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Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Highlights The Chinese authorities have progressively tightened capital account control regulations to staunch capital outflows, which will likely slow the drawdown of the country's official reserves in the near term. Rising yields in China are largely reflective rather than restrictive. Monetary easing through interest rate cuts has likely run its course, but it is highly unlikely that the PBoC will raise rates to protect the RMB. The Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Feature The mighty U.S. dollar occupied the cover of this week's Economist magazine - it has also clearly occupied the top spot on our clients' 'worry lists'. We were in China last week talking to clients and conducting some "field research", and the yuan's depreciation was a key focal point of the discussions. Historically, Economist magazine cover stories have mostly turned out to be perfect contrarian signals, and it remains to be seen whether this one will be a blessing or curse for the greenback. What's more certain is that there is a clear consensus among Chinese investors on the one-way descent of the RMB against the dollar going forward, and the People's Bank of China (PBoC) is facing an uphill battle in containing domestic capital outflows. The latest program linking Chinese equities and the overseas market is the Shenzhen-Hong Kong connect program, which debuted early this week. This suggests the Chinese authorities are still committed to capital account deregulation. In the near term, however, capital control measures have been tightened progressively to preserves official reserves and maintain domestic liquidity. Full-Court Press Heightened concerns over the CNY/USD cross rate of late have ignored the fact that the RMB has remained one of the stronger currencies among a synchronized plunge against the seemingly unstoppable dollar. The trade-weighted RMB has picked up notably in recent weeks, even though it has depreciated against the greenback (Chart 1). Nonetheless, Chinese investors' perception of the currency matters greatly, as it could potentially create a self-fulfilling downward spiral between capital outflows and exchange rate depreciation. It is both naïve and highly risky to expect the RMB to settle down at a "market clearing" level against the dollar without a chaotic undershoot. The "Impossible Trinity" theory in international finance dictates that a country cannot simultaneously control its exchange rate with independent monetary policy and free flow of capital. Among these conditions, free flow of capital has been the least expensive sacrifice for the Chinese authorities.1 In basketball, full-court press refers to a defensive tactic in which members of a team cover their opponents throughout the court, and not just near their own basket. This is what the Chinese authorities appear to be doing in terms of their efforts at staunching capital outflows. Cracking down on underground money smugglers facilitating RMB conversions with other currencies, particularly in regions neighboring Hong Kong. Anecdotal evidence suggests a sharp slowdown in illegal money transfers. Tightening scrutiny on trade invoicing verifications to crack down on "fake" international trades. Chinese imports from Hong Kong, sky-high last year as Chinese local firms fabricated import businesses to move money offshore, have tumbled to a fraction of last year's peak level (Chart 2). Restricting Chinese nationals from purchasing insurance policies issued by Hong Kong insurance firms. The massive boom of Hong Kong insurance sales to mainland residents in recent years will likely see a significant setback (Chart 3). Chart 1The RMB's Depreciation In Perspective Chart 2Blocking Capital Leakage In Trade... Chart 3...Services... These restrictive measures have been either targeting illegal channels or activities that are of minor importance to the economy as a whole. More recently, the authorities have also begun tightening rules on direct overseas investment by Chinese firms. Projects over US$10 billion and investments in "non-core" businesses are being tightly scrutinized. As companies' overseas expansion efforts are largely strategic in nature and tend to be long term, policymakers are potentially sacrificing long-term economic interests for a near-term fix of capital leakage. This underscores the authorities' increasing anxiety over capital outflows. Chart 4 shows net FDI outflows have become a major source of China's capital outflows in recent quarters, while Chinese firms paying off foreign liabilities was previously the main reason.2 Moreover, there has been a rush to acquire foreign assets among large Chinese firms this year, which is probably partially motivated by avoiding exchange rate losses (Chart 5). Chinese overseas investment activity will likely slow down significantly in the near term. Chart 4...And Outward Direct Investment Chart 5Overseas M&A Under Scrutiny Yesterday's data release show Chinese official reserves dropped to USD 3.05 trillion in November, down USD 69 billion from October. On surface, this is a marked deterioration from previous months. Underneath, however, our calculation shows that the decline in the headline official reserve number is more than explained by the mark-to-market paper losses from both a strengthening dollar and rising interest rates in the U.S. in the past month. Non-dollar assets account for about half of Chinese official reserves, and the 5% surge in the U.S. dollar index last month alone should have led to about $75 billion paper losses in the dollar value of Chinese reserves. Meanwhile, Chinese holdings of U.S. treasuries and agency bonds amount to about USD 1.4 trillion, and the sharp spike in U.S. risk free rates last month should have shaved off at least USD 30 billion in value. Taken together, the mark-to-market losses of Chinese reserve holdings are should be substantially higher than the decline in reserves last month. This may suggest that China's all-out efforts to stabilize capital outflows have been effective and should further reduce the drawdown of the country's official reserves. P.S. Over the years, we have been running a series of Special Reports tracking the composition and evolvement of China's foreign reserves. This year's update will be published next week. Stay tuned. Chart 6Interest Rate Vs Exchange Rate Will Interest Rates Be The Next Shoe To Drop? Chinese interest rates have also begun to pick up in recent weeks, as the RMB has continued to depreciate against the dollar (Chart 6). The increase in interest rates so far has been much milder compared with mid-2015, when RMB/USD depreciation sparked widespread financial volatility. Some have attributed China's higher interest rates to a weakening currency - as a sign that the country's monetary policy independence has been undermined. Recently, a senior PBoC official hinted that the central bank can raise interest rates if necessary to counter the downward pressure of the RMB, which further reinforces this view. Raising interest rates has been a typical policy response, especially among emerging countries look to defend their exchange rates, but it has rarely been proven successful. Hiking rates at a time of currency weakness further weakens domestic growth, which can in turn reinforce additional downward pressure on the exchange rate. The PBoC could certainly raise its benchmark rate, but we doubt the central bank is at all considering this option. In our view, the recent rise in Chinese interest rates may be attributable to both domestic and global factors: Globally, the synchronized selloff of bonds in major countries may have also pushed up Chinese interest rates. Chinese 10-year government bond yields have increased by 45 basis points since their August lows, not extraordinary considering the 102-basis-point selloff in U.S. Treasurys (Chart 7). Domestically, stronger growth numbers reported of late are providing additional evidence of growth improvement, which may have led to an adjustment in Chinese interest rate expectations (Chart 8). The latest PMI numbers point to further acceleration in both manufacturing and service industries, while the growth "surprise index" has been gradually improving and the yield curve has been steepening. Chart 7Higher Chinese Yields Reflect Global Factors... Chart 8... And Growth Improvement In short, we view rising yields in China as largely reflective rather than restrictive. As such, the PBoC is unlikely to rush in to push yields down just yet. In terms of monetary policy, we maintain the view that China's monetary easing through interest rate cuts has likely run its course, at least in the near term. Nonetheless, raising interest rates to protect the RMB would be a major policy mistake that would further undermine the exchange rate. Chart 9Cheaper Hong Kong Valuation Attracts ##br##Chinese Domestic Capital The Shenzhen-Hong Kong Connect Compared with the Shanghai-Hong Kong program that started over two years ago, the Shenzhen-Hong Kong connect program that debuted early this week has been received with much less enthusiasm from investors on both sides. The muted response in the marketplace likely reflects generally depressed sentiment within both Chinese and Hong Kong bourses. Given the large gap between Chinese domestic A shares and Hong Kong-listed stocks and well-entrenched expectorations of further RMB weakness, Chinese investors' purchases of Hong Kong-listed shares, or southbound purchases, will likely continue to increase (Chart 9). The establishment of the Shenzhen-Hong Kong connect program is also another step in liberalizing China's capital account controls. While in the near term this contradicts the authorities' recent efforts to block capital outflows, the new stock connect channel is subject to daily quotas, and capital movement is under close scrutiny. Meanwhile, capital flows through the stock exchanges are tiny compared with economic activity. In the past two years, Chinese domestic investors' cumulative "southbound" net purchases of Hong Kong-listed stocks only amounted to RMB 200 billion, or US$30 billion, a fraction of the country's capital movement and foreign reserve holdings. As far as investors are concerned, a major difference between the two Chinese domestic exchanges is their sectoral composition. The Shanghai Stock Exchange is heavily concentrated in the financial sector and state-controlled enterprises (Table 1). The Shenzhen Stock Exchange, on the other hand, is more tech-heavy with larger representation of private firms, and therefore has been more dynamic, which is also reflected in its stock prices. The Shenzhen stock index has outperformed that of Shanghai massively in recent years (Chart 10). In this vein, opening Shenzhen stocks directly gives overseas investors another option to tap into some of China's fastest growing sectors. This could also increase the odds that MSCI Inc. may include Chinese domestic stocks in its widely followed EM and global indices in its next review. Table 1Sectoral Components Of Shanghai And ##br##Shenzhen Exchanges Chart 10Shenzhen Market's Secular Outperformance##br## Against Shanghai The bottom line is that the Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization, allowing freer access between Chinese and overseas investors to each other's financial assets. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Despite the static headline GDP figures, most of our indicators suggest Chinese growth momentum has improved since the second quarter, particularly in the industrial sector. A dollar overshoot, domestic housing policy tightening and potential policy mistakes by the Chinese authorities need to be monitored for potential growth disappointments. The rally in commodity prices reflects improving Chinese demand, but it has ignored the surging dollar. Chinese H shares are a safer play on Chinese reflation and growth improvement. Feature Our recent conversations with clients suggest that global investors' concerns over China have slightly abated, as various economic numbers have shown improvement. Nonetheless, investors remain highly sceptical about China's macro situation, raising questions ranging from "traditional" distrust of China's economic data to the latest worries of a "trade war" with the U.S. under President Donald Trump. We dedicate this week's report to addressing some common issues that we have been discussing with clients of late. What Is The Actual GDP Growth In China? In Recent Quarters, It Seems To Be Holding In A "Too-Good-To-Be-True" Tight Range? Chinese real GDP growth has been 6.7% for the past three consecutive quarters, right in the middle of the government's official target of 6.5-7%. This seemingly incredible stability has stoked long-held suspicions among investors about the reliability of Chinese economic data. While we do not claim to have the ultimate insider story on official Chinese statistics, and it is certainly possible that the macro numbers are "smoothed out" to hide otherwise greater volatility in economic reality, it is also possible that stable headline numbers overshadow bigger underlying fluctuations among different sectors (Chart 1). Chart 1Greater Volatility Underneath ##br##Stable GDP For example, while real GDP growth has stayed at 6.7% since Q1 this year, there has been some fluctuations in both the industrial and service sectors. Within the service sector, the financial industry has had a major downturn, with nominal growth falling from 10.9% in Q1 to 8.2% in the last quarter, partly due to last year's base effect of the stock market boom-bust. The real estate sector, on the other hand, has been on the mend, with growth strengthening from 14% in Q1 to 16.3%. Regardless, the exact GDP growth figures rarely matter from an investor's perspective. What is more important is the growth trajectory and policy implications. On this front, most of our indicators suggest growth momentum has improved since the second quarter of the year, particularly in the industrial sector. A strong recovery in manufacturing-sensitive indicators such as railway freight, heavy machine sales and electricity consumption (Chart 2). Continued acceleration in profit growth, in both the overall industrial sector and among listed firms.1 Further improvement in pricing power and producer prices. Producer price deflation that lasted for over four years ended in September, compared with 5.3% deflation in January. Looking forward, we expect the economy to continue to improve, even though some of the high-flying variables may begin to moderate. On the policy front, the authorities will likely enter a wait-and-see mode, especially on interest rates. Our model signals that the central bank's interest rate cuts have likely come to an end, unless the economy relapses again (Chart 3). This is also reflected in the pickup in interest rates in the bond market. We will further explore China's growth outlook, policy orientation and investment implications for the New Year in the first week of 2017. Chart 2Broad Improvement In##br## Industrial Indicators Chart 3No More Rate Cuts, ##br##For Now There Appears To Be Growing Acceptance In The Market That China Will Not Suffer A Hard Landing. What Are You Monitoring To Gauge The Growth Risk? We have not been in the "hard landing" camp, and have been anticipating a "rocky bottoming" process in Chinese growth for the year.2 Despite enormous financial volatility in January associated with the domestic stock market and the RMB, growth has largely played out as we anticipated. We expect the economy to remain resilient, but are watching some pressure points that could lead to disappointments. The first is the RMB, which has been depreciating notably against the dollar in recent weeks, as the dollar uptrend has resumed with vigour. In our view, a strong dollar is one of the key risks, as it not only generates downward pressure on the CNY/USD cross rate, on which the market tends to focus closely, but also halts the "stealth" depreciation of the RMB in trade-weighted terms, which reduces the reflationary benefits of a weaker exchange rate on the Chinese economy (Chart 4). In other words, a weak CNY/USD and a strong trade-weighted RMB is a poor combination for both financial markets and the macro economy.3 So far, the CNY/USD decline appears orderly, and we doubt the greenback will massively overshoot against all major currencies within a short period without causing growth difficulties in the U.S. However, the situation should be closely monitored and continuously assessed. The second is housing policy tightening, which the authorities have re-imposed since October to check rapid gains in home prices. So far, the tightening measures have not led to a significant slowdown in home sales in major cities: Daily home sales in the major cities that we track have broken out to new record highs (Chart 5). However, new housing supply has already been very weak, which together with robust sales could lead to even lower housing inventory and a further spike in home prices. We maintain guarded optimism on China's housing construction, as we discussed in detail in our previous report.4 The risk is that unyielding home price gains will force the Chinese authorities to up the ante on tightening, which could lead to a sudden deterioration in housing activity. In this vein, price moderation should be good news from policymakers' perspectives, as well as for the overall economy. Chart 4The RMB: Weak Or Strong? Chart 5Monitor Housing Activity Finally, as we have argued repeatedly, China's growth difficulties in recent years have had a lot to do with the excessively tight policy environment post the global financial crisis - a policy mistake that compounded deflationary pressures in the economy, which had already been suffering from weak external demand. Despite budding improvement in the economy, China's overall macro environment remains highly challenging, and policy mistakes that undermine aggregate demand will prove extremely costly. In this vein, any broader attempt to tighten policies, hasten administrative enforcement to de-lever or prematurely withdraw fiscal support on infrastructure construction will prove counterproductive. A more recent risk is how China deals with the potential protectionist threat from the U.S. under President Donald Trump.5 Our view is that China should avoid escalating trade tensions with tic-for-tac retaliations that could further complicate the growth outlook. As far as the markets are concerned, Chinese equities appear to have begun to price in a lower "China risk premium." Forward P/E ratios for both A shares and H shares have been rising since early this year, likely a reflection of investors' easing anxiety on China's macro conditions (Chart 6). Nonetheless, Chinese stocks' forward P/E ratios remain well below other major markets and the global average, and the risk premium in Chinese equities is still substantially higher than historical norms. Beyond near-term volatility, we expect the risk premium in Chinese stocks to continue to revert to the mean, leading to multiples expansion and further price gains. At minimum, Chinese equities should outpace global and EM benchmarks. There Has Been A Massive Rally In Some Industrial Commodity Prices In China. Is This Driven By Speculative Frenzy? How Much Does The Commodities Rally Reflect Chinese Demand? Industrial commodity prices have rebounded sharply in both the Chinese domestic spot markets and various derivatives exchanges. For some products, prices have gone parabolic, and there is little doubt that these extreme moves cannot be fully explained by fundamental factors (Chart 7). Nonetheless, it is also well known that commodities in general are subject to volatile price fluctuations, as they are extremely sensitive to marginal shifts in the supply-demand balance due to very low price elasticity among both producers and end users. Therefore, it is impossible, and rather meaningless, to precisely detangle speculative forces and fundamental factors. Chart 6Risk Premium Will Continue ##br##To Mean Revert Chart 7No Clear Evidence Of Commodity ##br## Speculative Frenzy That said, from a macro perspective, a few observations are in order: There does not appear to be a particularly high level of over-trading and speculative activity involved this time around compared with historical norms. Futures transactions this year have been hovering at close to record low levels, despite sharp prices gains in numerous products. Even if prices decline sharply, the impact on the financial system should be negligible because of very low investor participation. Broad-based improvement in numerous industry-sensitive indicators shown in Chart 2 on page 2 suggest the gains in commodity prices are at least partially attributable to improving demand rather than purely driven by speculative frenzy. In fact, improving Chinese demand is also reflected in a firmer global shipping rate. The Baltic Dry Index has almost quadrupled since its February lows, which hardly has anything to do with Chinese retail speculators (Chart 8, top panel). Massive price gains in some commodities such as steel and coal have been partially driven by the Chinese authorities' attempts early this year to "de-capacity" the two sectors, with aggressive efforts to cut idle capacity and reduce domestic production. The self-imposed restrictions together with improving demand have led to sharp price gains and a significant rebound in imports of related products (Chart 8, bottom panel). This confirms our view that the overcapacity issue in the Chinese industrial sector has been overestimated.6 Moreover, regulators' control on domestic supply has been relaxed, which will likely lead to rising domestic production in due course - this bodes well for Chinese domestic business activity, but poorly for the prices of related products. Historically, commodity prices have been positively correlated with China's growth trajectory, and negatively correlated with the trade-weighted dollar (Chart 9). Currently, the commodities rally clearly reflects regained strength in Chinese industrial activity, but has ignored the recent strength of the greenback, leading to a glaring divergence that has been very rare in recent history. Chart 8More Signs Of ##br## Improving Demand Chart 9Macro Drivers And Commodity Prices: ##br##Mind The Gap It remains to be seen how such a divergence will eventually converge. Our hunch is that the dollar will likely continue to rally in the near term, which means commodity prices could converge to the downside. Our commodities team has upgraded base metals from underweight earlier this year on China's reflation efforts, and is currently neutral on the asset class. What is more certain, however, is that China's reflation efforts and growth improvement should also lift Chinese H shares, but the price gains of H shares so far have been much more muted. Earlier this year we recommended going long Chinese H shares against the CRB index, which so far has been flat. We are still comfortable holding this position. The bottom line is that we do not advocate chasing the current rally in base metals. Chinese H shares are a safer play on Chinese reflation and growth improvement. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming", dated January 6, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010", dated October 13, 2016, available at cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report, "China As A Currency Manipulator?", dated November 24, 2016; and "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com 6 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity", dated October 6, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Recommended Allocation The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots Chart 2Bond Yields Relate To Nominal Growth Chart 3Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term Chart 5Stocks Don't Often ##br##Underperform Outside Recession Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation
Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations