.e. not overdetermined by current members of the National Congress. The constitutional revision process is ultimately a positive way for a country with good governance to assuage its household grievances. But the process will continue through a revision process in April 2021, the November 2021 general election, and a final referendum in 2022, ensuring that political risk persists. Chilean assets have fallen short of their expected performance based on global copper prices, suggesting that they have upside in the near term (Chart 11). Positive news is driven by macro fundamentals, including Chinese stimulus, but political risk will periodically put a cap on rallies by highlighting Chile’s transition to expansive social spending, higher debts, and hence future currency risk. Thailand’s case is different, as it is not household grievances per se but rather the ongoing governance problem that is triggering mass protests. The governance problem stems from regional disparities in wealth and representative government. Modern society and pro-growth populism have repeatedly clashed with the royalist political establishment and its military backers over the past 20 years and that process is set to continue. Chart 12Thailand Not Fully Pricing New Instability Cycle Thailand Not Fully Pricing New Instability Cycle Thailand Not Fully Pricing New Instability Cycle The newest round of the crisis will build for some years and ultimately culminate in some degree of bloodshed before a new political settlement is achieved. Typically, over the past 20 years, Thai political unrest creates a buying opportunity for investors. But the previous major wave of unrest, from 2006-14, occurred during the lead-up to the all-important royal succession. Now the succession is “over” and it is not clear that the new king, Vajiralongkorn, will live up to his father’s legacy as a successful arbiter of society’s conflicts. It is possible that he will overreact to domestic opposition and abuse his powers. Our Emerging Markets Strategy has downgraded Thailand in its portfolio, showing that the economy is suffering from insufficient stimulus as a negative credit impulse offsets public spending during the crisis. Thai equities do not offer relative value within the emerging market space at present (Chart 12). Most likely Thai political troubles will continue to provide a buying opportunity, but at the moment the risks are not sufficiently priced. If Chile, Malaysia, and Thailand are already experiencing significant political risk despite their high rankings on our index, then Brazil, South Africa, Turkey, and the Philippines face even greater challenges going forward. We have written about Brazil recently – we continue to see a rising political risk premium there (Chart 13). We will update our views on South Africa and the Philippines in forthcoming special reports. For now we turn to Turkey. Turkey: One Step Forward, Two Steps Back Turkey scores near the bottom of our Social Unrest Index. The regime of President Recep Tayyip Erdogan has been in power for nearly two decades, is suffering cracks in public support, is continuing to suffer the inflationary consequences of populist monetary and fiscal policy, and is embroiled in a range of international adventures and conflicts, now including Nagorno-Karabakh. After a brief pause of tensions in September, we argued that President Recep Tayyip Erdogan’s retreat would be temporary and that geopolitical tensions would re-escalate. They have done so even sooner than we thought. The lira is collapsing, as registered by our GeoRisk Indicator, which is once again on the rise (Chart 14). Chart 13Brazilian Political Risk Nearing 2018 Levels Brazilian Political Risk Nearing 2018 Levels Brazilian Political Risk Nearing 2018 Levels Chart 14Turkish Political Risk Spikes Anew Turkish Political Risk Spikes Anew Turkish Political Risk Spikes Anew   Relations with Europe have worsened significantly. Aggressive rhetoric between Erdogan and Macron in response to France’s treatment of French Muslims and handling of recent terrorist incidents has led to a diplomatic crisis: Paris recalled its ambassador. The episode highlights both Erdogan’s increased assertiveness vis-à-vis the EU as well as his Neo-Ottoman bid to become the leader of the Muslim world. Erdogan has called for a boycott of French goods (alongside similar popular calls in various Muslim countries). The European Commission warned Turkey could face punitive action at its December summit.   The feud in the eastern Mediterranean is also escalating. Turkey’s Oruc Reis seismic research vessel was once again sent out on an exploratory mission in contested waters on October 12. The mission’s duration was extended multiple times.    