Emerging Markets
Highlights Lingering weakness evident in fundamental supply-demand data will fade next year, and with it the downward pressure on oil prices. Price risk is skewed to the upside: Continued monetary accommodation from systematically important central banks and fiscal stimulus will revive oil demand; OPEC 2.0 production restraint and market-imposed discipline in the US will slow the growth of oil supply. Shale-oil supply growth also is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth. Elevated geopolitical tensions cannot be ignored, particularly as economic and political discontent boils over in Iraq and Iran, where leaders could feel compelled to lash out. To the downside, global economic policy uncertainty remains elevated. It continues to keep the USD well bid. This raises consumers’ local-currency costs in the EM economies driving demand growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Weaker 2019 data showing up in demand and upward revisions to inventories pushed our 4Q19 Brent forecast down to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. We continue to expect WTI will trade $4/bbl below Brent. Feature In the multi-level game that drives the political economy of oil, domestic and international factors shaping supply-demand fundamentals are always shifting. As multiple constituencies vie for advantage, market participants will be forced to grapple with the consequences of policies now under consideration. The bullet points above provide a restricted aperture through which to view some of the issues currently in play.1 Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. Demand-side impacts of policy shifts and policy signaling remain the most prominent feature of fundamental adjustments markets will continue to grapple with, as fall-out from the Sino-US trade war; political discontent in DM and EM electorates; and ad hoc economic policy raise global economic policy uncertainty. Markets are responding favorably to the unwinding of tighter global financial conditions this year brought about by tighter US monetary policy last year, and China’s 2017-18 deleveraging campaign. This is most visible in our global Leading Economic Indicators (LEIs), particularly in EM economies, although DM demand also looks like it could pick up (Chart of the Week). For the real economy, it is useful to remember Milton Friedman’s “long and variable lags” regarding the effects of monetary policy and how they affect oil markets.2 Chart of the WeekGlobal LEIs Point To Demand Recovery Chart 2BCA's EM Commodity-Demand Nowcast Points Toward Upturn in Oil Demand EM growth is hugely important to global oil-demand growth in our analysis. Our proprietary EM Commodity-Demand Nowcast continues to indicate EM economies are responding to easier global financial conditions (Chart 2).3 Global growth expectations for oil demand are diverging sharply in the lead-up to OPEC 2.0’s December 5 meeting in Vienna. At the low end, the US EIA expects 2019 growth of 760k b/d this year, a sharply lower estimate than the agency’s co-eval institutions; OPEC is closing in on the 1mm b/d growth threshold at 0.98mm b/d, followed by the IEA at 1mm b/d. We lowered our estimate of oil-demand growth this year to 1.1mm b/d, in line with weaker consumption data being reported by these big agencies. Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. We are maintaining our expectation for growth of 1.4mm b/d next year, which is close to the EIA’s estimate (Chart 3). The IEA’s estimate for 2020 stays at 1.2mm b/d, while OPEC’s is just under 1.1mm b/d. On the supply side, we expect lower US shale-oil output growth next year. Lower prices, backwardated WTI futures curves – which results in lower forward prices for producers hedging their output – and recalcitrant investors who are unwilling to commit capital to all but the most profitable shale-oil producers will take their toll (Chart 4). As a result, we expect US shale output to reach ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko). This leads to an 800k b/d increase in our US lower 48 output over this year’s levels, which is down from our earlier estimate of a 900k b/d increase. Chart 3Stronger Oil Demand, Tighter Supply Will Lift Oil Prices in 2020 Chart 4Lower Prices, Backwardated WTI Curve Lead to Lower Rig Count, Shale-Oil Output Shale-oil production growth faces an additional risk from the flaring of associated natural gas in the Permian and Bakken basins. Failure to limit the burn-off into the atmosphere at oil-production sites could provide the environmental lobby an opening to challenge growth, as the electorate grows increasingly restive with the practice. Industry officials in Texas and North Dakota – home to the Permian and Bakken plays – already have been sounding the alarm on this issue.4 According to Rystad Energy, flaring reached another record high in the Permian at 752 million cubic feet per day in 3Q19 amid growing oil production. Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest. We also are penciling in an extension of OPEC 2.0’s 1.2mm-barrel-per-day output cut to year-end 2020. Over-compliance likely persists, particularly from the Kingdom of Saudi Arabia (KSA). Stronger non-OPEC output from Norway and Brazil offsets this somewhat (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Lastly, we continue to follow events in Iraq and Iran closely where economic and political discontent with the status quo has led to civil unrest. As our colleague Roukaya Ibrahim notes, “The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services … . This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace.”5 There is an underlying tension within the society between Iraqi forces loyal to Iran’s Shia theocracy and Iraqis seeking full autonomy for their country. “The widening rift between the rival Iraqi Shia blocs implies that any détente will be temporary,” according to BCA’s geopolitical strategists. We have consistently maintained markets are too complacent regarding these geopolitical risks, which also encompass US-Iran hostilities in the Persian Gulf. We are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl. That said, our balances still reflect the lingering demand weakness discussed above, and continue to work through higher inventories. In line with revisions by the EIA to historical inventory levels and lower demand growth, we are reducing our 4Q19 Brent forecast to $63/bbl from $66/bbl, and our 2020 forecast to $67/bbl from $70/bbl (Chart 5). We continue to expect WTI will trade $4/bbl below Brent (Chart 6). Chart 5Storage Revisions Help Weaken Price Forecasts Chart 6BCA 2020 Oil Price Forecasts Fall Slightly To $67/bbl For Brent, $63/bbl For WTI Global Economic Policy Uncertainty Persists While accommodative monetary policy and stimulative fiscal policy will foster a revival in commodity demand, global economic uncertainty remains elevated.6 This risks keeping the broad trade-weighted USD index for goods (TWIBG) well bid (Chart 7). This raises consumers’ local-currency costs in the EM economies driving growth, and lowers production costs ex-US, incentivizing supply growth at the margin. Chart 7Elevated Global Economic Uncertainty Keeps USD Well Bid, Retards Demand We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand. However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest. As the multi-level game dominating the evolution of the political economy of the oil market becomes more complex and uncertain – particularly in re the Sino-US trade war and domestic politics in systemically important economies – monetary and fiscal policy have an additional headwind to battle in the attempt to revive aggregate commodity demand. Bottom Line: We remain confident the combination of global monetary accommodation and fiscal stimulus will revive commodity demand. However, given the economic uncertainty confronting policymakers globally, this revival likely will be modest, with oil prices rising ~ 10% next year. That said, if the phase-one Sino-US trade deal leads to a phase-two and –three – i.e., a durable resolution to the trade imbroglio and political discontent roiling markets, the recovery could be more significant.7 Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Market Round-Up Energy: Overweight. Trade-related news continues to drive short-term price movements. On Tuesday, Brent prices fell 2.5% on rising pessimism about the US-China “phase one” deal. On the supply side, OPEC 2.0 countries will meet in early December to assess whether the group should extend – and possibly deepen – output cuts. Russia signaled it is unlikely to support deeper cuts, but appears to be open to extending the current quotas until year-end 2020. Our updated global oil market balances assume OPEC 2.0 will agree to extend the current production curbs. Separately, anti-government protests in Basra, Iraq, are impacting the oil sector. On Monday, protesters reportedly blocked roads leading to the major oil fields and to commodity export terminals. Base Metals: Neutral. Copper prices seem detached from their current fundamentals, moving up and down with expectations related to the US-China trade war and ongoing protests in Chile – the world’s largest copper producer. Negative sentiment has weighed on copper most of this year. Speculative short positioning reached a high of 137k contracts in August, pushing our Copper Composite Indicator into “oversold” territory. Going forward, the metal’s fundamentals will support higher prices; quarter-to-date copper prices increased 3.5%. Global visible copper inventories resumed their downward trend in 2H19 – reaching a 10-year low. We expect global growth to pick up in the coming months – led by emerging economies. Risks are skewed to the upside. Precious Metals: Neutral. Gold prices recovered to $1475/oz after trading close to our $1450/oz stop-loss last week. Slightly weaker real rates in the US and ratcheted-up trade tensions supported the yellow metal’s price this week. Over the short term, prices could be pushed lower as markets await positive developments re a Sino - US trade agreement. Ags/Softs: Underweight. Corn futures traded lower earlier in the week, but rebounded slightly Tuesday after the USDA Crop Progress reported the harvest rate for it was 76%, which was below analysts’ expectations of 77% and well below the five-year average of 92%. Wheat performed better, marking a 0.9% weekly increase in March futures on the back of a lower percentage of the crop being rated good or excellent by the USDA. Finally, soybeans were flat throughout the week but fell almost 0.8% on Wednesday, amid reports that a phase-one trade deal between US and China may not be completed by the end of 2019. Footnotes 1 Understanding and balancing these interests is difficult, as is forecasting outcomes. Please see Robert D. Putnam, “Diplomacy and Domestic Politics: The Logic of Two-Level Games,” International Organization, Vol. 42, No. 3 (Summer, 1988). 2 Friedman’s classic paper, “The Lag in Effect of Monetary Policy,” appeared in the Journal of Political Economy, Vol. 69, No. 5 (Oct., 1961). Our own research suggests these lags range from six to 18 months in commodity markets. 3 Our EM Commodity-Demand Nowcast uses our Global Industrial Activity (GIA) Index, and our Global Commodity Factor (GCF) and EM Import Volume (EMIV) models to characterize the current state of commodity demand. The GIA index uses trade data, FX rates, manufacturing data, and Chinese industrial activity statistics to gauge current global industrial activity, which is highly correlated with trade-related activity. The GCF uses principal component analysis to distill the primary driver of 28 different commodity prices traded globally. Lastly, the EMIV model is driven by EM import volumes, which are highly correlated with income; as income rises, oil demand – and commodity demand in general – rises. Please our report entitled Global Financial Conditions Support Higher Commodity Demand, which was published October 31, 2019, for additional discussion. It is available at ces.bcaresearch.com. Concerns over associated natural-gas flaring into the atmosphere are rising in the shale-oil community, as political discontent with the practice grows. Please see Gas Flaring “Running Rampant” In The Permian, published by oilprice.com, and New Initiative will Map and Measure Methane Emissions Across the Permian Basin, a press release issued by the Environmental Defense Fund outlining their initiative to install methane emissions-monitoring gear around the Permian to begin logging the massive amount of flaring in that basin. According to the Oil & Gas Journal, “… collective volumes of flared and vented gas from (the Permian and Bakken) basins up to about 1.15 bcfd. For comparative purposes, that represents 12 billion cu m/year of wasted gas, which exceeds the yearly gas demand of nations such as Israel, Colombia, and Romania.” Please see Permian gas flaring, venting reaches record high published by the OGJ June 4, 2019. Please see Permian gas flaring reaches yet another high, published by Rystad Energy on its website November 5, 2019. 4 S&P Global Platts posted an interesting podcast on its website featuring an interview with Lynn Helms, director of the North Dakota Department of Mineral Resources. He said flaring in the Bakken – where production is hitting record highs – will force state regulators to throttle back on the rate of shale-production growth beginning in 2Q20, when growth could slow substantially if gas-capture technologies are not deployed. Growth could remain subdued for 2020-21, he said. Please see North Dakota’s record oil growth to be upended by flaring rules, posted November 18, 2019. 5 Please see Iraq's Challenge To Iran Is Underrated, published by BCA Research’s Geopolitical Strategy November 8, 2019. It is available at gps.bcaresearch.com. 6 We measure uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related to economic policy uncertainty, which are found in newspapers and articles online from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 7 This is not our base case. Our geopolitical strategists expect a temporary ceasefire in the trade war, but doubt that a “grand compromise” leading to a new period of US-China economic engagement will emerge from the negotiations. Strategic tensions will keep rising on a secular basis between the two countries. Please see BCA’s Geopolitical Strategy weekly report entitled How Much To Buy An American President? – GeoRisk Update: October 25, 2019. It is available at gps.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of 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…
Historically, China’s credit formation has consistently led economic activity by about three quarters. Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start…
Feature We spent the past two weeks visiting and exchanging views with our clients in Asia. We presented our view that the ongoing stimulus measures are beginning to bear fruit in terms of stabilizing China’s economic activity, and that we expect the economic slowdown to bottom early next year. In addition, Chinese policymakers are signaling their willingness to accelerate stimulus on both monetary and fiscal fronts, which should mitigate the downside risks and help the economy regain traction in 2020. Interestingly, our view sparked divergent responses: clients outside of China were more upbeat about the state of the Chinese economy than clients from mainland China. While few investors we spoke to showed concerns over an imminent “hard landing” in China’s economy or systemic risk from China’s financial system, our mainland Chinese clients remain skeptical that the ongoing stimulus will be sufficient to revive the economy. They were also worried that financial regulations may be too restrictive to generate the amount of money growth needed for the economy. Another interesting observation was that while being pessimistic about the economy, our mainland Chinese investors share our assessment that Chinese