Geopolitics
Highlights Evidence continues to mount that the Chinese economy is in a bottoming process. This suggests the path of least resistance for the RMB is up. Meanwhile, as the U.S. and China move closer to a trade deal, any geopolitical risk premium in the RMB will slowly erode. The ultimate catalyst for CNY longs will be depreciation in the U.S. dollar, which we believe is slowly underway. The ECB is turning more dovish at a time when euro area growth is hitting a nadir. This will be bullish for the euro beyond the near term. Our limit buy on the pound was triggered at 1.30. Target 1.45 with stops at 1.25. With the Aussie dollar close to the epicenter of Chinese stimulus, data down under is increasingly stabilizing. We are closing our short AUD/NOK position for a small profit. Feature Chart I-1The Chinese Yuan Is Pro-cyclical In addition to the dovish shift by global central banks, most investors are rightly fixated on China at this juncture in the economic cycle. For one, it has been mostly responsible for the mini cycles in the global economy since 2014. And with improvements in both Chinese credit and manufacturing data in recent months, the consensus is drawing closer to the fact that we may be entering a reflationary window. Looking at risk assets, MSCI China is up 25% from its lows, while the S&P 500 is up 20%. Commodity prices are also rising, with crude oil hitting a new calendar-year high this week. The corollary is that if the improvement in Chinese data proves sustainable, it will propel these asset markets to fresh highs. The evolution of the cycle has important implications for the yuan exchange rate, because the RMB has been trading like a pro-cyclical currency in recent years. The USD/CNY has been moving tick for tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-1). Ever since its liberalization over a decade ago, the RMB may finally be behaving like a free-floating exchange rate. Therefore, a simple evaluation of how relative prices between China and the rest of the world evolve will be valuable input for the fair value of the RMB exchange rate. Reading the tea leaves from Chinese credit data can be daunting, but we agree with the assessment of our China Investment Strategy team that while the credit impulse has clearly bottomed,1 the magnitude of the rise is unlikely to be what we saw in 2015-2016. That said, a higher credit-to-GDP ratio also requires a smaller increase in credit growth to have an outsized effect on GDP. As such, monitoring what is happening with hard data in the economy concurrently – in particular, green shoots – could add valuable evidence to the reflation theme. A Repeat Of 2016? Cycle bottoms can be protracted and volatile, but also V-shaped. So it is useful when economic data is at a nadir to pay attention to any green shoots emerging, because by the time the last piece of pertinent economic data has turned around, it may well be too late to call the cycle. Admittedly, most measures of Chinese (and global) growth remain weak. But there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. Overall industrial production remains weak, but the production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production (Chart I-2). Electricity production for the month of February grew 5% after grinding to a halt in 2015-2016. Production of steel also rose by 7%. If these advance any further, they will begin to exceed Q4 GDP growth, indicating a renewed mini-cycle. Chart I-2A Revival In Industrial Activity Chart I-3Metal Prices Are Sniffing A Rebound In recent weeks, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role (Chart I-3). Overall residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signalling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales has tended to be in sync across city tiers. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China may be sniffing an eventual pick-up in property volumes (Chart I-4). Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months. Government expenditures were already inflecting higher ahead of last month’s China National People’s Congress (NPC). Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-5). In addition to the recent VAT cut for manufacturing firms from 16% to 13%, a string of policy easing measures will begin to accrue, including a cut to social security contributions effective May 1st, and perhaps a pickup in infrastructure spending. Already, real estate infrastructure spending growth is perking up, with that in the mining sector soaring to multi-year highs. Chart I-4Real Estate Volumes Could Pick Up Chart I-5The Fiscal Spigots Are Opening Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufactures cutting retail prices. Chart I-6Car Sales Typically Have V-Shaped Recoveries Over the last 20 years or so, Chinese credit growth has been a reliable indicator for car sales with a lead of about six months (Chart I-6). The indicator right now suggests we could witness a coiled-spring rebound in Chinese car sales over the next few months. Bottom Line: Both Chinese stocks and commodity prices have been suggesting a bottoming process in the domestic economy for a while now. Incoming data is beginning to corroborate this view. This has important implications for both the Chinese yuan and other global assets. Capital Flows Improving domestic and external conditions will likely offset any renewed pressure on the Chinese yuan from capital outflows. Our China Investment Strategy team reckons that even after adjusting for cross-border RMB settlements and illicit capital outflows, there is less evidence of capital flight today than there was in 2015-2016.2 Chart I-7Offshore Markets Don't See RMB Weakness Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, no such depreciation is being priced in (Chart I-7). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. For example, one of the often-rumored ways Chinese money has left the country is through junkets, key operators in Macau casinos.3 These junkets bankroll their Chinese clients in Macau while collecting any debts in China allowing for illicit capital outflows. This was particularly rampant ahead of the Chinese 2015-2016 corruption clampdown, when Macau casino equities were surging while equity prices in China remained subdued. Historically, both equity markets tend to move together, since over 70% of visitors to Macau come from China (Chart I-8). Right now, both the Chinese MSCI index and Macau casino stocks are rising in tandem, suggesting gains are more related to fundamentals than hot money outflows. Chart I-8Macau Casinos: A Good Proxy For Chinese Spending A surge in illicit capital outflows could also be part of the reason for an explosion in sight deposits in Hong Kong ahead of the 2015-2016 clampdown (Chart I-9). Admittedly, most of these deposits were and still are due to cross-border RMB settlements, but it is also possible that part of these constituted hot money outflows. With these sight deposits rising at a more reasonable pace, it suggests little evidence of capital flight. Chart I-9The Chinese Government Has Clamped Down On Illicit Flows Trade Truce A trade truce between the U.S. and China will be the final catalyst for a stronger yuan. The news flow so far has been positive, with both U.S. President Donald Trump and Chinese President Xi Jinping publicly acknowledging they are closer to a deal. Even well-known China hawk Peter Navarro, head of the U.S. National Trade Council, has admitted that the two sides are in the final stages of talks. But with a still-ballooning U.S. trade deficit with China, Trump will want to take home a win (Chart I-10). Chart I-10Trump Needs To Take A Win Back To America Concessions on the Chinese side so far seem reasonable, allowing us to speculate that there is a rising probability of a deal. They have agreed to increase agriculture and energy imports from the U.S. by about $1 trillion over the next six years, announced a cut on import tariffs, revised their Patent Law to improve protection of intellectual property, and provided a clear timeline for when foreign caps will be removed in sectors such as autos and financial services. These seem like very reasonable concessions that will allow Trump to go home and declare victory. Trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the midwestern battleground states is a thorn in his side. For President Xi, rising unemployment is a key constraint. On the currency front, the details of any agreement are still unknown, but should Chinese economic fundamentals start to genuinely improve, it will put upward pressure under rates – and ergo the yuan (Chart I-11). A gradually rising yuan exchange rate will further assuage any doubts or concerns that Trump may have. Bottom Line: Our fundamental models show the yuan as undervalued by about 3%. This means China could allow its currency to gradually appreciate towards fair value, with little impact on the domestic economy or even exports. Given some green shoots in incoming economic data, little risk of capital flight, and the rising likelihood of a trade deal between the U.S. and China, our bias is that the path of least resistance for the Chinese RMB is up (Chart I-12). Chart I-11Rising Chinese Rates Will Favor The Yuan Chart I-12The RMB Is Not Expensive Another Dovish Shift By The ECB In another dovish twist, the European Central Bank kept monetary policy unchanged following this week’s meeting, while highlighting that it might be on hold for longer. Unsurprisingly, incoming data has been weak of late, which the ECB (like other central banks) blamed on the external environment. It did fall short of speculation that it will introduce a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. Our bias is for the new Targeted Long Term Refinancing Operation (TLTRO III – in other words, cheap loans), to remain a better policy tool than a tiered central bank deposit system. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy. Beyond any short-term volatility in the euro, we think the ECB’s dovish shift could be paradoxically bullish. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent bounce could be a harbinger of positive euro area data surprises ahead (Chart I-13). Chart I-13Euro Area Growth Will Recover Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. House Keeping Our buy-stop on the British pound was triggered at 1.30. We recommend placing stops at 1.25, with an initial target of 1.45. As we argued last week,4 the odds of a hard Brexit continue to fall, with U.K. Prime Minister Theresa May explicitly saying this week that the path for the U.K. going forward is either a deal with the EU or with no Brexit at all. As we go to press, EU leaders have granted the U.K. an extension until the end of October, with a review in June. Chart I-14What Next For The Pound? Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard exit. Given that the can has been kicked down the road, markets are likely to turn their focus on incoming economic data. On that front, economic surprises in the U.K. relative to both the U.S. and euro area are soaring (Chart I-14). Elsewhere, we are also taking profits on our short AUD/NOK position. Since 2015, the market has been significantly dovish on Australia, in part due to a more accelerated downturn in house prices and a marked slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts and has brought it far along the adjustment path relative to its potential. Any potential growth pickup in China will light a fire under the Aussie dollar, which is a risk to this position. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see China Investment Strategy Special Report, titled “China: Stimulating Amid The Trade Talks,” dated February 20, 2019, available at fes.bcaresearch.com 2 Please see China Investment Strategy Special Report, titled “Monitoring Chinese Capital Outflows,” dated March 20, 2019, available at fes.bcaresearch.com 3 Farah Master, “Factbox: How Macau's casino junket system works,” Reuters, October 21, 2011. 4 Please see Foreign Exchange Strategy Weekly Report, titled “Not Out Of The Woods Yet,” dated April 5, 2019, available at bca.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: In March, 196K nonfarm jobs were created, surprising to the upside; unemployment rate stayed low at 3.8%, though average hourly earnings growth fell to 3.2% year-on-year. The factory orders in February contracted by 0.5% month-on-month. More importantly, headline consumer price inflation in March rose to 1.9% year-on-year, however this was mostly lifted by rising energy prices. Core inflation excluding food and energy dropped by 10 basis points to 2%. JOLTs job openings unexpectedly fell to 7.1 million in February, from 7.6 million. However, initial jobless claims fell to 196K. After a 3-month lull, producer prices are inflecting higher at a pace of 2.2% year-on-year for the month of March. DXY index fell by 0.44% this week. Global risk assets are on the rise this week. Meanwhile, the Fed minutes highlighted that members are in no rush to raise rates. Stalling interest rate differentials will be a headwind for the dollar. Report Links: Not Out Of The Woods Yet - April 5, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: The Sentix Investor Confidence index continues to inflect higher, coming in at -0.3 from -2.2. German industrial production grew by 0.7% month-on-month in February. Trade balances improved across the euro area. In France, the trade deficit fell to €-4.0B in February. In Germany, the trade surplus increased to €18.7B. Italian retail sales increased by 0.9% year-on-year in February. On the inflation front, consumer price inflation in Germany and France both stayed at 1.3% year-on-year in March. EUR/USD rose by 0.57% this week. On Wednesday, the ECB has decided to leave policy unchanged as expected. Mario Draghi also highlighted more uncertainties and downside risks to the euro area amid the ongoing trade disputes. While the global trade war might add volatility to the pro-cyclical euro, easier financial conditions should eventually backstop growth. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Preliminary cash earnings fell by 0.8% year-on-year in February, the only decline since mid-2017. Household confidence continues to tick lower, coming in at 40.5 in March. The trade balance in February came in at a surplus of ¥489.2B. Capex is rolling over. Machinery orders fell by 5.5% year-on-year in February. Machine tool orders remain extremely weak, at -28.5% year-on-year for the month of March. Lastly, the foreign investment in Japanese stocks increased to ¥1,463.7B. USD/JPY fell by 0.46% this week. In its April regional outlook, the BoJ downgraded most of the prefectures in Japan, with only Hokkaido that had an upgrade in the aftermath of the earthquake. As domestic deflationary pressures intensify, this will favor the yen. This also raises the probability the government defers the consumption tax hike. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been strong: In February, manufacturing production increased by 0.6% year-on-year; industrial production also increased by 0.1% year-on-year, both surprising to the upside. Both were deflating in January. The goods trade balance in February fell to £-14.1B, however the total trade balance came in at a smaller deficit of £4.86B. Monthly GDP also came in higher at 2% year-on-year in February. House prices gains have pared the increase of previous years, but the Halifax house price index still increased by 2.6% year-on-year for the month of March. GBP/USD rose by 0.41% this week. Theresa May got an extension for Brexit to October 31. Meanwhile, U.K. data have been stronger than consensus recently. We are long GBP/USD from 1.30, with a 0.6% profit. Report Links: Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have continued to improve: Investment lending for homes in February grew by 2.6%. Home loans in February increased by 2% month-on-month, surprising to the upside. Westpac consumer confidence came in at 100.7 in April, increasing by 1.9%. AUD/USD surged by 0.64% this week. The RBA Deputy Governor Guy Debelle hinted that a wait-and-see approach for interest rates seemed like the appropriate path, signaling that policy will continue to be accommodative. Meanwhile, the Australian dollar is probably anticipating better upcoming data from China, as it is Australia’s largest trading partner. If the world’s second largest economy can turn around, the Aussie dollar is likely to grind higher. Report Links: Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was little data out of New Zealand this week: The food price index came in at 0.5% month-on-month in March, shy of the estimate of 1.3%. NZD/USD plunged after rising by 0.5% initially this week, returning flat. Incoming data in New Zealand is likely to lag its commodity currency counterparts pushing the kiwi relatively lower. Our long AUD/NZD position is now 0.7% in the money since entry last Friday. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: On the labor market front, the participation rate in March fell slightly to 65.7%; 7,200 jobs were lost, underperforming the estimated creation of 1,000 jobs; unemployment rate was unchanged at 5.8%. On the housing market front, starts in March increased by 192.5K year-on-year, underperforming the expected 196.5K; building permits dropped by 5.7% month-on-month in February. USD/CAD rebounded quickly after falling by 0.7% earlier this week, offsetting the loss. While the dovish shift by the BoC and looser fiscal policy, together with rising oil prices are likely to be growth tailwinds, the data disappointment coming from the housing market and overall economy limit upside in the CAD. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data in Switzerland this week: The foreign currency reserves came in at 756B CHF in March. Unemployment rate in March was unchanged at 2.4%, in line with expectations. USD/CHF appreciated by 0.44% this week. With the euro area economy slowly recovering, the franc is likely to underperform as risk appetite rises. We are long EUR/CHF for a 0.1% profit. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been strong, with inflation grinding higher: Headline consumer price inflation increased to 2.9% year-on-year in March; core inflation also rose to 2.7% year-on-year, both surprising to the upside. Producer price index grew by 5.2% year-on-year in March, outperforming expectations. USD/NOK depreciated by 1.16% this week. The improving domestic economy, rising oil prices, and the tick up in inflation are all the reasons why we favor the Norwegian krone. We are playing the NOK via a few pairs, notably long NOK/SEK and short AUD/NOK, which are currently 3.11% and 0.75% in the money, respectively. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production fell to 0.7% year-on-year in February, lower than the previous reading of 3%. New manufacturing orders contracted by 2.8% year-on-year in February. However, the leading manufacturing new orders to inventory ratio is rising suggesting we might be near a bottom. Consumer price inflation came in higher at 1.9% year-on-year in March. USD/SEK fell by 0.21% this week. We remain bullish on the Swedish krona due to its cheap valuation and the imminent pickup in the euro area economy. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a…
Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown. President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has…
Highlights Foreign investors have been rushing into Indian equities in anticipation of a Modi win. While Modi’s chances are reasonable, he may not win an outright majority. Keep tactically underweighting Indian stocks for now. The structural outlook for Vietnam is strong and improving. A bottom in Vietnamese equities is in the making. Investors should overweight Vietnamese stocks within an EM equity portfolio. Feature Indian Equities: A Window Of Risk Remains Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Chart I-3Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel). Investment Recommendations Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Vietnam: Structural Tailwinds Getting Stronger; Buy On A Dip Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Chart II-1Vietnamese Equities: An Upturn Is Ahead Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-2Accelerating Supply Chain Shift Chart II-3Strong U.S. Imports From Vietnam Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come. In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth. Chart II-4Vietnam: Taking More Market Share From China Chart II-5Rising FIE Imports Herald Export Growth Acceleration Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Chart II-8Strong Domestic Demand Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com Footnotes 1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Most currency pairs continue to trade toward the apex of tight wedge formations. History suggests major breakouts could be imminent. While the trade-weighted dollar has historically tended to be the best performing currency over a six-month period following a U.S. yield curve inversion, this window is rapidly closing. As the tug of war between data disappointments and easier financial conditions plays out, we intend to selectively add to more USD short positions. The pound is sitting exactly where it was after the 2016 U.K. referendum results, but the odds of a hard Brexit have significantly fallen since then. Place a limit buy on GBP/USD at 1.30. The RBA’s dovish shift was widely expected, while the RBNZ’s was not. Meanwhile, the Aussie dollar is sitting close to the epicenter of any Chinese stimulus. Buy AUD/NZD for a trade. Feature Markets have taken a risk-on tone this week. On the data front, there was strong improvement in the Chinese composite PMI, as well as broad increases in the services component of the PMIs across Europe and the U.S. Retail sales data out of Europe and Asia were above expectations and U.S. housing data is beginning to benefit from the fall in interest rates. Case in point, mortgage applications jumped almost 20% week-on-week, nudging the mortgage purchase index towards new highs. On the political front, China and the U.S. appear to be approaching a trade deal, and the U.K. has reached across the aisle to forge a Brexit deal that will potentially include stronger support from the Labor party. Despite these positives, there remain some dislocations in financial markets as investors digest whether financial conditions have eased enough globally to lift us out of the growth slowdown. Since 2015, both the Japanese Nikkei 225 index and the 10-year U.S. Treasury yield have moved in lockstep (Chart I-1). Right now, these two global growth barometers are sending opposing signals. The Nikkei index bottomed in December 2018 and is 13% off its lows, while at 2.5%, U.S. bond yields are not far off the trough made last week. Back in 2016, both indicators bottomed together in a unified response to the Federal Reserve’s dovish shift as well as Chinese stimulus. Every time the U.S. 10-year versus three-month spread has inverted, pro-cyclical currencies have gotten clobbered. The important message is that monetary policy affects the economy with a lag, and over the last year, more central banks have tightened policy than at any time since 2011 (Chart I-2). Our central bank monitors are still falling, suggesting easy monetary policy is still required. It wasn’t so long ago that dismal manufacturing PMI readings from Europe and Japan sent equity markets into a tailspin, with the U.S. 10-year versus three-month spread inverting. At a minimum, this warns against betting the farm too early on pro-cyclical currencies. Chart I-1Who Is Right? Chart I-2Monetary Policy Still relatively Tight Bottom Line: Every time the U.S. 10-year versus three-month spread has inverted, the U.S. trade-weighted dollar has tended to be the best performing currency over the next six months, while other pro-cyclical currencies have gotten clobbered. This occurred whether or not the inversion was a head-fake (Chart I-3). Our bias is that this time is different, but we will await further confirmation from higher-frequency indicators before building aggressive USD short positions. Chart I-3ABeware Of Curve Inversions (1) Chart I-3BBeware Of Curve Inversions (2) What To Watch In our March 8th bulletin,1 we detailed the case for fading U.S. dollar tailwinds and what to watch for in order to adopt a more pro-cyclical stance. These included PMI differentials between the U.S. and the rest of the world, copper- and oil-to-gold ratios, Chinese M2 relative-to-GDP, emerging market currencies, and China-sensitive industrial commodities. The message from these indicators remains broadly consistent with what was observed a month ago, so we will not reprint them here. That said, there are a few additional indicators to consider. AUD/JPY: This cross has broadly tracked swings in the global manufacturing pulse, given the Australian dollar benefits from improving global growth, while the yen benefits from flights to safety and deteriorating liquidity (Chart I-4). The cross has been dead flat around 79 for three months, suggesting these two forces are largely in a stalemate. A break higher in the cross towards the 82-83 zone would be encouraging. EUR/USD: For the U.S. dollar to weaken significantly, the euro will have to strengthen meaningfully, given the large share of euros in global reserves. Following dismal manufacturing PMI numbers out of Europe, the more domestic service-oriented PMIs have proven more resilient. Yet they still point to GDP growth between 1%-1.5% (Chart I-5). The external sector will have to participate to finally put a floor under the euro. It is encouraging that the euro has weakened significantly relative to the Chinese RMB, which should help European exports to China. Chart I-4Bottoming Processes Could Last A While Chart I-5Dollar Weakness Needs A Strong Euro Chinese Bond Yields: A larger share of financial intermediation is now being done through the Chinese bond market, meaning it has the power to ease financial conditions. There is significant debate as to whether Chinese credit stimulus has been sufficient, but bond yields suggest this has been the case (Chart I-6). We will be watching the Chinese aggregate money data for further confirmation that it is time to put on reflation trades. Chart I-6All Confirmatory Signs From China Count Bottom Line: We noted last week that exports to China from Singapore jumped by 34% year-on-year and those to emerging markets by 22% year-on-year. Recent data from Taiwan corroborate the improvement in the Chinese manufacturing PMI for the month of March. With many currency pairs trading toward the apex of tight wedge formations, history suggests breakouts are imminent. Given that currency crosses can themselves be indicators, we will wait for confirmation of a breakout before putting on fresh pro-cyclical positions. Westminster Unifies It has been almost three years since the British voted to leave the European Union (EU). The original deadline of March 29th has been extended to April 12th. As the new deadline approaches, the odds are that a new one will be negotiated, probably by the May 23rd EU elections or even later. The imbroglio has been highly complex, even for the most astute of political analysts. However, our simple observation is that while the pound is sitting exactly where it was after the 2016 referendum results, the odds of a hard Brexit have significantly fallen since then. We are opening a buy-stop on GBP/USD at 1.30 today for a trade (Chart I-7). A very detailed scenario analysis for Brexit was discussed in this month’s Bank Credit Analyst publication.2 The historical context is that while complete sovereignty of a nation is and always has been a desirable fundamental right, a hard Brexit will do little to alleviate the British voters’ angst. Globalization, decades of supply-side reforms and competition from emerging markets have lifted income inequality in the U.K. to the detriment of the average U.K. voter. However, this is hardly due to European integration, given that this same sentiment afflicts many other independent nations. Economic surprises in the U.K. relative to both the U.S. and euro area are soaring. Back when the referendum was held in June 2016, even the pro-Brexit Tories, a minority in the party, promised continued access to the Common Market. Fast forward to today and there are simply not enough committed Brexiters in Westminster to deliver a hard Brexit. Meanwhile, there is scant evidence the general populace wanted a hard Brexit, given the very slim margin of victory for the Leave vote. It is also possible that absent the prominence of migration issues and terrorist attacks that were afflicting Europe at the time, we would not be having this debate today. Chart I-7Changing Landscape For The Pound Chart I-8What Brexit? As we publish this week, British Prime Minister Theresa May has kicked off negotiations with opposition party leader Jeremy Corbyn in a plan to muster a deal before the April 12th deadline. This falls into the first camp of our three scenarios, which are: 1) a softer Brexit deal; 2) a general election to break the impasse; or 3) another referendum. In the case of a general election, unless a hard Tory replaces Ms. May, chances are a softer Brexit will prevail. Meanwhile, our geopolitical strategists have ventured to say that Brexit is unsustainable over the secular horizon, and that the U.K. will remain in the EU. Bottom Line: While the political battle unfolds in the U.K., the reality is that the pound and U.K. gilt yields should be much higher solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-8). Economic surprises in the U.K. relative to both the U.S. and euro area are soaring. With the benefit of hindsight, it is possible cable made its lows in mid-2016-early 2017 as it became clearer that the probability of a hard Brexit was waning. We are placing a limit buy on the pound today at 1.30, with a wide stop at 1.22. Buy AUD/NZD Chart I-9AUD Is On Sale There are few times in markets and trading when you get a semblance of a free lunch. But one such opportunity may be on the table for the Aussie versus the Kiwi. For starters, over the past five years or so, whenever this cross has broken below the 1.04 support level, going long proved to be a profitable strategy over the ensuing 6-to-12 months. Meanwhile, over the last 35 years, the cross has spent more than 95% of the time over 1.06, with the low in 2015 close to parity. Finally, the cross is very cheap on a real effective exchange rate basis, which means that relative prices in Australia are at a discount to those in New Zealand (Chart I-9). The confluence of monetary policy shifts over the last few months may be blurring the direction of relative interest rate trends, but on the simple basis of real three-month interest rate differentials, the Aussie should be 15% higher relative to the Kiwi (Chart I-10). Ever since 2015, the market has been significantly more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. We may now be entering a window where economic data in New Zealand converges to the downside relative to Australia, the catalyst being a foreign ban on domestic house purchases (Chart I-11). Chart I-10Divergences Are Very Rare Chart I-11Australia Is Well Along The Adjustment Path Chart I-12Domestic Demand Pressures In New Zealand A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is 0.22%.3 However, the housing wealth effect is asymmetric with negative housing shocks, hurting consumption by more than the boost received from positive shocks. According to their calculations, the housing wealth elasticity for consumption is 0.23 for negative shocks, as compared to 0.13 for positive changes in housing wealth. This asymmetry may be due to the fact that, at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. The study proves timely, since the RBNZ began a new mandate on April 1st to now include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Falling consumption will depress aggregate demand which, in turn, will depress consumption further. Falling inbound migration levels at a time of rapidly dwindling labor supply everywhere means the goldilocks scenario of non-inflationary growth may be behind us (Chart I-12). And for an economy driven by agricultural exports, productivity gains will be hard to come by. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock, and evidence is rising that this is turning in favor of the Aussie (Chart I-13). China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-14). Given that eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. Australia overtook Qatar last year as the world’s biggest exporter of liquefied natural gas. As the market becomes more liberalized and long-term contracts are revised to reflect surging spot prices, the Aussie dollar will get a boost. Chart I-13A Positive Shift Chart I-14A Shifting Export Landscape Bottom Line: Go long AUD/NZD as a strategic position. Place stops at parity. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “Into A Transition Phase,”dated March 8, 2019, available at fes.bcaresearch.com 2 Please see The Bank Credit Analyst Special Report, titled “The State Of Brexit,” dated March 28, 2019, available at bca.bcaresearch.com 3 Mairead de Roiste, Apostolos Fasianos, Robert Kirkby, and Fang Yao, “Household Leverage and Asymmetric Housing Wealth Effects - Evidence from New Zealand,” Reserve Bank of New Zealand, Discussion Paper Series, (April 2019). Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been weak compared to the rest of the world: Retail sales in February contracted by 0.2% month-on-month, shy of consensus of 0.3%. The March Markit manufacturing PMI fell to 52.4 while ISM manufacturing PMI rose to 55.3. However, the ISM non-manufacturing PMI also decreased to 56.1. The February durable goods orders contracted by 1.6% while still better than expected. Initial jobless claims fell to 202k this week. DXY index initially fell by 0.3% before rebounding to end the week flat. The upbeat Chinese data earlier this week was the strongest in the manufacturing sector for the past 8 months. Easing financial conditions worldwide and progress on trade talks have brought back investors’ risk appetite, which is a headwind for the counter-cyclical dollar. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have shown tentative signs of a recovery: The Markit manufacturing PMI fell to 47.5 in March, the weakest number since 2013. However, the Markit composite PMI and services PMI increased to 51.6 and 53.3 respectively, both higher than expected. The unemployment rate stayed unchanged at 7.8% in February. Consumer price inflation in March fell slightly to 1.4%. Retail sales grew at 2.8% year-on-year in February, outperforming expectations of 2.3% growth. In Germany, retail sales surged by 4.7% year-on-year. EUR/USD depreciated by 0.2% this week. While the manufacturing data remains weak, the services PMI and retail sales in the euro area all show signs of an imminent pickup. During a speech last Wednesday, Mario Draghi highlighted that policy will continue to remain accommodative which should help financial conditions. Moreover, good news from U.K. and China could improve the trade outlook in the euro area. Report Links: Into A Transition Phase - March 8, 2019 A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Housing starts in February grew by 4.2% year-on-year. Nikkei manufacturing PMI in March came in at 49.2, surprising to the upside, while the services PMI fell slightly to 52. Foreign investment in Japanese stocks increased to 438.7 billion yen. USD/JPY appreciated by 0.5% this week. The Tankan survey for Q1 was a bit disappointing, but nascent green shoots in the global economic recovery are providing support for Japanese shares. On the flip side, the higher risk appetite will likely decrease the demand for the safe-haven Japanese yen. Report Links: Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly positive: The Q4 GDP surprised to the upside, coming in at 1.4% year-on-year. The Markit manufacturing PMI jumped to 55.1 in March, the strongest within the past year. The Markit construction PMI came in slightly below expectation at 49.7, while still above the last reading of 49.5. The services PMI fell to 48.9. GBP/USD appreciated by 0.7% this week. GBP/USD has been very volatile over the past weeks amid ongoing Brexit uncertainties. Despite this, the U.K. economy has been very healthy and cable is still trading at a discount to its fair value. Report Links: A Trader’s Guide To The Yen - March 15, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been improving: The NAB business confidence fell to 0 in March, but the business conditions component increased to 7. The February HIA new home sales increased by 1% month-on-month. Building permits in February increased by 19.1% month-on-month. Retail sales increased by 0.8% month-on-month in February. Trade balance came in at 4.8 million AUD in February. Legacy LNG projects almost guarantee trade surpluses for years to come. AUD/USD has been flat this week. On Tuesday, the RBA kept the interest rate unchanged at 1.5%, as was widely expected. AUD/USD is likely to form a floor if Chinese economic activity continues to improve and global industrial production picks up. Report Links: Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The global dairy trade price index increased by 0.8% in April. ANZ commodity prices increased by 1.4% in March. NZD/USD fell by 1% this week. Despite positive terms of trade, NZD/USD is still trading at a 10%-15% premium above its fair value. New Zealand will be held hostage to the downturn in the Aussie economy. Meanwhile, a new dual mandate for the RBNZ makes it difficult to gauge whether its recent dovish shift is a one-off or more perpetual. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: GDP grew by 0.3% month-on-month in January, surprising to the upside. However, the Markit manufacturing PMI fell to 50.5 in March, from a previous reading of 52.8. USD/CAD rebounded after the plunge on positive Canadian GDP data, returning flat this week. On Monday, Governor Poloz gave a speech in Nunavut, highlighting slowing trade growth and the downside risks from trade wars. He stated that the economic outlook continues to warrant a policy rate that is well below the neutral range, and trade among provinces and territories should be promoted. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been strong: The KOF leading indicator increased to 97.4 in March. The February retail sales growth came in at -0.2% year-on-year, above the estimated -0.8%. Consumer price index came in higher than expected at 0.7% year-on-year. USD/CHF increased by 0.47% this week. While the inflation rate took a step closer towards the target rate, the uptick in investment sentiment and rising appetite for risk assets could be a headwind for the safe-haven franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been improving: Retail sales contracted by 1.3% month-on-month in February. However, the registered unemployment fell to 78.32k in March. The unemployment rate decreased to 2.4% accordingly. House prices increased by 3.2% year-on-year in March. The manufacturing PMI rose from 56.3 to 56.8 in March. USD/NOK fell by 0.3% this week. The Norwegian krone has been one of our favorite currencies, as it remains most responsive to crude oil prices. Our BCA house view is in favor of rising oil prices amid Iran and Venezuela sanctions and production cuts. Report Links: A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been better than expected: The manufacturing PMI came in at 52.8 in March, slightly higher than 52.7 in February. USD/SEK has been flat this week. The Swedish krona is still trading below its one sigma band of fair value. A brighter picture for the euro area could improve trade conditions for Sweden. Our short USD/SEK position is now 1.84% in the money since initiated. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights Maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But be warned, absent a continued decline in the bond yield and/or oil price, short-term positive impulses on the economy will fade and even turn negative later in the year. Hence in the summer months, look for opportunities to take profits in these pro-cyclical positions. U.K. economy plays can outperform once a cross-party parliamentary majority is found for a course of action that leads to an orderly Brexit (or no Brexit). Feature At the end of last year, we made a bold prediction: economies and financial markets would follow the opposite path in 2019 compared to 2018. Specifically we pointed out that “through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse… 2019 will present investors a mirror-image pattern to 2018” (Chart of the Week). Chart of the WeekWhy 2019 Is The Opposite Of 2018 Four months on, we are delighted to report that the mirror-image pattern is unfolding exactly as predicted. This year, stock markets are up sharply; bond markets have rallied; metal prices have made double-digit gains, growth-sensitive industrial shares are outperforming; while defensive healthcare shares are underperforming. All of these are the precise opposite of what happened in early 2018 (Chart 1-2 - Chart I-6). Chart I-2Equities: 2019 Is The Opposite Of 2018 Chart I-3Bonds: 2019 Is The Opposite Of 2018 Chart I-4Commodities: 2019 Is The Opposite Of 2018 Chart I-5Cyclicals: 2019 Is The Opposite Of 2018 Chart I-6Defensives: 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 The basis for our bold prediction was twofold. We noted that China’s 6-month credit impulse “had gone vertical” (Chart I-7). Indeed, the rebound from the trough amounted to $500 billion (and still counting), equivalent to a near 1 percent shot in the arm for global GDP. Chart I-7China's 6-Month Credit Impulse Has Gone Vertical We also argued back then that “a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price is about to feed through into headline consumer price indexes. Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs.” “Coming at a time that central banks have professed a much greater reliance on incoming data, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Federal Reserve.” Lo and behold. China’s PMI has rebounded sharply, and the Fed has stopped hiking rates. Still, central banks’ enhanced ‘data-dependency’ carries perils. The high-profile hard data – such as CPI inflation and GDP growth prints – on which monetary policy ‘depends’ is a record of what happened in the past, sometimes the distant past. This year’s market moves are the precise opposite of what happened in early 2018. Hence, enhanced data-dependency means that central banks are now ‘driving by looking through the rear-view mirror’ rather than looking at the current terrain. In turn, monetary policy expectations are driving bond and equity market valuations. By contrast, equity market growth expectations are based on the here and now; they move in synch with economic activity in real-time, leading even the survey-based PMIs. This also solves the puzzle as to why bonds and equities can sometimes give conflicting messages. Last year, the configuration of accelerating inflation with decelerating global growth hit equities and with a lose-lose: heavy pressure on both valuations and growth expectations. Furthermore, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. Chart I-8In 2018, Higher Bond Yields Pressured Equity Valuations At low interest rates, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But in early 2018, as hawkish central banks pushed up 10-year global bond yield towards 2 percent, this process reversed viciously: bond prices lost their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets at a time that growth expectations were also sliding (Chart I-8).1 By contrast, the early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a ‘mirror-image’ win-win: a boost to both valuations and to growth expectations. What Happens Next In 2019? Chart I-9Headline Inflation Will Soon Tick Up Understand that the all-important impulses to an economy do not come from the level of the bond yield, oil price, net exports, inventories, and so on. The impulse always comes from the change in these metrics. And as the metrics cannot decline (or rise) incessantly, impulses always fade and then reverse. The oil price has rebounded 30 percent from its recent lows. Necessarily, this means that headline inflation prints will soon stabilise or even tick up (Chart I-9). Furthermore, central banks’ abrupt pivot to dovish has already happened. It would be hard to repeat or continue such a move. As central banks react to the inevitably backward-looking hard data prints, our expectation is that bond yields will stabilise or even tick up. Will equity markets also react positively to the better economic data prints? Not necessarily. To repeat, equity markets’ growth expectations move in synch with economic activity in real-time, leading even the survey-based PMIs. Equity markets never wait for the backward-looking data prints. China plays are tracking its short-term credit impulse which has gone vertical (Chart I-10). Hence, in 2019 to date, U.K. mining stocks are already up 25 percent; the Shenzhen Composite is already up 40 percent! Chart I-10China Plays Have Already Surged Still, the current win-win configuration can continue for a little while longer, given that a typical upswing in short-term credit impulses lasts around eight months. But be warned, absent a continued decline in the bond yield and/or oil price, short-term impulses will fade and even turn negative later in the year. The early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a win-win. Hence, maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But our strong advice is: in the summer months, look for opportunities to take profits in all of these positions. When Will Brexit’s Groundhog Day End? We really would prefer not to talk about Brexit. It is not just that every day is Groundhog Day, every day is a shambolic Groundhog Day. Still, on a positive note this means that our investment strategy for Brexit has also remained a constant (Chart I-11). Chart I-11For Investors, Brexit Simplifies To A Binary Outcome It is not sufficient for the U.K. parliament to express what it is against (a no-deal Brexit); parliament must express what course of action it is for, leading to an orderly Brexit, or no Brexit, and that this course of action must also be acceptable to the EU27. At that point, irrespective of the exact course of action – a customs union, Common Market 2.0, or a confirmatory referendum in which ‘remain’ is an option – buy the pound, the FTSE250, and U.K. homebuilder shares. Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction. In this regard, Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction, because it finally puts national interest above party interest. To be clear, Brexit has been trapped in Groundhog Day because there is insufficient support among Conservative and DUP MPs for a relationship with the EU27 that would: Protect the cross-border supply chains which are vital to so many U.K. businesses. Avoid a hard customs border on the island of Ireland or between Ireland and Britain. Deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice; rather than a desire to strike independent trade deals, which is irrelevant for a majority of voters. The ray of light is that there is potentially a broader cross-party parliamentary majority for a course of action that would meet the above three conditions. Once it is found, U.K. economy plays can look forward to the “sunlit uplands”. Fractal Trading System* In line with the main body of this report, we continue to see evidence that the recent rally in bonds is technically extended. Accordingly, this week’s recommended trade is to short the 10-year OAT. The profit target is 1.3 percent with a symmetrical stop-loss. In other trades, short INR/PKR hit its 3 percent stop-loss and is now closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades 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 So what? EM elections bring opportunities as well as risks. Why? Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3. First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle – which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14. Chart 10Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Chart 20...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup. Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2 See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com. 3 The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4 See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com. Geopolitical Calendar