The EU may impose sanctions as early as December. Brussels' response to Turkish provocations may include targeted anti-dumping measures, likely on steel and fish. There have also been calls to suspend the customs union, but this would require the conflict to rise above rhetoric as it would harm EU investments in Turkey. Turkey is growing even more assertive in its neighborhood with its support for Azerbaijan in the conflict with Armenia. Tensions with Russia are rising yet again. Erdogan is already overextended in Syria and Libya, and recently threatened to launch a new military operation in northern Syria if Kurdish militants do not relocate from along Turkey’s border. The warning follows a Russian airstrike on Turkey-backed Syrian rebels in Idlib earlier this week – the deadliest strike in Idlib since March. Provoking the United States, Turkey also tested its newly purchased Russian S400 missile defense system on October 16. This was swiftly followed by US warnings that Turkey faces US sanctions under the Countering America’s Adversaries Through Sanctions Act if it operationalizes the system. The risk of punitive action would rise under a Biden presidency as he is more likely to adopt a tougher stance on Erdogan than President Trump. Chart 15More Downside For Turkish Lira More Downside For Turkish Lira More Downside For Turkish Lira These developments all point to a continuation in geopolitical tensions, as Erdogan flouts various risks and constraints. Turkey’s relationship with NATO allies is continuing to deteriorate meaningfully. The lira’s collapse is also in response to economic developments. After a surprise 200 basis points rate hike in September, the CBRT disappointed markets by keeping the benchmark 1 week repo rate on hold at its October 22 meeting. Investors had hoped that the September hike marked a reversal of Erdogan’s unorthodox policies. However, the October decision disconfirms this hope, as the central bank is instead opting for stealth measures to raise the cost of funding (e.g. limiting funding at the benchmark rate and thus forcing banks to borrow at higher costs; widening the interest rate corridor to give itself more room to raise the weighted average cost of funding). These decisions come amid rising inflation, debt monetization, a loss in foreign interest in Turkish equities and bonds, and deteriorating budget and current account balances. All point to further lira weakness (Chart 15). Bottom Line: The TRY faces downside pressure from the deteriorating geopolitical and economic backdrop. Although the EU has so far shown restraint in penalizing Ankara, its stance has not dissuaded Erdogan from adopting a provocative foreign policy stance. Moreover tensions with the US are at risk of escalating due to the possibility of a Biden presidency. Economic factors also point to continued weakness as monetary policy is too loose and the CBRT has not abandoned Erdoganomics. Nigeria: No Political Change Waves of protests have erupted across Nigeria in recent weeks, largely driven by the country’s youth. Protests center on calls to end the special anti-robbery squad (SARS), an arm of the national police service, which has long been accused of extrajudicial killings, torture, extortion, and corruption. Most recently, dozens of soldiers and police officers approached the scene of a major protest site in Lekki, a large district in Lagos, and opened fire, killing 12 people. The violence fueled outrage toward the government and security forces. To quell unrest, the government announced that SARS would be disbanded and promised a host of reforms. Demonstrators are skeptical of government promises without clearly specified timeframes. After all, previous incumbents have suggested police reform would be expedited. This has yet to happen, so we do not expect national policy to meet public demand. Moreover, President Buhari is a former military dictator who has maintained a hard line on security matters. He is in his final term in office and not legally required to step down until 2023. While discontent grows toward the government for social injustices, the Nigerian economy remains vulnerable and imbalanced. The local currency is facing considerable risk of major devaluation stemming from strains on its balance of payments, as BCA’s Emerging Markets Strategy pointed out in a recent report. Low oil prices and weak FDI inflows will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and an uncompetitive currency (Chart 16). Foreign currency reserves stand at $36bn, barely above foreign debt obligations at $28bn. FDI inflows have reached their second lowest point over the past decade, weighing on productivity growth, which is near 0%. A positive for Nigeria’s macro fundamentals is that public debt is low, at 23% of GDP, decreasing the likelihood of a sovereign default in the near term. Government officials refrained from large COVID fiscal relief, keeping spending in check. Coupled with low debt servicing costs, of which the foreign share only represents 2% of government revenues, a currency depreciation to improve competitiveness would not make public debt dynamics a concern. Nominal GDP is above short-term rates (Chart 17). Hence there is room for the currency to fall and government spending to pick up into next year to support the economy.  Chart 16Nigeria Struggles With Economic Rebalance Nigeria Struggles With Economic Rebalance Nigeria Struggles With Economic Rebalance Chart 17Nigeria Has Fiscal Firepower Nigeria Has Fiscal Firepower Nigeria Has Fiscal Firepower   In the post-dictatorship era, oil revenues knit the country’s predominantly Muslim north with its oil-rich and predominantly Christian south. The country has struggled to rebalance the economy in the wake of the 2014 oil shock. Crude production has fallen from over 2 million barrels per day to around 1.6 million bpd since 2010, and Nigeria struggles to meet its modest OPEC quotas. The current global crisis could have a negative long-term impact as rig counts have fallen again. We expect global oil demand to be supported in 2021, as lockdowns will be less stringent the second time and global fiscal stimulus will keep coming. And while Buhari’s age and poor health make him vulnerable, he is not without reserves of political strength. He is seen as someone who has kept up a good fight against the Islamist militant group Boko Haram. Considering that he is a northerner and a Muslim by faith, this strategy has helped ease sectarian tensions across the country, strengthening his grip. The problem is that the size of the global crisis could upset even the most stable of petro-states. Like most of sub-Saharan Africa, the youth population is large – the median age is around 18. If global oil demand relapses amid the second wave of the pandemic and a lack of domestic and global stimulus, the country will suffer yet another wave of unemployment. And if policy remains hawkish, sociopolitical troubles will be amplified.  Nigeria’s impact on global oil prices is limited – it only provides 2% of global oil supply – but it could become a contributor to rising unplanned outages if instability gets out of hand. Bottom Line: The SARS protests are not likely to threaten overall government stability, but mounting economic pressures could exacerbate social unrest, and the negative feedback with security forces. This could deliver a significant blow to the aging Buhari’s government if he does not enact expansionary fiscal policy to smooth out the external shocks. Investment Takeaways Chart 18Biden Good For Global Trade Rebound Biden Good For Global Trade Rebound Biden Good For Global Trade Rebound The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. But a contested election is not unlikely and a deflationary risk arises in the 28% chance that Biden wins while Republicans retain the Senate. Stimulus would still be agreed but its size and timing would be uncertain, prolonging the selloff. Therefore we are updating our portfolio to book some gains and cut some losses. We are booking gains on our EUR-GBP volatility trade for a return of 13%. We are closing our long Indian pharmaceuticals trade for a gain of 12%. We are throwing in the towel on our long defense and aerospace trade for a loss of 21%. And we are closing our rare earths basket trade for a gain of 5%. We are closing two pair trades and re-initiating them as absolute longs: long China Play Index relative to MSCI global stocks (0.1% return) and long ISE Cyber Security Index relative to the NASDAQ (-6.8%). Chinese reflation and global cyber-attacks will remain relevant themes.  The inverse of Trump, Biden is positive for the euro, negative for the dollar, and supportive of global trade. However, a range of higher taxes and levies on corporations suggests that his administration will ultimately weigh on S&P global stocks relative to those at home. And while Biden appears softer on China, we consider this a mispricing, as he has largely coopted Trump’s and Sanders’s trade agenda (Chart 18). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Chart 19China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Chart 20Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Chart 21UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Chart 22Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Chart 23France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Chart 24Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Chart 25Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Chart 26Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Chart 27Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Chart 28Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Chart 29Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Chart 30Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Geopolitical Calendar Footnotes 1  There have been strange warnings in recent days – an unidentified aircraft intercepted over a Trump rally in Arizona, a Saudi warning of a potential Houthi attack on Americans, and a Chinese warning of a potential US drone attack against Chinese assets in the South China Sea. None of these have amounted to anything, and the idea of a US drone attack on China is absurd, but investors should be cautious nonetheless, particularly because a range of state and non-state actors will have an incentive to take actions once the US outcome is known. 2  Please see FBI Director Christopher Wray, “Statement Before The House Homeland Security Committee,” Washington DC, September 17, 2020, fbi.gov; Department of Homeland Security, “Homeland Threat Assessment,” October 2020, dhs.gov; Tresa Baldas and Paul Egan, “More details emerge in plot to kidnap Michigan Gov. Whitmer as suspects appear in court,” USA Today, October 13, 2020, usatoday.com.   

Please note that yesterday we published a Special Report titled Global Supply Chain: Moving Away From China? Please click on it to access it. Highlights Thailand has entered a phase of precarious, turbulent and potentially lasting political turmoil. Thailand’s governance system has largely favored the public sector and business elites over ordinary citizen. Political protests are therefore here to stay. Meanwhile, the pandemic has thrown the economy into a “knockout” and it will take a long time for it to recover. We are downgrading Thai equities from overweight to neutral for dedicated EM equity portfolios. Fixed income portfolios should maintain an overweight position on Thai local currency government bonds and sovereign credit. Feature Chart 1Thai Equities: Absolute And Relative To EM Performance Thai Equities: Absolute And Relative To EM Performance Thai Equities: Absolute And Relative To EM Performance Thailand has entered a phase of precarious, turbulent and potentially lasting political turmoil. These circumstances will weigh negatively on consumer and business confidence. Already the economy is unable to generate a strong recovery following the severe recession caused by the pandemic. As such, our overweight stance in Thai equities has been significantly challenged. We are recommending investors downgrade the allocation to Thai equities from overweight to neutral within a dedicated EM equity portfolio (Chart 1). Entering A Phase Of Persistent Political Volatility… Insistent Protestors And An Unresponsive Government A new wave of anti-establishment protests has gripped Thailand. In February of this year, the Constitutional Court and the Election Commission banned the progressive Future Forward Party – a youthful opposition party – triggering protests early in the year. The demonstrations then quickly dissipated as the COVID-19 pandemic broke out to then return with more momentum in July/August. The pro-democracy movement is demanding the resignation of Prime Minister Prayut Chan-o-cha and his military-backed government. It is also calling for the dissolution of parliament and the drafting of a new constitution. For the first time, protesters have violated a powerful taboo and have entered uncharted territory in their demand for the reformation of the monarchy. This reformation includes removing Section 112 of the Penal Code (which enshrines “lèse majesté” laws that criminalize any form of criticism of the monarchy), as well as reducing King Vajiralongkorn’s powers over national assets and the army. Finally, protesters are demanding that opposition parties be allowed more freedom to participate in the electoral system. The country’s political and economic systems have grossly favored the ruling military-monarchy nexus and the business elite class. Meanwhile, Prime Minister Prayut Chan-o-cha and his military-backed government seem unwilling to compromise in any serious way. Not only has the Prime Minister failed to engage with the protestors but is instead dangerously downplaying the gravity and depth of the problem with little acknowledgement of public anger. Please refer to Appendix 1 on page 14 for a more detailed assessment of the political situation in the Kingdom. Chart 2Share Of Employees' Income Is Smaller In Thailand Than In The US Share Of Employees' Income Is Smaller In Thailand Than In The US Share Of Employees' Income Is Smaller In Thailand Than In The US The Origins Of Thailand’s Public Anger The root cause of discontent in Thailand lies in deep structural issues related to the country’s governance system. The country’s political and economic systems have grossly favored the ruling military-monarchy nexus and the business elite class. National income and prosperity have not benefited broader social groups, and income inequality has grown. As such, a large section of the Thai population has experienced poor income growth, scarce job opportunities, and must contend with an inadequate social safety net: Income and wealth inequality: Income and wealth inequality gaps are at an extreme in Thailand. According to the 2018 Global Wealth Report, published by Credit Suisse, Thailand ranked as the most unequal country among the countries surveyed in the report. Over the last two years that same report has continued to assign this rank to Thailand, along with Russia and India.  Other indicators show similar trends on the income inequality front. For example, Chart 2 shows that the labor share of income in Thailand sits at 40%, much lower than corporate profits, entrepreneur and rental income. The latter two are income sources available to high-income households. By comparison, in the US, wages and salaries make up 56% of GDP, while total corporate profits and entrepreneur and rental income amount to just 24%. Private-sector wages in Thailand are also 30% lower than public sector wages (Chart 3). This is unsurprising given the preferential status that government and public sector employees get in Thailand. Stagnating incomes for middle and low-income employees: Not only is the share of income for middle- and lower-income workers small, but income growth for this class has stagnated as well. Chart 4 illustrates that private-sector wage growth has been very weak in the past few years and is beginning to contract in real (inflation-adjusted) terms.  