domestic stocks still have some upside in the coming year. On the other hand, global investors, who are more sanguine about China’s economic recovery, prefer to wait on the sidelines before favoring Chinese investable stocks (Chart 1). Chart 1AA Tale Of Two Markets: Onshore Outperforms Global Markets... Chart 1B...While Offshore Underperforms Below we present some of the top questions that were posed by investors during our trip, along with our answers. We recap the conclusions of our view, and draw out the investment implications of the differences between the sentiments towards China’s equity markets, in the last question of the report. Q: Recent economic data suggests a weakening Chinese economy. Why do you think the economy will reach a bottom in 2020? Historically, China’s credit formation has consistently led economic activity by about three quarters (Chart 2). Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start of 2019. This suggests that economic activity should turn around within the next two quarters. Chart 2Expecting A Turn In Q1 2020 Chart 3Emerging Green Shoots Furthermore, despite weakening headline economic data, some underlying components indicate promising improvements (Chart 3): Growth in infrastructure investment has ticked up modestly in the past couple months, and is set to improve further. The State Council mandated local governments to allocate the proceeds from special-purpose bond sales to infrastructure projects by the end of October. This, combined with a frontloading of next year’s local government bonds, should lend support to infrastructure spending in the coming months. After fluctuating in and out of contraction for a year, growth in auto manufacturing production picked up in August and remained positive through October. This improvement is due to less contraction in auto sales and a faster reduction in auto inventories. Moreover, electricity output surged in October, which also indicates that growth may be gaining momentum. Chart 4Trade Should Improve Into 2020 Lastly, global financial conditions have eased significantly and credit growth has picked up worldwide, which should help support global demand. Even though Sino-US trade negotiations are ongoing, our baseline view is that a “Phase One” trade deal will be inked in the next couple months. Eased trade tensions and even some rollbacks in the existing tariffs on Chinese export goods, coupled with improved global demand, should provide some tailwinds to China’s external sector (Chart 4). Q: What is your outlook on China’s economic policy for 2020? 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. Chart 5A Sign Of A Policy Shift For investors favoring China-related assets, the good news is that there has been an increasing urgency in policymakers’ tone to support economic growth since September. Capex growth from state-owned enterprises (SOEs) has increasingly outpaced the private sector, which is significant: A sustained rotation in the pace of SOE vis-à-vis private sector capex marked a turning point in the 2015-2016 cycle, when Chinese policymakers’ imperative to supporting growth outweighed their desire to continue with structural reforms (Chart 5). We do not expect a 2016-style drastic rise in SOE capex growth next year, because the current economic slowdown is not as severe or prolonged as in 2015. Nonetheless, the rotation in capex growth is an important signal that Chinese policymakers may be more willing to stimulate the economy by again allowing the state sector to upstage the private sector. In the meantime, we expect that some pro-growth “policy adjustments” will be deployed in 2020: Chart 6Infrastructure Investment Likely To Rise Monetary policy will incrementally ease, with one to two 10-15bps loan prime rate (LPR) cuts in the next 3-6 months. At the same time, China’s central bank (PBoC) will keep bank liquidity ample and commercial banks’ funding costs relatively low, by continuing frequent liquidity injections to stabilize the interbank rate. A further cut in the reserve requirement ratio (RRR) is also highly likely. Keeping banks well capitalized will partially mitigate the pressure commercial banks face from falling profit margins and rising credit defaults. Accommodative monetary conditions will also support more stimulus on the fiscal front. We expect that the National People’s Congress in March 2020 will approve higher quotas on the issuing of local government bonds. Chinese state-owned commercial banks will continue to be the main buyers for local government bonds. A portion of 2020 local government special-purpose bond issuance will be frontloaded to the remainder of 2019 and into the first months of next year. Relaxed capital requirements will likely boost local governments’ infrastructure project funding and expenditures. Our model suggests infrastructure spending should pick up from the current 3.3% year-on-year, to close to 7.5% in the second and third quarters next year (Chart 6). There are subtle signs that the government is starting to relax restrictions on the real estate sector. Land sales by local governments have increased since mid-2019, and the trend will continue into 2020 (Chart 7). Income from land sales accounts for 70% of local government revenues, thus allowing more land sales should help fund a larger local government spending budget next year. Declining government subsidies to shantytown renovation (namely the Pledged Supplementary Lending, or PSL) have recently abated and will likely continue to improve (Chart 8). Chart 7Some Improvement To Come In The Real Estate Sector Chart 8Government Subsidies Will Continue December’s Central Economic Work Conference (CEWC) will set policy priorities for the following year. We think Chinese policymakers will make economic growth a top priority for 2020. Credit growth swelled in the first quarter of 2019 following the December 2018 CEWC, and we expect a surge in early 2020 as well.Due to the unusually high credit growth in January this year and the seasonal factor next year (Chinese New Year will fall in January 2020), the surge in credit growth, on a year-over-year basis, will more likely be muted until towards the end of the first quarter and into the second quarter. Investors should overweight Chinese investable stocks in the next 6-12 months, but need to watch for more positive signs to upgrade tactical stance. Beyond the second quarter, however, the outlook gets cloudier as tension from the US election heats up and President Trump may change his trade negotiation strategies with China.1 This may have implications on China’s domestic policies. But for now, our baseline view is that Chinese policymakers will incrementally accelerate the pace of economic stimulus throughout next year. Q: Monetary policy has been accommodative for more than a year, but capex this year has fallen below market expectations compared with past cycles. How will further stimulus help to revive investment and economic growth next year? In short, our answer is this: interest rate cuts alone will not be enough to boost economic growth in China. Capex, and growth more generally, will only revive through synchronized policy support from the Chinese authorities. In a previous report2 we discussed that the lack of response to monetary easing has been due to a less effective monetary policy transmission mechanism, a reactive and reluctant central bank, and a debt-loaded corporate sector. More importantly, the “half-measured” stimulus has been preferred by Chinese authorities in this cycle, as they prioritized financial de-risking over growth and have significantly tightened financial regulations since 2016. Given the expected policy pivot to a more pro-growth stance in the coming year, the following underlines our conviction that capex should pick up in 2020. Modern Money Theory (MMT), with Chinese characteristics:3 local governments will ramp up debt again, and this quasi-fiscal stimulus will be a key support to the economy in 2020. During the 2015-2016 cycle, aggressive interest cuts did not result in a significant uptick in credit growth. Bank lending was not the core driver for economic recovery in 2016. The economy only bottomed following an unprecedented issuance of local government bonds after mid-2015 (Chart 9). Chinese authorities will keep a “back door” open: even though overall tight financial regulations will remain intact, we expect the PBoC to allow a more moderate contraction in shadow banking (Chart 10). This will provide smaller banks and enterprises access to tap into bank credit. Importantly, this means the government will acquiesce to local governments in providing extra funding through shadow banking. We already see local government financing vehicles (LGFV) making a comeback in recent months. Chart 9A Chinese Version Of MMT Chart 10The "Back Door" May Open Wider Small- and medium-sized enterprises (SMEs) will benefit from lowered financing costs through the new LPR system. As we pointed out in our previous report,4 the new LPR regime is not intended as much to expand bank credit as to help struggling SMEs survive economic hardships. This, along with tax cuts, should provide SMEs some relief from capital constraints. Q. CPI has been rising sharply and is above the government’s inflation target of 3%. Will inflation prevent the PBoC from maintaining an easy monetary policy? Chart 11PBoC Likely To Capitulate To Producer Deflation No. We think deflationary pressure in the industrial sector (measured by producer prices) poses a bigger threat to the economy, and that PBoC is more likely to loosen monetary policy than to tighten (Chart 11). Chart 12 shows that the recent surge in headline consumer prices has almost been entirely driven by soaring pork prices. There is compelling evidence from historical data that, unless core consumer price inflation also rises, climbing food prices alone will have a limited impact on PBoC policy (Chart 13). We think this approach is justified, as the necessity of “core feedthrough” is also what most central banks in the developed world look for when confronted with a detrimental supply shock. Chart 12Rising Pork Prices Have Driven Up Headline Inflation... Chart 13...But Won't Be Driving Up Interest Rates Chart 14A Wild Year For The RMB Core CPI has been trending downwards since February 2018, and there is no evidence to suggest that food prices will drive up core CPI inflation (Chart 13, bottom panel). This, in combination with deflating producer prices, means that the probability of tighter monetary policy over the coming 6-9 months is extremely low. In fact, we expect, with high conviction, that the PBOC will guide the LPR lower in the coming months. Q: What is your view on the RMB for 2020? The RMB depreciated by 5% against the US dollar from its peak in February this year, mostly driven by market expectations of US tariffs imposed on Chinese export goods. Interest rate differentials, short-term capital flows, and economic fundamentals all have played much smaller roles in the RMB’s value changes (Chart 14). The depreciation in the CNY/USD this year has pushed the RMB close to two sigma below its long-term trend (Chart 15). As we expect a “Phase One” trade deal to be signed and trade tensions abating at least in the near term, the RMB will face upward pressure through the first half of 2020. The appreciation will also be supported by, although to a lesser extent, China’s improved domestic economy, rising demand for RMB-denominated assets, and a weakening US dollar (Chart 16). According to our model, the USD/CNY exchange rate can return to a 6.8-7.0 range, if a significant portion of the existing tariffs is rolled back (Chart 17). This range seems to be within the “fair value” of the RMB, justifiable by the current China-US interest rate differential (Chart 14, bottom panel). Chart 15Has The RMB Gone Too Far? Chart 16Demand For RMB Assets On The Rise, Despite The Trade War However, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors. The large differential in the China-US interest rates would allow PBoC to cut interest and/or RRR rates, to ease upward pressure on the RMB. Chart 17Tariff Rollbacks Will Push Up RMB Q: How should equity investors position themselves towards China over the coming year? We are bullish on Chinese investable stocks in the next 6 to 12 months, based on our view that the Chinese economy will bottom in the first quarter next year, policy will be incrementally more supportive, and a “Phase One” trade deal will be signed soon. In the very near term, however, we think downside risks to Chinese equities are not trivial. We remain a neutral tactical stance, but will continue to watch for the following signs before upgrading our tactical call from neutral to overweight.5 Chart 18A (top panel) shows that cyclical stocks remain very depressed relative to defensives, underscoring investors’ lack of confidence in the Chinese economy and trade negotiations. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards Chinese economic growth. An uptick in the relative performance of industrials and consumer staples (Chart 18A, bottom panel). The negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance between the two sectors may be a reflationary barometer for China’s economy. The relative performance trend remains off its recent low, which suggests that China’s existing policy stance has not yet turned more reflationary. A technical breakdown in the relative performance of healthcare and utility stocks (Chart 18B) would also be a bullish sign. Investable health care and utilities stocks have historically led China’s economic activity, core inflation and stock prices by 1-3 months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a bottom in China’s economy. As we mentioned at the outset, we observed an interesting divergence in sentiment among our domestic versus global investors. This divergence is reflected in both the onshore and offshore stock markets; year to date, onshore A shares have outperformed global benchmarks by 5.6% (Chart 1, on page 1 of the report). Chart 18AWaiting For A Telltale Sign... Chart 18B...Before A Tactical Upgrade However, all of the outperformance in A shares occurred before end April, when the trade talks broke down and domestic credit expansion significantly slowed from the first quarter. Since May, the relative performance of A shares in US dollar terms has been mostly flat, reflecting the fact the markets were not expecting a significant stimulus forthcoming. Chinese investable stocks, on the other hand, have been trading heavily on the day-to-day news surrounding the trade negotiations and have significantly underperformed both domestic A shares and global benchmarks. Therefore, our base case view of a trade truce coupled with an improved Chinese economy and more supportive policy near year, warrant a cyclical overweight stance favoring Chinese investable stocks over their domestic peers. Earnings from both onshore and offshore markets will benefit from a modest improvement in economic activity, but we think the investable market will benefit more from the trade truce and more upside growth potential. Stay tuned. Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see Geopolitical Strategy Special Report, "Is China Afraid Of The Big Bad Warren?" dated October 25, 2019, available at gps.bcaresearch.com 2Please see China Investment Strategy Weekly Report, " Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10 2019, available at cis.bcaresearch.com 3We call it a “MMT” because China’s state-owned commercial banks own approximately 80% of local government bonds. The commercial banks are essentially backed by China’s central bank, which has a fiat currency system and can make independent monetary policy decisions. 4Please see China Investment Strategy Weekly Report, "Mild Deflation Means Timid Easing," dated October 9, 2019, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report, "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
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