Policy
Highlights The US-China trade talks will continue despite Hong Kong. The UK election will not reintroduce no-deal Brexit risk – either in the short run or the long run. European political risk is set to rise from low levels, but Euro Area break-up risk will not. There is no single thread uniting emerging market social unrest. We remain constructive on Brazil. Feature Chart 1Taiwan Indicator To Rise Despite Ceasefire President Trump signed the Hong Kong Human Rights and Democracy Act into law on November 27. The signing was by now expected – Trump was not going to veto the bill and invite the Senate to override him with a 67-vote at a time when he is being impeached. He does not want to familiarize the Senate with voting against him in supermajorities. The Hong Kong bill will not wreck the US-China trade talks, but it is a clear example of our argument that strategic tensions will persist and cast doubt on the durability of the “phase one trade deal” being negotiated. It is better to think of it as a ceasefire, as Trump’s electoral constraint is the clear motivation. Trump is embattled at home and will contend an election in 11 months. He will not impose the tariff rate hike scheduled for December 15. A relapse into trade war would kill the green shoots in US and global growth, which partly stem from the perception of easing trade risk. Only if Trump’s approval rating collapses, or China stops cooperating, will he become insensitive to his electoral constraint. Will China abandon the talks and leave Trump in the lurch? This is not our base case but it is a major global risk. So far China is reciprocating. Xi Jinping’s political and financial crackdown at home, combined with the trade war abroad, has led to an economic slowdown and an explosion in China’s policy uncertainty relative to America’s. A trade ceasefire – on top of fiscal easing – is a way to improve the economy without engaging in another credit splurge. The US and China will continue moving toward a trade ceasefire, despite the Hong Kong bill. The move toward a trade ceasefire will probably keep our China GeoRisk Indicator from rising sharply over the next few months. However, our Taiwan indicator, which we have used as a trade war proxy at times, may diverge as it starts pricing in the heightened political risk surrounding Taiwan’s presidential election on January 11, 2020 (Chart 1). Sanctions, tech controls, Hong Kong, Taiwan, North Korea, Iran, the South China Sea, and Xinjiang are all strategic tensions that can flare up. Yes, uncertainty will fall and sentiment will improve on a ceasefire, but only up to a point. China’s domestic policy decisions are ultimately more important than its handling of the trade war. At the upcoming Central Economic Work Conference authorities are expected to stay focused on “deepening supply-side structural reform” and avoiding the use of “irrigation-style” stimulus (blowout credit growth). But this does not mean they will not add more stimulus. Since the third quarter, a more broad-based easing of financial controls and industry regulations is apparent, leading our China Investment Strategy to expect a turning point in the Chinese economy in early 2020. This “China view” – on stimulus and trade – is critical to the outlook for the two regions on which we focus for the rest of this report: Europe and emerging markets. Assuming that China stabilizes, these are the regions where risk assets stand to benefit the most. Europe is a political opportunity; the picture in emerging markets is, as always, mixed. United Kingdom: Will Santa Bring A Lump Of Coal? The Brits will hold their first winter election since 1974 on December 12. Prime Minister Boris Johnson’s Conservative Party has seen a tremendous rally in opinion polls, although it has stalled at a level comparable to its peak ahead of the last election in June 2017 (Chart 2). Another hung parliament or weak Tory coalition is possible. Yet the Tories are better positioned this time given that the opposition Labour Party is less popular than two years ago, while the Liberal Democrats are more capable of stealing Labour votes. The Tories stand to lose in Scotland, but the Brexit Party of Nigel Farage is not contesting seats with them and is thus undercutting Labour in certain Brexit-leaning constituencies. Markets would enjoy a brief relief rally on a single-party Tory majority. This would enable Johnson to get his withdrawal deal over the line and take the UK out of the EU in an orderly manner by January 31. The question would then shift to whether Johnson feels overconfident in negotiating the post-Brexit trade agreement with the EU, which is supposed to be done by December 31, 2020. This date will become the new deadline for tariff increases, but it can be extended. Johnson is as unlikely to fly off the cliff edge next year as he was this year, and this year he demurred. Negotiating a trade agreement is easier when the two economies are already integrated, have a clear (yet flexible) deadline, and face exogenous economic risks. Our political risk indicator will rise but it will not revisit the highs of 2018-19 (Chart 3). The pound’s floor is higher than it was prior to September 2019. Chart 2Tories Look To Be Better Positioned For A Single Party Majority Chart 3UK Risk Will Rise, But Not To Previous Highs Bottom Line: A hung parliament is the only situation where a no-deal Brexit risk reemerges in advance of the new Brexit day of January 31. The market is underestimating this outcome based on our risk indicator. But Johnson himself prefers the deal he negotiated and wishes to avoid the recession that would likely ensue from crashing out of the EU. And a headless parliament can prevent Johnson from forcing a no-deal exit, as investors witnessed this fall. We remain long GBP-JPY. Germany: The Risk Of An Early Election Germany is wading deeper into a period of political risk surrounding Chancellor Angela Merkel’s “lame duck” phase, doubts over her chosen successor, and uncertainty about Germany’s future in the world. The federal election of 2021 already looms large. Our indicator is only beginning to price this trend which can last for the next two years (Chart 4). On October 27 Germany’s main centrist parties suffered a crushing defeat in the state election of Thuringia. For the first time, the Christian Democratic Union (CDU) not only lost its leadership position, but also secured less vote share than both the Left Party and the right-wing Alternative für Deutschland (AfD) (Chart 5, top panel). Chart 4Germany Is Heading Toward A Period Of Greater Political Risk The AfD successfully positioned itself with the right wing of the electorate and managed to capture more undecided voters than any other party (Chart 5, bottom panel). Chart 5The Right-Wing AfD Outperformed In Thuringia … While the rise of the AfD (and its outperformance over its national polling) may seem alarming, Germany is not being taken over by Euroskeptics. Both support for the euro and German feeling of being “European” is near all-time highs (Chart 6). The question is how the centrist parties respond. Merkel’s approval rating is at its lower range. Support for Annegret Kramp-Karrenbauer (AKK), Merkel’s chosen successor, is plummeting (Chart 7). Since AKK was confirmed as party chief, the CDU suffered big losses in the European Parliament election and in state elections. Several of her foreign policy initiatives were not well received in the party.1 In October 2019, the CDU youth wing openly rejected her nomination as Merkel’s successor. At the annual CDU party conference on November 22-23, she only narrowly managed to avoid rebellion. She is walking on thin ice and will need to recover her approval ratings if she wants to secure the chancellorship. Meanwhile the CDU will lose its united front, increasing Germany’s policy uncertainty. Chart 6... But Euroskeptics Will Not Take Over Germany Germany’s other major party – the Social Democratic Party (SPD) – is also going through a leadership struggle. Chart 7The CDU Party Leader Is Walking On Thin Ice Chart 8A Return To The Polls Would Result In A CDU-Green Coalition In the first round of the leadership vote, Finance Minister Olaf Scholz and Klara Geywitz (member of the Brandenburg Landtag) secured a small plurality of votes with 22.7%, just 1.6% more than Bundestag member Saskia Esken and Norbert Walter-Borjans (finance minister of North Rhine-Westphalia from 2010-17). The latest polling, and Scholz’s backing by the establishment, implies that he will win but this is uncertain. The results of the second round will be published on November 30, after we go to press. What does the SPD’s leadership contest mean for the CDU-SPD coalition? More likely than not, the status quo will continue. Scholz is an establishment candidate and supports remaining in the ruling coalition until 2021. Esken is calling for the SPD to leave the coalition, but Walter-Borjans has not explicitly supported this. An SPD exit from the Grand Coalition would likely lead to a snap election, not a favorable outcome for stability-loving Germans. A return to the polls would benefit the Greens and AfD at the expense of the mainstream parties, and would likely see a CDU-Green coalition emerge (Chart 8). Given that a majority of voters want the SPD to remain in government (Chart 9), and that new elections would damage the SPD’s prospects, we believe that the SPD is likely to stay in government until 2021, even if the less established Esken and Walter-Borjans win. The risk is the uncertainty around Merkel’s exit. October 2021 is a long time for Merkel to drag the coalition along, so the odds of an early election are probably higher than expected. Chart 9Germans Prefer The SPD Remains In Government Chart 10Climate Spending Closest Germany Gets To Fiscal Stimulus (For Now) Chart 11There Is Room For More Fiscal Stimulus In Germany, If Needed What would a Scholz win mean for the great debate over whether Germany will step up its fiscal policy? If the establishment duo wins the SPD leadership, the Grand Coalition remains in place, and the economy does not relapse, we are unlikely to see additional fiscal stimulus in the near future. Scholz argues that additional stimulus would not be productive, as the slowdown is due to external factors (i.e. trade war).2 The recently released Climate Action Program 2030 is the closest to fiscal stimulus that we will see. This package will deliver additional spending worth 9bn euro in 2020 and 54bn euro until 2023 (Chart 10). We are unlikely to see additional fiscal stimulus from Germany in the near future. Bottom Line: Germany is wading into a period of rising political uncertainty. In the event of a downward surprise in growth, there is room to add more fiscal stimulus (Chart 11). But there is no change in fiscal policy in the meantime, e.g. no positive surprise. France: Macron Takes Center Stage While Merkel exits, President Emmanuel Macron continues to position himself as Europe’s leader – with a vision for European integration, reform, and political centrism. But in the near term he will remain tied down with his ambitious domestic agenda. France is trudging down the path of fiscal consolidation. After exiting the Excessive Deficit Procedure in 2018, and decreasing real government expenditures by 0.3% of GDP, France’s budget deficit is forecasted to decline further (Chart 12). Macron’s government is moving towards balancing its budget primarily by reducing government expenditures to finance tax cuts and decrease the deficit. Macron’s reform efforts following the Great National Debate – tax cuts for the middle class, bonus exemptions from income tax and social security contributions, and adjustment of pensions for inflation – have paid off.3 His approval rating is beginning to recover from the lows hit during the Yellow Vest protests (Chart 13). These reforms will be financed by lower government expenditures and reduced debt burden as a result of accommodative monetary policy. Chart 12Fiscal Consolidation In France Chart 13Macron's Reform Efforts Have Paid Off Overall, France has proven to a very resilient country in light of a general economic slowdown (Chart 14, top panel). Business investment and foreign direct investment, propped up by gradual cuts in the corporate income tax rate, have remained steady, and confidence remains strong (Chart 14, bottom panels). France is consumer driven and hence somewhat protected from storms in global trade. Chart 14French Economy Resilient Despite Global Slowdown Chart 15Ongoing Strikes Will Register In French Risk Indicator Bottom Line: France stands out for remaining generally stable despite pursuing structural reforms. Strikes and opposition to reforms will continue, and will register in our risk indicator (Chart 15), but it is Germany where global trends threaten the growth model and political trends threaten greater uncertainty. On the fiscal front France is consolidating rather than stimulating. Italy: Muddling Through This fall’s budget talks caused very little political trouble, as expected. The new Finance Minister Roberto Gualtieri is an establishment Democratic Party figure and will not seek excessive conflict with Brussels over fiscal policy. Italy’s budget deficit is projected to stay flat over 2019 and 2020. The key development since the mid-year budget revision was the repeal of the Value Added Tax hike scheduled for 2020, a repeal financed primarily by lower interest spending.4 Equity markets have celebrated Italy’s avoidance of political crisis this year with a 5.6% increase. Our own measure of geopolitical risk has dropped off sharply (Chart 16). But of course we expect it to rise next year given that Italy remains the weakest link in the Euro Area over the long run. The left-leaning alliance between the established Democratic Party and the anti-establishment Five Star Movement hurt both parties’ approval ratings. In fact, the only parties that have seen an increase in approval in the last month are the League, the far-right Brothers of Italy, and the new centrist party of former Prime Minister Matteo Renzi, Italia Viva (Chart 17). We expect to see cracks form next year, particularly over immigration, but mutual fear of a new election can motivate cooperation for a time. Chart 16Decline In Italian Risk Will Be Short Lived Chart 17The M5S-PD Alliance Damaged Their Approval Bottom Line: Italy’s new government is running orthodox fiscal policy, which means no boost to growth, but no clashing with Brussels either. Spain: Election Post Mortem Chart 18A Gridlocked Parliament In Spain The Spanish election produced another gridlocked parliament, as expected, with no party gaining a majority and no clear coalition options. The Spanish Socialist Workers’ Party (PSOE) emerged as the clear leader but still lost three seats. The People’s Party recovered somewhat from its April 2019 defeat, gaining 23 seats. The biggest loser of the election was Ciudadanos, which lost 47 seats after its highly criticized shift to the right, forcing its leader Alberto Rivera to resign. The party’s seats were largely captured by the far-right Vox party, which won 15.1% of the popular vote and more than doubled its seats (Chart 18). Socialist leader Pedro Sanchez has arranged a preliminary governing agreement with Podemos leader Pablo Iglesias, but it is unstable. Even with Podemos, Sanchez falls far short of the 176 seats he needs to govern. In fact, there are only three possible scenarios in which the Socialists can reach the required 176 seats and none of these scenarios are easy to negotiate (Chart 19). The first – a coalition with the People’s Party – can already be ruled out. The other two require the support of the smaller pro-independence party, which will be difficult for Sanchez to secure, given that he hardened his stance on Catalonia in the days leading up to the election. Chart 19No Simple Way To A Majority Government The next step for Sanchez is to be confirmed as prime minister in an “investiture” vote, likely on December 16.5 He would need 176 votes in the first round (or a simple majority in the second round) to gain the confidence of Congress. He looks to fall short (Chart 20).6 If he fails to be confirmed, Sanchez will have another two months to form a government or face the possibility of yet another election. Chart 20Sanchez Set To Fall Short In Investiture Vote Spain’s indecision is leading to small conflicts with Brussels. Last week, the European Commission placed Spain under the preventative arm of the Stability and Growth Pact, stating that the country had not done enough to reach its medium-term budget objective.7 The European Commission’s outlook on Spain is slightly more pessimistic than that of the Spanish government (Chart 21). Deficit projections could worsen if a left-wing government takes power that includes the anti-austerity Podemos – which means that Spain is the only candidate for a substantial fiscal policy surprise. Chart 21A Fiscal Policy Surprise In Spain? Chart 22Spanish Risk Will Keep Rising We expect our Spanish risk indicator to keep rising (Chart 22). The silver lining is that Spain’s turmoil – like Germany’s – poses no systemic risk to the Euro Area. Spain could also see an increase in fiscal thrust. Stay long Italian government bonds and short Spanish bonos. Bottom Line: We remain tactically long Italian government bonds and short Spanish bonos. Italian bonds will sell off less in a risk-on phase and rally more in a risk-off phase, and relative political trends reinforce this trade. Emerging Markets: Global Unrest Civil unrest is unfolding across the world, grabbing the attention of the global news media (Chart 23). The proximate causes vary – ranging from corruption, inequality, governance, and austerity – but the fear of contagion is gaining ground. Chart 23Pickup In Civil Unrest Raising Fear Of Contagion A country’s vulnerability to unrest can be gauged by two main factors: political voice and underlying economic conditions. • Political Voice: The Worldwide Governance Indicators, specifically voice and accountability, corruption, and rule of law, provide proxies for political participation (Chart 24). The aim is to assess whether there is a legitimate channel for discontent to lead to change. Countries with low rankings are especially at risk of experiencing unrest when the economy is unable to deliver. Chart 24Greater Risk Of Unrest Where Political Voice Is Absent • Economic Conditions: Last year’s tightening monetary conditions, the manufacturing and trade slowdown, the US-China trade war, and a strong US dollar have weighed on global growth this year. This is challenging, especially for economies struggling to pick up the pace of growth (Chart 25). It translates to increased job insecurity, in some cases where insecurity is already rife (Chart 26). The likelihood that economic deterioration spurs widespread unrest depends on both the level and change in these variables. The former political factor is a structural condition that becomes more relevant when economic conditions deteriorate. Chart 25The Global Slowdown Weighed On Growth In Regions Already Struggling … Chart 26… And Raise Job Insecurity Chart 27Brazilian Risk Unlikely To Reach Previous Highs BCA Research is optimistic on global growth as we enter the end game of this business cycle. Nevertheless risks to this view are elevated and emerging market economies are still reeling from the past year’s slowdown. This makes them especially sensitive to failures on the part of policymakers. As a result, policymakers will be more inclined to ease monetary and fiscal policy and less inclined to execute structural reforms. Brazil is a case in point. Our indicator is flagging a sharp rise in political risk (Chart 27). This reflects the recent breakdown in the real – which can go further as the finance ministry has signaled it is willing to depreciate to revive growth. Meanwhile the administration has postponed its proposals to overhaul the country’s public sector, including measures to freeze wages and reduce public sectors jobs. On the political front, President Jair Bolsonaro’s recent break from the Social Liberal Party and launch of a new party, the Alliance for Brazil, threatens to reduce his ability to get things done. This move comes at a time when Brazil’s political landscape is being shaken up by former president Luiz Inacio Lula da Silva’s release from jail, pending an appeal against his corruption conviction. The former leader of the Worker’s Party lost no time in vowing to revive Brazil’s left. Our risk indicator might overshoot due to currency policy, but we doubt that underlying domestic political instability will reach late-2015 and mid-2018 levels. Brazil has emerged from a deep recession, an epic corruption scandal, and an impeachment that led to the removal of former president Dilma Rousseff. It is not likely to see a crisis of similar stature so soon. Bolsonaro’s approval rating is the lowest of Brazil’s recent leaders, save Michel Temer, but it has not yet collapsed (Chart 28). An opinion poll held in October – prior to Lula’s release – indicates that Bolsonaro is favored to win in a scenario in which he goes head to head against Lula (Chart 29). Justice Minister Sergio Moro, who oversaw the corruption investigation, is the only candidate that would gain more votes when pitted against Bolsonaro. He is working with Bolsonaro at present and is an important pillar of the administration. So it is premature to pronounce Bolsonaro’s presidency finished. Chart 28Bolsonaro’s Approval, While Relatively Low, Has Not Collapsed Chart 29Bolsonaro Not Yet Finished The problem, as illustrated in Charts 25 and 26, is that Brazil still suffers from slow growth and an uninspiring job market – longstanding economic grievances. This will induce the administration to take a precautionary stance and slow the reform process. The result should be reflationary in the short run but negative for Brazil’s sustainability over the long run. There is still a positive path forward. Unlike the recently passed pension cuts and the public sector cuts that were just postponed – both of which zap entitlements from Brazilians – the other items on the reform agenda are less controversial. Privatization and tax reform are less politically onerous and will keep the government and economy on a positive trajectory. Meanwhile the pension cuts are unlikely to be a source of discontent as they will be phased in over 12-14 years. Thus, while the recent political events justify a higher level of risk, speculation regarding the likelihood of mass unrest in Brazil – apart from the mobilization of Worker’s Party supporters ahead of the municipal elections next fall – is overdone. Bottom Line: The growth environment in emerging markets is set to improve in 2020. US-China trade risk is falling and China will do at least enough stimulus to be stable. Moreover emerging markets will use monetary and fiscal tools to mitigate social unrest. This will not prevent unrest from continuing to flare. But not every country that has unrest is globally significant. Brazil is a major market that has recently emerged from extreme political turmoil, so a relapse is not our base case. Otherwise one should monitor Hong Kong’s impact on the trade deal, Russia’s internal stability, and the danger that Iranian and Iraqi unrest could cause oil supply disruptions. In the event that the global growth rebound does not materialize we expect Mexico and Thailand – which have better fundamentals – to outperform. Our long Thai equity relative trade is a strategic defensive trade. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “Merkel’s Successor Splits German Coalition With Rogue Syria Plan,” dated October 22, 2019 and “Merkel's Own Party Wants Outright Huawei Ban From 5G Networks,” dated November 15, 2019, available at bloomberg.com. 2 Please see “Scholz Says No Need for German Stimulus After Dodging Recession,” dated November 14, 2019, available at bloomberg.com. 3 Please see “France: Draft Budgetary Plan For 2020,” dated October 15, 2019, available at ec.europa.eu. 4 Please see “Analysis of the Draft Budgetary Plan of Italy,” dated November 20, 2019, available at ec.europa.eu. 5 Please see “Investiture calendar | Can a government be formed before Christmas?” dated November 14, 2019, available at elpais.com. 6 If Sanchez convinces PNV, BNG, and Teruel Exists to vote in his favor for both rounds of the vote, he would need ERC and Eh Bildu to abstain in order to win. However, given that the PSOE has stated that it will not even negotiate with Eh Bildu, it is likely that this party will vote against Sanchez, giving the opposition 168 votes. In this case, Sanchez would not only need PNV, BNG, and Teruel in his favor, but also the support of either CC or ERC, both unlikely scenarios. 7 Please see “Commission Opinion on the Draft Budgetary Plan of Spain,” dated November 20, 2019, available at ec.europa.eu. Appendix Germany: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar
An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over? European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices Chart II-6Widening Current Account Deficit Chart II-7The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com Footnotes 1 Processing trade includes imports of goods that undergo further processing before being re-exported. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
The Reserve Bank of Australia has already cut interest rates by 75bps this year, taking the Cash Rate down to a record low of 0.75%. At the November 5th monetary policy meeting, the RBA did not ease policy but still delivered a dovish surprise, when it…
Global borrowing rates will rise, but only to a limited extent. Rightly or not, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up…
Highlights Monetary policy settings should continue to sustain the expansion,… : Tight monetary policy is a precondition for a recession. Although the line separating tight from easy is a matter of judgment, current Fed policy is squarely accommodative. … and the building blocks of GDP confirm that recession is not an imminent threat: A robust labor market and fortified household balance sheets should continue to support consumption; the fixed investment outlook is okay as long as trade tensions don’t wreck business confidence; and the fiscal taps are likely to remain open throughout 2020. Housing will not get in the way of the economy or the markets: Mortgage rates have fallen since we examined housing dynamics in a two-part Special Report this time last year, and residential investment will increasingly reflect it. We project that the beginning of the next recession is about two years away, and that the equity and credit bull markets still have room to run: We are not perma-bulls, but there’s no evidence that the long bull run is about to end. Feature We view the study of key cycles – the business cycle, the credit cycle, the monetary policy cycle and the sentiment cycle – as an essential element of investment strategy. The monetary policy cycle has been especially critical throughout the long expansion and bull market because it has held sway over the business cycle and the credit cycle since the crisis. We have also found that it exerts a powerful influence on equity returns: for six decades, stocks have done very well when policy is easy, but they have failed to generate positive real total returns when it’s tight. There is far more to investment returns than monetary policy, but a simple strategy of embracing risk during easy-policy phases of the fed funds rate cycle and limiting exposure to it when policy is tight has been a big winner over time. Although the fed funds rate cycle has been an especially valuable input in our process, it relies on an estimate. The equilibrium, or neutral, fed funds rate cannot be directly observed. We can only infer when the target fed funds rate crosses above or below it by observing actual economic performance. We continually review real-time data to gauge whether our equilibrium estimate is in the ballpark. As a formal check on that estimate, we regularly examine the building blocks of GDP for insight into where the business cycle is going. We update our review of the GDP equation in this report, and conclude that the expansion should remain on track over the next six to twelve months. We also provide an update on housing a year after our dedicated Special Reports on the topic, finding that it is unlikely to derail the expansion. The GDP Equation – Consumption As we all learned in Introductory Macroeconomics, GDP is the sum of consumption (C), investment (I), government spending (G) and net exports (X-M). As net exports are insubstantial in the comparatively closed US economy, US GDP growth reduces to the weighted sum of growth in consumption, investment and government spending, with consumption accounting for two-thirds of growth and investment and government spending accounting for one-sixth each. GDP = C + I + G Month-to-month moves in real retail sales and personal consumption expenditures (PCE) are volatile, but both series have recovered from their late-2018 softness to get back to their mean for this cycle, somewhat below the means of the previous two expansions (Chart 1). The activity supports our constructive take at the time of our initial review of the GDP equation in April,1 but the choppy series do not provide much insight into the consumption outlook. Looking forward involves examining households’ income prospects and balance sheets to project the money that will be coming in, and consumers’ ability and willingness to spend it. Chart 1Consumption Has Been Holding Up Well Labor market conditions drive household income, and they remain quite tight. The number of unfilled job openings continues to exceed the number of unemployed workers (Chart 2), indicating that demand for employees remains strong. An elevated quits rate indicates that employers are competing fiercely to meet that demand, even to the point of poaching employees from one another (Chart 3). Our payrolls model projects that employment growth will stay close to its pace of the last several years (Chart 4, top panel), as small businesses have ambitious hiring plans (Chart 4, second panel), temporary employment is still growing (Chart 4, third panel), and the 26-week moving average of initial unemployment claims is only slowly beginning to rise (Chart 4, bottom panel). Chart 2With More Jobs Than Workers, ... Chart 3... Employees Can Seek Out Greener Pastures Chart 4Payrolls Will Keep Expanding Wages are already growing around 3% year-over-year, and the tight labor-market backdrop should promote further gains. With employers forced to bid up wages to attract a shrinking pool of available workers, we expect that wage growth will peak somewhere above 3.5% before the cycle ends. Humans’ ability to see into the future does not extend beyond six to twelve months, but we are confident that more households will be working by the middle of 2020 than are working now, and that they’ll be earning more, in real terms. Households don't have to spend their income gains, but they're in a comfortable position to do so after several years of building up savings and working down debt. Households won’t necessarily spend all of their income gains. They may choose to direct them to paying down debt or increasing savings. Their balance sheets suggest they don’t have a need to do so, however, as the savings rate is back to early ‘90s levels above 8% (Chart 5, top panel), nearly all the debt as a share of GDP that they took on in the last expansion has been worked off (Chart 5, middle panel), and their aggregate debt service burden is lower now than it has been at any point in the last 40 years (Chart 5, bottom panel). Not only do households face little pressure to save their coming income gains, they have plenty of capacity to borrow to augment them. Chart 5Household Finances Are Solid The GDP Equation – Investment And Government Spending Investment accounts for just a sixth of GDP, but its volatility gives it a greater likelihood of tipping the economy into a recession than either consumption or government spending (Chart 6). Per the surveys we use to anticipate capital expenditures, the change since April is mixed. Small business capital spending plans as reported in the NFIB survey have ticked up and remain elevated (Chart 7, top panel), while capex intentions from the regional Fed manufacturing surveys have continued to slip and are only around their historical mean (Chart 7, bottom panel). We expect that the trade negotiations will exert a powerful near-term pull on corporate capex; if the US and China reach some sort of accord, capex should pick up, but if tensions worsen, corporate confidence will decline and capex may outright contract. Our base case calls for a modest détente around a Phase 1 agreement, so we do not expect that investment will break down, but it is the most vulnerable component of GDP and we are watching it closely. Chart 6Investment Is The Swing Factor Chart 7The Capex Outlook Is Only Okay, ... Government spending, on the other hand, doesn’t merit a whole lot of attention right now. It is a stable series that accounts for a modest share of GDP and for most of the postwar era, it was reliably countercyclical, shrinking when times were good and expanding when times were bad (Chart 8). The gaping divergence between the federal deficit and economic performance bodes ill for Treasuries and the dollar over the long term, but it shows that there’s no appetite for reining in federal spending ahead of the most hotly contested election campaign in recent memory. State and local spending accounts for about 60% of all government spending, and the strong labor market will boost state receipts, which come from income and sales taxes, while steady home price appreciation will support property tax receipts (Chart 9), keeping municipal coffers full. The longer-term implications of the debauched federal budget are unpleasant, but government profligacy will help sustain the expansion through the end of next year. Chart 8... But The Fiscal Party Rages On Chart 9Home Price Gains Will Fill Local Government Coffers Housing Residential investment finally broke out of a six-quarter string of detracting from GDP growth last quarter, though its drag in the first half of the year was modest. Residential investment may not exert the sway over the economy that it did earlier in the postwar era when the suburbs were being created from scratch, but its interest rate sensitivity makes it a good proxy for the effect of monetary policy on the economy. Housing has picked up as mortgage rates have fallen, and rates’ lagged effect suggests that more gains are in store (Chart 10). A high level of affordability should keep the momentum going (Chart 11), and new household formations continue to outstrip housing starts (Chart 12, top panel), at a time when inventories (Chart 12, middle panel) and vacancies (Chart 12, bottom panel) are historically low. Chart 10The Full Effect Of Lower Rates Is Yet To Be Felt Chart 11Affordability Is High, ... Chart 12... And Supply Is Tight We continue to believe that housing poses no threat to the expansion. New home sales should pick up as builders address the undersupply of homes for first-time and first move-up buyers. The cap on itemized deductions imposed by the December 2017 revision to the federal tax code does not appear to have had a material impact on regional sales activity, and the relationship between top marginal income tax rates2 and home price appreciation since the tax act passed is weak (Chart 13). The bottom line is that residential investment is more likely to boost fixed investment over the next year than it is to detract from it. Chart 13Post-Act Home Price Appreciation Among 20-City Case-Shiller Constituents Investment Implications The underlying elements of the GDP equation support our monetary policy-driven assessment that the expansion will keep chugging along. A robustly healthy labor market will support wage gains, and household balance sheets have firmed up enough to allow consumers to spend their increased income. Surveys indicate that fixed investment does not present a major economic headwind, and positive trade developments could turn it into a tailwind. Government spending will be well supported through 2020. It would be consistent with history if this bull market didn't end until it made one more big push higher. Recessions and bear markets coincide, so the equity bull market should persist until the next recession is in sight. Spread product should also continue to outperform Treasuries and cash, especially while lenders are desperately seeking incremental carry. We reiterate our broad recommendation to overweight equities and spread product, while underweighting Treasuries, and urge investors with more conservative mandates to remain at least equal weight equities and spread product. Excesses in the real economy or the financial markets are a recession prerequisite, and it is quite possible that the excesses that precipitate the next recession will not emerge until after stocks make another significant move higher. We want to be positioned to participate in that move, which would be consistent with bull markets’ established tendency to sprint to the finish line. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the April 8, 2019 US Investment Strategy Weekly Report, “If We Were Wrong,” available at www.bcaresearch.com 2 The 2017 Act capped the amount of state and local tax payments household filers could claim as itemized deductions, severely reducing the federal government’s homeownership subsidy. Residents of states with high income tax rates lost the most from the change, but those states’ housing markets have not yet experienced disproportionately negative impacts.
Dear Client, In addition to this short weekly report, you will also receive our 2020 outlook, published by the Bank Credit Analyst. Next week, I will be on the road visiting clients in South Africa. I hope to report my discussions and findings the following week. Best regards, Chester Ntonifor Highlights According to a simple attractiveness framework, the most desirable currencies are the Norwegian krone, the Swedish krona, and the Japanese yen. The least attractive are the New Zealand dollar and the British pound. Take profits soon on our long GBP/JPY position. Feature In this report, we use a simple framework for ranking G10 currencies. First, we consider the macroeconomic environment using as proxies a country’s basic balance and external vulnerability. Next, we look at valuation metrics, surveying a variety of both short-term and longer-term models. Finally, we consider positioning, to gauge if our view is mainstream or out of consensus. Below are our results. Basic Balance Chart I-1Basic Balance We consider the basic balance to be one of the most important concepts in determining the attractiveness of a currency. In a nutshell, it captures the ebb and flow of demand for a country’s domestic assets. Persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. The euro area sports the best basic balance surplus in the G10 universe, followed by Norway and then Australia (Chart I-1). In simple terms, this means there is constant strong underlying demand for these currencies - either for domestic goods and services, or for investment into portfolio assets. The UK and the US rank the worst in terms of basic balances, driven by Brexit uncertainty and the ebbing of tax reform benefits in the US. We will explore balance of payments dynamics within all of the G10 countries in detail next week. External Debt A currency is sometimes only as vulnerable as its external liabilities. In an absolute sense, external debt as a share of GDP is highest in the UK, euro area, and Switzerland (Chart I-2). However, what matters most times for vulnerability are net external assets rather than gross liabilities. On this measure, Japan, Switzerland, and Norway are the most attractive countries, while the US and Australia rank the worst (Chart I-3). Chart I-2External Vulnerability Chart I-3US Is Least Attractive Purchasing Power Parity (PPP) Chart I-4PPP Model Various models have shown PPP to be a very poor tool for managing currencies, but an excellent one at extremes. However, there is a roadblock that comes from measurement issues, since consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to run two regressions with the exchange rate as the dependent variable. The first regression (call it REG1) uses the relative price ratios of the five groups as independent variables. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. The second regression (call it REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. The results show the US dollar as overvalued, especially versus the Swedish krona, Japanese yen, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc. The euro is less undervalued than implied by the overvaluation in the DXY index (Chart I-4). Intermediate-Term Timing Model (ITTM) Back in 2016, we developed a set of currency indicators to help global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar. Our intermediate-term timing models are not sending any strong signals at the moment. Interest Rate Differentials: Under the lens of interest rate parity, if one country is expected to have lower interest rates versus another, the incumbent’s currency will fall today so as to gradually appreciate in the future and nullify the interest rate advantage. Chart I-5Intermediate-Term Model Inflation Differentials: Assuming no transactional costs, the price of sandals cannot be relatively high and rising in Mumbai versus Auckland. Either the Indian rupee needs to fall, the kiwi rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are not government bonds in that few treasury departments and central banks can guarantee a par value on them. Ergo, the ebb and flow of risk aversion will have an impact on the Norwegian krone as well as the yen. For the most part, our models have worked like a charm. On a risk-adjusted return basis, a dynamic hedging strategy based on our ITTMs has outperformed all static hedging strategies for all investors with six different home currencies since 2001. These results give us confidence to continue running these models as a sanity check for our ever-shifting currency biases. That said, our intermediate-term timing models are not sending any strong signals at the moment. The Swedish krona, Norwegian krone, and New Zealand dollar are the most attractive currencies, while the British pound and Swiss franc are the least attractive (Chart I-5). Long-Term Fair Value Model Chart I-6Long-Term Model Our long-term FX models are also part of a set of technical tools we use to help us navigate FX markets. Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. The models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their main purpose is to provide information on the longevity of a currency cycle, depending on where we are in the economic cycle. Our long-term FX models are not sending any strong signals right now, with the US dollar at fair value. The cheapest currencies are the yen, the Norwegian krone, and Swedish krona (Chart I-6). The priciest currencies are the South African rand and the Saudi riyal. Real Interest Rates One defining feature of the currency landscape is that pretty much across the G10 countries, we have negative real rates (Chart I-7). Within the G10 universe, the US and New Zealand dollars are the highest-yielding currencies, while the British pound and Swedish krona are the least attractive. Chart I-7Real Rates Speculative Positioning Being long Treasurys and the dollar has been a consensus trade for many years now (Chart I-8). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. Chart I-8Positioning That said, flow data highlights just how precarious being long US dollars is right now. Net foreign purchases by private investors are still positive, but the momentum of these flows is clearly rolling over. This is being more than offset by official net outflows. As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Concluding Thoughts Should the nascent pickup in global growth morph into a synchronized recovery, it will go a long way in further eroding the US’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. For example, yields in Norway, Sweden, Switzerland, and Japan have risen by much more than those in the US since the bottom. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar. This is the message being sent by an aggregate of our ranking model. The most attractive currencies are the Swedish krona, the Norwegian krone, and the Japanese yen. The least attractive are the British pound and New Zealand dollar (Chart I-9). Take profits soon on our long GBP/JPY position. Chart I-9Favor Norway, Japan and Sweden Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Retail sales grew by 0.3% year-on-year in October. Industrial production contracted by 0.8% month-on-month in October. On the housing market front, building permits and housing starts both increased by 5% and 3.8% month-on-month in October. However, MBA mortgage applications contracted by 2.2% for the week ended November 15th. The NY Empire State Manufacturing index fell to 2.9 from 4 in November. The Philly Fed manufacturing index, on the other hand, soared to 10.4 from 5.6 in November. The DXY index depreciated by 0.3% this week. The FOMC minutes released this Wednesday showed that the Fed now sees little need to further reduce rates. Last week, we did a reassessment of global growth and the USD, and entered a limit sell for the DXY index at 100. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4UR Technicals 2 Recent data in the euro area have been mostly positive: The seasonally-adjusted trade balance fell to €18.3 billion in September. The current account surplus slightly narrowed by €0.3 billion to €28.2 billion. Headline and core inflation were both unchanged at 1.1% and 0.7% year-on-year respectively in October. Consumer confidence improved from -7.6 in October to -7.2 in November. EUR/USD increased by 0.5% this week. The improvement in soft data confirms that the economy is in a bottoming process in the euro area. The fact that the largest economy, Germany, skirted a recession last week also boosted investor confidence. We continue to remain overweight the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Exports decreased by 9.2% year-on-year in October. Imports slumped by 14.8% year-on-year. The total trade balance shifted to a surplus of ¥17.3 billion. The industry activity index increased by 1.5% month-on-month in September. USD/JPY fell by 0.2% this week. While global growth is set to improve given a possible trade détente and easy monetary policy worldwide, uncertainties continue to loom. The US Senate unanimously passed legislation on the "Hong Kong Human Rights and Democracy Act," adding more difficulties to finalize the Phase I trade deal. Global trade uncertainty is positive for safe-haven demand. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: The Rightmove house price index increased by 0.3% year-on-year in November. Public sector net borrowing increased by £3 billion to £10.5 billion in October. The British pound continues to appreciate by 0.7% against the US dollar this week. With Brexit being less of a threat, the pound is poised to rise through next year. We are long GBP/JPY in our portfolio and it is in the money at 6.1%. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been soft: The Westpac leading index fell by 0.1% month-on-month in October, following a slight decline the previous month. AUD/USD has been more or less flat this week. In the monetary policy minutes released this week, the RBA expressed their expectations for stronger growth at 2.75% in 2020 and around 3% in 2021, supported by accommodative monetary policy, infrastructure spending, stabilizing house prices, and strong steel-intensive activities in China. The minutes also presented an argument against lower interest rates: while lower interest rates can support the economy through the usual transmission channels, they could be negative for savers and confidence. That said, the RBA is "prepared to ease monetary policy further if needed." Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: Both output and input components of the producer price index have increased in Q3: the output component grew by 1% quarter-on-quarter and input component by 0.9% quarter-on-quarter. NZD/USD increased by 0.7% this week. Both growth and inflation in New Zealand are showing signs that the economy is in a bottoming process. We are positive on the kiwi against the US dollar while we remain short against the Australian dollar and Swedish Krona. Report Links: Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Manufacturing shipments fell by 0.2% month-on-month in September. Both headline and core inflation were unchanged at 1.9% year-on-year in October. ADP employment showed a loss of 22.6K jobs in October. The Canadian dollar fell by 0.6% against the US dollar this week. While a possible trade détente between US and China and rising oil prices could put a floor under the loonie, the pipeline constraints in Canada have dampened the correlation between the oil prices and the loonie. This will limit the upside potential for the Canadian dollar. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus narrowed to CHF 3.5 billion in October from CHF 4.1 billion the previous month, due primarily to growth in imports, which grew by 1.9 billion month-on-month. Exports also increased by 1.3 billion month-on-month. Import demand remains firm for chemical products. Industrial production grew by 8% year-on-year in Q3. USD/CHF increased by 0.2% this week. The trade balance still remains at a high level in Switzerland, which is bullish for the franc. Moreover, global uncertainties could underpin the safe-haven franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The trade balance shifted to a surplus of NOK 5.9 billion in October, after a deficit of NOK 1.4 billion in September. However, this is compared to a surplus of NOK 32.6 billion in the same month last year. On a year-on-year basis, exports slumped by 27%, caused by a decrease in exports of mineral fuels and chemical products. The Norwegian krone appreciated by 0.3% against the US dollar this week, supported by the oil price recovery. On Wednesday, the EIA posted an increase of crude oil inventories by 1.4 million barrels from the previous week, lower than expectations. WTI crude oil prices thus surged by 4% on the news. Going forward, we remain overweight energy prices and the Norwegian krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased to 0.5% in Q3, up from 0.1% in the previous quarter. The Swedish krona increased by 0.7% against the US dollar this week. The Swedish krona has depreciated by 23% against the USD since its 2018 peak. A global growth revival is likely to give a boost to the krona from a valuation perspective. Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights Analysis on the Chinese property market is available below. In the Philippines, domestic demand is set to accelerate at the hands of the government’s fiscal boost. The current account deficit will widen and the peso and local bonds will likely sell-off. This warrants an underweight stance in this interest rate-sensitive bourse. A new trade: Pay 2-year swap rates. The outlook for China’s property market and construction activity is downbeat. Financial market plays leveraged to mainland construction activity remain at risk. The Philippines: The Cycle Is Turning The relative performance of Philippine equities against the EM benchmark is moving inversely to the direction of relative (Philippines minus EM) local bond yields (Chart I-1). When local Philippine bond yields drop versus those of other EMs, this bourse outperforms, and vice versa. Likewise, Philippine share prices in absolute terms exhibit a negative relationship with local bond yields (Chart I-2). The rationale behind this high sensitivity in share prices to local interest rates is the large presence of banks and property stocks in the Philippines' bourse. Banks account for 20% and real estate stocks another 21% of the local stock exchange. These sectors benefit in a falling interest rate environment and suffer during periods of rising rates. Chart I-1Philippines Vs. EM: Relative Stock Prices And Bond Yields Chart I-2Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Our underweight position in Philippine equities has not played out because the economy has slowed much more than we had expected, which has also coincided with collapsing US Treasury bond yields. Consequently, Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Chart I-3Philippine Growth Slowed Due To A Slump In Government Spending Chart I-4Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit The growth rate of the Philippines has decelerated markedly due to sharp slowdowns in both government spending and bank loan growth (Chart I-3). In fact, the combined bank loan and fiscal spending impulse has plunged, leading to a major slowdown in domestic demand, which in turn has stabilized the current account (Chart I-4). The latter effect has supported the currency and allowed the central bank to cut rates. A budget deadlock on a number of items delayed the approval of the 2019 budget, causing government spending to plunge in the first half of 2019. In short, it was unintended fiscal tightening that has wrong-footed our view on the direction of the macro cycle, and consequently Philippine financial markets. Government spending has been instrumental in driving fixed capital formation since President Rodrigo Duterte came to power in May 2016. Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Going forward, the macro cycle is set to reverse: Chart I-5Philippines: Signs Of A Growth Rebound Government expenditure will rise substantially – infrastructure spending in particular – lifting imports. The 2019 budget was approved back in April, and the House of Representatives has given the green light to extend the shelf-life of the current 2019 budget. Moreover, the fiscal 2020 budget, now approved by Duterte, entails 12% nominal growth in government expenditures in general and 14% growth in capital/infrastructure spending in particular. Duterte will oversee 100 flagship infrastructure projects estimated to cost 4.3 trillion Philippine pesos, or 24% of GDP. More than half of these projects are either ongoing or will commence construction in the next six to eight months. The larger infrastructure expenditure will encourage bank lending. Overall, domestic demand will revive considerably, causing the current account deficit to widen. Importantly, the expected fiscal boost will come on top of already strong consumer spending. The marginal propensity to spend among households and companies is already improving, confirming domestic growth acceleration (Chart I-5, top panel). In particular, both vehicle and machinery sales are recovering (Chart I-5, middle panel). Narrow and broad money impulses have bottomed (Chart I-5, bottom panel). Stronger imports amid still-depressed exports due to sluggish global demand will lead to a widening of the current account deficit. We expect the peso to resume its depreciation. Renewed currency weakness and a domestic demand revival will put a floor under inflation. The central bank is headed by Governor Benjamin Diokno, the former Budget Secretary and an associate of populist President Duterte. The odds are that the central bank will not hike interest rates in the face of a rising current account deficit and modestly rising inflation. This will reinforce currency depreciation. Finally, domestic bond yields are set to rise. A widening fiscal deficit has historically coincided with higher domestic bond yields (Chart I-6). Odds are it will not be different this time. Besides, Philippine banks have been relentlessly purchasing government bonds because credit demand from companies has been sluggish (Chart I-7). As private credit demand begins to recover and banks accelerate their loan origination, they will become net sellers – or will at least ease their pace of government bond purchases – pushing yields higher. Chart I-6Rising Fiscal Deficit Is Bad News For Bonds Chart I-7Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Bottom Line: Unintended fiscal tightening has slowed domestic demand, narrowed the current account deficit, supported the currency and induced a drop in local bond yields. This has allowed the Philippines’ interest rate-sensitive bourse to outperform the overall EM equity index. Going forward, the macro cycle is set to reverse. This cycle is about to reverse due to strong fiscal expansion: Domestic demand and imports will grow briskly, and the current account deficit will widen considerably. Widening twin deficits will lead to material currency depreciation and higher domestic bond yields. Investment Recommendations Continue shorting the Philippine peso versus the US dollar. 2-year swap rates are 48 basis points below the policy rate (Chart I-8). The market will price out rate cuts as the business cycle recovers and the currency depreciates. We recommend a new trade: pay 2-year swap rates. Dedicated EM fixed-income investors should underweight the Philippines in their EM domestic currency bonds and sovereign credit portfolios. Chart I-8The Market Is Expecting Rate Cuts Chart I-9Philippine Equity Market Is Not Cheap Does an upcoming growth revival warrant an overweight stance in Philippine stocks within an EM equity portfolio? As shown in Charts I-1 and I-2, this equity market is more sensitive to interest rates than growth. The growth deceleration did not prevent this stock market from outperforming its EM peers. Hence, higher local bond yields amid renewed currency depreciation will likely lead to a period of underperformance. Finally, Philippine stocks are not cheap in absolute terms or relative to the EM benchmark (Chart I-9). Hence, they will not respond well to rising interest rates. Chart I-10Philippine Property Stocks Will Suffer As Interest Rates Rise Within this bourse, underweight/short property stocks. These stocks are the most vulnerable to rising bond yields (Chart I-10). The key risks to our strategy are lower global bond yields and continuous flows of foreign capital into EM assets in general, and local bonds in particular. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com China: Making Sense Of The Property Market Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2). Chart II-2China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise. Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6). Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1 The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations
The Chinese economic growth model remains reliant on credit formation and capital investment. Therefore, the sustainability of an economic recovery depends on whether Chinese policymakers are willing to keep the stimulus wheel turning. We expect that some…