Chart 3Thailand: Public Wages Are Substantially Higher Than Private Ones Thailand: Public Wages Are Substantially Higher Than Private Ones Thailand: Public Wages Are Substantially Higher Than Private Ones Chart 4Thailand: Workers' Average Real Wage Have Stagnated Thailand: Workers' Average Real Wage Have Stagnated Thailand: Workers' Average Real Wage Have Stagnated   Overall, real GDP per capita growth has been unimpressive in Thailand. In particular, it averaged only 3% annually from 2010 till 2019 inclusive versus 6% from the 1980s to 1997 (Chart 5). The key reason for stagnating real per capita incomes is lower labor productivity growth over the past decades as Thai businesses have not been investing (Chart 6). The lack of investment has undermined productivity growth, and with it, real income growth. Chart 5Thailand: Real GDP Per Capita & Productivity Thailand: Real GDP Per Capita & Productivity Thailand: Real GDP Per Capita & Productivity Chart 6Thai Businesses Have Not Been Investing Thai Businesses Have Not Been Investing Thai Businesses Have Not Been Investing   Worryingly, small and medium businesses (SMEs) have also not deployed any capital expenditures either. Chart 7 illustrates how commercial bank lending to non-financial SMEs has been stagnating and has most recently been devastated by the COVID-19 pandemic. SMEs are the backbone of the Thai economy as they employ 80% of the labor force and their investments are critical to generating labor productivity gains in Thailand. While not financing SMEs, Thai commercial banks provided funding to consumers which is an unproductive form of credit versus loans for business investment (Chart 8). Chart 7Thailand's SMEs Have Been Starved From Credit Thailand's SMEs Have Been Starved From Credit Thailand's SMEs Have Been Starved From Credit Chart 8Thailand's Commercial Banks Have Mostly Lent To Consumers Thailand's Commercial Banks Have Mostly Lent To Consumers Thailand's Commercial Banks Have Mostly Lent To Consumers   High youth unemployment: Youth in Thailand – which are currently leading the anti-establishment movement – are struggling to find job opportunities. According to the Youth Employability Scoping Study report published by Thailand Development Research Institute & UNICEF, fewer Thais have jobs today than a decade ago. Indeed, youth unemployment is much higher than those aged 35 to 60+ (Chart 9). Chart 9Thai Youth Unemployment Is A Major Problem Thai Youth Unemployment Is A Major Problem Thai Youth Unemployment Is A Major Problem Moreover, higher education is not translating to jobs in Thailand. University graduates are much less likely to find jobs than those with a primary education. The unemployment rate for university graduates stands at 17.2% versus 2.4% for those with a primary education. Not surprisingly, the recent protests have been initiated and led by students. Absence of a social safety net: According to the International Labor Organization, Thailand lacks a proper social safety net to protect its most vulnerable citizens. Central government spending on social protection is low at 3% of GDP according 2018 data from the IMF’s Government Finance Statistics. This compares to 15% in Brazil, 11% in Turkey, 6% in Chile, and 5% in South Africa. Indeed, Thailand’s government spending is very low even by EM standards (Chart 10, top panel). Thailand’s public debt to GDP is also too small and at par with that of Chile (Chart 10, bottom panel). Chile itself lacks a proper social safety net and has been going through its own socio-political turmoil. Furthermore, not only is Thailand’s overall government budget spending small, but just a tiny 11% share of its already small budget gets allocated to social benefits, while 45% gets allocated to government employee compensation and the purchases of goods and services (Chart 11). Chart 10Thai Government Spending Is Too Small… Thailand Challenged Thailand Challenged Chart 11...And Favors Government Employees ...And Favors Government Employees ...And Favors Government Employees   Finally, existing social benefits mostly apply to formal employees in Thailand. Yet informal employment accounts for 50% of the entire work force. This leaves a large chunk of workers with minimal or no social protection at all. As to Thailand’s tourism industry, it is now virtually frozen. Bottom Line: Thailand’s governance system has largely favored the public sector and business elites. In turn, a large share of the population has experienced stagnant incomes for the past 15-20 years, faced poor employment prospects and suffered under an inadequate social security system. Protests are therefore here to stay and the nation is entering another phase of social and political instability. Crucially, the addition of the monarchy on the list of reforms by protestors is taking Thailand into uncharted and highly uncertain territory. Odds of slipping into periodic violence are also high. …Amid Crumbling Domestic Growth Not only is Thailand going through deep structural issues resulting from its poor public governance, but the nation is also suffering from its worst recession since the Asian Crisis. In turn, the confluence of these disturbing structural and cyclical dynamics will be weighing on the Thai economy. Worryingly, Thailand’s auto and tourism sectors – two critical segments of the Thai economy – have been devastated by the pandemic. Chart 12 illustrates that auto