Technology
Highlights The growth momentum of China's recent mini-cycle has peaked, but the ongoing slowdown is likely to continue to remain benign in nature. A return to 2015-like conditions is not the most likely outcome over the coming year. Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chinese ex-tech stocks have room to re-rate next year in a benign slowdown scenario. Investors should stay overweight Chinese investable equities vs EM and global stocks. Feature BCA recently published its special year end Outlook report for 2018,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week's China Investment Strategy report we expand on the Outlook, by reviewing our three key themes for China over the coming year. Key Theme # 1: A Benign End To China's Recent Mini-Cycle We presented our case that the cyclical slowdown of the Chinese economy will likely be benign in our October 12 Weekly Report. Chart 1 presents a stylized view of the Chinese economy over the past three years that was published in that report, which illustrated our framework of how cyclical growth conditions have evolved over this "mini-cycle". It also highlighted three possible scenarios for the coming 6-12 months, and noted that our bet was on scenario 2: A re-acceleration of the economy and a continuation of the V-shaped rebound profile A benign, controlled deceleration and settling of growth into the "stable" growth range, and An uncontrolled and sharp deceleration in the economy that threatens a return to the conditions that prevailed in early-2015 (or worse) Chart 1A Stylized View Of China's Recent "Mini-Cycle" Since we presented this framework, incoming evidence has been consistent with our call. Chart 2 shows that the Li Keqiang index has now decisively rolled over, but that economic conditions remain well away from their mid-2015 lows. We sketched out the basis for our benign slowdown view in our October 12 piece, but we followed up more formally in a two-part report that addressed the main factors arguing against a return to 2015-like conditions.2 Our view is grounded in the perspective that economic conditions in 2015 were not "normal", and we showed in these reports how a sharp slowdown in the economy was caused by an extremely weak external demand environment and overly tight monetary policy. On the trade front, Chart 3 highlights how Chinese export growth is likely to moderate over the coming several months, which argues against the re-acceleration scenario described above. Since mid-2011, Chinese export growth has lagged what most economic indicators would have predicted, and we noted in part I of our 2015 vs today comparison that this can be traced largely to two factors: a decline in global import intensity and, to a lesser extent, a decline in China's export "market share". Chart 2An Economic Slowdown In China##br## Is Now Underway Chart 3Chinese Export Growth Likely To##br## Converge To Global IP Growth Our analysis in that report suggested that China's 2018 export growth will converge to that of global industrial production, which implies a modest deceleration in the months ahead. Still, export growth of +4% would be a far cry from the significant contraction of exports that occurred in late-2015 / early-2016, which is consistent with a benign growth slowdown. On the monetary policy front, we showed how a monetary conditions approach captured the tightness of China's policy stance from 2012 to early-2015, which led to a material decline in China's industrial sector (Chart 4). Our Special Report last week further supported the view that monetary conditions matter enormously for China's economy; out of 40 macro data series that we tested to reliably predict the Chinese business cycle, only measures of money & credit passed our criteria.3 An aggregate indicator of these 6 series has a similar profile to the Bloomberg Monetary Conditions Index that we have shown in the past (Chart 4, panel 2), and neither suggests that a sharp further slowdown in China's economy is imminent. We will be watching these indicators closely in 2018 for signs of a more aggressive decline than we currently expect. Recently, some investors have pointed to a sharp rise in China's corporate bond yields as a sign that the monetary policy stance is, in fact, tighter than a standard monetary conditions approach would imply. Indeed, China's 5-year AA corporate bond yield has risen 230 bps since late-October 2016, from 3.6% to 5.9%, with most of this rise having occurred due to a rise in government bond yields. Corporate bond spreads have also risen, but relative to spreads on similarly-rated U.S. credit, the rise appears to reflect a rebound from extremely low levels late last year and is not (yet) symptomatic of major concerns over defaults (Chart 5). Chart 4The Ongoing Slowdown Is Likely ##br##To Be Benign Chart 5China's Corporate Bond Spreads ##br##Do Not Yet Look Onerous We are not complacent of the potential risk posed by rising corporate bond yields, and a further significant rise in 2018 could change our view that a benign economic slowdown is the most likely outcome. But for now, the fact that the stock of corporate bond issuance accounts for only 10% of ex-equity social financing suggests that the rise in yields this year is not likely to have an outsized impact on the economy in 2018, beyond the impact that monetary tightening has had on overall average interest rates (which, for now, is material but has not returned rates back to their 2015 levels). Chart 6The Rise In CPI Will Likely Soon Peak Finally, the 85 bps rise in Chinese core consumer price inflation that has occurred over the past year has also fed investor concerns that monetary policy will become even tighter next year. To us, this risk is probably overblown, given that demand-driven inflation lags growth (which has clearly peaked). Chart 6 shows the year-over-year change in Chinese core CPI vs that of the Li Keqiang index, and clearly suggests that the acceleration in core prices is likely to soon abate. Poor communication from the PBOC means that it is not clear how prominently core inflation features into the central bank's reaction function, but given that tighter monetary conditions have already caused a peak in both house prices and growth momentum, we doubt that policymakers will see the recent rise in consumer prices as a basis to aggressively tighten further. Bottom Line: The growth momentum of China's recent mini-cycle has peaked, but a return to 2015-like conditions is not the most likely outcome over the coming year. Key Theme # 2: Monitoring The Pace Of Renewed Structural Reforms We have written several reports concerning China's 19th Communist Party Congress over the past three months, both in the lead-up to the event and as a post-mortem.4 The Congress was significant because it likely heralds stepped-up reform efforts in 2018 and beyond. By "reforms", our Geopolitical Strategy team specifically means deleveraging in the financial sector accompanied by a more intense anti-corruption campaign focused on the shadow-banking sector, as well as ongoing restructuring in the industrial sector. Table 1 presents our geopolitical team's assessment of the likely reform scenarios and probabilities over the coming year. It should be clearly noted that the "reform reboot" scenario as described in Table 1 is likely negative for emerging market equities and other plays on China's industrial sector (such as industrial metals). Table 1Post-Party Congress Scenarios And Probabilities We agree that the "status quo" scenario of no significant reforms is highly unlikely given that President Xi has succeeded in amassing tremendous political capital and that he has an agenda for reform. But the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers, to avoid a repeat of the significant slowdown that occurred in 2014/2015. As such, the view of BCA's China Investment Strategy service is that the reform efforts over the coming year will be structured at a pace that is sufficient to avoid a meaningful deceleration in China's industrial sector and is conducive to the outperformance of Chinese ex-technology stocks. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity in 2018 is a risk to our view that China's ongoing economic slowdown is likely to be benign and controlled. We presented our framework for monitoring this risk in our November 16 Weekly Report,5 specifically our BCA China Reform Monitor (Chart 7). The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching in 2018 for signs that our monitor is rising largely due to outright declines in the denominator. Chart 7Our Reform Monitor Will Help Us Judge ##br##Whether The Pace Of Reforms Becomes Too Burdensome For now, there is no indication that reform risk is affecting the performance of the MSCI China index. Panel 2 of Chart 7 highlights that recent movements in our Reform Monitor have been driven by the "winner" sectors, with the recent selloff largely reflecting a modest correction in global technology stocks sparked by the passage of the U.S. Senate's tax reform plan.6 But we will be watching the monitor closely in 2018, and will adjust it as needed in reaction to additional reform announcements over the coming months. Finally, next year's reform announcements will be highly significant not just because of the "what", but also the "how". It is difficult to see how China's leadership can aggressively pare back heavy-polluting industry and deleverage the financial sector without destabilizing the economy in the near term, but their goal to significantly raise China's per capita GDP and escape the "middle income trap" over the long-term is equally nebulous. We have noted in previous reports that a country's income level is fundamentally determined by its productivity, which is in turn determined by the level and sophistication of its capital stock. Chart 8 shows a clear positive correlation between a country's per capita output, a measure of productivity, and its per capita capital stock. In general, industrialized countries enjoy much higher levels of per capita capital stock than developing economies, leading to much higher productivity, income, and living standards. Therefore, the process of industrialization is fundamentally a process of accumulation of capital stock through investment. As shown in Chart 9, despite some remarkable achievements, the productivity level of the average Chinese worker is still just a fraction of the level in more advanced countries. Conventional economics would suggest that if China wishes to keep progressing on the productivity and income ladder, that it should remain on the path of growing the capital stock through savings and investment. If, however, it abandons its current growth model and "rebalances" towards a consumption-driven one, the risk that the country will stagnate and fail to advance beyond the "middle income trap" looms large. Chart 8Productivity Is Positively Correlated ##br##With Capital Stock Chart 9China's Catchup Process ##br## Has A Lot Further To Run Chart 10 makes this point from a different perspective. At root, China's leadership is describing the desire to rapidly transition towards an economy with a much higher level of tertiary industry (services) as a share of GDP, but the U.S. experience suggests that this is a long process that is not investment-oriented. The chart shows the evolution of U.S. investment in private services excluding real estate as a share of total private fixed assets since 1947, when the U.S. had only a slightly higher level of real per capita GDP than China today. It has taken almost 70 years for the share of private services ex real estate to rise by 16 percentage points in the U.S., and it has yet to account for the majority of private fixed investment.7 Services activity/investment also typically requires a highly educated workforce as an input, and rate of China's post-secondary educational attainment appears to be too low to fit the bill (Chart 11). In short, crucial details about China's reform plan should hopefully emerge in 2018, which are likely to have both near-term and multi-year implications. Bottom Line: Chinese policymakers are likely to increase their focus on reform efforts next year, but the pace will have to be modulated to avoid a repeat of the significant slowdown that occurred in 2014/2015. The risk of a policy mistake is a key theme to watch for 2018. Chart 10China Cannot Easily Replace 'Hard' Investment Chart 11China's Workforce Is Not Well Equipped To Transition To Services Key Theme # 3: The Relative Re-Rating Of Chinese Investable Ex-Tech Stocks Over the past several years, this publication argued strongly that the valuation discount applied to Chinese equities was unjustified. For the investable benchmark, the past two years of material outperformance vs emerging market and global stocks has removed a significant portion of this discount, and we noted in our August 31 Weekly Report that Chinese equities are no longer "exceptionally cheap".8 However, a good portion of this revaluation has been isolated to the tech sector. Chart 12 shows that while the 12-month forward P/E ratio for Chinese tech stocks is 70% higher than the global average, ex-tech shares still trade at a 37% relative discount. Chart 13 echoes this conclusion by showing the ex-tech price-to-book ratio for every country in MSCI's All Country World index; by this metric China's ex-tech cheapness currently ranks in the 85th percentile, behind only Israel, Colombia, Italy, Jordan, Korea, Russia, and Greece. Chart 12China: Expensive Tech, Extremely Cheap Ex-Tech Chart 13China's Ex-Tech P/B Ratio Among The Lowest In The World Charts 12 and 13 are weighted simply by the remaining market capitalization in each country's market after excluding the technology sector, meaning that the deep discount applied to Chinese banks wields a disproportionate influence (financials would make up 40% of China's MSCI ex-tech "index", if one officially existed). Although we agree that the magnitude of the rise in debt over the past several years warrants somewhat of a P/B discount, we would argue that the risk is more earnings and dilution-related rather than solvency-related. It is highly unlikely that the Chinese government would allow large banks to fail outright in the event of a serious financial crisis, but the potential for a rise in provisioning and significant new capital raising suggests that the risk premium for these stocks should be somewhat higher than what would otherwise be normal. Chart 14China's Banks Can Re-Rate ##br##In A Benign Slowdown Scenario Still, either the Chinese bank risk premium is excessive, or the banking sectors of several major DM countries are significantly overvalued. For example, Chinese investable banks trade at a P/B ratio of 0.8, but Canadian, Australian, and Swedish banks trade at an average P/B ratio of 1.7. If the concern over credit excesses is the source of the higher risk premium applied to Chinese banks, Chart 14 suggests that there is a major inconsistency in pricing; an equally-weighted average of Canadian, Australian, and Swedish private sector debt-to-GDP is higher than that of China's, at 214% vs 211% as of Q2 this year. Our bet is the former: In a world where outsized returns are scarce and U.S. equities are overvalued, a benign growth deceleration and a modulated pace of reforms favor a lessening of the substantial valuation discount currently applied to China's investable ex-tech stocks. Barring a more pronounced slowdown in China's economy than we currently expect, investors should stay overweight the MSCI China investable index in 2018, within both an emerging markets and global equity portfolio. Bottom Line: Chinese ex-tech stocks have room to re-rate in a benign slowdown scenario. Investors should stay overweight Chinese investable stocks in 2018. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, and "China's Economy - 2015 Vs Today (Part II): Monetary Policy", dated November 9, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy and Geopolitical Strategy Special Reports, "China's Nineteenth Party Congress: A Primer", dated September 14, 2017, "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, and BCA Special Report "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress", dated November 16, 2017, available at cis.bcaresearch.com. 6 The Senate bill that was passed this week unexpectedly retained 20% alternative minimum tax (AMT) for corporations, which would disproportionately impact U.S. technology companies. Indications currently suggest that the final tax cut bill to be approved by both houses of Congress will repeal the AMT. 7 In 2016, real estate investment accounted for roughly 29% of total private investment in fixed assets, and the sum of primary and secondary industry (agriculture, mining, utilities, construction, and manufacturing) accounted for about 28%. 8 Please see China Investment Strategy Weekly Report, "A Closer Look At Chinese Equity Valuations", dated August 31, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Semiconductor stocks in general and semi equipment in particular have gone parabolic over the last year, prompting us to add the S&P semi equipment index on our speculative high-conviction underweight list earlier this week. The move looks prescient as the index, as of publishing, has fallen by more than 9% this week. A global M&A frenzy and the bitcoin/ICO mania (bottom panel) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel). This indefinite profit euphoria is unwarranted and we would lean against it. Accordingly, we are reiterate our speculative high-conviction underweight recommendation; see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC.
Highlights China stands out as the most likely candidate to send negative shock waves through EM and commodities in 2018. Granted the ongoing policy tightening in China will likely dampen money growth further, the only way mainland nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. Assigning equal probabilities to various scenarios of velocity of money, the outcome is as follows: one-third probability of robust nominal growth (continuation of the rally in China-related plays) and two-third odds of a non-trivial slowdown in nominal growth with negative ramifications for China-related plays. Hence, we reiterate our negative stance on EM risk assets Feature The key question for emerging markets (EM) in 2018 is whether a slowdown in Chinese money growth will translate into a meaningful growth deceleration in this economy, and in turn produce a reversal in EM risk assets. This week we address the above question in detail elaborating on what could make China's business cycle defy the slowdown in its monetary aggregates and how investors should approach such uncertainty. Before this, we review the status of financial markets going into 2018. Priced To Perfection Or A New Paradigm? Several financial markets are at extremes. Our chart on the history of financial market manias reveals that some parts of technology/new concept stocks may be entering uncharted territory (Chart I-1). Tencent's share price, for instance, has surged 11-fold since January 2010. Chart I-1History Of Financial Markets Manias: They Lasted A Decade This is roughly on par with the prior manias' average 10-year gains. As this chart indicates, the manias of previous decades run wild until the turn of the decade. It is impossible to know whether technology/new concept stocks will peak in 2018 or run for another two years. Regardless whether or not the mania in tech/new concept stocks endures up until 2020, some sort of mean reversion in their share prices is likely next year. This has relevance to EM because the magnitude of the EM equity rally in 2017 has been enormously boosted by four large tech/concept stocks in Asia. Our measure of the cyclically-adjusted P/E (CAPE) ratio for the U.S. market suggests that equity valuations are reaching their 2000 overvaluation levels (Chart I-2, top panel). The difference between our measure and Shiller's measure of CAPE is that Shiller's CAPE is derived by dividing share prices by the 10-year moving average of EPS in real terms (deflated by consumer price inflation). Our measure is calculated by dividing equity prices by the time trend in real EPS (Chart I-2, bottom panel). Our CAPE measure assumes that in the long run, U.S. EPS in real terms will revert to its time trend. Meanwhile, the Shiller CAPE is based on the assumption that real EPS will revert to its 10-year mean. Hence, the assumptions behind our CAPE model are quite reasonable if not preferable to those of Shiller's P/E. Remarkably, the U.S. (Wilshire 5000) market cap-to-GDP ratio is close to its 2000 peak (Chart I-3). With respect to EM equity valuations, the non-financial P/E ratio is at its highest level in the past 15 years (Chart I-4). EM banks have low multiples and seem "cheap" because many of them have not provisioned for NPLs. Hence, their profits and book values are artificially inflated. In short, excluding financials, EM stocks are not cheap at all, neither in absolute terms nor relative to DM bourses. Chart I-2A Perspective On U.S. Equity Valuation Chart I-3The U.S. Market Cap-To-GDP ##br##Ratio Is Close To 2000 Peak Chart I-4EM Non-Financial Equities Are Not Cheap Such elevated DM & EM stock market valuations might be justified by currently low global long-term bond yields. Yet, if and when long-term bond yields rise, multiples will likely shrink. The latter will overpower the profit growth impact on share prices, as multiples are disproportionately and negatively linked to interest rates - especially when interest rates are low - but are proportionately and positively linked to EPS.1 As a result, a small rise in long-term bond yields will lead to a meaningful P/E de-rating. Despite very high equity valuations, U.S. advisors and traders are extremely bullish on American stocks. Their sentiment measures are at all time and 11-year highs, respectively. So are copper traders on red metal prices (Chart I-5). The mirror image of the strong and steady rally in global stocks is record-low implied volatility. The aggregate financial markets' implied volatility index is at a multi-year low (Chart I-6). Finally, yields on junk (high-yield) EM corporate and sovereign bonds are at all-time lows (Chart I-7). They are priced for perfection. Chart I-5Bullish Sentiment On Copper Is Very Elevated Chart I-6Aggregate Global Financial Markets ##br##Implied VOL Is At Record Low Chart I-7EM Junk Bond Yields Are At Record Low Are we in a new paradigm, or are we witnessing financial market extremes that are unsustainable? In regard to the timing, can these dynamics last throughout 2018 or at least the first half of next year, or will they reverse in the coming months? We have less conviction on the durability of the U.S. equity rally, but our bet is that EM risk assets will roll over in absolute terms and begin underperforming their DM peers very soon. What could cause such a reversal in EM risk assets? China stands out as the most likely candidate to send negative shock waves through emerging markets and commodities. China: "Financial Stability" Priority Entails Tighter Policy The Chinese authorities are facing unprecedented challenges: The outstanding value of broad money in China (measured in U.S. dollars) is now larger than the combined U.S. and euro area broad money supply (Chart I-8, top panel). Chart I-8Beware Of Money Excesses In China As a share of its own GDP, broad money in China is much higher compared to any other nation in history (Chart I-8, bottom panel). In brief, there is too much money in China and most of it - $21 trillion out of $29 trillion - has been created by the banking system since early 2009. We maintain that the enormous overhang of money and credit in China represents major excess/imbalances and has nothing to do with the nation's high savings rate.2 Rather, it is an outcome of animal spirits running wild among bankers and borrowers over the past nine years. Easy money often flows into real estate and China has not been an exception. Needless to say, property prices are hyped and expensive relative to household income. Policy tightening amid lingering excesses and imbalances makes us negative on China's growth outlook. In a nutshell, we place more weight on tightening when there are excesses in the system, and downplay the importance of tightening in a healthy system without excesses. Importantly, excessive money creation seems to finally be pushing inflation higher. Consumer price services and core consumer price inflation rates are on a rising trajectory (Chart I-9, top and middle panels). As a result, banks' deposit rates in real terms (deflated by core CPI) have plunged into negative territory for the first time in the past 12 years (Chart I-9, bottom panel). Remarkably, the People's Bank of China's existing $3 trillion of international reserves is sufficient to "back up" only 13% and 11% of official M2 and our measure of M3, respectively (Chart I-10). If Chinese households and companies decide to convert 10-15% of their deposits into foreign currency and the PBoC takes the other side of the trade, its reserves will be exhausted. Chart I-9China: Inflation Is Rising And ##br##Real Deposit Rate Is Negative Chart I-10China: Low Coverage Of ##br##Money Supply By FX Reserves Therefore, reining money and credit expansion is of paramount importance to China's long-term financial and economic stability. "Financial stability" has become the key policy priority. "Financial stability" is policymakers' code word for containing and curbing financial imbalances and bubbles. Having experienced the equity bubble bust in 2015, policymakers are determined to preclude another bubble formation and its subsequent bust. Consequently, the ongoing tightening campaign will not be reversed in the near term unless damage to the economy becomes substantial and visible. By the time the authorities and investors are able to identify such damage in the real economy, China-related plays in financial markets will be down substantially. Chart I-11China: Corporate Bond Yields And Yield Curve Faced with significant excesses in money, leverage and property markets, the Chinese authorities have been tightening - and have reinforced their policy stance following the Party's Congress in October. There is triple tightening currently ongoing in China: 1. Liquidity tightening: Money market rates have climbed, and onshore corporate bond yields are rising (Chart I-11, top panel). Remarkably, the yield curve is flat, pointing to weaker growth ahead (Chart I-11, bottom panel). 2. Regulatory tightening: The China Banking Regulatory Commission (CBRC) is forcing banks to bring off-balance-sheet assets onto their balance sheets, and is reining banks' involvement in shadow banking activities. In addition, financial regulators are trying to remove the government's implicit "put" from the financial system, and thereby curb speculative and irresponsible investment behavior. Finally, many local governments are tightening investors' participation in the real estate market. 3. Anti-corruption campaign is embracing the financial institutions: The powerful anti-corruption commission is planning to dispatch groups of inspectors to examine financial institutions' activities. This could dampen animal spirits among bankers and shadow banking organizations. The Outlook: The "Knowns"... In China, broad money growth has already slumped to an all-time low (Chart I-12). The money as well as the credit plus fiscal spending impulses both point to a considerable slowdown in the mainland's industrial cycle and overall economic activity (Chart I-13). Chart I-12China: Broad Money ##br##Growth Is At All-Time Low Chart I-13China: Money And Credit & ##br##Fiscal Impulses Are Negative The slowdown is not limited to money growth; there are a few real business cycle indicators that are already weakening. For example, the growth rate of property floor space sold and started has slumped to zero (Chart I-14). Electricity output and aggregate freight volume growth have both decisively rolled over (Chart I-15). Chart I-14China: Property Starts Are Set To Contract Again Chart I-15China: A Few Signs Of Slowdown That said, based on the past correlation between money and credit impulses on the one hand and the business cycle on the other, China's economy should have slowed much more, and its negative impact on the rest of the world should have already been felt (Chart I-13, on page 9). This has been the key pillar of our view on EM, but it has not yet transpired. Is it possible that the relationship between money/credit impulses and the business cycle has broken down? If so, why? And how should investors handle such uncertainty? Bottom Line: China's ongoing policy tightening will ensure that money and credit impulses remain negative for some time. Can the country's industrial sectors de-couple from its past tight correlation with money and credit? ...And The "Unknowns" By definition, the only way to sustain nominal economic growth in the face of a decelerating money supply is if the velocity of money increases. This is true for any economy. Nominal GDP = Money Supply x Velocity of Money Provided China's policy tightening will likely further dampen money growth, the only way nominal GDP growth can hold up is if the velocity of money rises meaningfully, offsetting the drop in money growth. This is the main risk to our view and strategy. Chart I-16 portrays all three variables. Chart I-16China: Money, Nominal GDP ##br##And Velocity Of Money Even though the velocity of money has fallen structurally over the past nine years (Chart I-16, bottom panel), it has risen marginally in 2017, allowing the mainland's nominal economic growth to hold up despite a considerable relapse in money supply growth. Notably, this has been the reason why our view has not worked this year. What is the velocity of money, and how can we forecast its fluctuations and, importantly, the magnitude of its variations? The velocity of money is one of the least understood concepts in economic theory. The velocity of money is anything but stable. In our opinion, the velocity of money reflects animal spirits of households and businesses as well as government spending decisions. Forecasting animal spirits and the magnitude of their variations is not very a reliable exercise. In a nutshell, the banking system (commercial banks and the central bank) creates money via expanding its balance sheet - making loans to or acquiring assets from non-banks. However, commercial banks have little direct influence on the velocity of money. The latter is shaped by non-banks' decisions to spend or not (i.e., save). Significantly, non-banks' spending and saving decisions do not alter the amount of money in the system. Yet they directly impact the velocity of money. The banking system creates money, and non-banks churn money (make it circulate). At any level of money supply, a rising number of transactions will boost nominal output, and vice versa. Further, there is a great deal of complexity in the interaction between money supply and its velocity. Both are sometimes independent, i.e. they do not influence one another, but in some other cases one affects the other. For example, with the ongoing triple tightening in China and less money being originated by the banking system, will households and businesses increase or decrease their spending? Our bias is that they will not increase spending. This is especially true for the corporate sector, which has record-high leverage and where access to funding has been tightening. It is also possible that rising velocity will lead to more money creation as more spending leads to higher loan demand and banks accommodate it - i.e., originating more loans/money. These examples corroborate that money supply and the velocity of money are not always independent of each other. On the whole, it is almost impossible to reliably forecast the magnitude of changes in velocity of money. In the same vein, it is difficult to forecast animal spirit dynamics in any economy. Chart I-17U.S.: The Rise In Velocity Of Money ##br##Overwhelmed Slowdown In Money One recent example where nominal GDP has decoupled from broad money growth is the U.S. Chart I-17 demonstrates that in the past 12 months, U.S. nominal GDP growth has firmed up even though broad money (M2) growth has slumped. This decoupling can only be explained by a spike in the velocity of M2. In other words, soaring confidence and animal spirits among U.S. households and businesses have boosted their willingness to spend, even as the banking system has created less money and credit growth has slowed considerably over the past 12 months. Going back to China, how should investors consider such uncertainty in changes in the velocity of money? Investing is about the future, which is inherently uncertain. Hence, an investment process is about assigning probabilities to various scenarios. Provided the velocity of money is impossible to forecast, we assign equal probabilities to each of the following scenarios for China in 2018 (Figure I-1): One-third odds that the velocity of money rises more than the decline in broad money growth, producing robust nominal GDP growth; One-third probability that the velocity of money stays broadly flat - the outcome being meaningful deceleration in nominal GDP growth; A one-third chance that the velocity of money declines - the result being a severe growth slump. Figure I-1How Investors Can Consider Uncertainty Related To Velocity Of Money In short, a positive outcome on China-related plays has a one-third probability of playing out, while a negative outcome carries a two-thirds chance. This is why we continue to maintain our negative view on EM and commodities. Commodities Our view on commodities and commodity plays is by and large shaped by our view on China's capital spending. Given the credit plus fiscal spending impulse is already very weak, the path of least resistance for capital expenditures is down. Besides, the government is clamping down on local governments' off-balance-sheet borrowing and spending (via Local Government Financing Vehicles). A deceleration in capital expenditures in general and construction (both infrastructure and property development) in particular is bearish for industrial metals (Chart I-18). Money and credit impulses herald a major downturn in Chinese imports values and volumes (Chart I-19). Chart I-18Industrial Metals / Copper Are At Risk Chart I-19China Will Be A Drag On Its Suppliers As to China's commodities output reductions, last week we published a Special Report3 on China's "de-capacity" reforms in steel and coal. The report concludes the following: The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. Importantly, the mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity in order to replace almost entirely obsolete capacity. The combination of demand slowdown and modest production recovery will weigh on non-oil raw materials. As for oil, the picture is much more complicated. Oil prices have been climbing in reaction to declining OECD inventories as well as on expectations of an extension to oil output cuts into 2018. One essential piece of missing information in the bullish oil narrative is China's oil inventories. In recent years, China has been importing more crude oil than its consumption trend justifies. Specifically, the sum of its net imports and domestic output of crude oil has exceeded the amount of refined processed oil. This difference between the sum of net imports and production of crude oil and processed crude oil constitutes our proxy for the net change of crude oil inventories. Chart I-20 shows that our proxy for mainland crude oil inventories has risen sharply in recent years. This includes both the nation's strategic oil reserves as well as commercial inventories. There is no reliable data on the former. Therefore, it is impossible to estimate the country's commercial crude oil inventories. Chart I-20China: Beware Of High Chinese Oil Inventories Nevertheless, whether crude oil inventories have risen due to a build-up of strategic petroleum reserves or commercial reserves, the fact remains that crude oil inventories in China have surged and appear to be reaching the size of OECD total crude and liquid inventories (Chart I-20). In short, China has been a stabilizing force for the oil market over the past three years by buying more than it consumes. Without such excess purchases from China, oil prices would likely have been much weaker. Going forward, the pace of Chinese purchases of crude oil will likely slow due to several factors: (a) China prefers buying commodities on dips, especially when it is for strategic inventory building. With crude oil prices having rallied to around $60, the authorities might reduce their purchases temporarily, creating an air pocket for prices, and then accelerate their purchases at lower prices; (b) Commercial purchases of oil will likely decelerate due to tighter money/credit, possibly high inventories and a general slowdown in industrial demand for fuel. Bottom Line: Raw materials and oil prices4 are at risk from China and overly bullish investor sentiment. Beyond Commodities The slowdown in China will impact not only commodities but also non-commodity shipments to the mainland (Chart I-21). In fact, 47% of the nation's imports are commodities and raw materials and 45% are industrial/capital goods - i.e., China's imports are heavily exposed to investment expenditures, not consumer spending. This is why money/credit impulses correlate so well with this country's imports. Consistently, China's broad money (M3) impulse leads EM corporate profit growth by 12 months - and currently heralds a major EPS downtrend (Chart I-22). In addition, aggregate EM narrow money (M1) growth also points to a material slump in EM EPS (Chart I-23). Chart I-21China Is A Risk To ##br##Non-Commodity Economies Too Chart I-22Downside Risk To EM EPS The only EM countries that are not materially exposed to China and commodities are Turkey and India. The former is a basket case on its own. Indian stocks are expensive and will have a difficult time rallying in absolute terms when the EM equity benchmark relapses. As for Korea and Taiwan, their largest export destination is not advanced economies but China. China accounts for 25% of Korea's exports and 28% of Taiwan's. This compares to a combined 22% of total Korean exports and 20% of total Taiwanese exports going to the U.S. and EU combined Can robust growth in the U.S. and EU derail the growth slowdown in China when capital spending slows? This is very unlikely, in our view. Chart I-24 portends that China's shipments to the U.S. and EU account for only 6.6% of Chinese GDP, while capital spending and credit origination constitute 45% and 25% of GDP, respectively. Chart I-23EM M1 And EM EPS Chart I-24What Drives Chinese Growth? A final word on tech stocks. EM's four large-cap tech stocks (Tencent, Ali-Baba, Samsung and TSMC) have gone exponential and are extremely overbought. At this juncture, any strong opinion on tech stocks is not warranted because they can sell off or continue advancing for no fundamental reason. We have been recommending an overweight position in tech stocks, and continue recommending overweighting them, especially Korean and Taiwanese semiconductor companies. As for Tencent and Alibaba, these are concept stocks, and as a top-down house we have little expertise to judge whether or not they are expensive. These are bottom-up calls. Investment Strategy EM Stocks: Asset allocators should continue to underweight EM versus DM, and absolute-return investors should stay put. Our overweights are Taiwan, China, Korean tech stocks, Thailand, Russia and central Europe. Our underweights are Turkey, South Africa, Brazil, Peru and Malaysia. Chart I-25EM Currencies: A Canary In ##br##Coal Mine For EM Credit? Stay short a basket of the following EM currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. For traders who prefer a market neutral currency portfolio, our recommended longs (or our currency overweights) are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Continue underweighting EM sovereign and corporate credit relative to U.S. investment grade bonds. The mix of weaker EM/China growth, lower commodities prices and EM currency depreciation bode ill for already very tight EM credit spreads (Chart I-25). Within the sovereign credit space, our underweights are Brazil, Venezuela, South Africa and Malaysia and our overweights are Russia, Argentina and low beta defensive credits. The main risk to EM local currency bonds is EM currency depreciation. With foreign ownership of EM domestic bonds at all-time highs, exchange rate depreciation could trigger non-trivial selling pressure. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, China, India, Argentina and Central Europe. Other high-conviction market-neutral recommendations: Long U.S. banks / short EM banks. Long U.S. homebuilders / short Chinese property developers. Long the Russian ruble / short oil. Long the Chilean peso / short copper. Long Big Five state-owned Chinese banks / short small- and medium-sized banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 For example, given that interest rates are in the denominator of the Gordon Growth model, a one percentage point change in interest rates from a low level can have a significant impact on the fair value P/E ratio. 2 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016 and January 18, 2017; available on ems.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, link available on page 22. 4 This is the Emerging Markets Strategy team's view and is different from BCA's house view on commodities. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Overweight - High Conviction Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. The S&P software index is a clear capex upcycle beneficiary and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel). Recovering bank loan growth signals that businesses are beginning to loosen their purse strings anew (third panel). CEO confidence is pushing decade highs, pointing to a pickup in software investments and rekindling software M&A activity, with the number of industry deals jumping in recent months. Our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook (bottom panel). Overall, we recommend moving to an overweight position; see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA.
Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (Chart 4). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Chart 5S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.
Highlights There are a number of cracks emerging in global risk assets. Not only have U.S. junk bond prices recently posted sharp declines, but a number of economic and financial market developments within EM also warrant investors' close attention. In particular: Feature The EM manufacturing PMI has rolled over at relatively low levels, despite continued strength in advanced economies' manufacturing PMI (Chart 1). Importantly, the trend in relative manufacturing PMIs heralds EM equity underperformance against DM bourses (Chart 2). Chart 1EM Manufacturing: Rolling Over Chart 2EM Stocks To Underperform DM Stocks The Shanghai Container Freight Index has relapsed in recent months. This index has been a good indicator for EM/Asian export volumes (Chart 3, top panel). That said, DRAM semiconductor prices continue to surge (Chart 3, bottom panel). DRAM prices have jumped five-fold in less than two years, justifying the massive rally in semiconductors' stock prices. It is hard to know how long and how far the ascent in DRAM prices will continue. Nevertheless, our hunch is that non-technology exports in Asia will slow down, regardless of what happens in the global technology sector. Consistently, we expect EM non-technology stocks to relapse sooner than later, even as tech stocks remain a wild card. Global and EM tech stocks rallied exponentially and appear to be in a mania phase that could make any reasonable assessment and investment strategy off-mark. Weighing the pros and cons, we continue to recommend overweighting the tech sector within the EM universe, even as the outlook for their absolute performance remains highly uncertain. Within EM tech, we favor semi stocks (Samsung and TSMC) versus internet and social media stocks. The sheer magnitude of the EM equity rally has been driven by a few names such as Tencent, Alibaba, Baidu, Samsung and TSMC. Their combined market cap as a share of the overall MSCI EM equity index has risen to 19%. Remarkably, the equal-weighted MSCI EM stock index has massively underperformed the market cap-weighted MSCI EM equity index (Chart 4, top panel). In contrast, the same measure for DM equities has held up much better (Chart 4, bottom panel). Chart 3Asian/EM Exports At Risk Chart 4A Perspective On Internal Equity Dynamics: EM And DM EM stock prices have been firm so far despite the rebound in the broad trade-weighted U.S. dollar (Chart 5). As the greenback continues to advance, odds are that EM share prices will dive, as occurred in 2014 and 2015. In China, the effects of triple tightening - the liquidity squeeze by the central bank, the regulatory clampdown on banks and shadow banking by the Banking Regulatory Commission, and the anti-corruption drive that is targeting the financial industry - are gaining momentum. Onshore corporate bond yields and credit spreads over government bonds have risen further since the end of the most recent Party Congress. One of the reasons why policymakers are tightening is to rein in the enormous excesses prevalent in the credit, money and property markets that have developed in recent years. Given that advanced economies have now recovered, the Chinese authorities feel more confident to tighten domestically. Finally, while less recognized by the investment community, inflationary pressures have been rising in China. Although still at 2.25%, core consumer price inflation is clearly trending up, warranting a policy response (Chart 6, top panel). This is especially true given that real deposit rates - deflated by core consumer price inflation - have plummeted into negative territory (Chart 6, bottom panel). Chart 5U.S. Dollar Rebound = EM Pullback Chart 6China: Beware Of Rising Inflation Consistent with tightening, China's official broad money growth has decelerated to an all-time low (Chart 7, top panel). In the meantime, narrow money (M1) growth is falling rapidly. Remarkably, M1 growth has been correlated with Chinese H-share prices (Chart 7, bottom panel). We have extensively documented in past reports1 that China's money and credit impulses are good leading indicators of the mainland's business cycle. The current readings of these indicators signal considerable growth deceleration. In addition, general (central and local) government spending growth has already slowed a lot (Chart 8). Chart 7China: Broad Money Growth Is At Record Low Chart 8China: Aggregate Fiscal Spending Growth Is Also Weak The fundamentally weakest EM currencies such as the South African rand and the Turkish lira have already broken down. Some others have so far been only marginally weak. A chain, however, typically cracks at its weakest link. Hence, it makes sense that the selloff has begun with the fundamentally weakest currencies. We expect other EM currencies to follow. Currency depreciation in EM will undermine returns for foreign investors, and the latter will become marginal sellers in both EM equity markets and local currency bonds. Meanwhile, EM currency depreciation and potentially falling commodities prices will trigger credit spread widening in EM sovereign and corporate bonds. Investment Positioning Global equity portfolios should continue underweighting EM versus DM. The risk-reward profile for EM stocks' absolute performance is extremely unfavorable. We continue to recommend underweighting EM credit markets relative to U.S. investment grade bonds. Our strongest conviction shorts are a basket of the following currencies: ZAR, TRY, BRL, IDR and MYR. We are also shorting the COP and CLP. For traders who prefer a market neutral currency portfolio, our recommended longs are TWD, THB, SGD, ARS, RUB, PLN and CZK. INR and CNH will also outperform other EM currencies. Unlike in 2014-2015, EM currencies will depreciate not only versus the U.S. dollar but also the euro. This will erode EM returns for European investors, and temporarily halt or reverse capital inflows into EM. Among local currency bond markets, the most vulnerable are Turkey, South Africa, Indonesia and Malaysia. The least vulnerable are Korea, Russia, India, Argentina2 and Central Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Questions From The Road", dated September 20, 2017. 2 Please refer to the Emerging Markets Strategy Special Report, titled "Argentina: A Genuine Bull Market", dated October 25, 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations