Economy

Special Report

In lieu of the next weekly report I will be presenting the quarterly webcast ‘What Are The Most Attractive Investments In Europe?’ on Monday 17 February at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Dhaval Joshi Feature The recent coronavirus scare seems to have added a fresh deflationary impulse into the world economy, at a time that central banks are already struggling to achieve and maintain inflation at the 2 percent target. Begging the question: will central banks’ ubiquitous ultra-loose monetary policy ever generate inflation? The answer is yes, but not necessarily where the central banks desire it. Universal QE, zero interest rate policy (ZIRP), and negative interest rate policy (NIRP) have already created rampant inflation. The trouble is that it is in the wrong place. Rather than showing up in consumer price indexes it is showing up in sky-rocketing asset prices. Feature Chart Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Feature ChartUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Since 2014, ultra-loose monetary policy has boosted the valuation of equities by 50 percent. But that’s the small fry. The really big story is that ultra-loose monetary policy has boosted the value of the world’s real estate from $180 trillion to $300 trillion (Chart I-2).1 Chart I-2Ultra-Low Bond Yields Have Boosted The Value Of The World’s Real Estate By $120 Trillion Just pause for a moment to digest those numbers. In the space of a few years the value of the world’s real estate has surged by $120 trillion, equivalent to one and half times the world’s $80 trillion GDP. Moreover, it is a broad-based boom encompassing not just Europe, but North America and Asia too. Now add in the surge in equity prices, as well as other risk-assets such as private equity, corporate bonds and EM debt and the rise in wealth conservatively equals at least two times world GDP. To the best of our knowledge, there is no other time in economic history that asset prices have risen so broadly and by so much as a multiple of world GDP in such a short space of time. Making this the greatest asset-price inflation of all time. Yet central banks seem unmoved. To add insult to injury, Europe’s central banks do not even include surging owner-occupied housing costs in their consumer price indexes. This seems absurd given that the costs of maintaining owner-occupied housing is one of the largest costs that European households face. Europe’s central banks do not include surging owner-occupied housing costs in their consumer price indexes. Including owner-occupied housing costs would lift European inflation closer to 2 percent, eliminating the need for QE and negative interest rates. But its omission has kept measured inflation artificially low (Chart I-3), forcing European central banks to double down on their ultra-loose policies. Which in turn lifts risk-asset prices even further, and so the cycle of asset-price inflation continues. Chart I-3Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy European QE has spawned other major imbalances. Germany, as the largest shareholder of the ECB, now owns hundreds of billions of ‘Italian euro’ BTPs that the ECB has bought. But given the fragility of Italian banks, the Italians who sold their BTPs to the ECB deposited the cash they received in German banks. Hence, Italy now owns hundreds of billions of ‘German euro’ bank deposits. This mismatch between Germans owning Italian euro assets and Italians owning German euro assets combined with other mismatches across the euro area constitutes the Target2 banking imbalance, which now stands at a record €1.5 trillion. It means that, were the euro to ever break up, the biggest casualty would be Germany (Chart I-4). Chart I-4ECB QE Has Taken The Target2 Banking Imbalance To An All-Time High Meanwhile, the US Federal Reserve, to its credit, does include surging owner-occupied housing costs in its measure of consumer prices. As a result, US inflation has been closer to the 2 percent target enabling the Fed to tighten policy when the ECB had to loosen policy. This huge divergence between euro area and US monetary policies, stemming from different treatments of owner-occupied housing costs, has depressed the euro/dollar exchange rate and thereby spawned yet another major imbalance: the euro area/US bilateral trade surplus which now stands at an all-time high. Providing President Trump with the perfect pretext to start a trade war with Europe, should he desire (Chart I-5).  Chart I-5ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High What Caused The Greatest Asset-Price Inflation Of All Time? Why did the past decade witness the greatest asset-price inflation of all time? The answer is that universal QE, ZIRP, and NIRP took bond yields to the twilight zone of the lower bound (Chart I-6). At which point, the valuation of all risky assets undergoes an exponential surge. Chart I-6The Past Decade Was The Decade Of Universal QE Understand that when bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered last year, prices can no longer rise much in a rally, but they can collapse in a sell-off (Chart I-7). Chart I-7At Low Bond Yields, Bonds Become Much Riskier The upshot is that all (long-duration) assets become equally risky, and the much higher prospective returns offered on formerly more risky assets – such as real estate and equities – collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, this means that the valuation of risk assets undergoes an exponential surge. When bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic.  An obvious question is: which valuation measure best predicts this depressed prospective return offered on equities? Most people gravitate to price to earnings (profits), but earnings are highly problematic – because even if you cyclically adjust them, they take no account of structurally high profit margins. The trouble is that earnings will face a headwind when profit margins normalise, depressing prospective returns. For this reason, price to earnings missed the valuation extreme of the 2007/2008 credit bubble and should be treated with extreme caution as a predictor of prospective returns (Chart I-8). Chart I-8Price To Earnings Missed The 2007/2008 Valuation Extreme A much more credible assessment comes from price to sales – or equivalently, market cap to GDP at a global level (Chart I-9). This is because sales are quantifiable, unambiguous, and undistorted by profit margins. Using these more credible prospective returns, we can now show that the theory of what should happen to risk-asset returns (and valuations) at ultra-low bond yields and the practice of what has actually happened agree almost perfectly (Feature Chart). Chart I-9Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Some Investment Conclusions It is instinctive for investors to focus first and foremost on the outlook for the real economy. After all, the evolution of the $80 trillion global economy drives company sales and profits. But the value of the world’s real estate, at $300 trillion, dwarfs the economy. Public and private equity adds another $100 trillion, while other risk-assets such as corporate bonds and EM debt add at least another $50 trillion. So even on conservative assumptions, risk-assets are worth $450 trillion – an order of magnitude larger than the world economy. Now combine this with the overwhelming evidence that risk-asset valuations are exponentially sensitive to ultra-low bond yields. A relatively modest rise in yields that knocked 20 percent off risk-asset valuations would mean a $90 trillion loss in global wealth. Even a 10 percent decline would equate to a $45 trillion drawdown. Could the $80 trillion economy sail through such declines in wealth? No way. Such setbacks would constitute a severe deflationary headwind, and likely trigger the next recession. Hence, though equities are preferable to bonds at current levels, a 50-100 bps rise in yields – were it to happen – would be a great opportunity to add to bonds. Meanwhile, the record high Target2 euro area banking imbalance means that the biggest casualty of the euro’s disintegration would not be Italy. It would be Germany. As all parties have no interest in such a mutually assured destruction, investors should go long high-yielding versus low-yielding euro area sovereign bonds. Finally, the record high euro area/US trade surplus is a political constraint to a much weaker euro versus the dollar. In any case, the ECB is close to the practical limit of monetary policy easing, while the Fed is not. Long-term bond investors should prefer US T-bonds versus German bunds or Swiss bonds. Long-term currency investors should prefer the euro versus the dollar. Fractal Trading System*  This week’s recommended trade is long EUR/CHF. As this currency cross has relatively low volatility, the profit target and symmetrical stop-loss is set at a modest 1 percent. In other trades, short NZD/JPY achieved its profit target, while long US oil and gas versus telecom reached the end of its 65-day holding period in partial loss having reached neither its profit target nor its stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-10EUR/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills World Research. The last data point is $281 trillion at the end of 2017, but we conservatively estimate that the value has increased to above $300 trillion in the subsequent two years. Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Malaysian businesses and households have been deleveraging and the economy risks entering a debt deflation spiral. This macro-backdrop is bond bullish. EM fixed income-dedicated investors should keep an overweight position in both local currency and US dollar government bonds. In Peru, the central bank does not want its currency to depreciate rapidly; it will therefore defend the sol at the cost of slower economic growth. The outperformance of the Peruvian sol heralds an overweight stance in domestic and US dollar government bonds versus EM peers. Malaysia: In Deleveraging Mode Malaysian businesses and households have been deleveraging. The top panel of Chart I-1 illustrates that commercial banks’ domestic claims on the private sector – both companies and households – relative to nominal GDP have been flat to down in recent years. This measure is produced by the central bank and includes both bank loans as well as securities held by banks (Chart I-1, bottom panel). It does not include borrowing from non-banks or external borrowing. Other measures of indebtedness from the Bank of International Settlements (BIS) – which includes non-bank credit as well as foreign currency borrowing – portend similar dynamics: Household and corporate debt seem to have topped out as a share of GDP (Chart I-2). Chart I-1Malaysian Banks' Claims On The Private Sector Have Rolled Over Chart I-2Malaysia's Business And Household Total Leverage Has Peaked   Chart I-3Malaysia: The GDP Deflator Is About To Turn Negative The message is that after years of an unrelenting credit boom, households’ and companies’ appetite for new borrowing has diminished, and at the same time, creditors have become less willing to finance them.  At 136% of GDP, the combined total of household and company debt is non-trivial. If deleveraging among debtors intensifies, the economy risks entering a debt deflation spiral. To prevent such an ominous outcome, aggressive central bank rate cuts, sizable fiscal stimulus, some currency devaluation or a combination of all of the above is required. Not only is real growth very sluggish in Malaysia, but deflationary pressures are intensifying. Chart I-3 shows the GDP deflator is flirting with contraction. Moreover, headline and core consumer price inflation are both weak, while trimmed-mean inflation is at 1.1% (Chart I-4). Last year's spike in consumer inflation was due to low base effects from the abolishment of the country’s goods and services tax back in June 2018. Going forward, these base effects will dissipate, making deflation in consumer prices a likely threat. If prices or wages begin deflating, the highly-indebted Malaysian economy will fall into debt deflation. The latter is a phenomenon that occurs when falling level of prices and wages cause the real value of debt to rise. In such a case, demand for credit will plummet and banks could become unwilling to lend. A vicious cycle of further falling prices, income and credit retrenchment could grip the economy. Household and corporate debt seem to have topped out as a share of GDP. Nominal GDP growth has already dropped slightly below average lending rates (Chart I-5). When such a phenomenon occurs amid elevated debt levels, it can produce a lethal cocktail – namely, the debt-servicing ability of borrowers deteriorates, causing both demand for credit to evaporate and non-performing loans (NPLs) to rise. Chart I-4Malaysia: Consumer Price Inflation Is Very Low Chart I-5Malaysia: Nominal GDP Growth Dipped Below Lending Rates   Critically, falling inflation has caused real borrowing costs to rise. Lending rates in real terms are elevated, from a historical perspective (Chart I-6, top panel).1 Not surprisingly, loan growth has been decelerating sharply, posting a 13-year low (Chart I-6, bottom panel). Even though government expenditure growth has been accelerating over the past year or so and the central bank has cut interest rates twice in the past 8 months, economic conditions remain extremely feeble: Consumer spending has been teetering. Chart I-7 shows that retail sales are dwindling in nominal terms and have plummeted in volume terms. Chart I-6Malaysia: Real Lending Rates Have Risen & Credit Has Slowed Chart I-7Malaysia: Consumer Spending Is Teetering   Malaysian exports – which account for a 67% share of the economy – are still contracting 2.5% from a year ago, adding an additional unwelcome layer of deflation to the Malaysian economy. After years of travails, the property sector is not yet out of the woods. Residential property unit sales remain sluggish (Chart I-8, top panel). In turn, the number of unsold residential properties remains elevated and residential construction approvals are rolling over at lower levels (Chart I-8, second & third panels). As a result, residential property prices are beginning to deflate across various segments in nominal terms (Chart I-8, bottom panel). Listed companies’ earnings-per-share (EPS) in local currency terms are contracting (Chart I-9, top panel). Chart I-8Malaysia's Residential Property Market Is Struggling Chart I-9Malaysia: Capital Spending Is Contracting Chart I-10Malaysia: Weak Employment Outlook All of these ominous trends have induced Malaysian businesses to cut capital spending. The bottom three panels of Chart I-9 illustrate that real gross capital goods formation, capital goods imports and commercial vehicles units sales are all contracting. Equally important, the business sector slowdown is weighing on the employment outlook (Chart I-10). This will trigger a negative feedback loop of falling household income and spending. Bottom Line: Only by bringing borrowing costs down considerably for households and businesses and introducing large fiscal stimulus measures, can the Malaysian authorities prevent the economy from slipping into a vicious debt deflation spiral. On the fiscal front, the Malaysian government is committed to reducing its overall fiscal deficit from 3.4% to 3.2% of GDP this year, further consolidating it to 2.8% of GDP by 2021. Importantly, the government is also adamant about lowering its total public debt-to-GDP ratio from 77% to below 50% in the medium term by ridding itself of the outstanding legacy liabilities and guarantees incurred by the previous government. This leaves monetary policy and some currency depreciation as the likely levers to reflate the economy. Investment Recommendations We continue to recommend EM fixed -income dedicated investors keep an overweight position in local currency bonds within an EM local currency bonds portfolio. Malaysia’s macro-backdrop is bond bullish, and the central bank will cut its policy rate further. Consumer spending has been teetering. Consistent with further rate cut expectations, we also recommend continuing to receive 2-year swap rates. We initiated this trade on October 31, 2019, and it has so far produced a profit of 29 basis points. Furthermore, fiscal discipline and the government’s resolve to reduce public debt and government liabilities as a share of GDP will help Malaysian sovereign credit – US dollar-denominated government bonds – outperform their EM peers. Chart I-11The Malaysian Ringgit Is Cheap We recommend keeping a neutral allocation to Malaysian equities within an EM equity dedicated portfolio. In terms of the outlook for the currency, ongoing deflationary pressures are bearish for the MYR in the short-term. The basis is that the Malaysian economy needs a cheaper ringgit in order to help reflate the economy and boost exports. However, the Malaysian currency will sell off less than other EM currencies: First, foreign ownership of local bonds has declined from 36% in 2016-17 to 23% today. Likewise, foreign equity portfolios own about 31% of the stock market, which is less than in many other EMs. This has occurred because foreigners have been major net sellers of Malaysian equities. Overall, low foreign ownership of Malaysian financial assets reduces the risk of sudden portfolio outflows in case EM investors pull out en masse. Second, the current account balance is in surplus and will provide support for the Malaysian ringgit. Malaysia has become less reliant on commodities exports and more of a semiconductor exporter. We are less negative on the latter sector than on resources prices. Third, the currency is cheap, according to the real effective exchange rate, making further downside limited (Chart I-11). Finally, the ongoing purge in the Malaysian economy – deleveraging and deflation – is ultimately long-term bullish for the currency. Deflation brings down the cost structure of the economy and precludes the need for chronic currency depreciation in order to keep the economy competitive. All things considered, the risk-reward profile for shorting the MYR is no longer appealing. We are therefore closing this trade as of today. It has produced a 4% loss since its initiation on July 20, 2016.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Peru: A Pending Policy Dilemma Investors in Peruvian financial markets are presently facing three challenging macro issues: Will the currency appreciate or depreciate? If it depreciates, will the central bank cut or hike interest rates? If policy rates drop or rise, will bank stocks rally or sell off? Chart II-1Peru: Slow Money Growth Heralds Lower Inflation Looking forward, the central bank (also known as the BCRP) is facing a dilemma. On one hand, inflation is low and will likely drop toward the lower end of the central bank’s target band, as portrayed by narrow money (M1) growth (Chart II-1). Weak domestic demand and low and falling inflation – combined – justify additional rate cuts. On the other hand, the Peruvian currency – like most EM currencies – will likely depreciate versus the US dollar in the coming months, if our baseline view – that foreign capital will flow out of EM and industrial metals prices will drop further for a few months – transpires. In such a case, will the BCRP cut rates – i.e., will the monetary authorities choose to target the exchange rate, or inflation? If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the contrary, the BCRP will likely prioritize defending the nuevo sol by selling foreign currency reserves, as it has done in the past. This in turn will shrink banking system local currency liquidity and lift interbank rates (Chart II-2). Higher interbank rates will hurt the real economy as well as bank share prices. Chart II-2Peru: Selling BCRP FX Reserves Will Shrink Banking System Liquidity Is Peru more leveraged to precious or industrial metals? Precious and industrial metals account for 17% and 40% of Peruvian exports, respectively. Hence, falling industrial metals prices will be sufficient to exert meaningful depreciation on the sol, despite high precious metals prices. Foreign investors own about 50% of both Peruvian stocks and local currency bonds. Even if a fraction of these foreign holdings flees, the exchange rate will come under significant downward pressure.  Granted that Peru’s central bank does not want its currency to depreciate rapidly, it will defend the currency at the cost of the economy. All in all, the Impossible Trinity thesis is alive and well in Peru: In an economy with an open capital account, the central bank cannot target both interest rates and the exchange rate simultaneously. If the BCRP intends to achieve exchange rate stability, it needs to tolerate interest rate fluctuations. Specifically, interbank rates and other market-determined interest rates could diverge from policy rates. From a real economy perspective, it is optimal to target interest rates and allow the exchange rate to fluctuate. However, the Peruvian economy is still dollarized, albeit much less than before. Dollarization has been a motive to sustain exchange rate stability. If the Peruvian central bank follows its own historical footsteps, it will not cut rates, despite economic weakness and falling inflation. On the whole, Peru’s monetary authorities remain very mindful of exchange rate volatility. Odds are that they will sacrifice growth to avoid sharp currency fluctuations. This has ramifications for financial markets. The Peruvian sol will depreciate much less than other EM and Latin American currencies. This is why it is not in our basket of currency shorts. The central bank will not cut rates in the near term, even though the economy is weak and inflation is low. This is negative for the cyclical economic outlook. Growth will stumble further and non-performing loans (NPLs) in the banking system will rise. NPL growth (inverted) correlates with bank share prices (Chart II-3). Notably, the business cycle is already weak, as illustrated in Chart II-4. Higher interest rates and lower industrial metals prices will weigh further on the economy. Chart II-3Peru: Rising NPLs Will Depress Banks Share Prices Chart II-4Peru: The Economy Is Weak   Remarkably, local currency private sector loan growth has moderated, despite the 140 basis points decline in interbank rates over the past 12 months (Chart II-5). This indicates that either interest rates are too high, or banks are reluctant to originate more loans – or a combination of both. Whatever the reason, bank loan growth will decelerate further if interest rates do not drop. Investment Recommendations The Peruvian stock market has underperformed the aggregate EM index over the past five months (Chart II-6, top panel). This underperformance has not only been due to this bourse’s large weight in mining stocks but also because of banks’ underperformance (Chart II-6, bottom panel). Chart II-5Peru: Higher Rates Will Hinder Credit Growth Chart II-6Peruvian Equities Have Been Underperforming   Remarkably, bank shares have languished in absolute terms, even though their funding costs – interbank rates – have dropped significantly (Chart II-7). This is a definitive departure from their past relationship. Chart II-7Peruvian Bank Stocks Stagnated Despite Falling Interest Rates As interbank rates rise marginally, bank share prices will be at risk of selling off. This in tandem with lower industrial metals prices warrants a cautious stance on this bourse’s absolute performance. Relative to the EM benchmark, we remain neutral on Peruvian equities. The Peruvian sol will depreciate less than many other EM currencies, which will help the stock market’s relative performance versus the EM benchmark. Currency outperformance heralds an overweight stance in domestic bonds within the EM local currency bond portfolio. Dedicated EM credit portfolios should overweight Peruvian sovereign and corporate credit as well. The key attraction is that Peru’s debt levels are low, which will make its credit market a low-beta defensive one in the event of a sell off.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Juan Egaña Research Associate juane@bcaresearch.com Footnotes 1 Deflated by the average of (1) the GDP deflator, (2) core consumer price inflation, and (3) 25% trimmed-mean consumer price inflation.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear clients, Over the next couple of weeks, we will be further analyzing China’s coronavirus outbreak, its economic impact, and the likely policy response, as well as the attendant investment recommendations. We will also examine any sector-related or regional themes that stem from the outbreak. Stay tuned. Jing Sima, China Strategist Highlights The peak in the number of new cases outside of the crisis epicenter will be more market-relevant than the total number of infections. New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February. It will take longer for the service sector to recover, implying a larger hit to the economy compared with the SARS episode given that services have grown in importance. This will force Chinese policymakers to set their financial deleveraging agenda aside for the rest of the calendar year. We maintain an overweight stance on Chinese stocks both tactically and cyclically, based on our view that the outbreak will soon be contained outside of Hubei province and that China’s budding economic recovery will be delayed, but not prevented, by the crisis. Feature The coronavirus (2019-nCoV) outbreak in China has sparked a selloff in risk assets around the globe. China’s A-share equity market, after an extended Chinese New Year market closure, was in a free fall when it reopened on February 3. In the offshore market, the MSCI China Index has declined by 9% from its most recent high on January 13, 2020 (Chart 1).  When attempting to forecast a turning point in bearish investor sentiment stemming from the outbreak, it is important to note that during the 2003 SARS epidemic, both global and Chinese equity markets rebounded when the number of new cases peaked in Hong Kong SAR and globally (Chart 2).  Chart 1Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chart 2Markets Bottomed As Total SARS Infections Peaked We maintain our long stance both tactically and cyclically on Chinese stocks, based on the following assessments: In the next three months, the panic brought on by 2019-nCoV will abate before the total number of new cases peaks, as investors focus on the turning point in the outbreak outside of the epicenter (Hubei province). Beyond the next three months, the outbreak will likely delay China’s economic recovery. However, this means that Chinese policymakers will not likely reduce the scale of their stimulative efforts this year. The Market Correction May Be Short-Lived Since the onset of the 2019-nCoV outbreak, many studies have attempted to predict the speed and magnitude of the spread of the virus. Using a mathematical model called Susceptible-Exposed-Infected-Recovered (SEIR), The Lancet,1 The University of Hong Kong,2 and Johns Hopkins CSSE3 all drew a conclusion that a peak in the current episode is likely to occur between late April and early May. The number of cases outside of the crisis epicenter will likely drive financial market sentiment. While we think this conclusion may be true for the total number of new cases, the total count will be less relevant to investors during this episode than during the 2003 SARS outbreak. Instead, it will be more useful to break down the total infection count into two sets of data: the number of new cases within the city of Wuhan and Hubei Province (the epicenter of the outbreak), and the number of new cases outside of Hubei. The latter is more likely to be the primary driver of short-term outbreak-related market sentiment. While Hubei is experiencing an acceleration in the daily rate of new cases, the number of new cases across the rest of China seems to be flattening off of late (Chart 3). We think that the number of cases outside of Hubei will peak earlier than within the epicenter. This is in contrast to the 2003 SARS outbreak when the peak of new cases in the rest of China and globally lagged the epicenter Hong Kong SAR by a month (Chart 4). Chart 3Number Of 2019-nCoV New Cases Flattening Outside The Epicenter Chart 4SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter There are two reasons for the difference between the 2003 SARS peak and projections for the 2019-nCoV outbreak: Timely cutoff of virus mobility outside of epicenter: The world responded quickly to contain the virus. During the 2003 SARS episode, Chinese authorities responded with protective measures only after the outbreak had already peaked in the epicenter. This time the Chinese government intervened at an early stage of the outbreak with forceful and in some cases extreme actions, including a near-complete lockdown of Wuhan (the crisis epicenter) and restrictions on inter- and intra-city traffic in other major metropolitan areas. Foreign governments in North America, Europe, and Southeast Asia took unprecedented measures to ban or limit air traffic to/from China. Furthermore, with timely and sufficient medical care, the fatality rate outside of the epicenter has been much lower4 – a significantly underreported fact. Mishandling of the crisis within the epicenter: Within Hubei province, particularly the city of Wuhan where the virus originated, the number of infections will likely continue climbing in the next two to even three months. The abovementioned studies suggest the number of cases in the epicenter is five to seven times higher than the official count. Local hospitals are experiencing severe shortages of medical supplies, meaning that people with mild-to-medium symptoms have reportedly been turned away. These patients are not included in the official statistics as confirmed or suspect cases. The discrepancy in reporting means these cases will be confirmed and recorded at a much later date. Without quarantine and treatment, these patients may continue to transmit the virus to others within the epicenter. This will have a tragic human cost, but it will hold few consequences for financial markets. The corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Bottom Line: Market sentiment will rebound following the peak in new 2019-nCoV cases outside the epicenter of Wuhan/Hubei. We think the peak may come as early as mid to late-February, which suggests the corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Economic Recovery In Sight Beyond the near-term, our view on China’s likely policy response and the economy’s fundamentals support a positive outlook for Chinese stocks over the next 6 to 12 months. In absolute dollar terms, the scale of the economic impact from the 2019-nCoV outbreak will likely be larger than the SARS episode in 2003. Unlike with SARS, when disruptions were mild and limited to the travel and retail sectors, the extreme measures China took in response to the coronavirus outbreak have essentially placed Chinese economic activity on hold. Chart 5Service Sector Now A Larger Part Of China's Economy Compared With 2003 China’s service sector is also likely to be more affected than manufacturing, because the outbreak coincided with the Chinese New Year holiday when services are normally in high demand. In addition, the service sector accounts for a much larger share of the Chinese economy than in 2003 (Chart 5). Therefore, the reduction in services output will have a comparatively bigger economic impact. However, as we think the 2019-nCoV outbreak outside of the epicenter will likely peak in February, the majority of nationwide manufacturing activity should resume no later than the last week of February. Chinese authorities have already signaled they will speed up government-led infrastructure investment as early as March. Chart 6Service Sector Took Longer To Recover After SARS Outbreak The service sector will take longer to recover. Following the 2003 SARS outbreak, the recovery in the service sector lagged the manufacturing and primary sectors by one quarter (Chart 6). This will likely delay the bottoming of the aggregate Chinese economy. We project a bottom in China’s economy towards the end of the second quarter of 2020. A delay in economic recovery will force Chinese policymakers to put aside their financial deleveraging agenda, and focus on economic growth for the year. 2020 marks the final year for policymakers to accomplish their goal to double GDP from 2010. This means policymakers will likely augment the amount of stimulus in order to stabilize the economy and avoid falling short of their growth target. Bottom Line: Business activities should resume in late February, with a bottoming in the economy towards the end of the second quarter of 2020. Monetary Support Already Lining Up The Chinese economy is on a structurally slowing trend, but is in an early stage of cyclically recovering from last year (Chart 7). This is in contrast with 2003 during the SARS outbreak when China’s economic growth was structurally accelerating, but the monetary environment was in a tightening cycle and industrial profit growth was downshifting (Chart 8). Chart 7Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chart 8...And Is In An Expansionary Monetary Cycle   As the performance of Chinese onshore stocks reflects domestic policy, Chinese A-shares, after briefly rebounded when the 2003 SARS outbreak peaked, underperformed the global benchmark during much of the 2004-2006 period when monetary policy tightened (Chart 9). Contrasting with 2003, we expect the PBoC to maintain a more accommodative monetary stance throughout 2020 (Chart 10): the PBoC cut the open market operation interest rates by 10bps on February 3. We expect this move to lead to a 5bps LPR and MLF rate cut in March. Moreover, the chance that the PBoC will cut the bank reserve requirement ratio (RRR) in Q2 is also increasing. Chart 9Chinese Onshore Equity Market Largely Driven By Domestic Policy Chart 10Easy Monetary Stance Is Here To Stay Bottom Line: Monetary policy will become more accommodative this year. Investment Conclusions Chinese stocks just went on sale, but the sale likely will not last long. Chart 11Chinese Stocks Are Priced At An Even Deeper Discount Over the next 0-3 months, Chinese equities will likely rebound as soon as the peak in the number of new cases outside of Wuhan/Hubei occurs. We believe the peak will happen within the next two weeks, and manufacturing activities in the majority of Chinese cities will resume following the peak in the outbreak. Depressed valuations in Chinese stocks compared with the global benchmark and the expectation of a rebound in Chinese economic activity should provide a good buying opportunity for global investors (Chart 11). In short, Chinese stocks just went on sale, but the sale likely won’t last long. Over a cyclical time horizon, we had previously predicted that China’s authorities may reduce the scale of the stimulus in the second half of this year as the economy starts to recover in Q1. The 2019-nCoV outbreak will alter the leadership’s policy trajectory and extend pro-growth support through 2020, and both the central and regional governments have announced a slew of policies in supporting businesses, particularly for the private sector. Our expectation that the viral outbreak will not derail China’s economic recovery suggests that corporate earnings will also rebound over a 6-12 month time horizon. One risk that we will be monitoring over the coming several months is the potential for firm- or sector-specific effects on earnings. The nationwide city lockdowns are certain to reduce or halt the flow of cash to businesses, and it is unclear whether this will have any disproportionate effects on corporate earnings relative to what we expect will occur for the economy beyond Q1. However, for now, our assumption is that the trend in earnings growth is likely to match that of the economy more generally unless evidence to the contrary presents itself. This supports an overweight position in Chinese stocks compared with their global peers over the coming 6-12 months.   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1    “Nowcasting and forecasting the potential domestic and international spread of the 2019-nCoV outbreak originating in Wuhan, China: a modelling study”, The Lancet, January 31, 2020. 2   “Real-time nowcast on the likely extent of the Wuhan coronavirus outbreak, and forecasts domestic and international spread”, Hong Kong University, January 27, 2020 3   “Modeling the Spreading Risk of 2019-nCoV”, John Hopkins Center For Systems Science And Engineering, January 31, 2020. 4   As of February 3, 2020, the fatality rate of 2019-nCoV outside of Hubei stands at 0.2%, compared with a 3% fatality rate in Hubei province and 5.5% in Wuhan, according to the World Health Organization (WHO). Cyclical Investment Stance Equity Sector Recommendations