Gran China
Highlights Controversial gaffes aside, President Trump has started 2018 by moving to the middle; This comes at a time when animal spirits are reawakening thanks to tax cuts; And the path of least resistance for fiscal policy points towards more profligacy; Meanwhile, Chinese growth is imperiled by structural reform efforts; With money growth and import data showing signs of stress; The combination of upside growth risks in the U.S. and downside growth risks in the rest of the world should revive the U.S. dollar and threaten EM performance in 2018. Feature In just the first two weeks of 2018, U.S. President Donald Trump has: Hosted a meeting on immigration policy with Republican and Democratic leaders during which he said that the upcoming legislation should be a "bill of love," while encouraging congressional leaders to think big and pursue comprehensive immigration reform; Claimed that he has a "very good relationship" with Kim Jong-Un, while refusing to deny that he has already spoken privately with the North Korean leader; Supported bringing back "earmarks" in order to grease the wheels of bipartisanship in Congress - i.e., new spending that allocates funds to specific projects; Extended sanction relief to Iran, albeit with the caveat that it would be the last time he does so without demanding modifications to the Joint Comprehensive Plan of Action (the Iran nuclear deal); Broken with his former chief political strategist Steve Bannon - dubbing him "Sloppy Steve" in the process - while disparaging Bannon's penchant for scorched-earth tactics.1 On the whole, Trump's actions in January suggest a move towards the political center. Meanwhile, the media and political opponents continue to dwell on Trump's alleged comments where he disparaged immigrants from certain countries, obscuring the subtle shift in political strategy. What would be the reason for a Trump shift to the middle? As we wrote last week, the Pocketbook Voter Theory in political science suggests that Trump's Republican Party should be benefiting from a surge in popular support amid strong economic data and record-setting market performance.2 However, the 2018 generic congressional ballot still points to a very challenging midterm election for the Republican Party (Chart 1). Trump has two choices. First, he can ignore the poor GOP polling, as well as his own (Chart 2) in the face of stellar economic performance, and plow into an electoral disaster. This would make him the earliest "lame duck" president in recent U.S. history. As we wrote in December, this choice is a serious market risk for investors.3 Lame duck presidents have often sought relevancy abroad, given the lack of constitutional constraints to executive action in the foreign policy realm. In the case of Trump, we could think of three avenues by which he might increase geopolitical risk premiums: Protectionist policies towards China, the abrogation of NAFTA, or military tensions with Iran. Chart 1History Favors The Opposition Chart 2Trump Is Extraordinarily Unpopular The second option for President Trump is to move to the middle ahead of the midterms. This would be unexpected in every way other than that Trump is the master of the unexpected. We happen to agree with his supporters that he is a political genius. Unless, that is, he continues to waste an extraordinary bull market, strong economy, and soaring consumer/business confidence by refusing to woo the median voter. What would a shift towards the center mean for the equity market? First, the already low probability that domestic political intrigue will upend the ongoing rally would get even lower in a world where Trump moves to the center. Second, the risk of market-moving geopolitical risks prompted by White House policy would decline as Trump would presumably seek and follow the advice of his establishment advisers. In other words, it would be pure nectar for the already buoyant markets. This is not to say that there would not still be reason for a pullback in U.S. equities. The bull-bear ratio is dangerously high (Chart 3), and consumer confidence is ominously stretched (Chart 4). Chart 3Investor Bullishness Is At Record High... Chart 4...And So Is Consumer Confidence U.S.: Business Owners Are Republican While some of our clients in the financial community may fret about Trump's unorthodoxy, our clients in the corporate world clearly do not. This is not merely an offhand observation, it is an empirical fact (Chart 5). America's business leaders have given President Trump the benefit of the doubt since he was elected. Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business (NFIB), which publishes the Small Business Optimism survey, went on to comment this month: "we've been doing this research for nearly half a century ... and I've never seen anything like 2017 ... The 2016 election was like a dam breaking."4 It is dangerous, therefore, to be overly mathematical about U.S. growth prospects in 2017. While we agree with our colleague Peter Berezin that, on face value, the strict growth impact of the tax cuts may merely add 0.3% of GDP growth in 2018, the qualitative impact of unleashing animal spirits is incalculable.5 The risk to growth in the U.S. is therefore very much tilted to the upside. First, as we discussed in a Special Report published with our U.S. Equity Strategy colleague Chris Bowes, a crucial, yet under-reported change in the corporate tax bill allows the immediate expensing of capital investment.6 Most market observers have overlooked this part of the legislation as it is simply a shift in the "time value of money." The IRS already allows significantly accelerated depreciation of capex; this reform merely brings it forward. Our analysis, however, suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next upleg in capex. This comes at a time when the prospects for business investment are already positive (Chart 6).7 Chart 5Business Owners Are Depressed When##br## Democrats Control The White House Chart 6Animal Spirits Will ##br##Spur CAPEX Second, investors are underestimating the probability that the current budget impasse - which could lead to a government shutdown in late January - gets resolved through more, not less, federal spending. Trump surprised legislators during a meeting on immigration when he offered his support for "earmarks" - i.e., legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011 by the GOP following the Tea Party-inspired 2010 midterm victory, but they have crept back into the discussion through different guises (Chart 7). Chart 7Pork-Barrel Prohibition Is Ending The timing of Trump's statement on earmarks is interesting as the House Rules Committee is holding public hearings on the originally GOP-instituted earmark ban. In fact, the 115th Congress (the current one) almost reinstated earmarks at the beginning of 2017, only to be held back by House Speaker Paul Ryan and the newly elected White House. In January 2017, Ryan and the White House agreed that it would be unseemly to approve "pork barreling" so quickly after the election of a man who promised to "drain the swamp." Apparently, a year later, the appropriate amount of time has passed to make the move okay! What about the fears that the budget deficit is unsustainable? Investors may be fretting about a problem that does not exist (at least not yet). Chart 8 shows that budget deficits have decreased in almost every case ahead of a recession by 1.16% on average in the eight quarters before a downturn. This is because revenues are very important in determining deficit dynamics. Only just before the recession hits, as growth slows, does the deficit start to flatline or expand. If the risk to the U.S. economy is to the upside, as we believe it is, then deficits will come down regardless of tax or spending policy. Chart 8The Deficit Is Not A Problem... Yet Fiscal policy rhetoric may alone be far more important to the equity, bond, and currency markets than the market is currently pricing. Talk of draconian spending cuts - remember the May 2017 White House budget? Anyone? - could very quickly be replaced with an appropriation bill in late January that combines higher defense spending with higher discretionary spending. Given the current low levels of discretionary spending (Chart 9), the move towards greater spending could be sizeable and surprising. And if earmarks make a comeback, look out! Chart 9Government Spending Is Bottoming Chart 10Global Economy Is Firing On All Cylinders This fiscal fuel is coming when the fire of the U.S. economy is already well lit. Yes, global growth is strong (Chart 10), but U.S. growth is likely to beat it in 2018 (Chart 11). The global and U.S. economy may diverge just as the BCA's two-factor 10-year Treasury yield model is showing that U.S. long-dated bonds are expensive (Chart 12), while dollar bearishness is overcrowded (Chart 13). Chart 11U.S. May Outperform Global Growth Chart 12More Room For Yields To Rise Chart 13The Dollar Will Be Great Again Bottom Line: Tax cuts will unleash animal spirits in the U.S. in 2018. Meanwhile, the political path of least resistance on fiscal policy is towards profligacy. Fade any talk of austerity or entitlement reform, earmarks are back! A combination of easy fiscal policy and tax cuts should be good for equity markets, bad for Treasuries, and good for the greenback in 2018. Technical indicators flag some near-term risks to the dollar, but over the course of the year, our assessment is that it will hold at current levels or rally. China: Reform Reboot Is Growth-Constraining Unlike the U.S. economy, where risks lie to the upside, China is our top candidate for growth disappointments in 2018. Premier Li Keqiang has announced that China's GDP grew by 6.9% in 2017, slightly above expectations at the beginning of the year. However, growth momentum is already slowing due to cyclical factors, the waning of fiscal and credit stimulus, and the government's financial tightening measures that were implemented over the past year (Chart 14). Chinese imports are what really matter from a global macro perspective, and the latest import data suggest that the domestic economy is slowing more abruptly than expected. Import growth fell sharply to 5% year-on-year in December and 0.46% month-on-month. Import volume growth fell from 27.1% in early 2017 to 9.3% in December (Chart 15). Chart 14Chinese Economy: Weakness Ahead Chart 15What Happens In China, Does Not Stay In China Policy changes are highly likely to add to this slowdown. There can no longer be much doubt about the reformist turn in government policy that we highlighted last year.8 All of the policy announcements that came out of the nineteenth National Party Congress in October so far have had a reformist bent. The market agrees, as the sectors of the equity market most likely to benefit from reforms - health care, IT, energy and consumer staples - have outperformed the broad market significantly since President Xi's five-year policy speech on October 18, 2017 (Chart 16). Two separate news items that caused market jitters over the past week reflect the reformist turn. First came unconfirmed rumors that China would make its exchange rate more flexible by abandoning a "counter-cyclical factor" in its daily fixing rate; second came a "fake news" report that China planned to diversify its foreign exchange reserves away from U.S. Treasuries (Chart 17). The rumors were not significant in themselves, at least not without more information, but they were significant in suggesting that debates on major macro policies are intensifying.9 The question is how much resolve will China's central government have in executing its renewed reform agenda? President Xi obviously does not want to self-impose a recession, yet meaningful reform will constrain credit, investment, and growth. For instance, the current financial regulatory crackdown has caused a precipitous drop in the growth of wealth management products (WMPs), which are investment products that make up about 60% of the burgeoning non-bank credit flows; non-bank credit, for its part, makes up 28% of total credit (total social financing). And regulators have gone on to tackle entrusted loans, corporate bonds, and other innovative financial products as well (Chart 18). The impact could be material over the course of this year. Chart 16Markets Believe In China Reforms Chart 17Chinese Treasury Reserves Can Be Weaponized Chart 18China's Dodd-Frank Moment We strongly urge clients to fade the narrative that China is already "easing up" on reforms. In the three months since China's party congress we have seen a handful of false media narratives about how the government is backtracking on its policy agenda. For instance, both The Wall Street Journal and The New York Times declared that the outcome of the major annual economic policymaking meeting - the Central Economic Work Conference - included a turn away from deleveraging. This was not only a misreading of the high-level policy priorities but also a mistranslation of the Economic Work Conference documents, which argued that deleveraging remains a key policy focus.10 It would be humiliating for President Xi - who, not incidentally, has achieved Mao-like authority within the Communist Party - to backtrack on his second-term economic agenda before he has even officially been elected to his second term. Xi will be re-elected in March and he is looking at 2020-21 deadlines for progress on key reforms according to the thirteenth Five Year Plan (2015-20) and his own three-year plan to fight the "Three Battles" of systemic financial risk, poverty, and pollution. The only way to meet these deadlines while ensuring that the country is strong and stable for the 100th anniversary of the Communist Party in 2021 is to frontload the reform push in 2018-19.11 In Table 1 we update our "Reform Reboot Checklist" to reflect the reality that the Central Economic Work Conference produced a strikingly reform-oriented outcome. This is significant because it was billed as the first major statement of economic policy under "Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era." Table 1How Do We Know China Is Reforming? The money growth (M2) target for 2018, for instance, is rumored to be the lowest in China's history after that meeting (supposedly it will be 9%, down from the low- to mid-teens seen in previous years). Now all we need to confirm that serious reforms are afoot is slower bank loan growth (which will likely be tipped in January numbers due in early February), or substantially tighter interbank rates, plus the announcement of significant reform initiatives at the annual "Two Sessions" in early March. It is very common in China for central government decrees to be too draconian initially and then to be modified after an outcry from industry. This year, however, we would advise clients to avoid confusing the inevitable back-and-forth between the central and local governments for a lack of resolve from the central government.12 China's bark will have bite this time around because the political and macroeconomic constraints to the core leadership are lower than they have been at any point in the past ten years. Table 2 shows the issues that we are watching to gauge the reform process and its impact on growth. In light of the above initiatives, we give a 30% subjective probability that China's policymakers will overtighten this year, which could lead to a global risk-off move in financial assets. Table 2China Is Rebooting Economic Reforms Even in our baseline case - China slows abruptly but remains stable - we believe financial markets have yet to understand the shift in Chinese policymaker thinking, which means that China is the prime candidate for negative surprises in a year in which markets are priced for perfection. Chart 19China's Trade Surplus Is A Geopolitical Risk Finally, China is still a major geopolitical risk this year. It scored the largest trade surplus ever with the U.S. in 2017 (Chart 19) and several key U.S. trade rulings are looming that could trigger a tit-for-tat conflict. This was, of course, the real reason behind the rumors about halting U.S. Treasury purchases. We will discuss the trade and geopolitical tensions in a forthcoming report. Bottom Line: China's reform reboot is gaining steam. It will threaten to constrain growth via the anti-corruption campaign, financial and regulatory tightening, corporate and industrial restructuring, and local government scrutiny. In combination with a stronger U.S. economy, China's downward-sloping business cycle and reform-capable political cycle spell disappointments for global markets this year. Investment Implications A faster growing U.S. economy and a slower growing China is beneficial for DM versus EM, the USD versus the RMB and other EM and commodity-linked currencies, U.S. stocks relative to DM stocks (because China's slower growth will weigh on Japanese and European earnings), and Chinese stocks relative to EM. It is bearish for China/EM corporate bonds. It will have varying impacts on commodity prices, depending on the role of Chinese supply-side reforms, but in the long term - as overcapacity cuts are priced in - it should be marginally bearish base metals as a result of China's desired switch of the growth model to a less investment-intensive model.13 Could stronger U.S. growth compensate for slower Chinese growth? We doubt it very much. China is alone expected to make up a third of all global economic growth in 2018, with China-leveraged EM making up the other 45%, according to the latest IMF World Economic Outlook (Chart 20). It is unfathomable to see how the U.S., which is expected to contribute just 10% of all growth, can compensate for slower growth in developing nations. Even if U.S. growth massively surprised to the upside, the U.S. economy is far too domestically driven to make a genuine difference through higher imports. Chart 20Chinese Growth Outweighs U.S. Globally As for the U.S. economy and markets, a global slowdown may be precisely what the doctor ordered. With stretched valuations, a foreign-induced correction may be healthy from a valuation perspective while having no impact on domestic economic fundamentals. Meanwhile, a dollar rally combined with some market volatility later in the year may be enough to give the Fed just enough pause to slow down the pace of hikes. Technical indicators are flagging some near-term risks to the dollar, but over the course of the year our assessment is that it will hold at current levels or rally. While this is not our base case, it would be the type of event that could prolong the current economic cycle. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 In his official statement on the break with Mr. Bannon, President Trump concluded with an important paragraph: "We have many great Republican members of Congress and candidates who are very supportive of the Make America Great Again agenda. Like me, they love the United States of America and are helping to finally take our country back and build it up, rather than simply seeking to burn it all down." The statement was important as it aligned President Trump firmly with Congressional Republicans in their opposition to the Bannon/Breitbart Clique. 2 Please see BCA Geopolitical Strategy Weekly Report, "The American Pocketbook Voter," dated January 10, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see NFIB, "December 2017 Report: Small Business Optimism Index," dated December 12, 2017, available at www.nfib.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at gps.bcaresearch.com. 7 The biggest pushback against our view comes from the oft-repeated anecdote of a meeting between Gary Cohn, the Director of the National Economic Council, and American business leaders. Apparently, when Cohn asked the attendees how many would invest if their corporate taxes were cut, only one executive raised their hand. We have now heard this anecdote repeated to us so many times by clients that it has become clear that it is essentially the only evidence that U.S. corporations have no intention of increasing capex. Needless to say, we do not base our analysis on a single anecdote! 8 For this theme, please see BCA Geopolitical Strategy Weekly Report, "China Down, India Up?" dated March 15, 2017, available at gps.bcaresearch.com. 9 The change to the RMB fixing method is not confirmed, while the rumor of a change in the forex reserve portfolio management came from an unreliable media report that was denied by China's State Administration of Foreign Exchange (SAFE). China's purchases of U.S. Treasuries peaked in 2011; China would harm itself if it sold its Treasuries rapidly. However, it may want to highlight this threat in response to U.S. President Donald Trump's threats of broad tariffs on Chinese imports. 10 The official communique from the 2017 Central Economic Work Conference did not specifically use the term "deleveraging," as in the 2015 and 2016 statements. This omission triggered U.S. news reports claiming that Beijing was backing off its deleveraging goal. However, the 2017 communique clearly emphasized preventing financial risk, including the first of the administration's "three battles" for the next three years. It also indirectly referred to "deleveraging" by citing the "Three De's, One Lower, and One Make Up," which is shorthand for the policy phrase "De-capacity, de-stocking, deleveraging, lowering costs and making up for weaknesses," which has been a fixture in rhetoric on China's supply-side reforms. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 For instance, the central government is facing pushback on new asset management regulations that are set to be fully in force by June 2019. While there may be some compromise, we do not expect the regulations themselves to be watered down too much. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com; and BCA Emerging Markets Strategy Special Report "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com.
Puntos destacados
Las reformas medioambientales en China continúan reduciendo la capacidad siderúrgica. El cierre de instalaciones de inducción ilegales en China también está ajustando los mercados. Aunque la producción oficial de acero en China es más alta, esto probablemente refleja el hecho de que la producción de los molinos de inducción ilegales no se registraba —y por tanto no se contabilizaba— mientras que la producción de los molinos legales está aumentando para cubrir el vacío dejado por los cierres.
Los beneficios de los acereros están aumentando de forma pronunciada, lo que significa que la demanda de mineral de hierro en China se mantendrá firme al menos durante la 1S18. El cobre ha estado bien demandado desde junio de 2017, tras interrupciones en la oferta y un fuerte crecimiento de la demanda impulsado por la recuperación económica mundial. Esperamos que obtenga un impulso adicional en la 1S18, ya que los trabajos de cableado y fontanería en proyectos de construcción que ahora absorben acero en China se pondrán en marcha. Más adelante, el crecimiento global compensará cualquier desaceleración en China.
Nuestro análisis indica que el mercado mundial del acero se estrechará en la 1S18, como ya está ocurriendo en China. En consonancia con esto, estamos abriendo una posición táctica larga en futuros de barras corrugadas de acero Mar/18 en la Bolsa de Futuros de Shanghai, que se cotizan en RMB/ton. Incluimos un stop loss del 10% en esta recomendación.
Energía: Sobreponderar. Nuestra visión sobre el petróleo, que antaño estaba fuera del consenso, es ahora el consenso, por lo que estamos tomando ganancias en opciones spread alcistas sobre Brent y WTI $55 vs. $60/bbl para entrega en mayo y julio al cierre de esta noche. Estas posiciones registraron ganancias de 109.2% y 123.5% al cierre del martes. Cualquier caída ofrecerá una oportunidad para restablecer posiciones largas a lo largo de estas curvas a futuro.
Metales básicos: Neutral. El cobre seguirá estando bien demandado este año mientras continúe la recuperación económica mundial. Un gran número de renegociaciones de contratos en minas constituye un riesgo adicional al alza para los precios del cobre este año.
Metales preciosos: Neutral. Dada nuestra expectativa de cuatro subidas de tipos por parte de la Fed, es difícil ser demasiado optimistas con el oro. Sin embargo, cualquier indicio de que el banco central se incline hacia una postura más dovish —particularmente si no vemos una inflación más alta este año— hará repuntar el metal.
Ags/Softs: Infraponderar. Los mercados se mantendrán en compás de espera hasta el WASDE del USDA del viernes. Mantenemos una infraponderación, excepto en maíz.
Artículo principal
Gráfico de la semana
El mineral de hierro y los precios del acero se desviaron en 2017
Los precios del mineral de hierro y del acero divergieron en 2017
Los precios del mineral de hierro y del acero divergieron en 2017
Las acciones de política medioambiental de China han reducido la capacidad siderúrgica mundial en 100 mm MT entre la 1S16 y la 1S18. Esto es más visible en los precios del acero chinos, que ganaron más del 30% en 2017, tras un aumento de casi el 80% en 2016. La ganancia total en los precios del acero desde el inicio del enfoque de Pekín en las reformas del mercado del acero es un contundente 135%.
Los precios del mineral de hierro registraron ganancias similares a las del acero en 2016, pero se desviaron bruscamente en 2017, desplomándose más del 40% entre mediados de marzo y mediados de junio, terminando casi un 8% por debajo interanual (interanual) (Gráfico de la semana). Los precios del acero en alza dispararon los márgenes de beneficio en los molinos chinos, lo que, por supuesto, se tradujo en demanda de mineral de hierro, el ingrediente crítico para la fabricación de acero en China, hacia finales de año: los precios del mineral de hierro subieron un 20% en los dos últimos meses de 2017.
¿Cómo llegamos hasta aquí? Un resumen de las reformas del sector siderúrgico de China
Como parte de sus reformas destinadas a reducir la contaminación del aire eliminando capacidad industrial obsoleta y excesiva, Pekín se comprometió a eliminar entre 100-150 mm MT de capacidad siderúrgica durante el período 2016-2020. Hasta la fecha ha cerrado una estimada capacidad de 100 mm MT.
Además de estas reformas, Pekín se comprometió a cerrar los pequeños hornos de inducción en China, que funden chatarra y producen acero de mala calidad. Se estima que estos hornos de inducción representan entre 80-120 mm MT de capacidad anual, aunque su producción real es mucho menor: produjeron entre 30-50 mm MT en 2016, según S&P Global Platts.1 Esto es menos del 7% de la producción total de acero crudo de China.
Los recortes de producción de los molinos de inducción no son evidentes en los datos oficiales: las cifras de producción de acero crudo de China han seguido aumentando en medio de estos recortes, como discutimos en investigaciones anteriores (Gráfico 2).2 Los datos del International Iron and Steel Institute muestran que la producción mundial de acero alcanzó un récord en los primeros 11 meses de 2017, aumentando más del 5% interanual. Asimismo, la producción de acero crudo de China —que representa el 50% de la producción mundial— alcanzó su punto máximo en agosto: la producción en el mismo período fue la más alta registrada, aumentando un 5.28% en comparación con el mismo período de 2016.
Esta paradoja de la producción puede atribuirse al hecho de que muchos hornos de inducción chinos son ilegales y, como resultado, su producción no se contabiliza en los datos oficiales de producción. A medida que los productores legales de acero aumentaron su producción para compensar las disminuciones de los hornos de inducción cerrados, las cifras oficiales de producción de crudo aumentaron.
De hecho, un examen más detallado de los datos siderúrgicos chinos deja claro que el mercado del acero de China está en realidad más ajustado de lo que se puede inferir a partir de las cifras de producción de crudo (Gráfico 3). Las siguientes observaciones apuntan a un mercado tensionado:
Mientras la producción de acero crudo de China ha ido marcando nuevos récords, los datos de China Stat Info revelan una imagen contradictoria acerca de los productos de acero. La producción de productos de acero en el período de marzo a noviembre de 2017 fue un 3.46% inferior interanual, marcando la primera caída interanual para ese período desde 1995! Mientras que el acero crudo producido por hornos de inducción no se incluiría en las cifras oficiales de acero crudo, el metal acabaría utilizándose para fabricar productos de acero —alambres, varillas, rieles y barras— y están representados en estos datos. Por lo tanto, la caída en los productos de acero indica que la menor oferta de crudo ha lastrado la producción de productos siderúrgicos.
Las exportaciones de acero de China han estado en descenso. En teoría, esto puede deberse bien a un aumento de la demanda interna o a una disminución de la demanda externa. Dado el buen estado de la economía mundial y lo que sabemos sobre la producción de acero en China, creemos en la primera teoría. Las exportaciones de productos siderúrgicos de China bajaron un 30% interanual en los primeros 11 meses de 2017. Aparte de la caída interanual del 3.04% en 2016, estas marcan las primeras disminuciones anuales en las exportaciones desde 2009. Ante una menor oferta interna, China probablemente redujo sus exportaciones para satisfacer la demanda de los usuarios locales del acero.
Las importaciones de chatarra de acero de China cayeron en la 2S17. A diferencia de los altos hornos, que utilizan mineral de hierro como principal insumo en la fabricación de acero, los acereros ilegales cerrados usan chatarra que funden en un horno de inducción. Coincidiendo con la eliminación de estos hornos, las importaciones de chatarra de acero de China cayeron un 14.35% interanual en la 2S17. Esto es otra evidencia de la menor demanda de chatarra por parte de estos hornos.
Los inventarios de acero en China están cayendo. De hecho, los inventarios de productos siderúrgicos en las principales ciudades industriales están en mínimos históricos (Gráfico 4). Esto es un síntoma de un mercado ajustado con demanda superando la oferta, contradiciendo las cifras de producción de acero crudo de China.
Gráfico 2
Producción china récord de acero crudo##BR##En medio de la caída en la producción de productos siderúrgicos
Récord de producción de acero crudo en China en medio de la caída de la producción de productos siderúrgicos
Récord de producción de acero crudo en China en medio de la caída de la producción de productos siderúrgicos
Gráfico 3
Evidencia de los datos comerciales de China##BR##De un mercado ajustado
Datos comerciales de China: evidencia de un mercado ajustado
Datos comerciales de China: evidencia de un mercado ajustado
Gráfico 4
Los inventarios de acero##BR##En China están cayendo
Los inventarios de acero en China están cayendo.
Los inventarios de acero en China están cayendo.
Además, según la World Steel Association (WSA), la utilización de la capacidad en los 66 países para los que recopilan datos aumentó en 3.12 puntos porcentuales interanuales para el período de julio a noviembre de 2017 hasta promediar 72.64%, frente al promedio de 69.52% en el mismo período de 2016. Estas observaciones son evidencia de que, a pesar del aumento en las cifras oficiales de producción de acero crudo, la producción real ha caído y la oferta está más ajustada.
Que los precios del acero se mantengan impulsados por la escasez dependerá de si China tiene éxito en cerrar de forma permanente la capacidad excesiva y a los productores de acero de mala calidad, o si los operadores de hornos de inducción logran eludir estas políticas y traer acero ilegal de vuelta al mercado.
Las reformas de China dominarán el mercado del acero, al menos este invierno
Tras la conclusión de la Conferencia Central de Trabajo Económico de mediados de diciembre, las autoridades chinas anunciaron las "tres batallas difíciles" para los próximos tres años, que consideran cruciales para la prosperidad económica futura. Estas batallas se resumen en (1) prevenir riesgos mayores, (2) alivio de la pobreza dirigido, y (3) control de la contaminación. La Agencia Internacional de la Energía (IEA) estima que la contaminación del aire ha provocado ~1 millón de muertes prematuras mientras que la contaminación del aire en los hogares causó otras 1.2 millones de muertes prematuras en China anualmente.3 Por ello, mejorar la calidad del aire en China es un objetivo social y de salud primordial para el país.
Gráfico 5
La menor producción china de acero##BR##Impactará la producción mundial
La menor producción de acero en China afectará la producción mundial.
La menor producción de acero en China afectará la producción mundial.
Esto significará que las medidas para reducir la contaminación y despejar los cielos de China serán críticamente importantes para el sector siderúrgico. Según el Ministerio de Protección Ambiental, China se comprometió a una reducción interanual del 15% en la concentración de partículas en suspensión de menos de 2.5 micras de diámetro, conocidas como PM2.5, en 28 ciudades del norte propensas al smog. La industria del acero, que se concentra mayormente en la región norteña de China de Pekín-Tianjin-Hebei, es una de las principales fuentes de emisiones contaminantes en esa región. De hecho, las emisiones industriales —especialmente de los sectores del acero y del cemento— son supuestamente responsables del 40-50% de estas pequeñas partículas en suspensión.
El "plan de batalla" contra el smog invernal de China apuntará a estas industrias contaminantes ordenando recortes en la producción de acero, cemento y aluminio durante los meses propensos al smog, de mediados de noviembre a mediados de marzo, así como restringiendo el uso doméstico de carbón, los camiones diésel y los proyectos de construcción. Los recortes de producción de acero apuntan a un rango entre el 30-50%, lo que, según estimaciones de Platts, reducirá 33 mm MT de producción de acero —equivalente a ~3.9% de la producción de acero crudo prevista de China para 2017— durante el invierno. De hecho, según el ministro de medio ambiente de China, Li Ganjie, "estas campañas especiales no son puntuales, en cambio son una exploración de mecanismos a largo plazo."4 Por lo tanto, estos recortes podrían convertirse en un evento recurrente en el sector siderúrgico chino.
Las cifras oficiales de acero crudo de China comienzan a mostrar el impacto de estos recortes con la producción cruda de noviembre cayendo un 8.6% mes a mes (mom) y creciendo solo un 2.2% interanual —significativamente más lento que el promedio interanual del 7.6% experimentado desde julio. Como consecuencia, aunque la producción cruda en el resto del mundo creció en línea con los meses anteriores, la producción mundial de acero cayó casi un 6% mes a mes en noviembre, mientras que la producción interanual creció un 3.7% –una desaceleración significativa respecto al ritmo promedio interanual del 6.6% observado desde el comienzo de la 2S17 (Gráfico 5).
Los riesgos para esta perspectiva provienen del bajo cumplimiento de estos recortes. Hay informes recientes de evasiones por parte de productores de aluminio y acero en Shandong. No obstante, dado el enfoque de China en estas reformas, no prevemos violaciones generalizadas.
Otro riesgo proviene del lado de la demanda. Como parte de su agenda medioambiental, Pekín anunció planes para posponer la construcción de importantes proyectos públicos en la ciudad —proyectos viales y de agua— hasta la primavera. La suspensión no pretende afectar a los "proyectos de gran impacto en la vida de las personas" como ferrocarriles, aeropuertos y vivienda asequible.
La construcción es el mayor usuario final del acero —según la WSA más de la mitad del acero mundial se utiliza en edificios e infraestructura— una desaceleración en el sector de la construcción lastraría la demanda de acero.5 Si otras zonas de construcción importantes adoptan una política similar, el impacto de la menor oferta de acero se compensará con una demanda débil, atenuando el efecto general sobre el mercado del acero.
Conclusión: Esperamos ver una menor producción y exportaciones de acero de China en los próximos meses. Dada la determinación de Xi Jinping de mejorar la calidad del aire, esperamos que el cumplimiento de las reformas medioambientales entre los acereros sea fuerte este invierno. Esto, junto con la menor producción de los hornos de inducción en China, indica que el mercado podría estar más ajustado de lo que comúnmente se supone, al menos en la 1S18. La probabilidad de que la recuperación y expansión económica mundial persista durante 2018 sugiere que los mercados del acero podrían seguir bien demandados en la 2S18, particularmente si, como esperamos, el crecimiento fuera de China compensa la pérdida resultante de cualquier desaceleración en China. Sin embargo, tendremos que ver cómo serán las reformas reales para la industria tras la Asamblea Nacional Popular en marzo de 2018.6
Los márgenes de beneficio del acero impulsan la demanda de mineral de hierro
Dadas las excepcionales ganancias de precio del acero durante los últimos dos años, y el desempeño poco brillante del mineral de hierro en 2017, los márgenes de beneficio en los productores de acero chinos alcanzaron máximos de varios años (Gráfico 6). Normalmente, esto alentaría la producción de acero, lo que inundaría el mercado con oferta y presionaría los precios a la baja. Sin embargo, las reformas medioambientales de China limitarán la producción en la región siderúrgica más productiva del país en los próximos meses. En consecuencia, a menos que haya violaciones masivas de las políticas por parte de los productores de acero este invierno, no anticipamos un ajuste rápido de los precios a la baja.
En cambio, los productores de acero se están preparando para funcionar a plena capacidad cuando las restricciones de producción se levanten en la primavera. Por ello, están llenando inventarios de mineral de hierro y aprovechando los precios más bajos del mineral antes de que el mercado del mineral de hierro alcance al del acero. Las importaciones de mineral de hierro de China alcanzaron un récord histórico en septiembre, mientras que los últimos datos muestran un salto del 19% mes a mes (mom) en las importaciones, correspondiente a un aumento interanual del 2.8% (Gráfico 7).
Gráfico 6
Márgenes de beneficio saludables##BR##en el acero
Sólidos márgenes de beneficio del acero
Sólidos márgenes de beneficio del acero
Gráfico 7
Productores de acero acumulando mineral de hierro##BR##En preparación para la primavera
Productores de acero se abastecen de mineral de hierro en previsión de la primavera
Productores de acero se abastecen de mineral de hierro en previsión de la primavera
Esto va en contra de lo que esperaríamos durante un período de producción siderúrgica moderada. Especialmente en un entorno de inventarios saludables de mineral de hierro, como el que tiene actualmente China. Aunque los inventarios chinos bajaron desde los picos de mitad de año, reanudaron su tendencia al alza en el 4T17. Esto coincide con los recortes de capacidad del invierno siderúrgico y probablemente se deba a la menor demanda del mineral por parte de los molinos de acero. Hay dos teorías para explicar este fenómeno:
1. Los acereros chinos están aprovechando los precios más bajos del mineral de hierro y asegurando márgenes de beneficio más altos, anticipando precios más altos del mineral una vez que la producción de acero aumente de nuevo en la primavera.
2. En medio de los recortes invernales, los acereros chinos están demandando mineral de hierro de alta ley, importado de Brasil y Australia. Esto les ayudará a asegurarse de que pueden maximizar su producción sin violar las políticas medioambientales.
La conciencia medioambiental amplía los diferenciales del mineral de hierro
Una consecuencia de los recortes de capacidad del invierno siderúrgico es una mayor demanda de materias primas de mayor ley para reducir las fases más contaminantes de la producción de acero. El mineral de hierro de mayor ley, definido por su pureza o contenido de hierro, es más eficiente para los altos hornos, permitiéndoles producir más acero por cada tonelada de mineral de hierro que consumen, maximizando la producción y el beneficio. Esto es especialmente cierto en un mercado del acero ajustado, con márgenes de beneficio saludables: los acereros pueden permitirse las calidades superiores y están favoreciendo la eficiencia productiva.
El descuento por finos de mineral de hierro de menor ley —contenido de hierro del 58%— así como la prima por la mayor ley del 65% se han ampliado (Gráfico 8). Esto se debe a que los molinos han encontrado una manera de eludir legalmente las restricciones medioambientales invernales y seguir cumpliendo. Además, los minerales más puros son menos contaminantes, lo que ayuda a servir la agenda medioambiental de China.
Además, las primas por pellets de mineral de hierro y por guijarros de mineral de hierro también se han ampliado. A diferencia de los guijarros y pellets, que pueden alimentarse directamente a los altos hornos, los finos requieren un proceso de sinterización que es altamente contaminante. Por lo tanto, las reformas medioambientales de China han aumentado la demanda de minerales de mayor ley y menos contaminantes.
Un factor adicional que podría estar impulsando los diferenciales al alza son los mayores precios del coque metalúrgico (Gráfico 6). El mineral de hierro de mayor ley contiene menos sílice y, por tanto, requiere menos coque metalúrgico para purificar los minerales. Según evidencia anecdótica desde China, los finos de Carajás de Brasil —que tienen el mayor contenido de hierro y el menor contenido de sílice— están supuestamente en alta demanda.7
Además, las importaciones de China muestran una disminución del mineral de hierro procedente de India —que es de menor ley. En el período de julio a octubre, las importaciones cayeron un 11.26% interanual, con las importaciones de octubre cayendo casi un 25% interanual y un 30% mes a mes. Esto es consistente con la teoría de que los acereros están rechazando los minerales de menor ley. Por otro lado, se espera que las importaciones de Brasil y Australia se mantengan fuertes (Gráfico 9). El último Australian Resources and Energy Quarterly pronostica que las exportaciones australianas y brasileñas de mineral de hierro crecerán un 5.4% y un 4.2% respectivamente en 2018, mientras que se proyecta que las exportaciones indias caigan un 57.5% interanual.
Gráfico 8
Amplios diferenciales##BR##de precios del mineral de hierro
Amplios diferenciales de precio del mineral de hierro
Amplios diferenciales de precio del mineral de hierro
Gráfico 9
Las preocupaciones medioambientales apoyarán##BR##la demanda de mineral de hierro de alta ley
Las Preocupaciones Medioambientales Respaldarán la Demanda de Mineral de Hierro de Alto Grado
Las Preocupaciones Medioambientales Respaldarán la Demanda de Mineral de Hierro de Alto Grado
Conclusión: En un esfuerzo por mantener la producción alta y beneficiarse de los fuertes precios del acero frente a los recortes invernales de producción, los productores de acero están recurriendo a mineral de hierro de mayor ley, aumentando el diferencial entre minerales de alta y baja ley. El grado en que los productores de acero puedan mantener con éxito la producción gracias a los minerales de mayor ley amortiguará el impacto de los recortes de producción invernales en el sector siderúrgico. Dado que el enfoque medioambiental de China es un plan a largo plazo, esperamos que estos diferenciales permanezcan amplios, en lugar de volver a su promedio histórico.
Precios del acero y mercados del cobre
Gráfico 10
El consumo de acero ayuda a##BR##predecir los precios del cobre
El consumo de acero ayuda a predecir los precios del cobre
El consumo de acero ayuda a predecir los precios del cobre
El mercado del cobre vivió una montaña rusa en el cuarto trimestre. Los precios del metal rojo mantuvieron una tendencia general al alza desde mayo y alcanzaron un primer pico a principios de septiembre en $3.13/lb antes de tocar suelo en $2.91/lb a la segunda mitad de ese mes. Poco después, los precios del cobre alcanzaron un nuevo máximo de $3.22/lb a mediados de octubre —su nivel más alto en más de tres años. Los temores de una desaceleración en China tras los mensajes del XIX Congreso del Partido Comunista hicieron que el metal perdiera casi un 10% de su valor, cuando tocó fondo por segunda vez a principios de diciembre. De hecho, esto coincidió con una caída del 4.65% en el precio el 5 de diciembre. Aunque no hay una justificación clara para esta caída, puede atribuirse a una mezcla de factores que incluyen un aumento de ~10 th MT en los inventarios de la LME, preocupaciones sobre una desaceleración en China, así como una liquidación de posiciones antes del año nuevo. No obstante, el cobre ha recuperado estas pérdidas y cerró el año en $3.28/lb.
En nuestro modelado del cobre, encontramos que el consumo de acero es significativo para pronosticar el comportamiento futuro del precio del cobre. Más específicamente, el consumo de acero de China tiene una relación positiva significativa con los precios del cobre seis meses en el futuro (Gráfico 10). Esto se puede explicar por la importancia del sector de la construcción como usuario final de ambos materiales. Sin embargo, cada metal llega al sitio de construcción en marcos temporales diferentes. Mientras que los productos de acero se utilizan en la construcción de las estructuras y, por tanto, se necesitan al inicio del proyecto, el cobre se utiliza en el cableado eléctrico y la fontanería, y por tanto se necesita más tarde (aproximadamente 6 meses) en el proyecto.
Esto está en línea con nuestros hallazgos de que el acero es más significativo con un rezago de seis meses —reflejo del período medio entre la construcción de la estructura y la necesidad del cableado y la fontanería. El consumo de acero en China es un indicador adelantado útil de los mercados del cobre cuando los fundamentos del lado de la demanda dominan los mercados del acero y del cobre.
El estímulo gubernamental y un sólido sector de la construcción impulsaron la demanda de acero de China en 2017. Sin embargo, según la WSA Short Range Outlook, la demanda de acero se moderará este año debido a la reflación en China, parcialmente compensada por un fuerte crecimiento global. La WSA señala que el cierre de hornos de inducción infló las cifras de crecimiento de la demanda de acero hasta el 12.4% interanual, y en su lugar cita una estimación más razonable en torno al 3% interanual de crecimiento de la demanda de acero de China en 2017, llevando la tasa de crecimiento de la demanda mundial de acero al 2.8%. Mientras que la demanda de acero fuera de China creció un estimado del 2.6% en 2017, prevén que alcance el 3% en 2018. En contraste, esperan una demanda plana de China en 2018, llevando el crecimiento de la demanda mundial de acero al 1.6% en 2018 (Tabla 1).
Tabla 1
Demanda de acero (tasas de crecimiento interanual)
Las reformas ambientales de China impulsan el acero y el mineral de hierro
Las reformas ambientales de China impulsan el acero y el mineral de hierro
La moderación de la demanda desde China y la estabilidad (o falta de ella) del lado de la oferta dominarán el mercado del cobre este año. En el lado de la demanda, el mercado del acero de China ofrece perspectivas sobre la dirección futura del metal rojo.
Conclusión: Dado que el apetito de China por el acero se ha mantenido sano hasta la fecha y se proyecta que mantenga su nivel de 2017 este año, no esperamos una caída inducida por la demanda en los precios del cobre en el horizonte de 6 meses.
Roukaya Ibrahim, Editora asociada Commodity & Energy Strategy RoukayaI@bcaresearch.com
1 Véase "Will China's induction furnace steel whac-a-mole finally come to an end?" publicado por S&P Global Platts el 6 de marzo de 2017.
2 Véase el Commodity & Energy Strategy Weekly Report de BCA Research "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," publicado el 7 de septiembre de 2017, disponible en ces.bcaresearch.com.
3 Véase el informe especial World Energy Outlook 2016 de la IEA titulado "Energy and Air Pollution," disponible en iea.org.
4 Véase "Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily," publicado el 26 de diciembre de 2017, disponible en reuters.com.
5 Véase "Steel Markets" en worldsteel.org.
6 Para discusión adicional, véase "Shifting Gears in China: The Impact On Base Metals," en la edición del 9 de noviembre de 2017 de Commodity & Energy Strategy de BCA Research. Está disponible en ces.bcaresearch.com.
7 Véase "High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt," publicado el 22 de agosto de 2017, disponible en platts.com.
Visiones y temas de inversión
Recomendaciones
Recomendaciones estratégicas
Operaciones tácticas
Tabla de referencia de precios y estrategias de materias primas
Las reformas medioambientales de China impulsan el acero y el mineral de hierro
Las reformas medioambientales de China impulsan el acero y el mineral de hierro
Operaciones cerradas en 2017
Highlights Chinese policymakers are walking a tightrope, attempting to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. Recent price action in EM risk assets resembles a final bear capitulation phase, and a classic top formation. Currency appreciation and moderation in export growth will damp corporate profits of exporters in Korea and Taiwan. Stay short KRW versus THB and short MYR versus RUB and USD. Feature "...at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks." Irving Fisher, The Debt-Deflation Theory of Great Depressions (1933) China continues to tighten financial regulations1 and onshore corporate bond yields keep marching higher. Yet EM and China-related financial markets have been extremely buoyant, completely ignoring the tightening dynamics underway. This reminds us of the above quote from Irving Fisher. The Chinese economy has been able to "...bend under strain, ready all the time to bend back..." In other words, growth has so far done well, despite ongoing liquidity and regulatory tightening (Chart I-1). This has led many investors and commentators to proclaim that the economy is healthy and will slow only a bit, or not at all. Chart I-1China: Will Economy Continue ##br##Defying Weak Credit Impulse? Yet, financial market risks linger. At a certain point, cumulative pressure from policy tightening will cause China's recovery to falter - "break," as per Fisher's quote above - impacting the rest of the world in general and EM in particular. This precept is pertinent to China at present because its money, credit and property markets are frothy, as we have written repeatedly in recent years, making them especially vulnerable to tightening. We thought such a deceleration in China's business cycle would occur in 2017, but it has not yet transpired. Forward-looking indicators such as money supply growth and the yield curve have been heralding a growth slowdown for many months (see Chart I-1). Nevertheless, this recovery has proved to be enduring; even though some segments have slowed, overall nominal growth, corporate pricing power and profits have done well. Does such growth resilience warrant an upgrade on China's outlook? An economy's past performance does not guarantee its future performance. This is relevant to China now, especially given the cumulative impact of the ongoing triple policy tightening - liquidity, regulatory and anti-corruption efforts in the financial industry2 - which will likely be substantial. Walking A Tightrope China's policymakers are walking a tightrope trying to balance contradictory objectives such as curbing financial speculation and credit excesses, capping inflation and maintaining a stable currency on the one hand, and maintaining robust growth on the other. Inflationary pressures are escalating in the mainland economy. Chart I-2 demonstrates that pricing power for 5,000 industrial companies - a diffusion index for producer prices compiled by the People's Bank of China - is approaching its 2007 and 2010 highs, while nominal interest rates are currently much lower than they were in 2007 and 2010 (Chart I-2, bottom panel). Notably, most of China's nominal recovery in the past two years has been due to prices, not volumes (Chart I-3). Given that rising prices benefit corporate profits much more than rising volumes, Chinese corporate profits have surged. Yet, the flip side of these dynamics is rising inflation. Chart I-2China: Inflationary Pressure Are Rising, ##br##While Interest Rates Are Low Chart I-3China: It Has Been Nominal (Price) Not ##br##Volume Manufacturing Recovery Mounting inflation amid enormous money excesses - the Chinese banking system has originated RMB 142 trillion (equivalent to $22 trillion) since January 20093 - risks triggering rising inflation expectations, which would then feed back into inflation. With real interest rates already extremely low (Chart I-4), increasing inflation expectations could lead to growing demand for foreign currency, in turn exerting downward pressure on the RMB exchange rate. Chart I-4China: Inflation-Adjusted ##br##Interest Rates Are Low Chinese households have been uneasy about the real (inflation-adjusted) value of their deposits, and have been opting for speculative investments that promise higher yields than bank deposits. Hence, policymakers cannot ignore households' desire for higher real interest rates if they aim to cool down speculative investment activities and contain systemic risks in the system. Overall, the authorities need to tread carefully, balancing between the need to preserve decent growth while keeping inflation at bay. Falling behind the inflation curve is as dangerous as being too aggressive in tightening. For now, rising domestic inflationary pressures, robust DM growth and the resilience of financial markets will justify further policy tightening in China. Controlling leverage, curbing financial market excesses and limiting speculation in the real estate market are all major components of the structural reforms agenda that China's top policymakers committed to at the Party Congress in October. Bottom Line: Chinese policymakers are walking a tightrope, trying to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. The odds of successfully navigating these contradictory objectives amid lingering money, credit and property market imbalances are 30% or lower. In the meantime, financial markets seem priced for perfection. This gap between the market's views and our perception of risks leads us to maintain a negative investment stance. EM's Blow-Out Phase EM stocks and currencies have gone vertical in recent weeks, despite being overbought and not cheap. The recent price actions in EM and global risk assets looks like a final bear capitulation phase and a classic top formation. The EM overall equity and small-cap indexes have reached their 2011 high (Chart I-5, top and middle panels). Meanwhile, EM high-yield (junk) corporate and quasi-sovereign bond yields are at their historical lows (Chart I-5, bottom panel). Economic data, corporate profits and news flows are typically extremely positive at tops of cycles, and very negative at bottoms. Given that share prices have surged and credit spreads are extremely low, a lot of good news has already been discounted. In particular, EM long-term EPS growth expectations have shot up above their previous highs (Chart I-6). This indicator can serve as a proxy for investor sentiment on EM stocks, at the moment suggesting extreme bullishness. EM stocks topped out in the past when this indicator reached the current levels. Chart I-5Are EM At Their Zenith? Chart I-6Analysts Are Super Bullish On EM Profits Growth Needless to say, global investors' positioning is stretched in favor of risk assets. Chart I-7 entails that U.S. individual investors' holdings of cash was at a record low as of December, while their exposure to equities was not far from record highs. Apart from China-related risks, a potential rise in U.S. bond yields and/or the U.S. dollar, could spoil the EM party. Many investors have invested in EM on the assumption of continued weakness in the greenback and subdued U.S. bond yields. It would be unusual if this current robust global growth does not lead to higher inflation expectations or higher bond yields. With respect to market signals, Chart I-8 illustrates that global steel stocks in absolute terms, and the relative performance of emerging Asian stocks versus DM equities have approached their very long-term moving averages. The latter might become a major technical resistance. Failure to break above this resistance level would be consistent with EM share prices rolling over at their 2011 highs (see Chart I-7). Altogether, this could signal a major top in EM risk assets. Chart I-7Asset Allocation Of ##br##U.S. Individual Investors Chart I-8Select Segments Are At Their ##br##Long-Term Technical Resistances Bottom Line: The EM rally has endured much longer and has gone much farther than we envisioned. However, we maintain our cautious stance, and recommend underweighting EM stocks, currencies and credit versus their DM counterparts. Emerging Asia: Currencies And Business Cycle Chart I-9Geopolitics And Asian Currencies Emerging Asian currencies have recently been on the fly, surging versus the U.S. dollar. Apart from strong global manufacturing, one reason behind the emerging Asian currency appreciation has been geopolitics. We suspect political leaders in Taiwan and Korea have instructed their central banks to allow their currencies to appreciate to gratify the Trump administration's aspirations of a weaker greenback. The top panel of Chart I-9 shows that the Taiwanese dollar's sharp appreciation coincided with Trump's controversial phone call with the Taiwanese president on December 3rd, 2016. Similarly, Trump's visit to South Korea on November 7th, 2017 jives with the latest up leg in the Korean won (Chart I-9, bottom panel). It seems President Trump's geopolitical assurances to Taiwan and Korea are somewhat tied to these policymakers' increased tolerance for currency appreciation. Notably, foreign exchange reserves in both Taiwan and Korea have risen little, despite their strong trade surpluses and foreign capital inflows over the past year. This confirms that their central banks have been reluctant to purchase U.S. dollars and in turn cap their currencies' appreciation. In addition to the political context, there are a number of other important drivers of Asian exchange rates and the region's business cycle: The growth rate of Korean and Taiwanese total exports in U.S. dollars has moderated (Chart I-10). This, along with KRW and TWD appreciation, implies a meaningful deceleration in exporters' revenue growth in local currency terms. Besides, China's container freight index - the price to ship containers worldwide - has relapsed and it correlates well with Asia's export cycle (Chart I-11). Chart I-10Moderation In Asian Exports Growth Chart I-11A Negative Signal For Asian Exports Even though DRAM prices are rising, other semiconductor prices have rolled over (Chart I-12). Semiconductor prices and volumes are vital for the tech-heavy Taiwanese and Korean manufacturing sectors. The RMB rally is also late. Enormous pent-up demand for foreign assets from Chinese residents due to low mainland real interest rates creates the potential for capital outflows to cap RMB strength. This would weigh on the ongoing Asian currency rally. Finally, net EPS revisions of Korean and Taiwanese technology companies' have rolled over (Chart I-13), probably reflecting a dampening effect of currency appreciation. This could in turn lead to foreign capital outflows from their equity markets causing currency selloffs. Chart I-12Divergence In Semiconductor Prices Chart I-13Asia Tech Companies: Net EPS Revisions Corroborating budding signs of a slowdown in exports and corporate profits, emerging Asian stocks have begun underperforming DM equities, as shown in Chart I-8 on page 7. The deceleration in export revenues and currency appreciation are adverse developments for share prices in export-related sectors of Korea and Taiwan. Nevertheless, for dedicated EM equity portfolios, we recommend overweighting the Taiwanese bourse and Korean technology stocks (and being neutral on the rest of KOSPI). The basis is that share prices of hardware tech manufacturers have less downside than other EM sectors. Their attractive relative valuations combined with prospects for robust growth in DM warrant their outperformance against the overall EM equity index in common currency terms. As to exchange rates, the Trump factor will delay and mitigate Asian currency depreciation, but will not preclude it if export growth slows, as we expect. In such a scenario, policymakers in Asia will opt for modest currency depreciation, reversing their recent gains. In terms of investment strategy, we have been shorting the Korean won versus the Thai baht. This trade has so far been flat, but we are maintaining it because the won is a higher-beta currency than the baht, and the former will underperform the latter as Asia's business cycle eventually slows. In addition, we are also shorting the Malaysian ringgit versus the U.S. dollar and the Russian ruble due to weak domestic fundamentals in Malaysia. Bottom Line: Currency appreciation will damp corporate profits of exporters in Korea and Taiwan. This will weigh on EM share prices in aggregate, given that the Korean and Taiwanese markets together account for 27% of the MSCI EM market cap, compared with an 12% share of the entire Latin American region. The 12-month outlook for Asian currencies is downbeat: continue shorting the MYR versus both the U.S. dollar and the RUB, and stay long the THB versus the KRW. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 This week the China Banking Regulatory Commission (CBRC) announced a set of sweeping new rules to control banks' entrusted lending (Source: Caixin). This is in addition to a slew of regulatory measures for financial institutions that have been introduced over the past year. 2 We discussed these in details in Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, a link available on page 13. 3 Please see Emerging Markets Strategy Special Report, titled "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, a link available on page 13. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights A "decision tree" for the allocation to Chinese stocks highlights several key questions for investors over the coming year. The equity allocation decision hinges on the condition of the global economy, the stance of monetary policy, the pace of structural reforms, and the character of the ongoing economic slowdown. Despite several identifiable risks, our "decision tree" suggests that investors should be overweight Chinese vs global stocks. Feature Unlike in past years, BCA's China Investment Strategy service published its 2018 themes report in December, as an addendum to BCA's special year end Outlook report.1 Our final report for 2017 echoed our key themes by recapping some of the most important developments in China last year, as well as their longer-term implications.2 These reports outline our framework for evaluating China's economy in 2018, and will serve as an important reference point over the coming months relating to the pace of China's economic slowdown, policymakers' actions and priorities, and investor attitudes toward Chinese assets. In today's brief report, we begin the New Year by walking through the Chinese equity "decision tree" that flows from the framework that we detailed in our themes piece noted above (Chart 1). The chart presents a set of questions that should be answered over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio. We elaborate on the decision tree below. Chart 1The Chinese Equity "Decision Tree" Is The Global Economy Slowing Significantly?: Developments in China need to be considered within a global context. We have noted in previous reports that a synchronized global economic slowdown was a key factor behind China's economic slowdown in 2015.3 If global growth were to slow significantly this year, it would bode poorly for the relative performance of Chinese stocks. Next week's report will discuss the evolution of the alpha and beta characteristics of China's investable stock market; while our research is still ongoing, the evidence suggests that Chinese equities in US$ terms have become a high-beta market that would likely suffer in relative terms if the global equity market stumbles. Chart 1 highlights that the appropriate allocation to Chinese equities vs global stocks is underweight if the answer to this first question is yes, with the upgrade/downgrade bias determined simply by whether there has been an appropriate response from Chinese and global policymakers. Is Significant Further Monetary Policy Tightening Likely?: Overly tight monetary policy was the second ingredient that contributed to the 2015 slowdown. Monetary conditions tightened somewhat in the first half of 2017 (Chart 2), but the overall stance is not restrictive. Taken alone, hawkish rhetoric from the PBOC would imply that significant further tightening is imminent. However our sense is that the bark of monetary authorities will be worse than their bite over the coming months, especially since growth momentum and house price appreciation has already peaked. Is The Pace Of Renewed Structural Reforms Likely To Be Aggressive?: October's Party Congress heralded stepped-up reform efforts in 2018 and beyond, which we have highlighted is a risk to a constructive stance towards Chinese stocks. While the "status quo" scenario of no significant reforms is highly unlikely, the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers to avoid a repeat of the 2015 experience. Even if policymakers feel that their threshold for pain will be higher in 2018 than has previously been the case, they are very likely to avoid a significant slowdown as it would raise the risk of returning to the exact set policies that they are trying to turn away from. In other words, an intense pace of reform would risk turning a "two steps forward, one back" situation into a full-blown retreat from structural reform momentum. For now, our China Reform Monitor continues to suggest that reform intensity will be consistent with a rising equity market (Chart 3). Chart 2Chinese Monetary Conditions ##br##Have Tightened Chart 3Investors Don't Believe That Reforms##br## Will Upset The Apple Cart Is The Existing Slowdown In China's Growth Momentum Metastasizing? Our view of China's significant growth slowdown in 2015 suggests that the end of the recent economic "mini-cycle" is likely to be benign and controlled, absent a policy mistake or a major global shock. However, it is possible that the lagged effect of a deceleration in export growth and tighter monetary policy, both of which have already occurred, could cause a broader or deeper slowdown in economic growth beyond what we have already observed. In order to gauge this risk, we tested a wide range of commonly-watched macro data series for signs that they reliably lead economic activity in China,4 using the Li Keqiang index as our proxy for the business cycle. We concluded that measures of money & credit are among the most important predictors, and presented a composite leading indicator of the Li Keqiang index based on six series that passed our test criteria (Chart 4). For now, our indicator suggests that the Chinese economy will continue to slow over the coming months, but that the pace and magnitude of the decline will be benign and controlled. The first question in our decision tree is the easiest to answer: The highly synchronized nature of global economic growth suggests that a significant slowdown is not imminent, even if the pace of growth becomes narrower or slows modestly (Chart 5). While our decision tree highlights that answering "yes" to any of the last three questions means that investors should have a negative bias towards Chinese investable stocks (and should downgrade them in response to a technical breakdown), these questions are still addressing risks rather than probable events. This supports our current recommendation of being overweight Chinese investable equities with a positive bias. Chart 4The Chinese Economy##br## Will Gradually Slow Chart 5No Sign Of A Significant ##br##Global Economic Slowdown As a final point, some investors and market participants have noted that investable Chinese stocks experienced a non-trivial selloff at the end of 2017, with some questioning whether it is a harbinger of a more pronounced economic slowdown. Our answer is no, for two reasons. First, there is some evidence to suggest that the selloff was technical in nature, as the sectors that had experienced the largest gains prior to the selloff also experienced the largest declines (Chart 6). Second, the timing of the relative selloff in Chinese stocks coincided exactly with a relative selloff in the global tech sector (Chart 7), which is strongly indicative of a common, global, factor. But given the underlying strength in the global economy, we regard this event as idiosyncratic and do not view it as a threat to the relative performance of Chinese vs global stocks over the coming year. Chart 6The Late-Year Selloff Was Partially ##br##Driven By Technical Conditions Chart 7Global Tech Also Drove The Selloff##br## In Chinese Relative Performance Bottom Line: While there are several identifiable risks that need to be monitored in 2018, for now our "decision tree" for the relative allocation to Chinese equities suggests that investors should be overweight within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, and Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, and "China's Economy - 2015 vs Today (Part 1): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? Chart I-10Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances Chart II-15Anti-Corruption Is Popular Chart II-16Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... Chart II-17B...But There's A Long Way To Go Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations Chart II-10U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield ComponentsChart II-13U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Chart II-20Euro Technicals Chart II-21Euro/Yen Technicals Chart II-22Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Chart II-24Commodity Prices Chart II-25Commodity Prices Chart II-26Commodity Sentiment Chart II-27Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot Chart II-30U.S. Growth Outlook Chart II-31U.S. Cyclical Spending Chart II-32U.S. Labor Market Chart II-33U.S. Consumption Chart II-34U.S. Housing Chart II-35U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China