production, sales and exports – which were all distressed even before the pandemic began – have collapsed and will unlikely recover to pre-pandemic levels for some time. As to Thailand’s tourism industry, it is now virtually frozen. Tourist revenues collapsed to zero in July and August (Chart 13, top two panels). Hotel occupancy rates fell and sit at a timid 14% (Chart 13, bottom panel). Tourism brings in around $50-60 billion annually (about 10% of GDP) into Thailand and employs 12% of the Thai labor force. Chart 12Thailand's Auto Industry Is In The Doldrums Thailand's Auto Industry Is In The Doldrums Thailand's Auto Industry Is In The Doldrums Chart 13Thai Tourism Collapsed Thai Tourism Collapsed Thai Tourism Collapsed   The Thai government promptly unleashed a large fiscal stimulus back in March and April worth about 14% of GDP to prop up domestic demand. Yet while the stimulus was large on paper, it does not seem to have been successful. Chart 14Government Spending Has Been Offset By A Negative Credit Impulse Government Spending Has Been Offset By A Negative Credit Impulse Government Spending Has Been Offset By A Negative Credit Impulse For example, the monthly handout scheme failed to reach half of Thailand’s informal workers (its targeted recipients). The scheme ended quickly on July 31. Moreover, only 15% of small business owners have utilized the government’s soft loans scheme (the government’s most important stimulus item). It seems that access to the government’s stimulus programs has been limited. Particularly, a few stimulus programs were implemented via third-party channels such as banks and utility companies with no clear procedures in place. This vague administrative structure ended up rejecting many applicants. Meanwhile, actual spending by the government was modest and was more than offset by the weak overall bank credit impulse (Chart 14). Provided that Thai commercial banks remain unwilling to lend, the credit impulse will remain negative and, accordingly, will continue to weigh on domestic demand. Finally, the new Finance Minister, Predee Daochai, resigned after just 26 days on the job due to jockeying inside the ministry over senior roles. This suggests that government economic policy is in disarray and will weigh on business confidence delaying investment and hiring. As to monetary policy, the Bank of Thailand (BoT) has been ultra-accommodative. The BoT has been purchasing government bonds and injecting liquidity into commercial banks (Chart 15, top). Meanwhile commercial banks have been buying government bonds en masse (Chart 15, bottom). The BoT has also slashed its policy by 125 BPs since January 2019. Yet it seems that Thai commercial banks are adamant about not passing lower interest rates aggressively to borrowers because they want to protect their high net interest rate margins at a time when they are set to face mounting losses from rising NPLs (Chart 16). Chart 15Public Debt Monetization By Central And Commercial Banks Public Debt Monetization By Central And Commercial Banks Public Debt Monetization By Central And Commercial Banks Chart 16Commercial Banks Prime Lending Rates Are Still Too High Commercial Banks Prime Lending Rates Are Still Too High Commercial Banks Prime Lending Rates Are Still Too High Chart 17Commercial Banks Net Interest Rate Margins Are Elevated Commercial Banks Net Interest Rate Margins Are Elevated Commercial Banks Net Interest Rate Margins Are Elevated As a result, the real economy’s borrowing rates – although have fallen by 85 basis points – are still too elevated at 5.4% given the collapse that has occurred in nominal GDP growth (Chart 17). In brief, a 85 basis points drop in lending rates will not be enough to restore household debt servicing capacity at a time when their incomes have been devastated. Thailand’s household debt to their disposable income ratio sits at a particularly elevated level of 120% (Chart 18, top panel). If household nominal income contracts further, a debt deflation spiral may follow. Falling nominal income at a time of elevated household debt burden and relatively high lending rates will result in consumer defaults and/or reduced spending. Rising NPLs at banks will lead to less bank lending and falling consumption feeding into lower employment and wages. All of these will heighten price and income decline pushing up the real value of debt and real lending rates (Chart 18, bottom panel). Worryingly, the Thai economy is already dangerously close to deflation territory (Chart 19). Chart 18Elevated Real Lending Rates Amid High Consumer Indebtedness Elevated Real Lending Rates Amid High Consumer Indebtedness Elevated Real Lending Rates Amid High Consumer Indebtedness Chart 19The Thai Economy Is Dangerously Close To Deflation The Thai Economy Is Dangerously Close To Deflation The Thai Economy Is Dangerously Close To Deflation   Bottom Line: The pandemic has thrown the economy into a “knockout” and it will take a long time for it to recover. The stimulus has been insufficient or poorly administrated to revive the economy quickly and meaningfully.  Investment Recommendations Chart 20Thai Equities Are Not Cheap Thai Equities Are Not Cheap Thai Equities Are Not Cheap Equities: We are downgrading Thai equities from overweight to neutral for dedicated EM equity portfolios. The reason why we are reluctant to move to underweight is because the currency will outperform other EM currencies and share prices have already underperformed the EM benchmark dramatically. The poor outlook for corporate and bank profits is the main rationale behind our downgrade. The business cycle recovery will be very subdued and will take longer in Thailand than in other EM economies. Besides, political uncertainty will weigh on both business and investor confidence. In the meantime, Thai equities are not cheap at all. The forward price-to-earnings ratios stands at 18 for Thailand versus 15 for EM (Chart 20). Absolute return investors should stay put on the Thai bourse. We expect equities to continue underperforming local bonds.  EM local currency bond portfolios should maintain an overweight position on Thai local currency government bonds. The currency will not sell off a lot as the current account balance is in a large surplus of 5.5% and is unlikely to change any time soon. Meanwhile, the Thai central bank has been accumulating FX reserves in an attempt to weaken the baht. Without the central bank’s interventions, the Thai baht would have been much stronger. Importantly, political turmoil in Thailand does not typically lead to major sell offs in local government bonds and currency. EM credit managers should continue overweighting Thai sovereign credit too (US dollar government bonds). Thailand has a very low public debt to GDP ratio and its fiscal dynamics will not deteriorate as much as in other EM countries. An 85 basis points drop in lending rates will not be enough to restore household debt servicing capacity at a time when their incomes have been devastated. APPENDIX 1 Thailand’s Political Dynamics: An Uncharted Territory It is impossible to predict each twist and turn in Thailand’s politics. What is certain is that Thailand is again entering another precarious multi-year phase of social and political instability that will occasionally turn violent. In the near term, the revival of unrest will weigh the already fragile Thai economy and share prices: Neglecting the protestors: Prime Minister Prayut’s government seems unwilling to compromise with the protestors in any serious way which risks fueling public anger. For instance, Prayut has been using rising COVID-19 cases and the dire impact the former has on the economy as reasoning to discourage Thais from protesting. Prayut also warned that protests could cause the nation to be “engulfed in flames,” harkening back to previous periods of chaos, such as 2006-14. Prayut also unleashed 8,000 police officers in one of the recent protests as a signal to pro-democracy protestors to tread carefully. Furthermore, the parliament voted on September 24 to delay until November a decision on whether to amend the constitution. Such lack of sympathy on the part of the government is fueling public anger and will likely push pro-democracy protestors to escalate their stance. Some really love the king: The pro-democracy/anti-establishment movement is demanding the reformation of the monarchy. Thailand however is still a deeply religious and conservative society with parts of the population – mostly elders and persons living in the southern regions – who deeply love and respect the monarchy. This part of Thai society is enraged by protestor demands for reform. Therefore, the anti-establishment protestors will face counter-protests – even if smaller in number – from royalists. Already the latter group gathered in Bangkok’s sports arena on August 30 to show support for King Vajiralongkorn. This group could gain momentum in the coming months and years, increasing chances of the two camps clashing and giving the authorities a pretext to forcefully and violently intervene. Threat of force: Prayuth’s government maintains military backing and shares a mutual interest with the palace in suppressing the populist democratic movement. Prayuth will limit the use of force against protesters only for a time and he will resort to force if protests start to affect critical infrastructure and business. If protesters also persist in criticizing the monarchy, it will enable the regime to divide the opposition, since the traditional opposition players will refrain from violating royal taboos. Importantly, because the king lacks the moral authority of his predecessor, the royal succession cannot be said to be “finished” from the point of view of the royalist establishment. The emerging protests are the first major challenge to the new order and the military-backed government will defend it with force. Where Is Thailand Headed: As of yet, there is no basis for believing that the royal and military establishment will be fundamentally shaken. However, in the coming years they could be forced to cede some powers in the wake of this full-fledged socio-economic crisis. The critical question is, when the crisis point is reached, whether the new king will successfully play the role of arbiter and peacemaker in settling the dispute. If he fails to do so, then polarization will escalate, setting Thailand on a very uncertain path with no clear roadmap to follow. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations