財政

Highlights Six months into a credit expansionary cycle, China’s economic recovery remains fragile. Lack of government support for the auto and property sectors is undermining a cyclical recovery. Accommodative monetary policy is not enough to lift the Chinese economy out of its doldrums, particularly as households and companies remain restrained in levering up and spending. Fiscal policy has become more proactive this year by front-loading local government bond financing in the first half of 2019. But if policymakers are to stick to their budget deficit target for the year, the second half of the year will see fiscal tightening. Early signs suggest China is positioning for a further loosening of fiscal spending. However, the Chinese leadership will likely only allow limited additional stimulus this year, resulting in a “W-shaped” economic trajectory for the rest of 2019. In the near-term, the risk to Chinese equity underperformance is high. But over the coming 6-12 months, odds are that the economy will have weakened enough for the Chinese government to make concerted efforts to stimulate. An overweight stance on Chinese stocks is hence warranted over that time horizon. Feature China’s credit growth bottomed in December last year. Six months later, however, China’s economy is showing few signs of emerging from the woods: official GDP growth in the second quarter of this year rang in at its lowest pace in 27 years. Our monthly gauge of China’s business activity, after a brief improvement earlier this year, has flat-lined. The growth of investable earnings per share has fallen into negative territory (Chart 1).More concerning, however, is that manufacturing output has been trending straight down following a first-quarter blip (Chart 2). Chart 1Not Yet Out Of The Woods Chart 2Turning The Corner In Q3? As we mentioned in our July 10th, 2019 China Investment Strategy Weekly,1 while keeping monetary policy accommodative, China’s central bank has not been particularly proactive at significantly stimulating the economy. We believe the People’s Bank of China will continue to sit on the sidelines until the economy deteriorates further, and until they receive more clear guidance from China’s top leadership. The Politburo mid-year economic review meeting in late July will likely shed some light on any upcoming policy shift. In the meantime, fiscal policy has taken a more proactive role in supporting the economy this year: unprecedented tax cuts that account for about 1.7% of GDP started on January 1st, and local government bond issuance accelerated in the first half of 2019 relative to the past two years (Chart 3). Nevertheless, reflationary efforts in the past six months measured by aggregate credit growth as a percentage of nominal GDP have been “half-measured” compared to previous credit expansions. As a result, it is taking longer for China’s economy to find its footing.  The Missing Two “Prongs” It is convenient to blame the ongoing U.S.-China trade war for the sluggishness in the Chinese economy, especially in the manufacturing sector. But in our view, the trade war has only magnified what was already a weak and deteriorating domestic Chinese economy due to previously tight policy.2 What’s more, the magnitude of the stimulus so far has not been large enough to fully reverse the decline in Chinese domestic demand growth. The imbalances in China’s “old economy” have also stymied the effectiveness of the stimulus. Among the three “prongs” that supported a “V-shaped” economic recovery in 2015-2016 (stepped-up infrastructure spending, and support for the auto and real estate sectors), the latter two have been missing in the current episode3: Automobile. Both car sales and production have been contracting for almost a year. The contractions deepened in the second quarter from the first quarter, despite accommodative monetary and credit conditions. This is in sharp contrast from what happened in the 2015-2016 cycle: As credit growth picked up in mid-2015, year-on-year growth in auto sales and production both turned positive three months later and stayed mostly in positive territory until 2018 (Chart 4). Chart 4Auto Sector Has Not Responded To Stimulus Chart 5ALess Demand For Autos BCA’s Emerging Markets Strategy team has written at length on this topic.4 From their lens, both secular and cyclical factors have contributed to this year’s auto sector slump: First, a sharply higher automobile ownership rate in recent years has cyclically reduced household demand for cars (Chart 5A); Second, the central government has only allowed regional governments to loosen up policy restrictions on automobile purchases and license applications, as opposed to providing monetary incentives through sales tax reductions and subsidies in both 2009 and 2016. Another important contributing factor to depressed auto sales is the constraint on Chinese households’ balance sheets (Chart 5B). The rapid growth in mortgage and consumer borrowing from 2015-2017 has pushed Chinese household debt to nearly 120% of disposable income, higher than that in the U.S. (Chart 5C). Chart 5BSlower Pace In Leveraging For Chinese Households... Chart 5C...Following A Borrowing Binge Real Estate. The real estate sector was another “prong” that was crucial to the 2015-2016 cyclical recovery in China’s economy. Property sales picked up sharply in 2015, along with ballooning mortgage loans (Chart 6). In this cycle, however, housing sales have been sluggish, and real estate developers have been struggling to complete projects they have started (Chart 7). The three factors that drove property demand in 2015-2017 are now absent: Chart 6Property Market Was Red Hot In 2015-2016 Chart 7The Party Did Not Repeat In Current Cycle Skyrocketing mortgage lending. As mentioned above, the acceleration in household leveraging is unlikely to repeat in the current cycle. Real estate developers’ access to funding was the key to the strength of construction activity in the property market in 2016. Presently, real estate developers lack access to credit, including financing through shadow banking (Chart 8A). The China Banking and Insurance Regulatory Commission (CBIRC) has stepped up in real estate financing regulations and supervisions: It recently issued window guidance to curb certain borrowing activities among real estate developers in the offshore market, and also from obtaining financing through shadow banking domestically. Government subsidies are missing. Most importantly, subsidies from China’s central bank to the real estate sector was another key pillar of support for the property boom in the previous cycle. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Supplementary Lending5 (PSL) facility designed for slum area reconstruction.6 As of June, PSL has remained deeply in negative territory for 11 straight months (Chart 8B). Chart 8ARestrictive Lending Environment Unlikely To Change Soon Chart 8BGovernment Subsidies Are Missing The high level of leverage in both the household and property sectors have been focal points in the Chinese leadership’s financial deleveraging and de-risking campaign. Indeed, the restrictive financing environment for both sectors reflects the Chinese authorities’ determination to curb excessive borrowing and speculation in the housing market. Bottom Line: Two of the three impetuses that supported the upswing in the Chinese economy in 2015-2017 – auto sales and real estate – have so far been subdued or have acted as a drag on the economy in the current cycle. China will have to rely on the third pillar – infrastructure spending – to support the economy. Fiscal Policy “China will continue to implement a proactive fiscal policy, a prudent monetary policy and an employment-first policy, while making good use of counter-cyclical regulation tools and carrying out anticipatory adjustments and fine-tuning when necessary.” - Premier Li Keqiang, July 15, 2019. Fiscal policy has been proactive this year, but so far has failed to catalyze a recovery in investment spending. More importantly, the existing institutional framework on fiscal policy suggests that unless the Chinese government is willing to remove budgetary constraints, we will see fiscal tightening in the second half of the year. During the first half of this year, 70% of 2019’s total budgeted local government bonds were issued, double the amount issued in the same period last year.7 According to the Ministry of Finance, 65% of total local government bonds issued (including both general and special-purpose bonds) were invested in infrastructure projects.8  However, the growth figure for fixed-asset investment (including infrastructure) for the first six months of 2019 was the weakest in the past five years. The considerable deceleration in infrastructure investment since late 2017 can be attributed to three factors: a.  Sharply shrinking shadow banking. Local government spending has been stymied by the central government’s financial deleveraging efforts (Chart 9A). This affects both on-book fiscal spending and off-book spending by local government financing vehicles (LGFV). Although the exact impact on the latter is hard to quantify, the cracking down on shadow banking, a major financing channel for LGFV, coincides with the peak of infrastructure investment growth. Chart 9AShadow Banking Was A Crucial Funding Source For Infrastructure Investment Chart 9BA Thinner Wallet This Year   b.  Lower government revenue. Sluggish land sales have undermined local governments’ revenue streams. Land sales account for three quarters of local government revenue. Chart 9B shows that both land sales and government revenue decelerated in mid-2018, as lending conditions for the property sector became restrictive. In addition, as part of its fiscal stimulus efforts, the Chinese authorities stepped up on tax cuts to businesses and individuals this year. Tax cuts are estimated to augment the government’s 2019 deficit by 0.2 percentage points of GDP. As a result, government revenue from tax income in the first half of 2019 only grew by 0.9% year-on-year, way below the 14% growth clocked last year (Chart 9B, middle panel). By law, local governments cannot exceed their annual budgetary deficit by more than their quote of general purpose bond issuance. Lower revenue from slower land sales and tax cuts have impeded local governments’ spending capabilities. A bigger concern for investors is that the Chinese central and local governments are approaching their annual budgetary limits. By the end of June, while central and local governments have spent half of their budgeted expenditures for 2019, local governments had reached 70% of their total debt limits for the year. If the Chinese government is to stick to its 2019 budget, the fiscal impulse will lose steam in the second half of 2019: fiscal policy will actually tighten through the remainder of the year. Chart 10A and 10B illustrate that under such scenario, both fiscal spending and local government bond issuance will be trending down.  Chart 10AFiscal Impulse Losing Steam In 2H? Increasing spending by raising the budgeted deficit target ceiling is an option, though the least likely one. The basis is that a mid-year budgetary deficit revision would need the National People’s Congress’ approval, which has not occurred in the past 30 years.9  Nonetheless, the tone from the latest policy announcements suggests that the Chinese leadership is increasingly willing to work around these constraints and is positioning for a further loosening of fiscal spending. Chart 11Additional Funds Could Help, A Lot On June 11th, the Ministry of Finance made a policy announcement, relaxing financing restrictions on local government infrastructure spending. Local governments can now use proceeds from special-purpose bonds as capital to finance new spending on infrastructure projects.10 The new policy only applies to non-land development related infrastructure projects, which can make a maximum of 800 billion yuan available for infrastructure investment.11 As Chart 11 shows, if all of the additional 800 billion yuan is invested, a simple calculation suggests that it could lift infrastructure spending by as much as 4 percentage point before year end.  The government is also preparing for another round of local government off-balance-sheet debt swaps. The plan, which is still being formulated by the authorities, is to allow financial institutions to either extend or swap maturing local government off-balance-sheet debt with bank loans that carry lower interest rates and longer maturities. There are strict criteria as to what debt qualifies to be swapped. But with an estimated 30-40 trillion yuan of local government implicit debt, the size of this program could potentially be comparable to that of 2015-2016.12 But if the Chinese government were to allow the program to morph into a meaningful stimulus effort, it would require concerted effort from the central bank to equip commercial banks with the required liquidity. This would mean a further loosening in monetary conditions. Bottom Line: There are “soft constraints” hindering China from broadening its scope of fiscal spending for the year. For investors to feel confident that the policy response will lead to a meaningful re-acceleration in economic activity, these constraints will have to be overcome. Investment Implications As we pointed out in our previous China Investment Strategy Weekly,13 even with June’s large number in bank lending and total local government bond issuance, the cumulative progress in credit growth for the first half of the year is still closer to 27% of nominal GDP (assuming 8% nominal GDP growth for the remainder of 2019). This still falls into our “half-strength” credit cycle scenario relative to past reflationary episodes (Chart 12A & 12B).  Our bias is that the Chinese leadership will only allow limited additional stimulus this year, and are likely to wait until the economy weakens further before removing all budgetary and regulatory constraints. This will put the economy and financial market on a “W-shaped” trajectory for the rest of 2019. Therefore we recommend an underweight position in Chinese stocks for the remainder of the year. Ultimately, though, policymakers will respond if the economy weakens meaningfully further. The odds are good that the economy will have weakened enough for the Chinese government to make a concerted effort to fuel its economy over the coming 6-12 months. Thus, an overweight on Chinese stocks over a cyclical horizon is warranted, but the journey to eventual outperformance will be a turbulent one.   Jing Sima China Strategist JingS@bcaresearch.com     Footnotes: 1      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 3      In 2015, nominal GDP growth bottomed 5 months following a pickup in credit growth. 4      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “The Chinese Auto Market: Moderate Recovery Ahead”, dated February 13, 2019, available at cis.bcaresearch.com. 5      Pledged supplementary lending (PSL) scheme refers to China’s central bank’s direct lending to the real estate market. 6      The People’s Bank of China (PBoC) released RMB 698 billion in 2015 and RMB 971 billion in 2016 in the form of PSL injections into the real estate market as part of its attempts to revive the property market. 7      Including both general and special-purpose bonds, but discounting bonds issued for debt-to-bond swap or refinancing purposes. 8      Ministry of Finance Mid-Year Budgetary Press Conference, July 15, 2019 9      The last time the Chinese government issued a mid-year budget revision was following the Tiananmen Square Massacre, the only year China had a classical business cycle. It did NOT revise the budget during the 2008-‘09 global financial crisis, though. 10     Special-purpose bonds must be used for projects that are proven to make certain returns on investment and are supposed to be repaid with returns from the specific projects they are invest in, rather than fiscal revenue. Previously, local governments were prohibited from using borrowed money as capital in infrastructure projects. http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201906/t20190610_3274511.htm 11     The non-land development portion accounts for about 30% of total special-purpose bonds. 12     Some estimates suggest about 3-4 trillion yuan of local government implicit debt is qualified for the new swap program. 13     Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights So What? U.S. policy uncertainty adds to a slew of geopolitical reasons to remain tactically cautious on risk assets. Why? U.S. fiscal policy should ultimately bring market-positive developments – though the budget negotiation process could induce volatility in the near-term. We expect spending to go up and do not expect a default due to the debt ceiling or another prolonged government shutdown. Former Vice President Joe Biden remains the frontrunner for the Democratic Party’s presidential nomination in 2020. But left-wing progressive candidates are gaining on him and their success will trouble financial markets. With Persian Gulf tensions still elevated, go long Q1 2020 Brent crude relative to Q1 2021. Feature Chart 1U.S. Politics Poses Risks Through Next November Economic policy uncertainty is rising in the United States even as it falls around the world (Chart 1). Ongoing budget negotiations and the Democratic primary election give equity investors another reason to remain cautious in the near term. We expect more volatility. There also remain several persistent global threats to markets posed by unresolved geopolitical risks – rising Brexit risks with Boris Johnson likely to take the helm in the United Kingdom; oil supply threats amid Iran’s latest rejection of U.S. offers to negotiate its missile program; and a major confirmation of our theme of geopolitical risk rotation to East Asia, with Japan, South Korea, Hong Kong, Taiwan, and the South China Sea all heating up at once. In sum, political and geopolitical risks are showing investors a yellow light, even though the macroeconomic outlook still supports BCA’s cyclical (12-month) equity overweight. U.S. Fiscal Policy Will Remain Accommodative While U.S. monetary policy has taken a dovish turn – supported by other central banks – fiscal spending is now coming into focus for investors. We expect the budget battle to be market-relevant this year, injecting greater economic policy uncertainty, but the end-game should be market-positive. Brinkmanship will not get as bad as during the debt ceiling crises of 2011 and 2013, though market jitters will be frontloaded if Pelosi and the White House fail to conclude a deal immediately. Chart 2The 'Stimulus Cliff' Awaits President Trump The U.S. budget process is always rocky and is usually concluded well into the fiscal year under discussion. This year the fight will be more important than over the past few years because, as the two-year bipartisan agreement of 2018 lapses, the so-called “stimulus cliff” looms over the U.S. economy and will get caught up in the epic battle over the 2020 election. The stimulus cliff is the automatic imposition of fiscal spending cuts (“sequestration”) in FY2020 that would take effect as a result of the Budget Control Act of 2011. Standard estimates of the U.S. budget deficit expect that the deficit will shrink in 2020 if the spending caps are not raised, resulting in a negative fiscal thrust (Chart 2). The result would be to decrease aggregate demand at a time when the risk of recession is relatively high (Chart 3). Chart 3Recession Odds Still High Over Next 12 Months This is clearly not in President Trump’s interest, since a recession would devastate his reelection odds. Hence, Treasury Secretary Steve Mnuchin and other White House officials are pushing for a budget deal before the House of Representatives goes on recess on July 26 and the Senate on August 2. Ideally, an agreement would raise the spending caps, appropriate funds for the rest of the budget, and lift the “debt ceiling,” the statutory limit on U.S. debt. But it would be surprising if a deal came together as early as next week. A failure to agree on a budget deal before Congress goes on recess will make the market increasingly jittery. Congress can cancel the August recess, or wait until September 9 when they reconvene, but a failure to agree on something between now and then will make the market increasingly jittery. The U.S. has already surpassed the current debt limit and the latest estimates suggest that the Treasury Department’s “extraordinary measures” to meet U.S. debt payments could be exhausted by early-to-mid September.1 This would give Congress only a week in September to raise the debt limit. There are three main reasons to expect that the debt ceiling fight will not get out of hand: Chart 4Americans Stopped Worrying And Love Debt First, a technical default on U.S. debt could result in a failure to meet politically explosive obligations, such as sending social security checks to seniors. No one in Washington would benefit from such a failure and President Trump would suffer the most. Second, the public is not as worried about national deficits and debt today as it was in the aftermath of the financial crisis (Chart 4). Democrats, as the pro-government party, do not have an incentive to stage a showdown over the debt like Tea Party Republicans did under the previous administration. To be fair, they did do so in January 2018, but backed off after merely two days due to high political costs. Third, the one budget conflict that could create a catastrophic impasse – funding for Trump’s border wall – can be assuaged by Trump’s use of executive action, as he demonstrated by declaring a national emergency and appropriating military funds for fencing. Trump is fighting a general election in 2020 and is unlikely to use the debt ceiling as leverage to the point that the U.S. defaults on its obligations. The risk to investors, however, is that he goes back to threatening a 25% tariff on Mexico if it fails to staunch the flow of immigrants from Central America. What if the Republicans and Democrats cannot agree on the budget and spending caps? Democrats say they will not raise the debt limit unless they get non-defense spending increases. House Democrats need to reward their constituents for voting for them in 2018 and want to increase non-defense spending at “parity” with increases to defense spending. They also want to reduce the defense increases that Republicans seek in order to pay for non-defense increases. President Trump and the Republicans have a higher defense target and a lower non-defense target. The truth is that the Republicans and Democrats have agreed three times to increase spending caps beyond the levels required under the 2011 law – and they have done so most emphatically under President Trump with the FY2018-19 agreement (Chart 5). This year the two parties stand about $17 billion apart on defense and $30 billion apart on non-defense spending.2 We would expect both sides to splurge on spending and get what they want, but they could also split the difference: the amounts are small but the acrimony between the two parties could extend the talks. Congress may have to pass one or more “continuing resolutions” (stopgap measures keeping spending levels constant) to negotiate further. A continuing resolution could at least raise the debt ceiling and leave the rest of the budget negotiation until later, removing the majority of the political risk under discussion. Is another government shutdown possible? Yes, but not to the extent of early 2019. Trump saw a sharp drop in his approval ratings during the longest-ever government shutdown last year (Chart 6). Brinkmanship could lead to another shutdown, but he is likely to capitulate before it becomes prolonged. In early 2020, he wants to be lobbing grenades into the Democratic primary election rather than giving all of the Democrats an easy chance to criticize him for dysfunction in Washington. Ultimately, Trump can simply refrain from vetoing whatever the House and Senate agree – it is not in his interest to shrink the budget deficit in an election year. The Democrats’ spending increases would boost aggregate demand and are thus in President Trump’s personal interest. Trump is the self-professed “king of debt” – he is not afraid to agree to a deal that will be criticized by fiscal hawks. The latter have far less influence in Congress anyway since the 2018 midterm election. Why should House Democrats extend the economic expansion knowing that it would likely improve President Trump’s reelection chances? Because Trump will capitulate to most of their spending demands; voters would punish them if they are seen deliberately engineering “austerity”; and they need to show voters that they can govern. As for the 2020 race, they will focus on other issues: they will attack Trump on trade and immigration and focus on social policy: health care, the minimum wage, taxes and inequality, climate change, and student debt. What will be the fiscal and economic impact of a budget deal? The budget deal under negotiation ($750 billion in defense discretionary spending, $639 billion in non-defense discretionary spending) would raise the spending cap by about $145 billion – this is slightly above the $112 billion negative fiscal thrust expected in 2020.3 The result is that the U.S. fiscal drag expected in 2020 will at least be eliminated (if not turned into a fiscal boost), helping to prolong the cycle. The removal of fiscal drag will coincide with monetary easing, which is positive for markets since inflation is subdued. The Federal Reserve abandoned rate hikes this year (after four last year) because of the asymmetric risk of deflation relative to inflation (Chart 7). The FOMC believes that they can always jack up interest rates to combat an inflation overshoot, as their predecessors did in the 1980s, but that they are constrained by the zero lower-bound in interest rates. They may never recover from a loss of credibility and collapse of inflation expectations, so an insurance policy is necessary. The result is likely to be one or two rate cuts this year, which has already improved financial conditions. Chart 7The Fed Fears The Asymmetric Threat Of Deflation Bottom Line: Budget brinkmanship could become a near-term source of volatility but it is ultimately likely to be resolved with the pro-market outcome of less fiscal drag in 2020. The debt ceiling debate is unlikely to result in a U.S. default and any government shutdown is likely to resemble the short one of 2018 more than the long one of 2019. We expect U.S. equities to grind higher over the 12-month cyclical horizon, but we remain exceedingly cautious on a three-month tactical horizon. The price of Trump’s capitulation on border funding could be a renewed threat of tariffs against Mexico. The Budget Deal, Geopolitics, And The Dollar Chart 8China Shifts From Reform To Stimulus What does this fiscal outlook imply for the U.S. dollar? Near-term moves will probably be negative, since the fiscal boost outlined above will not be comparable to 2018-19, and meanwhile our view on China’s stimulus is bearing out reasonably well (Chart 8). Improvements in global growth, Fed cuts, and rising oil prices will weigh on the greenback even though later we expect the dollar to recover on the back of renewed U.S.-China conflict and global recession in 2021 or thereafter. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity, or geopolitical competition among the world’s great powers. Beyond the recession, two of our major political and geopolitical themes continue to point to large downside risk to the dollar: populist politics and multipolarity. Populism and the Fed: Domestically, the United States is seeing a rise in populism that is continuing across administrations and political parties. This is conducive to easier monetary policy. Left-wing firebrand Alexandria Ocasio-Cortez’s (AOC) recent exchange with Fed Chairman Jay Powell highlights the trend. AOC asked one of the most frequent questions that BCA’s clients ask: Does the Phillips Curve still work? Powell answered that in recent years it has not. President Trump’s Economic Director Larry Kudlow applauded AOC, saying “she kind of nailed that” (obviously the administration is pushing for lower rates). If inflation is not a risk, monetary policy need not guard against it. This interchange should be taken in the context of President Trump’s attempts to jawbone Powell into rate cuts and the notable monetary promiscuousness of his ostensibly “hard money” Federal Reserve nominees. The extremely different ideological and institutional profiles of these various policymakers suggests that a new consensus is forming that is conducive to more dovish monetary policy than otherwise expected over the long run. Populists of any stripe, from Trump to AOC, would like to see lower interest rates, higher nominal GDP growth, and a lower real debt burden on households. We are reminded of an oft-overlooked point about the stagflation of the 1970s. Fed Chair Arthur Burns is usually depicted as a lackey of President Richard Nixon who succumbed to political influence and failed to raise interest rates adequately to fight inflation. But this is only part of the story. Leaving aside that the Fed only had a single mandate of minimizing unemployment at that time, Burns was conflicted. He saw the need to fight inflation, but he had more than Nixon’s wrath to fear. He also dreaded the impact on the Fed’s credibility and popular support as an institution if he hiked rates too aggressively and stoked unemployment (Chart 9).4 Chart 9Rate Hikes Are Hard To Defend Amid High Unemployment In other words, populism can constrain the Fed from the bottom up as well as from the top down in a context of rising unemployment.5 Multipolarity and Currency War: Since President Trump’s election we have highlighted that dollar depreciation is likely to be the administration’s ultimate aim if President Trump’s overall economic strategy is truly to stimulate growth, reduce the trade deficit, and repatriate manufacturing. Jacking up growth rates relative to the rest of the world while disrupting global trade via tariffs is a recipe for a strong dollar that undermines the attempt to bring jobs back from overseas. We have always argued that China would not grant the U.S. “shock therapy” liberalization and market opening – and that neither China, nor Europe, nor Japan would or could engage in currency appreciation along the lines of a new Smithsonian or Plaza Accord. The U.S. does not have as much geopolitical clout as it had in the 1970s-80s when it forced major currency deals on its allies and partners. The remaining option is for the U.S. to attempt unilateral depreciation. The combination of profligate spending, easy monetary policy, and populism may do the trick. But it is also possible that President Trump will attempt to engineer depreciation through Treasury Department intervention. If a slide toward recession threatens his reelection – or he is reelected and hence gets rid of the first-term reelection constraint – his unorthodox policies pose a significant risk to the dollar. Bottom Line: The U.S. dollar faces near-term risks as growth rebalances towards rest of the world, but will probably resume its rise in the impending recessionary environment and expected re-escalation of tensions with China. Over the long run, it faces severe risks due to fiscal mismanagement, domestic populism, and geopolitical struggle. A Progressive Overshoot Will Hurt Democrats … And Equities Chart 10A Democratic Win Will Weigh On Animal Spirits The Democratic Party’s primary election is also a risk to the equity rally. We see a 45% risk that President Trump will be unseated in November 2020 and hence that the U.S. will once again experience a dramatic policy reversal (as in 2000, 2008, and 2016). The risks are to the downside because the market is at all-time highs and Democratic proposals include raising taxes on corporations and re-regulating the economy (Chart 10). Whether you accept our 55% odds of Trump reelection, the race will be a continual source of uncertainty for investors going forward. How extreme is the uncertainty? Former Vice President Joe Biden remains the frontrunner in the race, though he has lost his initial bump in opinion polls (Chart 11). Biden’s success is market-positive relative to the other Democratic candidates since he is an establishment politician and a known quantity. Given his age, a Biden presidency would likely last for one term and focus on repudiating Trumpism and consolidating the Obama administration’s signature achievements (the Affordable Care Act, Dodd-Frank, the Joint Comprehensive Plan of Action, environmental regulation, etc). Greater predictability in the health care sector and a return to lower-level tensions with Iran would be market-positive. The financial sector would be consoled by the fact that nothing worse than Dodd-Frank would be in the offing. A Biden victory would be more likely to yield Democratic control of the senate than a progressive candidate’s victory.6 This means that the risk of Democrats taking full control of government and passing more than one major piece of legislation after 2020 increases with Biden. Yet any candidate capable of defeating Trump is likely to take the senate in our view; and Biden’s legislative initiatives are likely to be more centrist.7 So as long as Biden remains in the lead in primary polling, he increases his chances of winning the nomination, maximizes the 45% chance of Democrats winning the White House, and decreases the intensity of the relative policy uncertainty facing markets. The risk to the Democrats is … a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election.  The risk to the Democrats is that the leftward policy shift within the party (Chart 12) may lead to a left-wing or progressive overshoot that knocks out Biden in the primary, replacing him with a progressive candidate who may not be as electable in the general election. This would give President Trump the ability to capitalize on his advantage as the incumbent by inveighing against socialism. Most of the major progressive candidates are electable – they have a popular and electoral path to the White House – as revealed by their successful head-to-head polling against Trump in battleground state opinion polling (Chart 13). But these pathways are narrower than Biden’s. Biden is the only candidate whose name has been on the ballot in two presidential elections carrying the critical Rust Belt swing states Michigan, Pennsylvania, and Wisconsin (not to mention Ohio and Florida). He is from Pennsylvania. And he is more competitive than most of his rivals in the American south and southwest, giving him the potential to pick up Florida or Arizona in the general election. But none of this matters if Biden cannot win the Democratic nomination first. The risk of a progressive overshoot is growing at present. Biden is losing his lead in the primary polling, as mentioned. Progressive candidates taken together are polling better than centrists, contrary to previous Democratic primaries (Chart 14). This is true even if we define centrists broadly, for instance to include Buttigieg (Chart 15). Biden is in a weaker position than Hillary Clinton in 2007 – and the more progressive candidate Obama ultimately defeated her (Chart 16). Biden has now slipped to second place in one national poll and some state polls. The second round of Democratic debates on July 30-31 will be a critical testing period for whether Biden can maintain frontrunner status. The first round fulfilled our expectation of boosting the progressives at his expense, especially Elizabeth Warren. It surprised us in dealing a blow to the campaign of Bernie Sanders, the independent Senator from Vermont who initiated the progressive left’s surge with his hard-fought race against Hillary Clinton in 2016. Sanders is more competitive than the other progressives in the Rust Belt, and in the general election, based on his head-to-head polling against Trump. Yet he has fallen behind in recent Democratic primary polling, ceding ground to Warren, Harris, and Buttigieg, who are all his followers in some sense. The second debate is a critical opportunity for him to arrest the loss of momentum. Otherwise he is likely to be fatally wounded: a collapse in polling beneath his floor of about 15%, and relative to other progressives, despite extensive name recognition, will make it very difficult for him to recover in the third round of debates in September. His votes will go toward other progressives, particularly Buttigieg – the other white male progressive-leaning candidate who is competitive in the Midwest.8 Our 55% base case that Trump is reelected rests on the high historical reelection rate for incumbents, particularly in the event of no recession during the first term – yet discounted due to Trump’s relatively low nationwide popularity, as it is reminiscent of a president in a recessionary environment (Chart 17). Trump has his ideological base more fired up than Obama did (Chart 18), which helps drive voter turnout, although as a result he risks losing support from the rest of the population. Still, Trump’s approval rating is in line with Obama’s at this stage in his first term. As long as the economy holds up and Trump does not suffer a foreign policy humiliation, he should be seen as a slight favorite. A Trump victory is not positive for risk assets, aside from a relief rally on policy continuity. This is because in a second term he cannot reproduce the same magnitude of pro-market effects (huge tax cuts and deregulation) yet, freed from the need for reelection, he has fewer political constraints in producing higher magnitude anti-market effects (tariffs and/or sanctions on China, Iran, Russia, and possibly the EU and Mexico). This view dovetails with the BCA House View which remains overweight equities relative to bonds and cash over a cyclical (12 month) horizon but underweight over the longer run with the expectation that a recession will loom. Bottom Line: The Democratic Primary election should start having an impact on markets – the general election is likely to be too close for market participants to have a high conviction, driving up uncertainty. Uncertainty will be especially pronounced if, and as, leftwing or progressive candidates outperform in the primary races and poll well against Trump in the general election. This dynamic is negative for business sentiment and the profit outlook, especially if Biden’s polling falls further in the wake of the second debate. Investment Conclusions We recommend staying long JPY-USD, long gold, and short CNY-USD. We remain overweight Thai equities within emerging markets, a defensive play. And we would not close our tactical overweight in health care sector and health care equipment sub-sector relative to the S&P 500. The rally in Chinese equities – despite China’s Q2 GDP growth rate of 6.2%, the worst in 27 years – brings full circle the view we initiated in April 2017 that Chinese President Xi Jinping’s consolidation of power would result in a major deleveraging drive that would drag on the global economy. Since February we have argued that the U.S. trade war has pushed Chinese policymakers to favor stimulus over reform – but we have also maintained that the effectiveness of stimulus is declining, especially as a result of the trade war hit to sentiment. Nevertheless, as a result of this turn in Chinese policy – along with the turn in U.S. monetary and fiscal policy – we see the global macroeconomic outlook improving. Combining this view with ongoing tensions in the Persian Gulf and the expectation that oil markets will tighten, we recommend our Commodity & Energy Strategy’s trade of going long Brent crude Q1 2020 versus Q1 2021.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See U.S. Department of Treasury, “Secretary Mnuchin Sends Debt Limit Letter to Congress,” July 12, 2019, home.treasury.gov. Jordan LaPier, “New Projection: Debt Limit “X Date” Could Arrive in September,” July 8, 2019, bipartisanpolicy.org. 2 See Jordain Carney and Niv Elis, White House, Congress inch toward debt, budget deal,” July 17, 2019, thehill.com. 3 See the Congressional Budget Office, “The Budget and Economic Outlook: 2019 to 2029,” January 2019; “Final Sequestration Report for Fiscal Year 2019,” February 2019; and Theresa Gullo, “Discretionary Appropriations Under the Budget Control Act,” Testimony before the Committee on the Budget, United States Senate, February 27, 2019, www.cbo.gov. 4 See James L. Pierce, “The Political Economy of Arthur Burns,” The Journal of Finance 34: 2 (1979), pp. 485-96, esp p. 489 regarding a congressional testimony: “Interestingly, no questions were raised or innuendo offered that monetary expansion would be excessive to support Richard Nixon’s reelection efforts. Instead, Burns was urged by the Democrats to follow an expansionary monetary policy in order to reduce the level of unemployment.” See also Athanasios Orphanides and John C. Williams, “Monetary Policy Mistakes and the Evolution of Inflation Expectations,” Federal Reserve Bank of San Francisco, Working Paper 2010-12 (2011), www.frbsf.org. 5 An analogy might be drawn with the Supreme Court, whose independence as one of three constitutional branches is much more firmly grounded in U.S. law than the Fed’s, but nevertheless cannot make decisions in an ivory tower. It must consider the effects of its judgments on popular opinion, since universally deplored decisions would reduce the court’s credibility and legitimacy in the eyes of the public over time and ultimately the other government branches’ adherence to those decisions. 6 This is both because Biden is more electable (thus more likely to bring a vice president who can break a tie vote in the senate) and because his candidacy can help Democrats in all of the senate swing races – for example, Arizona as well as Colorado and Maine. Harris is not as helpful in Maine while Warren and Sanders are not as helpful in Arizona. 7 Biden would return to the 39.6% top marginal individual tax rate and double the capital gains tax on those earning incomes of more than $1 million. See Biden For President, “Health Care,” joebiden.com. 8 Conversely, if Biden somehow collapses, Buttigieg unlike Sanders has the option of moving toward the political center to absorb Biden’s large reservoir of support.

Oil prices will remain volatile as markets work through the lingering effects of tighter financial conditions prevailing last year, which, along with extended angst over Sino-U.S. trade tensions, slowed commodity demand growth (Chart of the Week). In 2H19, globally accommodative monetary policy and fiscal stimulus will revive demand for industrial commodities, particularly in EM economies. This will be most apparent in oil markets, where we continue to expect demand growth to strengthen going into 2020, aided in part by a weaker USD. On the supply side, this week’s extension of OPEC 2.0’s production cuts into 1Q20 means growth will remain constrained. Prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand.1 We continue to expect Brent to average $73/bbl this year and $75/bbl next, respectively. We expect WTI to trade $7/bbl and $5/bbl below that this year and next. Chart of the WeekEasing Financial Conditions Will Spur Oil Demand Highlights Energy: Overweight.  Venezuela’s oil production reportedly recovered to 1.1mm b/d in June.  Most of the increased production found its way to China, which accounted for just under 60% of crude and product exports.2  Given its modus operandi, we believe OPEC 2.0 likely will accommodate higher production in Venezuela by reducing production in other member states, keeping overall output relatively constant. Base Metals: Neutral.  Copper treatment and refining charges fell to new lows at the end of last week, with Fastmarkets MB’s Asia – Pacific TC/RC index recording its lowest level on record at $52.40/MT ($0.0524/lb).3  TC/RC levels fall when supplies are low, as refiners have to discount their services to attract concentrate supplies.  Elsewhere, workers at Codelco’s Chuquicamata copper mine agreed to a new contract last week, ending a brief strike.  Precious Metals: Neutral.  Gold’s rally resumed this week, reflecting investors’ expectations for expanded central-bank accommodation globally, which, all else equal, will keep interest rates lower for longer. The Fed's dovish turn, in particular, will weaken the USD later this year, which will be positive for EM commodity demand, the engine for commodity demand growth globally. Ags/Softs: Underweight.  The USDA reported 56% of corn in the ground was in good to excellent condition last week, vs. 76% of the crop last year.  For soybeans, 54% of the U.S. crop was in good or excellent condition, vs. 71% last year.  The USDA’s Crop Progress reports cover 92% and 95% of total acreage planted in the U.S., respectively. Feature Oil prices will remain volatile over the short term, as markets transition from tighter monetary conditions to a more accommodative global backdrop (Chart 2). Based on our research into the drivers of oil-price volatility, this should translate into a less stressful pricing environment for industrial commodities generally, base metals and oil in particular (Chart 3).4 Chart 2Volatility Indicators Are Moderating Chart 3Signaling Oil Price Volatility Will Fall Much of the current oil-price volatility is being driven by worries over damage to aggregate global demand and growth expectations in the wake of the Sino-U.S. trade war, and by what now appears to be a too-aggressive posture by central banks implementing rates-normalization policies last year. Both of these can affect consumption and investment locally and globally.5 Fear That Real Demand Will Weaken At present, any indication real demand is faltering – e.g., weaker manufacturing PMIs – gives industrial commodities an excuse to sell off (Chart 4). In the case of the Sino-U.S. trade war, presidents Xi and Trump appear to have agreed to re-start trade negotiations. Markets are not going to be terribly concerned with the specifics of a trade deal between the U.S. and China, but it does appear some rollback in U.S. tariffs will be necessary for a trade deal – perhaps in exchange for greater access to Chinese markets. However, our geopolitical strategists make the odds of a trade deal by the time U.S. elections roll around 1:3. Our colleagues in BCA Research’s Global Investment Strategy note, “The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a ‘small’ trade war and a ‘moderate’ trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system.”6 As for monetary policy, major central banks are embarked on a coordinated effort to reverse falling inflation expectations, and will be vigorously stimulating their money supply and credit growth over the balance of the year. In addition, fiscal stimulus globally – in the U.S. and China most prominently – will boost real demand for industrial commodities, particularly oil and base metals.7 Monetary and fiscal stimulus operates with a lag, which is why we continue to expect its more visible for commodity demand to become apparent in commodity prices later in 2H19 and next year. This lagged effect can be seen in our expectation for the evolution of EM import volumes to year end, which we estimate using data compiled the CPB World Trade Monitor (Chart 5). EM import volumes are closely tied to the evolution of EM income, which drives global commodity demand.8 Chart 4Globally, The Real Economy Has Slowed Chart 5EM Imports and Income Will Rebound In our modeling of supply-demand balances and prices, we accounted for the reduced EM GDP growth brought about by more restrictive monetary policy last year and the slowdown in global trade in our most recent forecast. In our base case, we took our expected global oil-demand growth this year down to 1.35mm b/d from 1.5mm b/d earlier, and to 1.55mm b/d next year from 1.6mm b/d previously. These adjustments reduced our price expectation for Brent crude oil slightly to $73/bbl this year and $75/bbl next year, with WTI trading $7/bbl and $5/bbl below those respective levels (Chart 6). Chart 6Our Forecasts Reflect Lower Demand, Tighter Supply Oil Markets Will Get Tighter   For all of the concern over real demand, prompt demand remains stout relative to available supply, as can be seen in the backwardations for global benchmark crude oil prices (Chart 7). This week’s extension of OPEC 2.0’s production cuts into 1Q20 means supply growth will remain constrained, which, given our demand expectation, will tighten balances globally (Chart 8).9 Chart 7Global Oil Benchmarks Remain Backwardated Chart 8Oil Supply Demand Balances Will TightenChart 9Oil Inventories Will Fall, As Supply Is Constrained As balances tighten in the wake of global fiscal and monetary stimulus, oil prices will rise, and forward curves, particularly for Brent, will steepen as refiners are forced to draw inventories to meet product demand (Chart 9). For this reason we remain long September – December 2019 Brent vs. short September – December 2020 Brent, expecting backwardation to increase.10 Bottom Line: We remain constructive toward oil markets, as they transition to a more accommodative monetary backdrop globally. Combined with fiscal stimulus in the U.S. and China in particular, demand will remain supported in 2H19 and 2020. The extension of OPEC 2.0’s production-cutting deal will tighten markets, forcing refiners to draw down inventories.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1      OPEC 2.0 is a name we coined for the OPEC/non-OPEC oil-producing coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Their agreement to extend production cuts of 1.2mm b/d into 1Q19 was announced this week in Vienna. Please see OPEC/non-OPEC rolls over oil output cuts for 9 months published by S&P Global Platts on July 2, 2019. Compliance with these cuts has been higher by ~ 400k b/d in 1H19 by our reckoning. 2      Please see Venezuela's June oil exports recover to over 1 million bpd: data published July 2, 2019, by reuters.com. 3      Please see Copper concs TCs drop marginally on traders purchase; Cobre Panama’s fresh supply hits market published by Fastmarkets MB June 28, 2019. 4      We are using “volatility” in the technical sense here – i.e., the standard deviation of per-annum returns. We have shown this can be explained by different variables, including EM volatility; U.S. financial conditions – as seen in the St. Louis Fed’s financial-stress index; and by speculative positioning, which tends to follow the evolution of prices as news flows change. For discussions of our volatility modeling, including the construction of Working’s T index, please see Specs Back Up The Truck For Oil, published April 26, 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility, published May 10, 2018, by BCA Research’s Commodity & Energy Strategy. Both are available at ces.bcaresearch.com. 5      Please see The economic implications of rising protectionism: a euro area and global perspective published by European Central Bank April 24, 2019. 6      Please see Third Quarter 2019 Strategy Outlook: The Long Hurrah, BCA Research’s global macro outlook for 3Q19, published June 28, 2019, by our Global Investment Strategy. It is available at gis.bcaresearch.com.  The larger issues that will have to be addressed at some point in the future are non-tariff barriers to trade, exemplified by Huawei’s exclusion from access to U.S. technology on national security grounds.  An expansion of such non-tariff barriers would strand huge amounts of capital globally, which likely would lead to a global recession. 7      Our chief global strategist, Peter Berezin, notes in the above-cited BCA Research third-quarter outlook that Fed policy is expected to remain ultra-accommodative into late 2021, which will push the USD lower later this year, and will support commodity demand generally. 8      We use an FX-based model to estimate EM import volumes to year end off the CPB data. 9      We will be updating our Venezuela and OPEC 2.0 production estimates to reflect this development in our July global oil market balance publication later this month. 10     We have been long 2H19 Brent vs. short 2H20 Brent since February 28, 2019.  The July and August pieces of this position returned 222.7% and 273% since inception. We remain long the September – December exposure. Investment Views and Themes Recommendations Strategic Recommendations TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Analysis on Thailand is available below. Feature Last week we were on the road meeting with some of our U.S. clients. This week’s report presents some of the key topics of our discussions in a Q&A format. Question: You have been downplaying the potentially positive impact of lower bond yields in advanced economies on EM risk assets. Why do you think lower bond yields in developed markets (DM) and potential rate cuts by DM central banks won’t suffice to lift EM markets on a sustainable basis? Answer: Falling interest rates are positive for share prices when profits are growing, even at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Presently, EM and Chinese corporate earnings are shrinking rapidly (Chart I-1). This is the primary reason why we believe DM monetary easing will not help EM share prices much. Furthermore, EM exchange rates follow relative EPS cycles in local currency terms (Chart I-2). In short, EM currencies are driven by relative corporate profitability between EM and the U.S. – not by interest rate differentials. Chart I-1EM & China EPS Are Contracting Chart I-2Relative EPS And Exchange Rate   The contraction in EM and China EPS has not been caused by higher interest rates and slump in DM domestic demand. Rather, the EM/China profit contraction has been due to China’s economic slowdown spilling over to the rest of EM. Crucially, there is no empirical evidence that interest rate cuts and QEs in DM preclude EM selloffs when EM/Chinese growth is slumping. Specifically: Chart I-3A and I-3B illustrate that neither the level of G4 central banks’ assets nor their annual rate of change correlates with EM share prices or EM local bonds’ total returns in U.S. dollar terms. Hence, QEs have not always guaranteed positive returns for EM financial markets. Chart I-3APace Of QE And EM Performance Chart I-3BPace Of QE And EM Performance Chart I-4U.S. Treasury Yields And EM Performance Chart I-4 demonstrates the correlation between U.S. 5-year Treasurys yields on the one hand and EM spot exchange rates, EM sovereign credit spreads and EM share prices on the other. There has been no stable relationship – at times it has been positive, and at other times negative. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. Even though DM monetary policy has not been the driving force of cyclical fluctuations in EM financial markets, it has had a structural impact. QEs and lower bond yields in DM have prompted an expanded search for yield and have produced substantial compression in risk premia worldwide. For example, Chart I-5 demonstrates that excess returns on EM corporate bonds have historically been correlated with the global manufacturing cycle, but the correlation has diminished in recent years. The widening gap between the two lines is due to investors’ search for yield. Investors have bought and continue to hold securities of “zombie” companies and countries that have low productivity and poor fundamentals. In short, QEs have undermined the efficiency of global capital allocation. This is marginally adverse for productivity in the global economy in the long run. Question: But doesn’t DM monetary policy influence DM demand, which in turn affects EM corporate profits? Answer: DM monetary policy influences DM domestic demand, but there is little correlation between DM domestic demand and EM corporate profits. For example, U.S. import volumes have been growing at a decent pace, yet EM corporate profits have shrunk (Chart I-6). Indeed, robust growth in U.S. imports did not preclude EM EPS contraction in 2012, 2014-‘15 and 2018-‘19, as shown in this chart. Chart I-5Fundamentals Have Become Less Important Due To QE Programs Chart I-6EM EPS And U.S. Imports   Chart I-7 reveals additional evidence of the diminished impact of U.S. growth on Asian exports. Korean, Taiwanese, Japanese and Singaporean exports to the U.S. are growing at 7% rate, while their shipments to China are contracting at an 11% rate from a year ago as of May. As a result, these countries’ overall exports are shrinking because they ship to China considerably more than they do to the U.S. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. The deceleration in global trade can be tracked to Chinese imports contraction (Chart I-8). Chart I-7Asia's Exports To China And U.S. Chart I-8Chinese Imports And Global Trade   U.S. manufacturing is the least exposed to China, which is the main reason why it was the last shoe to drop in the global manufacturing recession. Question: So, what drives EM business cycles if it is not DM growth and DM interest rates? Chart I-9China's Credit & Fiscal Impulse And EM EPS Answer: The key and dominant driver of EM risk assets – stocks, credit markets and currencies – has been the global trade and EM/China growth cycles. There is a much stronger correlation between EM financial markets and the global business cycle in general, and Chinese imports in particular than with DM interest rates. In turn, Chinese imports are driven by its capital spending cycle. 85% of the mainland’s good imports are composed of industrial goods and devices, machinery, chemicals, various commodities and autos. Only 15% are non-auto consumer goods. Meanwhile, the credit/money cycles drive capital spending. That is why China’s credit and fiscal spending impulse leads EM corporate profits (Chart I-9). This is also why we spend a significant amount of time analyzing and discussing China's credit cycle. Question: Why has the policy stimulus in China not revived growth in its economy and its suppliers around the world? Answer: Our aggregate credit and fiscal spending impulse bottomed in January of this year, but its recovery has so far been timid. In the past, this indicator led China’s business cycle and the global manufacturing PMI by an average of about nine months (Chart I-10, top panel) and EM corporate profits by 12 months (Chart I-9). According to this pattern, the bottom in global manufacturing should occur in August of this year. However, global share prices have not led global manufacturing PMI during this decade; they have instead been coincident (Chart I-10, bottom panel). Hence, there was no historical justification for global share prices to rally since early January - well ahead of a potential bottom in the global manufacturing PMI in August. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. That said, due to the U.S.-China confrontation and other structural reasons currently prevailing in China – including high levels of indebtedness and more regulatory scrutiny over shadow banking as well as local government debt – a recovery in mainland household and corporate spending is likely to be delayed. Crucially, as we have documented in previous reports, the marginal propensity to spend for consumers and companies continues to fall (Chart I-11). This is the opposite of what occurred in early 2016. Chart I-10Chinese Stimulus, Global Manufacturing And Global Stocks Chart I-11China: What Is Different From 2016   Overall, a revival in China’s growth will likely take longer to unfold and EM risk assets will likely sell off anew before bottoming. Chart I-12Global Slowdown Is Not Yet Over Chart I-13Global Semiconductor Demand Is Shrinking Question: Apart from China’s credit and fiscal spending impulse and marginal propensity to spend among households and companies, what other indicators are you monitoring to gauge a bottom in the global manufacturing cycle? Answer: Among many variables and indicators we continuously monitor, there are a few we have been paying particular attention to: The difference between global narrow (M1) and broad money growth correlates well with global corporate earnings (Chart I-12). The rationale for this indicator is that it is akin to the marginal propensity to spend: When demand deposits (M1) outpace time/savings deposits, it is indicative that households and companies are getting ready to spend on large-ticket items or kick off capital spending, and vice versa. Presently, this narrow-to-broad money growth differential continues to point to lower global growth. Last week we published a report on the global semiconductor industry, arguing that upstream demand for semiconductors is withering as sales of servers, smartphones, PCs and autos are all shrinking globally (Chart I-13). With consumption of these goods contracting, demand for semiconductors remains lackluster, and semiconductor prices are still deflating (Chart I-14). Hence, semiconductor prices can be used as an indicator of final demand dynamics in many important segments of the global economy. China’s Container Freight Index – the price to ship containers – is also currently lackluster, reflecting weak global trade dynamics (Chart I-15, top panel). Chart I-14Semiconductor Prices Are Still Deflating Chart I-15Global Shipments Are Very Weak   In the U.S., both total intermodal carloads and railroad carloads excluding petroleum and coal are tanking, reflecting subsiding growth (Chart I-15, middle and bottom panel). In turn, Chinese imports continue to contract. This is the primary channel in terms of how the Middle Kingdom affects the rest of the world economy. From the rest of the world’s perspective, China is in recession because their shipments to the mainland are shrinking. In China and Taiwan, the seasonally adjusted manufacturing PMI new orders have rolled over after the temporary pick up early this year (Chart I-16). Finally, we are monitoring our Reflation Indicator and Risk-On/Safe-Haven Currency Ratio (Chart I-17). Both are market-based indicators and are very sensitive to global growth conditions – especially to the dynamics in commodities markets – making them very pertinent to EM investors. Chart I-16Manufacturing PMI: New Orders Seasonally-Adjusted Chart I-17Market-Based Indicators   As with any marked price-based signals, both are very volatile. Even though both indicators have rebounded in recent days, only a major trend reversal matters for macro investors. Technically speaking, the profile of both indicators is consistent with a breakdown rather than a breakout. Question: You have highlighted that EM corporate EPS is contracting. How widespread is the profit contraction, and how long will it persist? Answer: EM corporate EPS contraction is widespread across almost all sectors. Chart I-18A and I-18B illustrate EPS growth in U.S. dollar terms for all sectors. EPS growth is negative for most sectors, close to zero for three (technology, financials and materials) and still positive for the energy sector. However, technology, materials and energy EPS are heading into contraction, given the drop in semiconductor, industrial metals and oil prices, respectively. Chart I-18ASynchronized EM EPS Contraction Chart I-18BSynchronized EM EPS Contraction   Consequently, all EM equity sectors will soon be experiencing synchronized profit contraction. EM corporate EPS contraction is widespread across almost all sectors. Our credit and fiscal spending impulse for China leads EM EPS growth by about 12 months, and it currently entails that the profit contraction will continue to deepen all the way through December (Chart I-9 on page 6). It would be surprising if EM share prices stage a major rally amid a hastening decline in corporate EPS (please refer to Chart I-1 on page 1). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: A Defensive Play Within EM The Thai parliament has elected to keep the ex-military general Prayuth Chan-ocha as the country’s prime minister. This will instill political stability for now, which is positive for investor confidence. In absolute terms, Thai financial markets are leveraged to global trade and will, therefore, sell off if our negative views on the latter and EM risk assets play out. Chart II-1Thailand's Current Account Is In Surplus Relative to their EM peers, Thai equities, credit, currency and domestic bonds will continue outperforming: The Thai current account balance remains in large surplus, which provides a large cushion for the Thai baht amid the slowdown in global growth (Chart II-1). Critically, Thailand is less exposed to China and is more leveraged to the U.S. and Europe than its EM peers. Thailand’s shipments to China account for 12% of the former’s total exports, while exports to the U.S. and EU together account for 21%. Both U.S. and European imports are holding up better than those of China. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. The country’s current FDOs stand at 8% relative to its exports of goods and services and 12% relative to the central bank’s foreign exchange reserves. The rest of EM countries have much higher ratios. In addition, foreign ownership of local currency bonds is amongst the lowest in the region (18%). As a result, currency depreciation will not trigger major portfolio outflows and a self-reinforcing downtrend in Thai financial markets. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. Chart II-2Thailand: Moderate Growth In Private Consumption Thailand’s private consumption is growing reasonably well (Chart II-2, top panel). Likewise, passenger and commercial vehicle sales are rising and so is household credit (Chart II-2, bottom two panels). The Thailand MSCI index carries a large weight in domestic and defensive stocks such as transportation, utilities, telecommunication, and consumer staples. These sectors will benefit from moderate consumption growth. In fact, Thai equity outperformance versus EM has been justified by its non-financial companies’ EBITDA outpacing that of EM non-financials (Chart II-3). This trend remains intact. Concerning banks, Thailand’s commercial banks suffer from credit excesses, as do many of their EM peers. However, Thai commercial banks have been responsible in terms of recognizing NPLs and have been properly provisioning for them (Chart II-4). This is contrary to many other EM banks. This means that share prices of Thai commercial banks will outperform their EM counterparts. Finally, although the Thai bourse is more expensive than its EM counterparts, relative equity valuation will likely get even more stretched before a major reversal occurs. Given our cautious view on overall EM, we continue to prefer this richly valued and defensive bourse to the more cyclical, albeit cheaper, but fundamentally vulnerable EM peers. Chart II-3Equity Outperformance Has Been Justified By Earnings Chart II-4Thai Commercial Banks Are Well Provisioned Bottom Line: Investors should keep an overweight position in Thai equities, currency, domestic bonds and credit markets. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations