Mexico
Highlights Spread Product Valuation: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Corporate Defaults: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Mexican Sovereign Bonds: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Feature Corporate bonds have been on fire since the start of the year. High-yield excess returns have already made back all of their lost ground from 2018, and investment grade credits are on their way (Chart 1). With the Fed’s rate hike cycle on hold and some signs of credit easing in China, the near-term backdrop is amenable to further spread compression. Especially from current elevated levels. Chart 1Corporate Bonds Having A Good Run In 2019 On the flipside, some indicators of corporate default risk are starting to deteriorate and we can easily envision a more difficult environment for corporate spreads in the second half of this year. Especially if the Fed re-starts rate hikes, as we expect.1 In this week’s report we illustrate the extent of undervaluation in corporate spreads, and also detail our concerns related to budding default risk. We conclude that investors should maintain an overweight allocation to corporate bonds (both investment grade and high-yield) for now, but be prepared to trim exposure once spreads reach more reasonable levels. Finally, we identify an opportunity in USD-denominated Mexican sovereign bonds. Too Cheap For Phase 2 In our Special Report from mid-December that laid out our key themes for 2019, we described how we split the economic cycle into different phases based on the slope of the yield curve (Chart 2).2 We define the three phases of the cycle as follows: Chart 2Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Phase 1: From the end of the prior recession until the 3-year / 10-year Treasury slope flattens to below 50 bps Phase 2: When the 3/10 slope is between 0 bps and 50 bps Phase 3: From when the 3/10 slope inverts until the start of the next recession Dividing the cycle this way reveals a reliable pattern in corporate bond excess returns versus Treasuries. Excess returns tend to be highest in Phase 1. They tend to be quite low but still positive in Phase 2, and they tend not to turn negative until Phase 3. We argued in December that we are currently in Phase 2 and that we will probably stay there for most, if not all, of 2019. The main reason that excess returns are lower in Phase 2 than in Phase 1 is that corporate bond spreads are much tighter in Phase 2. Most of the cyclical spread compression occurs in Phase 1, in the immediate aftermath of the recession. With that in mind, consider the data presented in Chart 3. The chart shows 12-month breakeven spreads for each corporate bond credit tier as a percentile rank relative to history.3 For example, a percentile rank of 50% means that the breakeven spread has been tighter than its current level half of the time throughout history. Chart 3 also divides the historical data into two samples, showing how breakeven spreads rank relative to the entire history of available data, and also how they rank relative to other Phase 2 periods only. When the full historical sample is considered, only the B-rated and Caa-rated credit tiers have breakeven spreads above their historical medians. However, when we focus exclusively on Phase 2 environments we see that spreads for every credit tier other than Aaa look extremely cheap. Essentially, Chart 3 shows that today’s spread levels are more consistent with periods when the economy is either just exiting or entering a recession. Absent that sort of macro environment, there would appear to be an obvious buying opportunity in corporate bonds. Interestingly, other spread products don’t look nearly as cheap as corporate bonds. Chart 4 shows the same data as Chart 3 but for all non-corporate U.S. spread products with available data prior to 2000. It shows that Agency MBS and Consumer ABS spreads are close to median Phase 2 levels. USD-denominated Sovereign debt looks somewhat cheap. Meanwhile, Domestic Agencies and Supranationals both look expensive. What’s clear is that right now corporate credit offers the most attractive opportunity in U.S. fixed income. Bottom Line: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Default Cycle At A Turning Point? Another valuation tool in our arsenal is the High-Yield default-adjusted spread. This is the excess spread available in the high-yield index after accounting for expected 12-month default losses. It can also be thought of as the 12-month return earned by the High-Yield index in excess of a position in duration-matched Treasuries, assuming that default losses match expectations and that there are no capital gains (losses) from spread tightening (widening). Expected default losses are calculated using the Moody’s baseline default rate forecast and our own forecast of the recovery rate. Combining the Moody’s baseline default rate forecast of 2.4% and our recovery rate forecast of 45% gives expected 12-month default losses of 1.3%. Those expected default losses are then subtracted from the average High-Yield index option-adjusted spread to get a default-adjusted spread of 274 bps. This is slightly above the historical average of 250 bps (Chart 5). In other words, junk investors are currently being compensated at slightly above average levels to bear default risk. Chart 5A Look At The Default-Adjusted Spread Another way to conceptualize the default-adjusted spread is to ask what default rate would have to prevail over the next 12 months for junk investors to earn average historical excess compensation. This spread-implied default rate is denoted by the ‘X’ in the second panel of Chart 5. It is currently 2.8%, slightly above Moody’s baseline expectation. Is The Baseline Default Rate Forecast Reasonable? If we view the Moody’s 2.4% default rate forecast as reasonable, then we should conclude that junk bonds are attractively valued. However, some macro indicators suggest that 2.4% might be too optimistic. Chart 6 shows a model of the 12-month trailing speculative grade default rate based on gross leverage, which we define as total debt over pre-tax profits, and C&I lending standards. Chart 6A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate Gross leverage has improved during the past few quarters as profit growth has outpaced corporate debt growth (Chart 6, panel 2). This has acted to push down the fair value reading from our default rate model. On the other hand, commercial & industrial (C&I) lending standards tightened in the fourth quarter of last year (Chart 6, bottom panel). A net tightening in C&I lending standards is consistent with a higher default rate. Overall, the fair value reading from our default rate model is currently 3.5%, above the current 12-month trailing default rate of 2.6%. For the purposes of valuation, where the default rate will be 12 months from now is more important than where it is currently. To get a sense of where the fair value from our model is headed we need forecasts for corporate profit and debt growth. Profit growth will almost certainly moderate from its current lofty levels (Chart 7). Pressures on revenues and expenses both point in that direction. Total business sales and the ISM Manufacturing PMI have both fallen sharply from their recent highs (Chart 7, panel 2), suggesting lower corporate revenue growth going forward. Meanwhile, wages continue to accelerate (Chart 7, bottom panel). Chart 7Forecasting Profit Growth Using a model based on nominal GDP growth, wage growth, industrial production and the trade-weighted dollar, if we forecast that nominal GDP growth slows to the same rate as wage growth over the next 12 months, then the model predicts that profit growth will fall into the mid-single digits (Chart 7, top panel). This would be more or less consistent with the recent growth rate in corporate debt, meaning that gross leverage would flatten-off and the fair value reading from our default rate model would stabilize near 3.5%. In summary, if profit growth moderates in line with our expectations during the next 12 months, then it is likely that the corporate default rate will be somewhat higher than the current Moody’s forecast of 2.4%, possibly as high as 3.5%. But even a 3.5% default rate would still translate to a default-adjusted junk spread of 211 bps. Positive compensation for default risk, though less than average historical levels. In that case we would still expect solid positive excess returns from junk bonds. However, it will be important to monitor our default-adjusted spread during the next few months. If junk spreads tighten in the near-term, as we anticipate, then the excess compensation for default risk will evaporate quickly. Bottom Line: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Buy Mexican Bonds While most spread products have benefited from the Fed’s pause, delivering excellent year-to-date returns. We notice that the spreads on Mexico’s USD-denominated sovereign debt have not tightened alongside other comparable credits (Chart 8). This presents an attractive opportunity. Chart 8Mexican Bonds: An Attractive Opportunity When we compare 12-month breakeven spreads between the USD-denominated sovereign debt of different emerging market countries versus the spreads on equivalently-rated U.S. corporate bonds, we see that Mexico has now joined Argentina, Saudi Arabia, Qatar, UAE and Poland as the only countries that offer attractive compensation relative to the U.S. corporate sector (Chart 9). Why has this happened? Our Emerging Markets Strategy service postulates that many investors fear that the new political regime will bring fiscal profligacy, but in fact, the AMLO administration is proving to be less populist and more pragmatic than expected.4 The 2019 budget, for example, targets a primary surplus of 1% of GDP, and envisages a decline in nominal expenditures in 29 out of 56 categories. This commitment to sound fiscal policy should benefit Mexican sovereign bond spreads. More fundamentally, our Emerging Markets strategists note that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs. This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite interest rates being much higher in Mexico than in the U.S. The Mexican 10-year real yield is currently 4.1%, well above real GDP growth which was 2.6% during the past four quarters (Chart 10). Contrast that with the U.S., where the 10-year real yield is a meagre 0.8% versus real GDP growth of 3% during the past four quarters. In other words, interest rate differentials favor a stronger peso, which is positive for USD-denominated sovereign spreads. Chart 10Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Though the Mexican/U.S. interest rate differential remains wide, it is likely to compress going forward. Elevated Mexican interest rates relative to growth signal that monetary policy is restrictive. A fact that is already evident in decelerating Mexican money supply (Chart 10, bottom panel). Meanwhile, low U.S. real yields relative to GDP suggest that further Fed tightening is necessary before U.S. rates are similarly restrictive. Bottom Line: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 The 12-month breakeven spread is the spread widening required over the next 12 months for the corporate bond to break even with a duration-matched position in Treasury securities. We use the breakeven spread instead of the average index spread because it takes into account the changing duration of the bond indexes. 4 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Chart II-1Fiscal Tightening In 2019 Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-2Historical Perspective On Minimum Wage Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-4High Real And Nominal Interest Rates Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Chart II-6Remain Overweight Mexican Currency And Fixed-Income Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers.
Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel). Chart I-8China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy. We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can. Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst. Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity. This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2 Yes. He literally said that. Geopolitical Calendar
This week we are publishing Part 1 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of the largest EMs. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries will be covered in next week’s Part 2. Chart A Chart B Korea: Overweight Equities Korea: Overweight Equities Korea: Overweight EquitiesKorea: Overweight Equities ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency ...But Negative On Currency Taiwan: Overweight Equities But... Taiwan: Overweight Equities... Taiwan: Overweight Equities... Taiwan: Overweight Equities... Taiwan: Overweight Equities... ...Absolute Return Investors Should Mind Cracks In Semi Sector ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector ...Absolute Return Investors Should ##br##Mind Cracks In Semi Sector India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Remain Overweight India: Strong Domestic Growth & Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition India: Strong Domestic Growth & ##br##Advanced NPL Recognition South Africa: On Shaky Foundations - Underweight South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: On Shaky Foundations South Africa: Strong Consumption, No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness South Africa: Strong Consumption, ##br##No CAPEX And No Competitiveness Brazil: Heading Towards A Fiscal Debacle - Underweight Brazil: Heading Towards A Fiscal Debacle Brazil: Heading Towards A Fiscal DebacleBrazil: Heading Towards A Fiscal Debacle Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Brazil: More Downside In Financial Assets Mexico: Domestic Fundamentals Are Improving - Overweight Mexico: Domestic Fundamentals Are Improving Mexico: Domestic Fundamentals Are ImprovingMexico: Domestic Fundamentals Are Improving Mexico: External Sector Is Faring Well Mexico: External Sector Is Faring Well Mexico: External Sector Is Faring WellMexico: External Sector Is Faring Well Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Orthodox Monetary And Fiscal Policies Russia: Gradual Cyclical Improvements - On Upgrade Watchlist Russia: Gradual Cyclical Improvements Russia: Gradual Cyclical ImprovementsRussia: Gradual Cyclical Improvements Turkey: A Genuine Inflation Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: A Genuine Inflation ##br##Breakout Amidst Credit Excesses Turkey: Still In Dangerous Territory - Underweight Turkey: Still In Dangerous Territory Turkey: Still In Dangerous TerritoryTurkey: Still In Dangerous TerritoryTurkey: Still In Dangerous Territory Equity Recommendations Fixed-Income, Credit And Currency Recommendations