Emerging Markets
Feature The BCA Corporate Health Monitor (CHM) - designed to assess the financial well-being of companies - is one of our most reliable indicators that is also extremely popular with our clients. That is no surprise, as the CHMs have a solid track record in signaling broad turning points in company credit quality. This makes them useful in determining asset allocation recommendations on Investment Grade (IG) and High-Yield (HY) corporate bonds. Chart 1U.S. Corporates Outperforming, ##br##Despite Worsening Credit Quality In this Weekly Report, we present the "top-down" CHMs based on corporate data from national income (i.e. "GDP") accounts for the U.S., Euro Area and the U.K. We also show the "bottom-up" CHMs constructed using the actual reported financial data of individual companies in the U.S., Euro Area and Emerging Markets (EM). The CHMs are shown in a chartbook format that allows for quick visual analysis and comparisons. Going forward, we will publish this CHM Chartbook on a quarterly basis as a regular part of Global Fixed Income Strategy. The broad conclusion from looking at the CHMs is that corporate credit quality has been steadily improving in Europe, the U.K. and in the EM universe over the past couple of years, in sharp contrast to the worsening financial health of highly-levered U.S. companies. Bond investors seem to be ignoring the relative message sent by our CHMs, however, as U.S. corporate debt has outperformed other developed credit markets since the beginning of 2016 (Chart 1). An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is an indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios similar to those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the metrics used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.1 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team last September, which extends the CHM analysis to EM hard-currency corporate debt.2 Table 1Definitions Of Ratios That Go Into The CHMs U.S. Corporate Health Monitors: Still Deteriorating Chart 2Top-Down U.S. CHM: Still Deteriorating Our top-down CHM for the U.S. has been flashing a deteriorating state of corporate health since mid-2014 (Chart 2). That trend had been showing signs of stabilization last year, but the Q1/2017 data worsened on the back of lower profit margins and returns on capital. The latter now sits just above 5% - a level last seen during the 2009 recession. Corporate leverage, as measured in our top-down CHM using the value of debt versus equity, does not look to be a problem. The story is quite different when using alternative measures like net debt/EBITDA, however, with U.S. leverage exceeding the highs from the Telecom bubble of the early 2000s. While booming equity values certainly flatter the leverage ratio in our top-down CHM, a strong stock market should, to some degree, reflect a better backdrop for growth in corporate profits and creditworthiness. Even against this positive backdrop, however, other credit indicators are flashing some warning signs that leave our top-down CHM in the "deteriorating health" zone. Interest coverage and debt coverage ratios, while still above the lows seen during past recessions, are steadily falling. This does raise concerns for U.S. corporate health if U.S. bond yields begin to climb again, as we expect. However, given the historically low interest rate backdrop for corporate debt, a bigger threat to interest coverage ratios and overall credit quality would come from an economic slump that damages company profits. That is not going to be a problem for the rest of this year, but weaker growth is a more likely outcome in 2018 as the Fed continues its monetary tightening cycle. Our bottom-up CHMs for U.S. IG (Chart 3) and U.S. HY (Chart 4) have shown a bit of improvement in recent quarters relative to the signal from our top-down CHM. This is likely related to the growing gap between corporate profits as reported in the U.S. national accounts data, which are slowing, compared to the reported earnings of publicly traded companies, which are accelerating. Also, leverage in the bottom-up CHMs uses the book value of equity, which is more readily reported by individual companies, and is thus much higher than the measure used in our top-down CHM. Return on capital is at multi-decade lows for both IG and HY corporates, although profit margins look to be in much better shape for IG names relative to HY issuers. HY margins have enjoyed a cyclical improvement, however, largely due to better earnings from HY energy companies (Chart 4, panel 4). Interest coverage and debt coverage are depressed, with HY issuers in much worse shape than IG. Chart 3Bottom-Up U.S. Investment Grade CHM: ##br##Deteriorating Chart 4Bottom-Up U.S. High-Yield CHM: ##br##Some Cyclical Improvement The cumulative message from our top-down and bottom-up U.S. CHMs is that U.S. corporate health has enjoyed some cyclical improvement over the past few quarters, but the state of balance sheets is slowly-but-steadily worsening. High corporate leverage will become a major problem during the next U.S. recession, but is not a major factor weighing on credit spreads at the moment (Chart 5). We are maintaining our overweight stance on U.S. IG and higher-rated U.S. HY, both of which should continue to outperform Treasuries over the next few months, but a repeat performance is far less likely next year. Chart 5No Signs Of Concern##br## In U.S. Corporate Credit Spreads Chart 6Top-Down Euro Area CHM:##br## Improving Euro Area Corporate Health Monitors: Solid Improvement Our top-down Euro Area CHM has been showing steady improvement since 2013, driven by strong profit margins and rising interest and debt coverage ratios (Chart 6). The ultra-stimulative monetary policies of the European Central Bank (ECB) have likely played a large role in helping lower corporate borrowing costs and boosting the interest coverage ratio. The average coupon on bonds in the Bloomberg Barclays Euro-Aggregate Investment Grade corporate index is now down to a mere 2.3% - a far cry from the 5% level that prevailed during the peak of the 2011 Euro Debt crisis or the 3.5% level just before the ECB began its asset purchase program in 2015. Return on capital has fallen over the past decade and now sits at 8%, although profit margins remain quite strong on our top-down CHM measure. Short-term liquidity is at a record high, suggesting no imminent problems for European corporate borrowers. Our bottom-up CHMs for Euro Area IG (Chart 7) and HY (Chart 8) are telling a broadly similar story to the top-down CHM. The bottom-up CHMs have steadily improved in the past couple of years, most notably for domestic issuers of Euro-denominated debt.3 Some improvement in the bottom-up aggregates for operating margins and interest coverage ratios is providing a boost to European credit quality. Chart 7Bottom-Up Euro Area Investment Grade CHMs Chart 8Bottom-Up Euro Area High-Yield CHMs The bottom-up measure of leverage for domestic IG issuers has been steadily declining since the 2009 recession, a sign that European companies have been much more cautious in managing their balance sheet risk than their U.S. counterparts. The same cannot be said for Euro Area domestic HY issuers, where all the individual ratios are at weak absolute levels. When splitting our bottom-up Euro Area IG company list into issuers from core Europe versus countries on the Periphery (Chart 9), the "regional" European CHMs tell broadly similar stories of improving credit quality. The fact that even Peripheral issuers are seeing rising interest coverage and liquidity ratios, despite much higher levels of leverage than in the core, is an indication of how the ECB's low interest rate policies and asset purchase programs (which include buying corporate debt) have helped support the European corporate sector. Net-net, our Euro Area CHMs are sending a signal that there are no immediate stresses on corporate balance sheets or profitability. This is already reflected in the current low level of corporate bond yields and spreads, though (Chart 10). A bigger threat to Euro Area corporates comes from monetary policy. The ECB is under increasing pressure to consider announcing a tapering of its asset purchases - likely to include slower buying of corporates - starting in 2018. There is a risk of a negative market reaction that could undermine future Euro Area corporate bond performance. Because of this, we continue to prefer U.S. corporate debt over Euro Area equivalents, despite the large gap between the U.S. and European top-down CHMs (Chart 11). Chart 9Bottom-Up Euro Area IG CHMs: ##br##Core Vs. Periphery Chart 10Euro Area Corporate Bonds ##br## Have Had A Great Run Chart 11Relative CHMs Starting ##br##To Turn Less Favorable For U.S. Credit U.K. Corporate Health Monitor: Solid Balance Sheet Fundamentals The top-down U.K. CHM has steadily improved over the past couple of years, led by rising profit margins, higher interest coverage and very robust liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop. Fundamental analysis of U.K. corporates may not be of much use at the moment given the extremely accommodative monetary policy environment provided by the Bank of England (BoE). Low interest rates, combined with BoE asset purchases (which include a small amount of corporate debt) and a steep fall in the Pound in the aftermath of the Brexit-driven political uncertainty, are all helping keep the U.K. economy afloat. The BoE is now having to deal with a currency-driven climb in U.K. inflation, with three members of the BoE policy committee even calling for a rate hike at the latest policy meeting. The political backdrop after last year's Brexit vote and this month's closer-than-expected U.K. election result remains too volatile for the BoE to seriously consider any imminent tightening of monetary policy. While it can be debated how much the Brexit uncertainty is truly weighing on the U.K. economy, the BoE is unlikely to take any risks on triggering a growth slowdown by becoming too hawkish, too soon - even with the relatively high level of currency-driven inflation. A combination of a strong CHM and a dovish BoE will allow U.K. corporate debt, both IG and HY, to continue to outperform Gilts. We continue to recommend an overweight allocation to U.K. corporates even though, as in the other countries shown in this report, valuations are not cheap (Chart 13). We have not yet constructed bottom-up versions of the CHM for U.K. corporates to allow us to make any additional comments on the relative merits of U.K. IG and HY debt. This is something we intend to look into for future reports. Chart 12U.K. Corporate Balance Sheets ##br##Are In Good Shape... Chart 13...Which Is Already Reflected In ##br##Tight Credit Spreads Emerging Market Corporate Health Monitor: Cyclically Strong, Structurally Weak The CHM for EM corporates built by our Emerging Markets Strategy team is purely a bottom-up measure. The financial data from 220 EM companies in over 30 countries is used to construct the EM CHM. Only firms that issue U.S. dollar-denominated bonds are included, with banks and other financials also omitted in a similar fashion to the CHMs for the developed economies. A shorter list of financial ratios is used in the EM CHM than the developed CHMs, including: Profit margins Free cash flow to total debt: Liquidity Leverage Unlike the developed CHMs, the ratios are not equally weighted in the construction of the EM CHM. Profit margins and cash flow/debt combined represent 75% of the EM CHM. The weightings are designed to optimize the performance of the EM CHM versus the actual spread movements in the J.P. Morgan CEMBI benchmark index for EM corporate debt. Chart 14EM Corporate Health: Cyclically Solid... The EM CHM is currently pointing to very strong fundamental underpinnings for EM corporates with the indicator at the most credit-positive level in a decade (Chart 14). That recent strength is a modest cyclical improvement after a multi-year deterioration in all the individual EM CHM components (Chart 15). The uptick in global commodity prices in 2016 played a major role in the improvement in the growth-sensitive components (top two panels). However, the biggest structural headwind for EM corporates is the unrelenting rise in balance sheet leverage (bottom panel) - a problem that could come to the forefront if the recent slump in commodity prices persists or developed market interest rates begin to rise more sharply as central banks become marginally less accommodative. For now, we continue to recommend only a neutral allocation to EM hard currency debt, as the positive message sent by the EM CHM appears fully priced into the current low level of EM yields and spreads (Chart 16). Chart 15...But Structurally More Challenged Chart 16EM Corporate Debt Is Not Cheap Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. 3 Given the large share of non-European issuers in the Euro-denominated corporate debt market, we have split our sample set of companies in our bottom-up Euro Area CHMs into "domestic" and "foreign" issuer groups. This allows a more precise analysis of the corporate health of European-domiciled companies. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index
Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights While the yield curve is a critical indicator for developed economies, its significance in China should be put in proper perspective, as the country's market-based financial intermediation is much less important compared with the West. The inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. The near term impact of MSCI's A Share inclusion should be negligible for the broader market. Valuation indicators of the select 222 large-cap names are much more attractive compared with their domestic peers, which may well provide a catalyst for some catch-up rally. Feature Chart 1China's Inverted Yield Curve The Chinese authorities' tightening measures on the financial sector have significantly pushed up interest rates across the curve, particularly in the short end, leading to rapid yield-curve flattening. By some measures, long-dated interest rates are currently lower than short rates, generating an inverted yield curve (Chart 1). Some have viewed an inverted Chinese yield curve as a harbinger of an impending material growth slowdown. While the yield curve is undoubtedly a critical indicator for developed economies, its significance in China should be put in proper perspective. In short, bank loans still play a dominant role in financial intermediation, the interest rates on which are still largely determined by the policy lending rate. Therefore, a simple comparison of the Chinese yield curve to its counterparts in the West misreads the situation and is overly alarmist. Moreover, we suspect that the phase of maximum strength of policy tightening is over, at least in the near term. Therefore, Chinese interest rates are likely to fall in the coming three to six months. This week we recommend a long position in Chinese onshore corporate bonds. Why The Yield Curve Matters Less For China To be sure, the yield curve is among the most relevant and watched indicators in some developed economies. In the U.S., for example, an inverted yield curve, defined as U.S. 10-year Treasury yields resting below three-month Treasury yields, has historically been a reliable indicator in predicting economic recessions (Chart 2). Evidence from other developed economies such as Japan and Europe is less compelling, but a flat/inverted yield curve is still generally regarded as a market signal for growth problems. Chart 2U.S. Yield Curve Inversion Predicts Economic Recession The reasons for the linkage between yield curve inversion and economic recessions have been the subject of lengthy debates among academia, policymakers and investors. From a financial market perspective, it is generally accepted that an inverted yield curve occurs when the bond market anticipates a significant slowdown in growth and/or decline in inflation, which bids down long-term yields, while policymakers fail to respond in a timely manner, which holds short-term rates at elevated levels. Yield curve inversion is typically followed by aggressive monetary easing as central banks wake up to the economic reality predicted by the bond market. Economically, the costs of funding in most developed countries are tightly linked with interest rates in the bond markets. One of banks' key functions as financial intermediaries is to transform maturity - i.e. to "borrow short and lend long," and therefore interest rates of bank loans are tied to government bond yields at the longer end, while their costs of funding are linked to the shorter end. Therefore, an inverted yield curve typically compresses banks' interest margins, which tends to hinder credit origination and slow down business activity. For example, Chart 3 shows that U.S. mortgage interest rates historically have been tightly linked with 10-year Treasury yields, while interest rates of banks' deposit base and interbank rates for "wholesale" funding are both determined by short-term Treasury yields, which is in turn determined by the fed funds rate. In China, the yield curve plays a much smaller role than in the developed world, simply because the country's market-based financial intermediation is much less important. Traditionally both lending rates and deposit rates of commercial banks were rigidly set by the People's Bank of China, and there was little lending/borrowing activity outside the formal commercial banking system. The situation has been gradually changing in recent years as a result of financial reforms. Banks are given flexibility to set their own interest rates, and non-bank lending, or shadow banking activity that is more driven by market interest rates, has expanded. However, commercial banks still play a dominant role. Chart 3U.S. Bank Loan Rates Follow Treasury Yields Closely Chart 4China: Bank Loans Still Dominate Bank loans currently account for over 70% of China's total non-equity social financing, both in terms of flow and total outstanding stock (Chart 4). Commercial banks' average lending rate still closely tracks the PBoC policy benchmark. Banks' prime lending rate moves in lock step with PBoC interest rate adjustments, and average interest rates on new mortgages are also primarily determined by the policy rate (Chart 5). Banks' cost of funding is also primarily determined by retail deposit interest rates, which are in turn set by the PBoC. Retail deposits account for about 80% of total loanable funds for large banks, or 70% for smaller banks (Chart 6). Repo and interbank transactions, which are subject to the central bank's liquidity tightening, only account for 14% of smaller lenders' source of funds, or a mere 2% for large lenders. Chart 5Chinese Bank Loan Rates ##br##Still Track PBoC Benchmarks Chart 6Retail Deposits Are Still The Dominant Funding Source ##br##For Commercial Banks The important point is that market signals from China's juvenile and volatile financial markets should be taken with a healthy dose of skepticism, and a simple comparison with the West is often misleading. For example, a significant decline in stock prices in developed economies may well herald a growth recession in their respective economies. In China, however, domestic stock prices have routinely gone through massive boom and bust cycles without any tangible impact on the broader economy, as the equity markets play a marginal role for both the corporate sector in terms of raising capital and for households in managing their wealth. In recent years, China's financial sector reforms have been gradually introducing market forces in setting interest rates, but the process is far from advanced enough to have a meaningful and direct impact on the cost of funding for both the corporate sector and banks. Overall, the inverted Chinese yield curve indicates tighter interbank liquidity in recent months, but the impact on the economy should be limited. PBoC Tightening: Passing The Phase Of Maximum Strength Moreover, it is noteworthy that yield-curve flattening has been a global phenomenon rather than a China-specific development (Chart 7). What's different is that in other countries the flatter yield curve has been mostly due to falling yields of longer-dated bonds, while in China it has been entirely driven by a sharp increase in short-term yields due to the PBoC's liquidity tightening.1 Looking forward, the PBoC will maintain close scrutiny on the financial sector to keep financial excesses in check. However, we believe the phase of maximum strength of liquidity tightening is likely over, at least in the near term. There is no case for genuine monetary tightening, as inflation is extremely low and growth momentum is already softening. It is very unlikely that the PBoC will tighten monetary conditions further, amplifying deflationary pressures in the process.2 The PBoC's tightening measures have already significantly reduced the pace of leverage buildup and excesses in the financial system. Banks' exposure to non-bank financial institutions has tumbled, net issuance of commercial banks' negotiable certificates of deposits has turned negative of late, and overall off-balance-sheet lending by financial institutions, or shadow banking activity, has slowed sharply in recent months (Chart 8). In other words, the tightening campaign has achieved the intended consequences, diminishing the odds of further escalation. Chart 7Synchronized Yield Curve Flattening Chart 8Financial Excesses Are Being Reined In Global developments are also conducive for some loosening by the PBoC. Last week's rate hike by the Federal Reserve has further pushed down both U.S. interest rates and the dollar. The spread between Chinese 10-year government bond yields and U.S. Treasurys has widened sharply of late, which is helping stabilize the RMB (Chart 9). All of this has reduced pressure on the PBoC to follow the Fed with additional domestic tightening. Already, the PBoC has stepped in to ease liquidity pressure in the interbank system in recent weeks. After massive liquidity withdrawals early this year, the PBoC has been injecting liquidity into the interbank market through various open market operations in the past two months, according to our calculations - likely a key reason why interbank rates have stopped rising of late (Chart 10). Chart 9China - U.S. Interest Rate Spread Versus##br## Exchange Rate Chart 10The PBoC Is Stepping In ##br##To Ease Interbank Liquidity Pressure Chart 11Onshore Corporate Bonds ##br##Are Attractive Chinese corporate bonds will benefit the most, should the authorities stop further tightening (Chart 11). Onshore corporate spreads have widened sharply since late last year amid the PBoC crackdown, and are now substantially higher than in other countries. Chinese corporate spreads should recover without further escalation in liquidity tightening, and will also benefit from the ongoing profit recovery in the corporate sector. We expect both quality spreads and government bond yields to drop in the next three to six months, lifting corporate bond prices. Bottom Line: The PBoC will at minimum pause its liquidity tightening campaign, which will provide a window for bonds to rally. Go long Chinese onshore corporate bonds. A Word On The MSCI A-Share Inclusion MSCI Inc. announced this week its decision to include Chinese A shares in its widely followed emerging market and world equities indexes. The company will add 222 China A large-cap stocks to its EM benchmark at a 5% partial inclusion factor, which will account for about 0.73% of EM market cap. This marks a major milestone in China's capital market development and financial sector liberalization. Increasing participation of foreign institutional investors will also over the long run help improve China's corporate governance and regulatory practices - all of which are instrumental for improving the efficiency of domestic capital market as well as the efficiency of capital allocation. Table 1Valuation Of China A-Share Universe The near-term market impact, however, should be negligible. After all, the inclusion will take effect June next year. In addition, foreign investors already have access to these A share companies through the existing Stock Connect channels between Chinese domestic exchanges and Hong Kong. Moreover, potential capital inflows from global managed assets benchmarked to MSCI indexes in the initial step will be marginal. It is estimated that a total of US$18 billion, or RMB 125 billion, foreign capital may follow the MSCI decision into the A share market, a tiny fraction of A-shares' almost RMB 40 trillion market cap. That said, the valuation indicators of the select 222 large-cap names look attractive compared with their domestic peers, with median trailing P/E and P/B ratios at 23 and 2 times, substantially lower than other major domestic indexes (Table 1). MSCI inclusion may well provide a catalyst for some catch-up rally. We will follow up on this issue in the following weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Reports, "A Chinese Slowdown: How Much Downside?," dated June 8, 2017, and "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Odds the leaders of the OPEC 2.0 petro-states will be forced to back up last month's "whatever it takes" declaration - perhaps deepening and extending the 1.8mm b/d production cuts agreed at the end of last year - are not yet overwhelming. All the same, they will continue to increase, if markets do not see sustained draws in visible storage. Our updated supply-demand balances indicate global crude inventories will continue to draw, and that these draws will accelerate. This will keep global storage levels on track to normalize later this year or in 1Q18. We continue to expect Brent to trade to $60/bbl by December, with WTI ~ $2/bbl under that. Energy: Overweight. Our low-risk call spread initiated last week - long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls - is down 18.9%, following continued selling. We are adding to the position with the same Dec/17 strikes in Brent at tonight's close. These are strategic positions. Base Metals: Neutral. SHFE copper inventories fell on the back of increased demand for collateral to support financing deals in China. Tightening credit conditions are beginning to bite as the government pushes deleveraging policies, according to Metal Bulletin. Precious Metals: Neutral. We remain long gold, despite the hawkish rhetoric being thrown around by Fed officials, particularly William Dudley, head of the NY Fed. Our long gold portfolio hedge is up 1.1% since it was put on May 4, 2017. Ags/Softs: Underweight. Chicago and KC winter wheat remain bid, as concerns over drought-induced damage to the crop continue to weigh on markets. Feature Chart of the WeekUpdated Balances Leave Us Bullish Crude Insomuch as such things can ever be "official," crude oil officially entered a bear market - down 20% or more from recent highs - with the unexpected arrival of WTI futures below the lower end of our long-time $45-to-$65/bbl trading range this week.1 The proximate causes of this turn of events are persistently sticky inventory levels - most visible in the high-frequency data from the U.S. - and growing fears increasing Libyan and U.S. shale-oil production will undermine OPEC 2.0's 1.8mm b/d production cuts. We are hard-pressed to see the case for such fears, even though the market is consistently trading in a manner that is more aligned with supply cuts being far less than advertised by OPEC 2.0, or demand slowing considerably more than any agency or data service has yet picked up on. We will never be able to confirm sovereign hedging - e.g., Mexico or Iraq hedging oil-production revenues - until after the fact. However, this cannot be dismissed out of hand. Based on our latest supply-demand analysis, OPEC 2.0 - the coalition lead by the Kingdom of Saudi Arabia (KSA) and Russia - will have removed some 1.4mm b/d of production on average from the market between January 2017 and end-March 2018 vs. peak production in November of last year (Chart of the Week). This will be diluted somewhat by the Libyan and U.S. production gains, but this increased production will not be sufficient to counter the OPEC 2.0 cuts entirely. Global Oil Supply Contracting Sharply Chart 2OECD Storage Draws On Track Against peak production in November 2016, we see just over 1.2mm b/d of crude oil production being cut by OPEC between January and end-March-2018.2 Throw in another 200 - 300k b/d or so from the non-OPEC members of the OPEC 2.0 coalition - mostly Russia - and we get to 1.4 to 1.5mm b/d of production taken off the market in the Jan/17 - Mar/18, interval in our modeling. This will leave the highly visible OECD storage levels being targeted by OPEC 2.0 at ~ 2.70 billion barrels by the end of the year, or some time close to the start of next year (Chart 2). In our modeling, we do not agree with the implied 1.9mm b/d of production cuts that follow from the reported OPEC 2.0 compliance statistics in the press. These reports indicate OPEC 2.0 coalition members are at 106% compliance. This is remarkably high, even if reports of this compliance rely on anonymous sources speaking to reporters following the coalition's technical committee meeting in Vienna earlier this week.3 If the production discipline attested to is true, we will raise our estimate of how quickly inventories will draw this year, and lower our expected global inventory levels for the end of March 2018. As for U.S. crude production, while we do have Dec/17 production 1.1mm b/d over Dec/16, we expect America's contribution to yoy global production growth to be only ~ 340k b/d on average over the course of 2017. The U.S. gains will be driven by shale-oil production, which we expect to grow ~ 410k b/d to 5.2mm b/d this year (Chart 3). Libya's production recently surged to 900k b/d, according to press reports, but, so far this year, it is averaging just under 700k b/d (Chart 4). This is slightly higher than the level we've been modeling in our balances for this year. The 300k b/d yoy increase in Libya's production is impressive, but it does not overwhelm OPEC 2.0's cuts. Even if Libyan production were to average 1mm b/d in 2H17, its net contribution to global production this year would be ~ 840k b/d, an increase of ~ 400k b/d over 2016's levels. We also note that as production and revenue increase the likelihood of renewed violence in Libya also increases.4 Chart 3U.S. Shale-Oil##BR##Growth Could Slow Chart 4Libya's Recover Is Impressive,##BR##But It Won't Reverse OPEC 2.0's Cuts Between them, combined growth in U.S. and Libyan production looks like it will be a touch under 650k b/d yoy (on average). Meanwhile, OPEC 2.0's production cuts - assessed against peak output for 2016 - are on track to exceed targets set at the outset of the agreement last December. Net, on a yoy basis, we expect to register inventory draws of close to 900k b/d this year. This should lead to cumulative draws in global storage levels of at least 400mm bbls by end-March. Demand Remains Strong The EIA revised its liquids demand estimates in its most recent Short-term Energy Outlook (STEO), and now has 2015 global consumption up 300k b/d from previous estimates at 95.4mm b/d, and 2016 consumption up 180k b/d at 96.9mm b/d. Our expected growth in global demand for this year and next is in line with the EIA's average estimate of ~ 1.6mm b/d, which will put 2017 demand at 98.5mm b/d and 2018 at 100.1mm b/d, respectively. Growth this year and next is expected to be slightly higher than last year's level (Chart 5). Once again, we expect EM demand - proxied by non-OECD liquids consumption - to lead global growth this year and next. Concern over apparent slowing in U.S. refined-product demand - particularly gasoline - is, we believe, overdone. Growth this year is being compared to stellar rates last year (Chart 6), which still leaves the level of demand above 20mm b/d. Growth in gasoline demand specifically also has slowed, but, again, this is occurring in a market where the level of demand remains high, pushing toward 10mm b/d, which is a mere 2.5% below record demand set in August of last year (Chart 7). Chart 5Expect Global Demand##BR##To Remain Stout Chart 6The Level Of U.S. Product##BR##Demand Remains High Chart 7U.S. Gasoline Demand##BR##Also Remains Stout 2018 Getting Foggy Uncertainty surrounding the evolution of the oil market next year is growing. The EIA believes markets will tighten in 3Q17, but then get progressively looser going into 2018, apparently disregarding OPEC 2.0's efforts to date, and the high likelihood - in our view - that the coalition will maintain production discipline for the most part (Chart 8). Combined with the robust demand growth BCA and the EIA expect, we get a fairly balanced market next year (Chart of the Week). U.S. shale-oil production, once again, will dictate just how tight markets become next year. Presently, we have average 2018 U.S. shale production in the Big 4 basins - Bakken, Eagle Ford, Niobrara, and the Permian - coming in more than 1mm b/d over 2017 levels. However, the recent sell-off that took WTI into bear-market territory this week could have a profound effect on shale-drilling activity next year, if it persists. Recent econometric work we've done confirms rig counts in the Big 4 plays are highly sensitive to WTI price. A prolonged stretch below $45/bbl could reduce rig counts by as much as 40% next year, especially if private-equity-backed companies cut spending. With hedging levels down, this is not a trivial concern (Chart 9).5 If prices stay depressed for any length of time for whatever reason - an outcome we do not expect - U.S. shale drilling activity could once again plummet. Chart 8EIA Fades OPEC 2.0's Resolve,##BR##BCA Does Not Chart 9Weak Prices Could##BR##Reduce Shale Rig Counts In addition, low prices also increase fiscal stress levels in petro-state revenues. This is of particular concern for KSA and Russia. The former is almost wholly dependent on oil revenues to fund its budgets, and will be looking to IPO its state-owned oil company, Aramco, next year. The latter is heavily dependent on oil and gas revenues, and will be holding an election in mid-March, just ahead of the expiry of the OPEC 2.0 production-cut extensions. The benchmark Russian crude, Urals, trades ~ $1.00 to $1.25/bbl under Brent, and any prolonged excursion into the low-$40s by Brent would stress the state's revenues. This is not our base case, but it is worthwhile considering. This mutual dependence on oil prices to support their respective economies is what compels strong compliance with the OPEC 2.0 production deal. Bottom Line: Our updated balances modeling continues to support our view global oil storage will draw, with OECD inventories likely falling below five-year average levels by year-end or early next year. Self-reported compliance with OPEC 2.0's production-cutting agreement exceeds 100%, implying the coalition is tracking to a 1.9mm b/d reduction in crude-oil output at present. On the demand side, even after upward revisions to 2015 and 2016 demand figures by the U.S. EIA, liquids consumption still is expected to grow on average ~ 1.6mm b/d this year and next. Cuts in production by OPEC 2.0 this year are more than sufficient to offset increases in Libyan and U.S. production, leaving overall production below consumption globally by close to 900k b/d, which will ensure inventories draw. For next year, after storage draws have abated, we expect supply and demand to be roughly balanced. We continue to expect Brent prices to trade to $60/bbl by year-end, and, on that basis, are recommending a long Dec/17 $50/bbl Brent call vs. short a Dec/17 $55/bbl Brent call. Longer term, our central tendency for price remains $55/bbl, with a range of $45 to $65/bbl prevailing most of the time. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 We are using the front-line WTI futures contract, which hit its recent high on Feb. 23 at $54.45/bbl (last price) and traded down to $43.23/bbl on June 20, registering a drop of 20.6%. First-line Brent has yet to fall more than 20% from its recent high of $57.10/bbl on Jan. 6 to $46.02/bbl on June 20 (a 19.4% drop). 2 Measuring against peak production - rather than the October levels referenced by OPEC 2.0 coalition members - is an inherently more conservative way of assessing the effect of the production cuts. 3 Please see "OPEC, non-OPEC compliance with oil cuts hits highest in May: source," published by reuters.com on June 21, 2017. 4 An uptick in Nigerian production also is cited by some observers as a cause for concern vis-à-vis slowing the normalization of global storage levels. However, as Chart 4 illustrates, that country's production remains on either side of 1.5mm b/d, more than 500k b/d below recent steady-state levels. 5 Looking at rig-count sensitivity to prices and rig productivity, we find a 1% increase (decrease) in nearby prices translates into a roughly 70bp increase (decrease) in rig counts, while a 1% increase (decrease) in lagged, deferred WTI futures prices (out to 3 years forward) translates into a 2% change in the same direction. The R2 coefficients of determination for the models we estimated average ~ 0.95. 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 Our "fair value" models incorporate prevailing domestic risk-free interest rates and long-term earnings, which provide an assessment on market valuation levels from a historical perspective. Hong Kong and Chinese A shares are substantially "undervalued" compared with their respective "fair values," while Taiwanese and Chinese investable stocks are roughly "fairly valued" according to our models. The PBoC will continue to enforce deleveraging in the financial sector through liquidity tightening. However, without genuine inflation pressures and any sign of economic overheating, the "deleveraging" process is likely to remain gradual, and its impact on growth will continue to be closely monitored by the authorities. Feature Investors have become increasingly concerned about the rapid expansion of U.S. equity multiples. By some measures, the market appears frothy by historical standards. The forward price-to-earnings ratio for U.S. stocks currently stands at about 18 times, and the cyclically adjusted PE (CAPE), or the Shiller PE for U.S. stocks, is over 26 times - both of which are substantially higher than historical norms (Chart 1). The red-hot performance and elevated valuation levels of the U.S. tech sector has brought back memories of the Internet mania of the late 1990s, which in part triggered a mini-meltdown in the NASDAQ last Friday. Beyond Valuation Indicators Compared with American bourses, other major markets are more reasonably valued, particularly emerging markets, including stocks in the greater China region. EM stocks are trading at about 13 times forward earnings, compared with 18 times for the U.S. (Chart 2). Similarly, forward PE ratios for Taiwan, Chinese A shares and Chinese investable stocks are all at around 13 times, and 16 times for Hong Kong. In addition, our calculations show that CAPEs for Taiwan and Chinese domestic A shares are both about 18 times, 12 times for Hong Kong stocks and a mere 8 times for investable Chinese shares, compared with over 26 times for the U.S. market. Chart 1U.S. Stocks: Valuation Looks Stretched Chart 2Greater China Markets Are Much Cheaper While these valuation indicators are useful to identify potential value plays globally, they do have limitations from a historical perspective. Stocks, as an asset class, compete with other assets, and therefore, the valuation levels of competing asset classes need to be taken into consideration. More specifically, inflation, monetary policy and interest rates determine the "risk free" discount factor for valuing equities. Historically the fed funds rate has been a defining factor for U.S. stock multiples. The famed "Fed model" argues that forward earnings yields should track 10-year Treasury yields (Chart 3). On both accounts, U.S. stocks do not look exceptionally expensive, considering exceedingly low interest rates. In fact, U.S. stocks' earnings yields have diverged with "risk free" rates since the Global Financial Crisis. This offers a glimmer of hope that U.S. stocks are not immediately vulnerable, even if interest rates continue to rise, unless higher rates tilt the U.S. economy into recession, which in turn leads to a major contraction in equity earnings. A Fair Value Assessment This week we incorporate interest rates into the valuation matrix for Greater China markets. Our "fair value" models incorporate prevailing domestic risk-free interest rates and long-term earnings, providing an assessment on market valuation levels from a historical perspective. Our models suggest that Hong Kong and Chinese A shares are substantially "undervalued" compared with their respective "fair values," while Taiwan and Chinese investable stocks are roughly "fairly valued." Hong Kong The Hong Kong market is currently standing at one standard deviation below its long-term "fair value," underscoring more upside potential in prices (Chart 4). In fact, the current reading matches that of the early 1980s, which marked the beginning of a dramatic bull market that lasted several decades, despite some sharp pullbacks. This comparison of course does not take into consideration that the Hong Kong market graduated from an electrifying developing market with excessive gains and risks into a developed one, and therefore a "fair-value" assessment based on historical norms could be misleading. Overall, Hong Kong stocks appear cheap, but a replay of a mega bull market is not realistic. Chart 3U.S. Stocks Do Not Appear Expensive ##br##Considering Interest Rate Chart 4Hong Kong Stocks Are Deeply Undervalued ##br##Compared With 'Fair Value' Taiwan Taiwanese stocks currently are almost exactly "fairly valued," according to our model (Chart 5). Our indicator has been hovering around current levels in recent years, despite price gains, due to improved earnings and more importantly, lower interest rates. Taiwanese local government bond yields are the lowest among the Greater China economies, and therefore our fair-value assessment of Taiwanese stocks' can change quickly if interest rates rise. Overall, Taiwanese stocks do not appear particularly appealing from a valuation perspective, especially compared with other bourses in the region. Chinese Investable Shares Chinese investable shares, although still deeply undervalued by most conventional valuation yardsticks, are now roughly "fairly valued" according to our model (Chart 6). In fact, this asset class was deeply undervalued in the early 2000s, followed by parabolic price moves that transformed into a feverish mania in 2007, but they have not been unduly cheap by this matrix in recent years. We suspect this is likely due to the high earnings volatility of this asset class, attributable to its heavy concentration in highly cyclical sectors such as energy and materials. Furthermore, investor sentiment on Chinese investable stocks swings dramatically, pushing their valuation indicators routinely to overshoot or undershoot extremes. Currently, investors are still skeptical on China's macro profile, and Chinese investable shares are likely under-owned by investors. We continue to expect this asset class to be positively re-rated, but the current situation does not appear too extreme compared with historical episodes. Chart 5Taiwanese Stocks Are Roughly 'Fairly Valued' Chart 6Chinese Investable Shares Are No Longer 'Undervalued' Chinese A shares Chart 7Chinese A Shares Appear Deeply Undervalued The Chinese domestic market, however, scores surprisingly high on our "fair value" assessment. The broad A-share index is well below its historical "fair value" level, and has in fact continued to improve (i.e. fall deeper into undervalued territory) since last year along with rising stock prices and a sharp spike in local bond yields (Chart 7). Although A shares historically have rarely been cheap in a global comparison, this asset class is now well below its historical average valuation levels, underscoring room for mean reversion. Moreover, Chinese local government bond yields are the highest among the Greater China economies. Any decline in bond yields will make A shares more attractive to local investors. In short, Taiwanese stocks appear to be the least attractive in our "fair value" assessment, both compared with other bourses in the region and from their own historical perspective. Hong Kong stock valuations look appealing. We continue to favor H shares over A shares to play the Chinese reflation cycle, but the tide could soon shift. A shares are still trading at a premium compared to their H-share counterparts, but the A-H premium has shrunk to 25% from 45% early last year. We will be looking for an opportunity to lift our bullish rating on A shares at the expense of H shares in the coming weeks. Stay tuned. A Word On Macro Numbers And The PBoC Most of China's macro numbers for May released on Wednesday have come in largely as expected. Taken together, the macro data confirm that the economic momentum has softened, but growth remains stable, as growth rates of capital spending, industrial production and retail sales have remained largely unchanged. A more disconcerting development is the continued decline in broad money growth, which decelerated from 10.5% in April to 9.6% in May, a new record low, underscoring continued pressure from the authorities to enforce financial deleveraging, which could further inflict downward pressure on the economy. The saving grace, however, is that bank loan growth remains stable, which means that the slowdown is mainly due to a contraction in off-balance sheet "shadow banking" activity. Meanwhile, broad money growth currently is well below the official target, which reduces the odds of further escalation in tightening measures. Furthermore, inflationary pressure is muted. While headline consumer price inflation (CPI) did pick up slightly to 1.5% in May compared with 1.2% in April, it is still exceedingly low (Chart 8). Moreover, the recent sharp decline in food prices in the wholesale market suggests that food CPI will come in much weaker next month, which will lead to a further decline in headline CPI, likely to below 1%, a further departure from the official CPI estimate (Chart 9). Chart 8Chinese Food Inflation Will Drop Sharply Chart 9Headline Inflation Is Chronically Below Official Estimate As this report goes to press, the Fed has just announced a 25 basis point rate hike, a widely anticipated move. As far as China is concerned, domestic factors are the top priority for the PBoC's decision-making considerations. On this front, there is no reason for the central bank to hasten its tightening. For now, we expect the PBoC will continue to enforce deleveraging in the financial sector through liquidity tightening. However, without genuine inflation pressures and any sign of economic overheating, the "deleveraging" process is likely to remain gradual, and its impact on growth will continue to be closely monitored by the authorities. As such, there is no case at the moment for monetary overkill that could risk major growth disappointments. We will follow up on these issues in the coming weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The sharp downturn in oil prices triggered last week by an unexpected jump in weekly U.S. oil inventories, along with word Mexico's finance ministry had begun soliciting offers for its 2018 oil-revenue hedge, will be reversed by strong fundamentals in the next few weeks. On the data side, we believe markets simply over-reacted to high-frequency U.S. statistics. Taking a slightly broader view of the data suggests the trend in U.S. oil markets is continued tightening, as the northern hemisphere enters the summer driving season. Globally, we expect the OPEC 2.0 production-cut extension and continued strong EM demand to lead to a normalization of global storage levels by end-2017. We continue to expect Brent to trade to $60/bbl in 4Q17, with WTI trailing by ~ $2/bbl. Energy: Overweight. We were stopped out of our long Dec/17 vs. short Dec/18 WTI and Brent spreads by last week's sell-off. We continue to favor long front-to-back exposure, but will wait to re-establish these positions. We will, however, take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Base Metals: Neutral. Copper's brief rally stalled, taking front-month COMEX prices below $2.60/lb this week. The IMF's upgrade of China's growth prospects likely will support copper prices. Precious Metals: Neutral. Spot gold's chart has formed a bullish inverted head-and-shoulders pattern, which could take prices into a gap that opened in the continuation chart at $1,292/oz in the aftermath of November 2016's price plunge. We remain long spot gold. Ags/Softs: Underweight. The USDA's WASDE report did little to temper expectations for another record harvest - or something close enough to it. Even so, given recent U.S. Midwest weather, we would close any shorts. Feature This past week in the oil markets amply demonstrates that the old adage "One week does not a trend make" is more honored in the breach than in the observance. Events we view as transitory - the unexpected 3.3mm bbl jump in weekly U.S. crude-oil inventories, along with news Mexico's finance ministry began lining up offers on crude-oil put options for its 2018 revenue hedge - conspired to shave close to 6% from Brent prices in less than a week. From just over $51/bbl at the beginning of the month, when the Mexican finance ministry reportedly began soliciting offers on crude-oil put options, to the end of last week, Brent prices had fallen ~ $3/bbl. Front-month Brent continued to languish around that level as we went to press.1 Stronger fundamental data, particularly from the U.S., where last week's inventory shock hammered prices, will reverse these transitory effects going into 2H17. Chart of the WeekU.S. Refinery Runs At Record Levels U.S. Fundamental Strength Will Reverse Weak Crude Prices Third-quarter refining - typically a high-activity period in the U.S. - is opening on a very strong note: U.S. refining runs are at record highs, with net crude inputs posting a four-week average 17.3mm b/d run rate at June 2, 2017 (Chart of the Week). U.S. demand is reviving and now is back over 20mm b/d (Chart 2). We expect low product prices, particularly for gasoline, to boost demand going into the summer driving season. In addition, surging refined-product exports, particularly into Latin American markets, will keep U.S. refiners' appetite for crude high, allowing storage levels to drain (Chart 3). Note the end-2016/early-2017 surge and the ongoing strength in product exports year to date - exports are seasonally strong, even if they dipped a bit. The resumption in export growth after a short-lived downturn will continue to pull total crude and product net imports down in the U.S. (Chart 4). Chart 2U.S. Product Demand Back##BR##Over 20mm b/d Chart 3U.S. Product Exports##BR##Are Surging Chart 4U.S. Crude And Product Export Growth##BR##Continues To Lower Net Import Levels On the supply side, U.S. crude-oil production is up sharply after bottoming yoy with a decline of ~ 850k b/d last September, and stood at ~9.20mm b/d at the beginning of June, based on monthly production data from the EIA (Chart 5). This is up 330k b/d yoy. Much of this is being consumed domestically, but export volumes continue to increase, after hitting a recent high of close to 1mm b/d on a four-week-moving-average basis in March (Chart 6). Given the reception U.S. light crude is receiving in Asian markets, we expect continued growth, which will support the build-out of export-related facilities along the Gulf. Chart 5U.S. Crude Production Is Recovering Smartly ... Chart 6... And U.S. Crude Exports Are Surging Strong product demand and exports will allow crude inventories to continue to draw in the U.S. (Chart 7), particularly in the critically important Cushing storage market, where the NYMEX WTI futures contract delivers (Chart 8). Note that using 4-week-moving-average data shows yoy crude and product storage levels down an average 2.4mm bbl/week over the past eight weeks even with the unexpected surge in stocks reported last week. Cushing storage has become increasingly integrated with U.S. Gulf storage, which supports the strong refining activity there. Chart 7Strong Demand And Exports Allow##BR##U.S. Crude And Product Stocks To Draw Chart 8Cushing Crude Storage##BR##Continues To Draw Mexico's Revenue Hedge Is A Transitory Event Earlier this month, Mexico's Ministry of Finance reportedly began soliciting market-makers for offers on put options, signalling its annual revenue hedge will be forthcoming in the not-too-distant future. Reportedly, the finance ministry began lining up offer indications at the beginning of June, and by the end of last week the news was on the wire services.2 By purchasing puts, the finance ministry secures the right - but not the obligation - to sell oil at the strike price of the options. This puts a floor on the revenue realized by the ministry, since, if oil prices move higher next year, they will be able to sell into the market at the higher market-clearing price. However, if prices go below the strike price of the options, the market-makers - typically banks and, last year, for the first time, the trading arm of a major oil company - have to pay the difference between the puts' strike price and the market price. These hedges paid out $6.4 billion in 2015 and $2.7 billion last year, according to Bloomberg. The Mexican finance ministry's program, which can hedge up to 300mm bbl worth of production revenue, will keep markets leery for a couple of weeks. This is because the market-makers writing the puts for Mexico's ministry of finance will soak up available liquidity by hitting bids across the WTI, Brent, and refined products futures and swaps forward curves. The market-makers typically try to trade out of the exposure they've taken on by providing the hedge to the ministry, because, at the end of the day, they do not want to be made long oil if the options go into the money. This is what would happen if oil prices were to fall below the strike price of the puts purchased by the ministry, when the options approach their monthly expiry dates and their value is determined. To hedge themselves against this potential risk, the market-makers will sell volumes into the futures and swaps markets that are determined by the output of an option-pricing model. The lower prices go, the more they sell forward, and vice versa. More than likely, market-makers will be selling into rallies, so, at least while this hedge is moving through the market, any rally likely to be short-lived, as market-makers hedge themselves. However, once this activity is out of the way and refinery demand for crude kicks into high gear, we expect the physical reality of crude and product draws to take prices higher and backwardate WTI and Brent curves later this year. As an aside, we would expect lower prices will accelerate the draws at the margin, as we approach the peak of the northern hemisphere's summer driving season, as noted above. Strong Demand, Lower Supply Will Draw Stocks And Lift Prices Chart 9OPEC Really Is Cutting ~1.0mm b/d##BR##For More Than 400 Days The extension of OPEC 2.0's production cuts to the end of 1Q18 means that - for more than 400 days from January 2017 to March 2018 - OPEC producers with the ability to hold production at relatively high levels, and to even increase it, will have removed more than 1mm b/d from global flows (Chart 9). This will be supplemented by some 300k b/d of cuts from Russia and sundry non-OPEC producers.3 On the demand side, we continue to expect robust growth, given the behavior of EM global trade volumes and non-OECD oil demand strength, led by continued growth in China and India (Chart 10).4 We will be updating our balances next week, but we see no reason to lower our expectation that global demand will grow by more than 1.5mm b/d this year, especially following the IMF's upgrade of China's expected GDP growth this year to 6.7% from 6.6% on the back of "policy support, especially expansionary credit and public investment."5 This is the third upward revision to China's GDP growth made by the Fund this year. We continue to expect lower supply and robust demand this year and into early 2018 to draw visible inventories down to more normal levels (Chart 11), lift prices and backwardate the Brent and WTI forward curves. Given our analysis, we expect Brent to trade to $60/bbl later this year, with WTI trailing it by ~ $2/bbl. Chart 11... And Inventories Will Normalize Bottom Line: Markets appear to have extrapolated the weekly data into a trend that would reverse - or at least materially slow - the normalization of inventories, despite the extension of OPEC 2.0's 1.8mm b/d production cuts to the end of 1Q18, and continued strength in EM oil demand, which is driven by continued strength in China's and India's economies. Net, we believe Mexico's revenue hedge and the one-week surge in U.S. inventories are transitory events, which will be reversed in the weeks ahead. Despite being stopped out of our long Dec/17 vs. short Dec/18 Brent and WTI recommendations following last week's sell-off we still are inclined to keep this exposure. However, we will wait for the market to process Mexico's revenue hedge and to work through the IEA's subdued 2017 demand forecast before re-establishing these positions. In the meantime, we will take a lower-risk position consistent with our view and get long Dec/17 $50/bbl WTI calls vs. short $55/bbl WTI calls at tonight's close. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "Mexico Said to Take First Steps in Annual Oil Hedging Program," published by bloomberg.com on June 9, 2017. 2 Please see footnote 1. 3 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", published June 1, 2017, for an in-depth analysis of OPEC 2.0's production cuts. It is available at ces.bcaresearch.com. 4 Please see the BCA Research's Commodity & Energy Strategy Weekly Report "Strong EM Trade Volumes Will Support Oil," published June 8, 2017. It is available at ces.bcaresearch.com. 5 Please see "IMF Staff Completes 2017 Article IV Mission to China," published June 14, 2017, on the IMF's website imf.org. 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 main driving force behind EM risk assets this year has been downshifting U.S. interest rates and a weak U.S. dollar. These factors have more than offset the relapse in commodity prices and the deteriorating growth outlook for China/EM. Going forward, odds favor a rise in U.S. interest rates and a stronger dollar. If this scenario materializes, the EM rally will reverse. Meanwhile, China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth. Altogether, the outlook for EM risk assets is extremely poor, and we reiterate our defensive strategy. In Argentina, we continue favoring local currency bonds and sovereign credit, especially relative to their EM counterparts. Feature What Has Not Worked In This Rally Financial market actions of late have been rife with contradictions, and momentum trades have been prevalent. In the past few months we have been highlighting that EM risk assets - stocks, currencies and bonds - have decoupled from most of their historically reliable indicators such as commodities prices, China's money and credit impulses and China/EM manufacturing PMI.1 This week we highlight several additional indicators and variables that EM risk assets have diverged from. Chinese H shares - the index that does not contain internet/social media stocks - have decoupled from the Chinese yield curve (Chart I-1). The mainstream press have been focused on inversion in the 10/5-year Chinese yield curve, but we do not find it to be a particularly credible or useful indicator for the economy. Our preference is the 5-year to 3-month yield curve to gauge the cyclical growth outlook. Chart I-1China's Yield Curve Heralds Lower Share Prices Not only has the yield curve been flattening, but it has also recently inverted, suggesting an impending downturn in China's business cycle (Chart I-2). Chart I-2China's Yield Curve Inversion Points To A Growth Slump In China, commercial banks' excess reserves at the People's Bank of China (PBoC) have begun shrinking since early this year, reflecting the PBoC's liquidity tightening (Chart I-3, top panel). Banks' excess reserves are the ultimate liquidity constraint on banks' ability to originate new credit/money and expand their balance sheets. Meanwhile, Chinese commercial banks are stretched and overextended, as illustrated by the record-high ratios of both M2 and commercial banks' assets-to-excess reserves (Chart I-3, bottom panel). These are true measures of the money multiplier, and they have surged to very high levels. Besides, financial/bank regulators are clamping down on speculative activities among banks and other financial intermediaries, and are also forcing banks to bring off-balance-sheet assets onto their balance sheets. Faced with dwindling liquidity (excess reserves), rising interest rates and a regulatory clampdown, banks will slow down credit / money origination. Slower credit growth will cause a considerable slump in capital spending, and overall economic growth will downshift. On a similar note, interest rates lead money/credit growth in China, as evidenced in Chart I-4. Chart I-3China: Dwindling Excess Reserves ##br##Will Cause A Credit Slowdown Chart I-4China: Interest Rates ##br##And Money Growth The considerable - about 200 basis points - rise in Chinese money market and corporate bond yields since November heralds a deceleration in money/credit growth. Historically, interest rates affect money/credit growth and ultimately economic activity with a time lag. There is no reason why this relationship will not hold in China this time around. Given that Chinese companies are overleveraged, credit growth is likely to be more sensitive to rising than falling interest rates. Hence, the lingering credit excesses in China make rising interest rates more dangerous. Industrial commodities prices have reacted to liquidity tightening in China sensibly by falling since early this year (Chart I-5A and Chart I-5B). Chart I-5AWidespread Decline In Commodities Prices (II) Chart I-5BWidespread Decline In Commodities Prices (I) The weakness in commodities prices since early this year is especially noteworthy because it has occurred at a time of U.S. dollar weakness and dissipating Federal Reserve tightening concerns. When and as the U.S. dollar gains ground again, the selloff in commodities will escalate. Outside commodities, there are early signposts that another Chinese slowdown is beginning to unfold - slowing exports in May from Korea and Taiwan to China, being one glaring example (Chart I-6). This chart corroborates our argument that the surge in Chinese imports in late 2016 and the first quarter 2017 was a one-off growth boost, and appeared very strong because of the low base from a year ago. Consistently, Taiwan's manufacturing shipments-to-inventory ratio has rolled over, which correlates well with the tech-heavy Taiwanese stock index (Chart I-6, bottom panel). With respect to the broader EM universe, EM equities and currencies have decoupled from U.S. inflation expectations (Chart I-7). Chart I-6Shipments To China Have Rolled Over Chart I-7EM And U.S. Inflation Expectations: ##br##Unsustainable Decoupling? Historically, falling U.S. inflation expectations have reflected dropping oil prices and caused real rates (TIPS yields) to rise. In turn, lower oil prices and/or rising TIPS yields weighed on EM risk assets. The decline in U.S. Treasurys yields since last December has been largely due to inflation expectations rather than real rates. Such a mixture has historically been ominous for EM risk assets. Notwithstanding, EM risk assets have rallied a lot, despite such a hostile backdrop year-to-date. Finally, the Brazilian and South African exchange rates and their bonds have been among the more stellar performers in the past 12 months. Nevertheless, first quarter GDP releases in Brazil and South Africa have confirmed that there has been little domestic demand recovery in either country. Remarkably, in both countries, agriculture and mining volumes boomed in the first quarter, boosting GDP growth, yet final domestic demand remained shockingly depressed, as illustrated in Chart I-8. This discards the popular EM rally narrative that improving global growth will lift EM economies. Neither a poor domestic growth backdrop and political volatility nor falling commodities prices have prompted a meaningful plunge in either the Brazilian or South African exchange rate. Chart I-9 portends that the BRL and ZAR have historically been correlated with commodities prices but have recently shown tentative signs of decoupling. Chart I-8Not Much Recovery In Brazil ##br##And South Africa's Domestic Demand Chart I-9BRL And ZAR And Commodities Bottom Line: EM financial markets have veered away from many traditional indicators. These constitute important contradictions and raise the question of whether this time is different. We do not think so. What Has Driven This EM Rally: U.S. Rates And The U.S. Dollar The variables that have explained the EM rally in the past six months have been falling U.S. interest rate expectations and a weaker U.S. dollar, as well as the global technology mania. We elaborated on the tech rally in recent weeks,2 and this week re-visit EM's link with U.S. interest rates and the greenback. The main driving force behind EM risk assets, year -to-date, has been U.S. TIPS yields and the greenback (Chart I-10). In short, it has been the carry trade that has transpired since the Fed's meeting on December 15, 2016 - regardless of EM growth dynamics and fundamentals. Going forward, barring a major growth relapse in China/EM growth and an associated U.S. dollar rally, the odds favor a rise in U.S. interest rates in general and U.S. TIPS yields in particular: The U.S. composite capacity utilization gauge (Chart I-11, top panel) - constructed by our Foreign Exchange Strategy team based on the unemployment gap and industrial capacity utilization - is moving above the zero line, denoting that there is little slack in the U.S. economy. Chart I-10U.S. TIPS Yields, Dollar And EM Chart I-11The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? Any time the indicator has moved above the zero line in the past 55 years - the shaded periods on Chart I-11 - inflationary pressures, wages and bond yields have typically risen, and vice versa. The message from this indicator is unambiguous: U.S. inflationary pressures will become evident soon, and interest rates will rise. In this context, U.S. interest rate expectations are too low. Re-pricing of U.S. interest rates will shake off lingering complacency across many financial markets worldwide. Notably, the U.S. mortgage purchase index is surging, job openings are very elevated (Chart I-12), financial and property markets are buoyant and the dollar has been weak. If the Fed does not normalize interest rates now, when will it? Finally, both nominal and inflated-adjusted U.S. bond yields are at their technical support, and will likely bounce from these levels (Chart I-13). Chart I-12Are U.S. Rate Expectations Too Low? Chart I-13U.S. Bond Yields Are At A Critical Juncture Chart I-14U.S. Growth Underperformance Is Late Rising U.S. interest rates will trigger another up leg in the U.S. dollar. Notably, the relative economic surprise index between the U.S. and the G10 is close to its post-crisis lows (Chart I-14). The relative U.S. growth underperformance versus DM is late and will turn around very soon. While it does not always define the fluctuations in the U.S. dollar, we would still expect it to lend some support to the greenback. BCA's Emerging Markets Strategy service believes the broad trade-weighted U.S. dollar is still in a bull market, especially versus EM, DM commodities currencies and Asian currencies. We have less conviction on the magnitude of the downside in the euro, but the latter at minimum will not rally above 1.14 -1.15 for now. Finally, various EM currencies are facing an important technical resistance (Chart I-15A and Chart I-15B). We expect these technical levels to mark their top. Chart I-15AEM Currencies Are Facing Technical Resistance (II) Chart I-15BEM Currencies Are Facing Technical Resistance (I) At the same time, the precious metals index seems to be rolling over at its 200-day resistance level (Chart I-16). A top in the precious metals index would be consistent with a bottom in U.S. TIPS yields and the U.S. dollar. Chart I-16Precious Metals Are Facing ##br##A Major Resistance Bottom Line: U.S. interest rate expectations are too low and are set to rise. Rising interest rates will remove a major support underpinning the EM rally. A Resolution There are three potential scenarios as far as the ongoing EM rally is concerned: The goldilocks scenario of low interest rates in the U.S., a weaker dollar and steady-to-improving growth in EM/China. The markets have already priced in a lot of good news, but the rally could feasibly continue for some time if this scenario transpires. Re-pricing of the Fed. U.S. interest rates will rise and the dollar will get bid up. The rationale is the modest U.S. inflationary pressures will become evident amid solid U.S. growth. This will weigh on EM risk assets, even if EM/China growth does not falter. The basis for this is the EM rally year-to-date has been driven by diminishing U.S. interest rates expectations. Deflation trade redux. China/EM growth will deteriorate meaningfully (for reasons discussed above), causing a considerable downshift in commodities prices and EM risk assets. This could well occur even if U.S. rates stay low. In fact, this is the main plausible reason to bet against a rise in U.S. interest rate expectations from current levels. Investing is about assigning probabilities. We assign much lower probability to the first scenario (no more than 20%), while we see the odds of either the second or third scenarios playing out in the short term at closer to 40%. In the medium term (nine-to 12 months), scenario 3 will be the most prevalent one. If conditions in scenario 2 (rising U.S. bond yields) coincide with a deflationary shock emanating from China, EM financial markets will face a perfect storm. Bottom Line: We continue to recommend a defensive investment strategy for absolute-return investors, and recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, 2017, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?", dated May 17, 2017, and Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, links available on page 19. Argentina: Favor Local Bonds And Sovereign Spreads EM fixed-income portfolio should continue to overweight Argentine local currency bonds and sovereign credit based on the following reasons: Policymakers continue pursuing credible orthodox policies. The central bank has been accumulating foreign exchange as a part of its explicit program to increase international reserves from 10% to 15% of GDP and keep the peso competitive. At the same time, the monetary authorities have partially siphoned off liquidity via reverse repos (Chart II-1). On a net-net basis, monetary stance is rather tight as evidenced by money and credit contraction in real (inflation-adjusted) terms (Chart II-2). Chart II-1Argentina: Rising Reserves ##br##And Reverse Sterilization Chart II-2Argentina: Inflation-Adjusted Money ##br##And Credit Are Contracting Rapid disinflation is proving difficult to achieve due to inflation inertia and high inflation expectations. However, the authorities are holding their position steady in wage negotiations. Wages in both the public and private sectors are contracting in real terms (Chart II-3). Provided wages are a major driver of inflation, employee compensation growing at a slower pace than inflation signals lower inflation ahead. The economy is not yet recovering as evidenced by Chart II-4 and lingering economic stagnation will foster disinflation. Chart II-3Argentina: Lower Wage Growth ##br##Is Critical To Anchor Inflation Chart II-4Argentina: The Economy ##br##Is Still In Doldrums A change in our fundamental view on inflation would require an irresponsible central bank tolerating run away money and credit growth. We find this scenario unlikely and hold the view that the inflation outlook will improve (Chart II-5). Chart II-5Argentina: Inflation Is On The Right Track In regard to the currency, the Argentine central bank will allow the peso to depreciate as maintaining a competitive exchange rate is a major policy priority for them. This is especially true if commodities prices fall and the regional currencies (BRL and CLP) depreciate versus the greenback. The current account and fiscal deficits are large but Argentina is seeing significant FDI and foreign portfolio capital inflows. Hence, funding will not be a problem for some time. The eventual economic recovery and the cheap currency, as well as slow but progressing reforms, will make Argentina a more attractive destination for foreign investors and ensure foreign capital inflows. Overall, there are many challenges, but the outlook for Argentina is much better compared with EM economies in general, and Brazil in particular. Hence, we recommend staying long Argentinian assets on a relative basis versus EM counterparts, particularly Brazil. Specifically, we maintain the following positions: Long ARS versus BRL. We do not expect the currency to depreciate more than what the NDF market is pricing in the next 12 months, and believe it will outperform the BRL on a total return basis (including carry). Stay long Argentine 7-year local currency government bonds. Stay long Argentine / short Brazilian and Venezuelan sovereign credit. Overweight Argentine stocks within the emerging and frontier market universes. Equity Recommendations Fixed-Income, Credit And Currency Recommendations