Emerging Markets
Highlights China's mini-cycle has peaked, which has raised concerns among global investors that China may return to below-trend growth over the coming year, similar to what occurred in 2015. In our view, the severe slowdown in the Chinese economy in 2015 was due to overly tight monetary policy coupled with a severely weak external demand environment. A monetary conditions approach has done an excellent job of predicting industrial activity in China over the past several years. While monetary policy has tightened somewhat since the beginning of the year, none of the monetary conditions indexes that we track have come close to returning to 2015 levels. In short, an uncontrolled and sharp deceleration in the Chinese economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Feature Last week's report was replaced by a Special Report prepared by my colleague Matt Gertken, Associate Vice President of our Geopolitical Strategy team.1 The report presented a full "postmortem" on the Party Congress, and outlined how stepped up reform efforts in China are likely over the coming year, and beyond. By "reforms", our geopolitical 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. The implications of the "reform reboot" scenario presented in last week's report are negative for emerging markets (EM) and other plays on China's industrial sector (such as industrial metals). We agree that a "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, even though the momentum of China's "mini" economic cycle of the past two years has very likely peaked. However, the potential for a brisk pace of reforms to cause a more acute decline in industrial activity is a risk to our view that the slowdown in China's economy is likely to be benign and controlled. Monitoring reform progress is likely to be a key theme for this publication over the coming year. Over the nearer term, the potential impact of reform efforts is not the only risk to the economy, as many market participants appear to be worried that the peak in China's mini-cycle presages a destabilizing decline in economic activity. This week's report is the second of two parts examining the key differences facing China today from what prevailed in mid-2015,2 when the Chinese economy operated below what investors and market participants considered to be a "stable" pace of growth. In Part II we focus on monetary policy, and outline how the monetary environment remains stimulative despite a significant rise in corporate bond yields over the past year. China's Monetary Policy Stance: A Brief Review Chart 1 presents the one-year policy lending rate over the past decade, and highlights the four distinct phases that have prevailed since the global financial crisis in 2008: Chart 1A Brief Review Of China's Monetary Policy Stance A long period of significant easing that began during the Great Recession and lasted until late-2010 A material rate tightening cycle that began in late-2010 and ended in mid-2012 A half-reversal of the 2011/2012 rate cycle, which happened quickly in the summer of 2012 and was followed by a long pause until late-2014, and A significant series of rate cuts over the course of 2015, followed by a 2-year pause at current levels. We contend that policymakers were too timid in responding to economic weakness in China at the end of the third monetary policy phase highlighted in Chart 1, and that this hesitation magnified the impact of the serious deterioration in China's external demand environment that we discussed in Part I of this report. Chart 2Monetary Conditions Predict ##br##Chinese Industrial Activity Of course, in a large, trade-sensitive, economy like that of China, interest rates are not the only determinant of the degree of monetary accommodation. In order to capture the effects of the exchange rate and other factors affecting the efficacy of monetary policy, we have tended to show a Monetary Conditions Index (MCI) as a stand-in for the policy stance. As shown in Chart 2, the Bloomberg MCI has done an excellent job of leading industrial activity in China over the past several years, particularly during the mini-cycle of the past two years. While the MCI appears to have peaked early this year, it remains well above (i.e. more accommodative) the levels reached in mid-2015 when policymakers finally became serious about easing monetary conditions. Looking Forward Chart 3 presents a few alternative MCIs for China alongside Bloomberg's measure. Analysts tend to employ a variety of approaches when calculating monetary conditions indexes, but the real interest rate and the real effective exchange rate almost always feature prominently. Of the three alternative measures, Citigroup's MCI is the most bearish, as it includes the year-over-year growth rate of M2 which has recently languished. The remaining two measures are BCA calculations, one that deflates interest rates using producer prices, and one that uses core consumer prices. Both of our measures employ an equal split between the real interest rate and the exchange rate. Chart 3 highlights that all four MCIs have either peaked or are now falling, suggesting that a tightening in financial conditions earlier this year has somewhat reduced the degree of monetary accommodation to the economy. However, there are three key points to consider when judging the likely impact of monetary tightening on China's economy over the coming 6-12 months: None of the MCIs shown in Chart 3 have returned to their 2015 low, implying that the policy tightening that has occurred over the past year is not likely to cause Chinese industrial activity to crash in over the coming 6-12 months. Most of the appreciation in the RMB this year has occurred versus the dollar, not against the euro or in trade-weighted terms (Chart 4). In fact, in trade-weighted the RMB remains 6.5% below where it was in August 2015 prior to the currency devaluation. This highlights that the recent appreciation largely reflects dollar weakness, rather than policy-induced strength in the RMB. Chart 3Monetary Conditions Have Not Returned##br## To 2015 Levels Chart 4Recent RMB Appreciation##br## Reflects Dollar Weakness Average lending rates have only increased approximately 40 bps over the past year, in comparison to the 200 bps of easing that occurred from 2014 to 2016 (Chart 5). In real terms (when deflated by core consumer prices), average interest rate have barely risen at all this year. The still modest rise in average lending rates is an important consideration, because it contrasts with the rise in Chinese bond yields, both in the government and corporate sectors. For example, Chart 6 shows that corporate bond yields have risen by 160 bps since late-2016 and are 25 bps higher than they were in early-2015. Chart 5Average Lending Rates ##br##Have Risen Only Modestly Chart 6Corporate Bond Yields##br## Have Tightened Materially But our view is that average lending rates are a more important driver of debt service payments for China's non-financial sector. In fact, Table 1 highlights that while corporate bond financing is a growing component of Chinese private social financing, it is still quite small. The table presents a breakdown of adjusted social financing, which highlights that the sum of local currency loans, foreign currency loans in RMB, trust and entrusted loans equals roughly 85% of total social financial excluding equity issuance. Corporate bonds, by contrast, account for only about 10%, suggesting that the economic impact of the rise in bond yields this year will be relatively small. Table 1Corporate Bonds Account For A Small Percent Of China's Social Financing Investment Implications We noted in our October 12 Weekly Report that the acceleration in the Chinese economy that began in mid-2015 has likely peaked (Chart 7), ending the upswing of this "mini" economic cycle. Chart 7A Stylized View Of China's Recent The framework illustrated in Chart 7 presented three distinct scenarios for China over the coming 6-12 months: 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). In our view, the Chinese economy in early-2015 began to operate below the "stable" growth range shown in Chart 7, owing to a "double whammy" of excessively tight monetary conditions and a synchronized global downturn. While our research suggests that China's export growth will moderate over the coming year and that monetary conditions have tightened somewhat, the magnitude of these changes are not sufficiently large to return the Chinese economy back to 2015-like conditions. To us, this is consistent with the second scenario presented above. From an absolute equity perspective, this conclusion is positive for Chinese stock prices. Chart 8 highlights that the Li Keqiang index correlates fairly well with the growth in earnings for the MSCI China index ex technology; a moderate decline in the pace of growth in China's industrial sector would blunt the earnings growth of these firms, but not enough to cause an outright contraction. The combination of positive ex-tech earnings growth and very cheap valuation (Chart 9) suggests that the absolute uptrend in Chinese ex-technology stocks that began at the beginning of 2016 is likely to continue. Chart 8Ex-Tech EPS Growth Will Moderate, ##br##But Not Contract Chart 9Excluding Technology, ##br##China Is Extraordinarily Cheap In relative terms, the picture is somewhat cloudier, although for now we would continue to favor the China MSCI index versus global and emerging market stocks. Chart 10 highlights that Chinese equities have outperformed global stocks even when excluding tech companies, although it is clear that most of the recent outperformance is due to the IT sector. On the earnings front, while we expect Chinese ex-tech earnings growth to moderate over the coming year, this is also true of overall U.S. equities (Chart 11). Finally, Chart 12 highlights that while Chinese technology firms are richly priced vs their global counterparts, the multi-year relative outperformance trend has been fundamentally-driven, a situation that does not appear to be threatened by a slowdown in China's industrial sector (given the largely domestic & consumer orientation of Chinese technology firms). Chart 10China Is Beating Global,##br## Even Excluding Technology Chart 11U.S. Earnings Growth##br## Is Set To Moderate Chart 12China's Tech Rally Is ##br##Fundamentally-Driven Bottom Line: The economic momentum of China's 2-year mini-cycle has probably peaked, but an uncontrolled and sharp deceleration in the economy is not in the cards. This favors the performance of Chinese stocks, both in absolute and relative terms. Stay overweight. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Report, "China: Party Congress Ends ... So What?", dated November 2, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs Today (Part I): Trade", dated October 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Chart of the WeekChina Developments Significant##BR##To Base Metal Prices Reading the tea leaves following China's 19th National Communist Party Congress suggests a looming shift in President Xi Jinping's second term from pro-growth to pro-reform. Having consolidated power, Xi now has the capacity to implement his agenda over the next five years. Given China's outsized role in global base metals production and consumption, the direction of Xi's policy changes will have a profound impact on these markets (Chart of the Week).1 The Party Congress set the tone for economic policy and reforms going forward, from which we can extrapolate future policy direction. However, concrete plans and details will not be revealed until the National People's Congress, scheduled in March 2018. In this report we highlight the main takeaways of the Congress specifically those relevant to base metals. Broadly, these can be summarized as: Xi now has the political capital needed to implement real reform in his second term. Based on Xi's remarks at the Congress during his work-report commentary, we believe the environmental and supply-side reforms initiated during his first five-year term will be continued in his second term. Because these reforms will shrink the domestic production capacity for base metals and steel in China, they likely will be a tailwind for these commodities' prices. However, a focus on sustainable growth - i.e., organic growth that is not dependent on regular injections of credit to keep it going - and the elimination of GDP targets past 2021 risk weighing down base metals demand. Real-estate market fundamentals are more supportive than most perceive. This will prevent tighter policies from triggering a significant construction downturn, which will be supportive for steel and copper prices. China's efforts to expand its economic influence globally through the Belt and Road initiative (BRI) will be insufficient in offsetting a mainland slowdown, should one occur. Feature Balancing Stability And Reform Chart 2Stability Was A Priority...Not Anymore Despite reiterating a need for economic reforms, the focus of Xi's first term was maintaining stability and garnering the political capital necessary to implement his desired reforms. Emphasizing stability is a recurrent theme in Chinese politics, regardless of who is at the helm. The 2015-16 state interventions in the economy - including higher infrastructure spending, provincial government bailouts, currency depreciation and capital controls - illustrated the dominance of stability over reforms, during Xi's first term (Chart 2).2 The 19th Party Congress was the capstone event in Xi's effort to accumulate the support needed to implement long-sought reforms. BCA's Geopolitical Strategy points to three outcomes that support this assessment: With the inscription of Xi Jinping Thought on Socialism with Chinese Characteristics for a New Era in China's constitution, the president has cemented his position as one of the most powerful leaders of modern China. In fact, according to our geopolitical strategists, this induction signals that he is "second only to Chairman Mao as a philosophical guide in the party."3 Practically speaking, this means his economic initiatives will carry more weight than anything China has seen since at least the 1998-99 intense reform period. The leanings of members of the new Politburo Standing Committee (PSC) also are telling. Each of the three most recent presidents is represented by two protégés on the PSC. This is an almost-ideal configuration for reform.4 Finally, the appointment of Xi loyalist Zhao Leji as chief of the Central Commission for Discipline Inspection (CDIC), and the creation of the National Supervisory Commission to oversee the anti-corruption campaign give Xi the tools he needs to implement his policies. Thus, Xi has garnered sufficient ammunition to be much more effective in implementing reform policies during his second term. As such, we expect the pace of reform to accelerate. While the policy details are yet to be known, many of the takeaways from the party congress point toward supply- and demand-side changes. Supply-Side Reforms: Short-Term Sacrifice For Long-Term Benefit? While the aim for environmental regulation is not new - an "ecological" section was included in the work report for the first time by Xi's predecessor Hu Jintao in 2012 - we have reason to believe that, given Xi's focus on sustainable development, he will tackle environmental policies with more fervor than in the past. This signals that Xi may prioritize environmental preservation and pollution-reduction measures going forward, which would continue the efforts begun in his first term. In fact, environmental spending was the fastest growing category in central-government spending at the beginning of Xi's first term (Table 1). Table 1Xi Jinping Favors A Greener China Xi's environmental agenda will get an assist from his anti-corruption campaign. Our Geopolitical strategists highlight Xi's use of the CDIC - the anti-corruption watchdog - in enforcing the reforms as a signal of his resolve to implement change. The stakes are high for noncompliant managers who now risk not only financial penalties, but also arrest and jail time. Chart 3Shifting Gears: From Pro-Growth To Pro-Reform This reinforces the message that Xi is still keen on implementing the supply-side structural reforms first announced in 2015, and that he is willing to change the old-line economic model, forgoing potential growth drivers from traditional industries in favor of greener sectors (Chart 3). As the leading base metals producer in the world, a continuation - and potential intensification - of these reforms will weigh on global production and prop up base metal prices, as they have since last year. In fact, some of these reforms have already materialized in the form of earlier-than-anticipated winter production cuts. Steel production in Tangshan - China's largest steel-producing city - will be halved over the winter, with three other top steel producing cities - Shijiazhuang, Anyang, and Handan - expected to announce similar cuts.5 Similarly, the government of Shandong - a major producer of alumina and aluminum - recently instituted a crackdown program that includes production cuts during the winter months.6 Bottom Line: Xi used his platform at the Party Congress to reiterate his resolve to set China's economy on a more sustainable growth path through supply-side reform. Given that he has accumulated the political capital necessary to implement these changes, we expect to see a renewed push toward a "greener" China. Ceteris paribus, this will weigh on base metals production by reducing global supply and will support prices. "Houses Are Built To Be Inhabited, Not For Speculation" During the party congress, Xi reiterated his resolve to tighten control of the real estate market. In fact, the Chinese government has been trying for years to rein in demand for real estate, which typically involves raising mortgage rates. Tightening measures announced in late September include controls on home sales in eight major cities, which, among other things, prevent the resale of homes within five years of purchase. These controls have weighed on both prices and sales of real estate (Chart 4). More recently, the Ministry of Housing and Urban-Rural Development and the National Development and Reform Commission announced that they will jointly inspect real estate developers and commercial property sales agents, looking for "irregularities," including artificially inflating prices and hoarding unsold homes.7 Nonetheless, our China Investment Strategy desk does not foresee a major slowdown in construction activity.8 Simply put, they argue that strong demand amid declining inventories will prevent a construction slowdown, even in face of tighter policies (Chart 5). In fact, they do not see much excess in China's current property market to begin with, and thus doubt we will witness a major downturn. This will be important to bear in mind going forward, given that construction is the most important source of demand for base metals - copper in particular - and steel in China, accounting for about one-third of copper demand and half of steel demand. Chart 4Real Estate Policies Weigh##BR##On Prices And Sales Chart 5Housing Destocking Becomes Advanced Fundamentals##BR##Will Prevent A Major Real Estate Downturn Bottom Line: Despite efforts to tighten the property market, a sharp downturn in the construction sector, which is a major metals consumer, is unlikely. Structural tailwinds - most notably from China's continued urbanization - will eventually prevail, and the construction sector will remain a major contributor to China's economy, and base metals and steel consumption. Quality Over Quantity: Deleveraging The renewed focus on "sustainable and sound" growth, especially given the elimination of GDP growth targets beyond 2021, elevates the risk of a potential economic slowdown. The Xi administration has signaled that it is not afraid to prioritize financial regulation - targeting excessive risk and under-regulation - over economic growth. It is likely that it will continue doing so. In fact, Xi singled out systemic financial risk as a hazard to overall stability. While this is not China's first time to announce a deleveraging campaign, given that Xi has consolidated power and will use the CDIC to implement reforms, we expect these efforts to be more effective this time around. Furthermore, China has bounced back from the 2015 - 16 deflationary spiral so well that interest rate hikes and tighter financial controls are now on the table (Chart 6). Chart 6Interest Rate Hikes Are Now On The Table While the reforms are expected to improve Chinese productivity in the long-run, they may shake up the economy in the short run. We are somewhat reassured by the fact that traditionally, Chinese leaders have boosted fiscal spending when faced with slowing credit growth in periods when they aim to combat the negative effects of supply-side structural reforms and deleveraging. However, we remain cautious that, as Xi's priorities have shifted, fiscal stimulus may not be used with the same enthusiasm going forward. Given China's outsized role as a consumer of base metals, a slowdown would have serious repercussions on global markets. Researchers at the IMF find that surprises in the strength of China's economy - measured as the scaled deviation of year-on-year industrial production growth from the median Bloomberg consensus estimates immediately prior to the announcements - have significant impacts on base metals prices.9 This is true for all metals they studied - copper, nickel, lead, tin, and aluminum - with the exception of iron ore, which they put down to the relatively recent financialization of iron ore markets. In fact, they find that the more important China is to a specific base metal's fundamentals, the stronger the impact on prices. Using China's import share as a percent of world total as their measure of China's footprint in each individual market, they find that copper is most impacted by Chinese IP shocks, followed by nickel, lead, tin, and aluminum.10 Bottom Line: Beijing is continuously reassuring markets it will push for reforms - in the form of deleveraging the financial sector, restructuring industry, eliminating overcapacity, and environmental controls - without sacrificing growth. Nonetheless these reforms, which we believe are forthcoming following Xi's consolidation of power post-19th Congress, will be headwinds to growth. It is true that Xi may be willing to tolerate slower growth going forward in order to see his policies go through. Yet in all likelihood, fiscal stimulus will be used if social stability is threatened by reform measures. That said, reform is definitely in the cards. The Revival Of China's Silk Road - Enshrined In The Constitution Along with supply-side reforms, the Belt and Road initiative (BRI) - Xi's solution to a global slowdown through the physical integration of China's trading partners - was written into the constitution. This is a reiteration of Xi's intent to shift China away from being the factory of the world and toward playing a key role in global development. The ambition of the BRI plan is to connect many of China's trading partners in Asia, Europe, the Middle East, and Africa through a modern infrastructure of roads, ports, railway tracks, pipelines, airports, transnational electric grids, and fiber-optic lines. The objectives of the project, although speculative, are believed to be two-fold: It is an opportunity to create new markets for Chinese goods - giving the Chinese economy a push even in the event of a mainland slowdown. This is especially relevant, given the need to export excess capacity, most notably in the cases of steel and cement. In fact, Chinese industrial production will also benefit from the secondary effects of an improvement in demand for consumer goods from countries receiving economic aid from China. Furthermore, Xi hopes the project will help revive the economies of China's border regions. There is a possible ancillary benefit, in that heavy industry - e.g., steel mills and aluminum smelters - could be moved away from population centers to support the BRI. Chart 7BRI Investments On The Ascent Policymakers foresee the project - which was initiated in 2013 - injecting an estimated $150 billion annually into the construction of massive amounts of infrastructure (Chart 7). BCA's Frontier Markets Strategy (FMS) projects the value of Chinese BRI project investments will reach $168 billion in 2020.11 While this would boost China's economy in general, and base metals, steel and iron ore demand in particular, our FMS strategists argue that at ~ $102 billion, China-funded BRI investment expenditure in 2016 is dwarfed in comparison to China's gross fixed-capital formation (GFCF), which amounted to ~ $4.8 trillion last year. Simply put, the BRI is incapable of offsetting a general slowdown in China, were it to occur. In fact, our FMS desk estimates that a 0.4% contraction in GFCF is all that will be needed to offset BRI-related investments in 2018. Bottom Line: With the Belt and Road Initiative written into the constitution, we expect greater follow-through directed toward meeting the goals specified in it. On its own, this is positive for base metals, which will benefit from greater demand from infrastructure projects, as well as the secondary effects in the form of demand for consumer goods from trading partners. However, the BRI, in and of itself, will not super-charge base metals demand. The BRI will counteract some of the negative impacts of a slowdown in China growth on commodity markets generally. However, since the size of BRI investment expenditure accounts for only a small fraction of China's fixed capital formation, we are skeptical of the extent to which it can offset a slowdown, were it to occur in the mainland. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 In our modelling of base metal prices, we find China's PMI has a large and significant impact on metal prices. Using year-on-year growth rates since 2010, a 1% increase in China's PMI is associated with a 0.54% increase in the LMEX base metals price index. 2 Please see BCA Research's Geopolitical Strategy's Special Report titled "China: Party Congress Ends...So What?," dated November 1, 2017. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report titled "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 4 Li Keqiang and Wang Yang are both from Hu Jintao's Communist Youth League, Han Zheng and Wang Huning are Jiang Zemin followers, and Li Zhanshu and Zhao Leji are Xi Jinping loyalists. 5 While this is positive for steel prices, it would dampen demand for iron ore, weighing down on its prices. 6 Alumina, aluminum, and carbon producers that meet emission discharge standards are ordered to cut production by over 30%, around 30%, and over 50%, respectively. Producers that do not meet emission discharge standards are ordered to halt production. 7 Please see "China to launch nationwide inspection on commercial housing sales," published October 25, 2017, available at www.chinadaily.com.cn. Noted "irregularities" include fabricating information on housing sales, publishing fake advertisements and artificially inflating housing prices, market manipulation, and hoarding unsold homes. 8 Please see BCA Research's China Investment Strategy Weekly Report titled "Chinese Real Estate: Which Way Will The Wind Blow?," dated September 28, 2017, available at cis.bcaresearch.com. 9 Please see IMF Spillover Notes, Issue 6 "China's Footprint in Global Commodity Markets," published September 2016, available at www.imf.org. 10 Interestingly, given the U.S.'s role as a harbinger of the global economy, U.S. IP surprises have a similar impact on commodity prices. 11 Please see BCA Research's Frontier Markets Strategy Special Report titled "China's Belt And Road Initiative: Can It Offset A Mainland Slowdown?," dated September 13, 2017, available at fms.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016
Highlights The private sectors in Brazil, Russia and India have indeed experienced some deleveraging. Yet in China, deleveraging has not even begun. In fact, the money and credit excesses have become ever larger in the past two years. China's broad money (M3) is as large as the entire outstanding stock of broad money in the U.S. and euro area banking systems combined. In China, the triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign - will lead to lessened money and credit origination. That in turn will weigh on mainland capital spending and growth in general. Chart I-1Some Deleveraging In Brazil, Russia, And India Feature A judgment on the sustainability of the rally in EM/China-related risk assets, from a big picture perspective, should include whether deleveraging in these economies is in late stages - i.e., whether credit and debt excesses accumulated following the 2008 global financial crisis have been unwound, at least partially. The objective of this week's note is to provide an update on the status of deleveraging within EM/China. Herein, deleveraging is defined as a falling debt-to-GDP ratio. The private sectors within Brazil, Russia and India have indeed experienced some deleveraging, with their private sector debt-to-GDP ratio either falling or moving sideways (Chart I-1). However, in China, deleveraging has not yet even begun (Chart I-2). Excluding Korea, Taiwan, and the BRIC economies, the rest of EM has not seen much deleveraging either (Chart I-3) - we exclude Korea and Taiwan because their equity markets are contingent on global demand rather than domestic dynamics. Note that this debt-to-GDP aggregate is weighted by each country's respective market cap in the MSCI EM stock index. The latest stabilization in this ratio might be due to these countries' currency appreciation, which has reduced their foreign currency debt burden relative to GDP. While deleveraging in many individual developing economies will not affect the rest of the world, deleveraging in China will have an impact on global trade in general and EM economies in particular. This remains one of the most important reasons why we believe the current recovery in EM growth will not be sustained. Chart I-2Deleveraging Has Not Started Yet In China... Chart I-3...Nor In The Rest Of EM Some investors and commentators have remarked that in the U.S., the euro area and Japan, there was no deleveraging following their respective credit bubbles and crises. As such, they argue that there is no compelling reason to expect deleveraging in EM/China. The point about the lack of deleveraging in Japan, the U.S. and Europe following their credit bubbles is only true when one includes public debt (Chart I-4). Yet, their private sectors did deleverage as can be seen in Chart I-5. Chart I-4DM: Deleveraging Concealed By ##br##Acceleration In Public Credit Chart I-5Private Sector Deleveraged ##br##Meaningfully In DM In the U.S. and euro area, deleveraging lasted an average of about seven years. As to Japan - which had a larger credit bubble but never experienced an acute credit crisis - private sector deleveraging endured over more than 21 years (Chart I-5, bottom panel). Did deleveraging in these DM economies involve outright nominal contraction in private credit and bank loans, or only decline in private debt-to-GDP ratio? Both bank loans and private credit nominal growth contracted, as demonstrated in Chart I-6. In short, despite massive policy support - i.e. monetary and fiscal easing and various bank recapitalization programs - private credit growth shrunk in nominal terms in the U.S. and euro area for a couple of years, and for many more years in Japan. China An update on China's debt burden is in order: Despite the vast local government financing vehicle (LGFV) debt swap of about RMB13 trillion conducted over the past two years the corporate debt-to-GDP ratio has not dropped (Chart I-7, top panel). Chart I-6DM: Bank Loans & Private Sector Credit ##br##Contracted In Nominal Terms Chart I-7China's Breakdown ##br##Of Debt By Sector The corporate debt-to-GDP ratio has stopped rising because LGFV debt - which belonged to SOEs and was classified as corporate debt - has been converted into provincial government debt. Since the onset of the Chinese equity market crash in the summer of 2015, our measure of broad money (M3) has expanded by RMB38 trillion ($6 trillion). Similarly, total social financing excluding equity issuance and including local government debt issuance - our so-called TSF+ measure - has surged by RMB49 trillion ($7.4 trillion). In terms of annual growth rates, M3 and TSF+ are still expanding at 10% and 14%, respectively. Chart I-8China's Money Impulse Points ##br##To Growth Deceleration We do not expect China's credit growth to contract in nominal terms, but we do expect credit/money growth to slow further. If and when this occurs, the money and credit impulses - the second derivatives - will become negative. The growth rates of GDP, industrial production, capital spending, profits and imports are impacted by the second derivatives of money and credit, which have been declining. In fact, the M3 impulse is already negative, which is consistent with deceleration in China's business cycle (Chart I-8). Some commentators and strategists have argued that debt should be compared with debtors' assets not GDP. This is a very weak argument. The sustainability of debt is contingent on borrowers' ability to service it. In turn, the ability to service debt is determined by debtors' cash flow generation which can be measured / approximated by nominal GDP. This is why the debt-to-nominal GDP ratio is the best metric for debt sustainability on a macro scale. It factually measures debt relative to corporate nominal revenues and household income. What about assets? Just because a company has assets does not mean it can service its debt. Note that in China, debt sustainability concerns are primarily around companies not households or government. First, if a company's assets do not generate sufficient cash flow to service debt, the value of these assets will be low. Second, asset valuations in EM state-controlled companies in general and among Chinese SOEs in particular, where most of the debt is concentrated, cannot be taken at face value. When evaluating the creditworthiness of a debtor, should investors rely on the accounting value of buildings that a debtor owns, or on the cash flow that these assets generate? We believe the latter is a much more prudent approach to investment analysis than the former. Third, if assets indeed need to be liquidated to service debt across many debtors, the situation is already very dire. Finally, we acknowledge that the Chinese government has a lot of fiscal room to bail out corporate debtors. When the authorities do so and overall corporate debt declines, we will seriously contemplate changing our view and investment strategy. So far, corporate indebtedness has not declined. For all of the above reasons, the debt-to-nominal GDP ratio is a much more reasonable measure than the debt-to-assets ratio. To be clear, we are not suggesting that Chinese companies are heading into a massive default and liquidation cycle. Our key premise as it relates to China's debt burden is as follows: overleveraged companies that could potentially struggle to service their debt are unlikely to embark on major capital spending initiatives. And in fact, their creditors should not lend to these debtors. As a result, capital spending will slow, weighing on commodities and other related areas. Conclusions The credit and money excesses in China and EM have been increasingly getting larger. Not only does China have too much corporate debt, but its stock of outstanding broad money is very high compared to any other economy in the world (Chart I-9). Chart I-9China's 'Money Bubble' Money is created by banks "out of thin air" (subject to regulatory capital ratios and other constraints) when they lend or buy assets from non-bank entities. Banks' ability to originate money does not relate to or depend on consumers or national savings. We have explored these issues in detail in Trilogy of reports in the past.1 Chart I-10China: Beware Of Rising Inflation Chart I-9 illustrates that China's official broad money (M2) is equivalent to $25 trillion while our measure of broad money (M3) is equivalent to about $29 trillion. This compares with broad money of $14 trillion in each of the U.S. and the euro area. Hence, China's broad money (M3) is as large as the U.S. and euro area's aggregate broad money combined. Furthermore, as of January 1, 2009, China's M2 and M3 were only $7.3 trillion and $8 trillion, respectively. This entails that the Chinese banking system has increased the broad money supply by the equivalent of $18-21 trillion. The triple tightening - higher corporate bond yields and money market rates, ongoing tightening by banking regulators and the anti-corruption campaign that is moving into the financial system - will lead to lessened money and credit origination. This will weigh on capital spending and growth in general. The odds are that tightening will escalate. First, after the party Congress, President Xi has consolidated power and can now enact meaningful structural reforms. Second, as we documented several weeks ago, core consumer inflation is rising (Chart I-10). Producer prices inflation is holding up around 7%. This is not surprising, given the amount of money that has been created in the economy in the past two years. Even marginal policy tightening amid lingering credit excesses is very dangerous. Yet a moderate slowdown in credit growth can translate into a notable drop in the credit impulse, weighing on growth as a result. This is especially true for capital spending and construction and is one of the primary reasons why we maintain a negative stance on China-related and EM risk assets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 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 Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Chart I-17Kiwi Housing Is Expensive It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Chart I-21Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades
Highlights The synchronized upturn lifting global GDPs will pull demand for stainless steel higher, as consumers increase purchases of autos, ovens, refrigerators, freezers and other household durables. That's good news for nickel, since roughly two-thirds of demand for the metal worldwide is accounted for by the stainless steel market. This means the current nickel supply deficit will persist into 2018, which will be supportive of prices over the next 3 - 6 months (Chart of the Week). Going into 2H18, however, we expect nickel supply growth to pick up, which is keeping us neutral on the metal for now. Chart of the WeekDeficit Will Further Support Prices Into 1H2018 Energy: Overweight. Leaders of OPEC 2.0 are strongly signaling they will extend their 1.8mm b/d production cuts to end-December 2018, when they meet at the end of the month. This could lift our 2018 Brent and WTI forecasts - $65/bbl and $63/bbl, respectively - by as much as $5.00/bbl, should it materialize. We remain long $55/bbl calls vs. short $60/bbl Brent and WTI call spreads expiring in May, July and December 2018; they are up an average 26.5%. In anticipation of a more pronounced backwardation arising from tighter supply-demand fundamentals in the WTI forward curve, we are getting long Jul/18 WTI vs. short Dec/18 WTI at tonight's close. Base Metals: Neutral. Nickel markets will remain in deficit into next year, as stainless steel demand is lifted on the back of the synchronized global upturn in GDP (see below). Precious Metals: Neutral. Gold markets appear to have fully discounted the appointment of Jerome Powell as the next Fed Chair, trading on either side of $1,280/oz since the beginning of October. Ags/Softs: Neutral. U.S. ag officials on the ground in Argentina reported corn production for the 2017/18 crop year is projected to be 40mm tons, or 2mm tons below the USDA's official estimate, due to smaller areas planted in that country. Wheat production is expected to be 16.8mm tons, 700k tons below the USDA's official forecast, due to excess rain. Directionally, these unofficial posts are supportive of our long corn vs. short wheat position, which is up 4% since inception on October 5, 2017. Feature Focus On Demand For Nickel Price Guidance Synchronized global GDP growth will fuel demand for consumer durables - autos, refrigerators, freezers, etc. - which will lift demand for stainless steel. This, in turn, will increase consumption of nickel, given the stainless steel market accounts for some two-thirds of nickel demand (Chart 2). Receding fears of an imminent slowdown in China, which accounts for 46% of global nickel demand, also is supportive: China's manufacturing PMI currently stands at multi-year highs (Chart 3). Likewise, the pace of investment in China's real estate, automobile, infrastructure, and transportation sectors - all of which are stainless steel end users - remains strong (Chart 4). Chart 2Consumer Durables Demand##BR##Will Lift Nickle Consumption Chart 3Easing Fears Of China##BR##Slowdown Also Supportive Chart 4Stainless Steel End-Use##BR##Markets Growing We do not foresee a near-term slowdown in China's consumer sector, following the conclusion of the 19th National Congress of the Communist Party of China. On the contrary, we expect stainless steel demand will remain strong, and a bullish factor in nickel fundamentals going into the beginning of next year.1 However, we are watching the evolution of China's economy closely, now that President Xi has consolidated power.2 Weak ore output from nickel mines was the main culprit behind the deteriorating nickel balance since 2014. Although the global deficit has contracted significantly from its 2016 record, declining consumption - rather than accelerating production - was the driver of the improvement in the supply-demand balance to this point. Increased Supply Won't Be Enough In The Short Run Over the short term, growth in stainless steel demand will outpace increased nickel ore output, which is slowly adjusting to the return of Indonesian ore exports following the 2014 ban. Indonesia's ban on nickel-ore exports fundamentally shifted the market in several ways. In 2013, just before the export ban, China's imports of Indonesian nickel ore stood at more than 41mm MT. Providing almost 60% of China's nickel ore imports, Indonesia was vital to China's thriving nickel pig iron (NPI) industry - which uses low grade nickel ores to produce a cheaper alternative to refined nickel. Output of NPI is then used in the production of stainless-steel. An immediate consequence of the Indonesian export ban was the emergence of the Philippines as China's main nickel ore supplier. It exported 29.6mm MT of nickel ores to China in 2013, accounting for the remaining 40% or so of China's nickel ore imports then. With the Indonesian export ban, the Philippines became China's top, and practically only, supplier of nickel ores (Chart 5). Although the Philippines captured almost all of China's nickel ore trade, it failed to grow the volume of its exports. This had a profound impact on China's domestic processing and refining market. Restricted access to nickel ores meant that China no longer had the necessary supply to keep its NPI industry churning. Instead, it turned to NPI imports, which grew more than 5-fold in the three years following the ban (Chart 6). Similarly, China's unwrought nickel net imports stand above pre-ban levels. The loss of access to Indonesian ores also coincided with a fall in China's laterite inventory.3 Chart 5Indonesia Export Ban Crippled China Imports Chart 6China NPI Imports Up 5-Fold Since 2013 Loss Of Ore Exports Created Refined Nickel Deficit The shrinking supply of nickel ores had a knock-on effect on refined supply. Global production of refined nickel - which was expanding by an average 11.4% yoy between 2011 - 2013 collapsed by 7.3% in 2014, and has remained largely unchanged since. At the same time, demand remained strong, growing by 11.4% and 7.4% in 2015 and 2016, respectively. The combined characteristics of shriveling production amid stable demand put nickel in a large deficit in 2016. This is also evidenced in LME inventory data, which by the end of last year was down 20% from its mid-2015 peak (Chart 7). Chart 7Inventory Draw On Shriveling Production However, Indonesia's export ban appears to have attracted some $6 billion in nickel smelter investments, which allowed it to capture value-added revenues above and beyond those associated with simply exporting raw ores. In fact, many of the NPI operating plants in Indonesia - now in excess of 20 - were built by Chinese companies looking to circumvent the ban by off-shoring NPI production. While Indonesia's minerals export ban was partially lifted in May of this year, we do not expect the market to suddenly return to its pre-2014 fundamentals. The government still maintains an export quota, and has limited the granting of exemptions to companies that have already constructed a value-add processing plant within Indonesia. Instead, we expect Indonesia will lift the quota gradually. Just this past week, the government granted state-owned miner Aneka Tambang additional export rights equal to 1.25mm MT of laterite ore over the next 12 months. The company's initial export capacity, approved in March, was 2.7mm MT.4 This would be a windfall for China's domestic nickel processing plants as their unrefined ore supplies from Indonesia would increase. However, longer term, the reversal of the country's export ban could eventually lead to nickel smelter closures in Indonesia. Virtual Dragon is a China-backed NPI smelter in Indonesia which shipped its first 10k MT to China in August and has a 600k MT annual output target in its first stage. Yet the smelter is concerned with the impact of the ban's reversal on its longer run plan, and reportedly put a $1.83 billion expansion on hold following the policy change.5 In any case, we expect the complete lifting of the ban to transpire gradually, rather than shock the market. Consequently, we do not foresee a sudden flooding of nickel ores to international markets. Bottom Line: Indonesia's ban on nickel ore exports altered trade flows and reversed production trends. While the eventual lifting of the export quotas will change the nickel market, we expect this to transpire gradually. Thus the policy U-turn is not a bearish force in our near term assessment of the nickel market. Stainless Steel Demand To Dominate In Near Term Despite Indonesia's move towards scraping its export ban, we expect strong consumption to drive the evolution of the market in the near term. Solid demand from the stainless steel sector will dominate over supply side growth, and we expect the market to remain in deficit until early next year. In fact, despite the partial return of Indonesian ores to global markets, nickel ore production grew by a modest 1.3% yoy while refined production fell 4.2% yoy in the first 8 months of 2017. A 65% increase in refined output from Indonesia could not offset declines from many of the top producers, including an 11.3%, 22%, and 18.5% yoy decrease in production from China, Russia, and Brazil, respectively. Chart 8Stainless Steel Demand To##BR##Recharge Nickel Market China's share of global stainless steel production has stalled at around 52% since Indonesia's export ban. Stainless steel production was strong - growing an average of 22.4% yoy prior to 2014 (Chart 8). Although it continues to grow, it is doing so at a slower rate. In fact, production stayed largely unchanged last year. We expect the re-emergence of Indonesia's nickel ores will recharge China's stainless steel market. Furthermore, reports of capacity closures in Shandong will stifle China's NPI production. These closures - which aim to reduce smog and pollution during the wintertime - are expected to begin next month and last until mid-March. Thus even with an increase in global ore exports, China's NPI production will be limited in the short run by domestic capacity closures and will continue to depend on imports. Eventually, we expect a supply boost from the return of Indonesian ores to global markets. Refined production has been falling by 2.5% per year since the ban, compared to an average annual production growth rate of 11.4% in the three years prior to the ban. However, we do not expect production to immediately return to the pre-2014 growth pace. While global production has been on the uptrend since June, a comeback in demand will keep nickel in shortage. In fact, the supply deficit would have been significantly wider were it not for declining consumption so far this year. Global refined nickel consumption fell a staggering 7.8% yoy in the first 8 months of 2017, reflecting the 24.8% yoy decline in Chinese consumption. Thus, nickel demand from its top user - the stainless steel sector - will determine the market's direction for the remainder of this year and the beginning of next. The main risk to this view comes from a stronger-than-expected U.S. dollar. This would make the commodity more expensive to holders of other currencies, reducing its demand. Furthermore, while we do not anticipate it, a sudden - rather than gradual - reversal of Indonesia's export ban would tilt the balance to a surplus. Bottom Line: Declining refined nickel production from top producers this year is worrying. However, a simultaneous fall in China's demand - the world's top consumer - means that the net effect on the nickel balance was a shrinking of the supply deficit. Going forward, we expect a gradual increase in supply on the back of a steady expansion of Indonesian ore export quotas. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Given the slow adoption of EVs we project over the next 20 years or so, we do not expect Electric Vehicle (EV) batteries to be a material source of demand growth for nickel for the next 3 - 5 years. Please see "Electric Vehicles Part 3: EVs' Impact on Oil Markets Muted Over Next 20 Years," part of a three-part Special Report jointly researched and written by BCA Research's Technology Sector Strategy, Energy Sector Strategy and Commodity & Energy Strategy. It was published August 29, 2017, and is available at ces.bcaresearch.com. EV battery demand currently accounts for 70k TH, or 3%, of nickel usage. According to estimates from UBS, nickel demand from EVs will reach 300-900k MT annually by 2025. Goldman Sachs are much more conservative in their nickel demand estimate, expecting it to remain under 100k MT prior to 2020, and to grow to 200k MT thereafter. 2 Please see BCA Research's Geopolitical Strategy and China Investment Strategy Special Report "China: Party Congress Ends ... So What?," published on November 1, 2017. Available at gps.bcaresearch.com and cis.bcaresearch.com. 3 Laterites are a type of soil containing nickel, and account for more than 70% of world nickel reserves, according to "Geology for Investors." Please see https://www.geologyforinvestors.com/nickel-laterites/ 4 Please see "PT Antam approved to export another 1.25m tonnes of nickel ore from Indonesia," dated October 26, 2017, available at metalbulletin.com. 5 Please see "Indonesia's Virtue Dragon smelter ships first nickel pig iron," dated September 28, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016