Argentina
Highlights The main driving force behind EM risk assets this year has been downshifting U.S. interest rates and a weak U.S. dollar. These factors have more than offset the relapse in commodity prices and the deteriorating growth outlook for China/EM. Going forward, odds favor a rise in U.S. interest rates and a stronger dollar. If this scenario materializes, the EM rally will reverse. Meanwhile, China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth. Altogether, the outlook for EM risk assets is extremely poor, and we reiterate our defensive strategy. In Argentina, we continue favoring local currency bonds and sovereign credit, especially relative to their EM counterparts. Feature What Has Not Worked In This Rally Financial market actions of late have been rife with contradictions, and momentum trades have been prevalent. In the past few months we have been highlighting that EM risk assets - stocks, currencies and bonds - have decoupled from most of their historically reliable indicators such as commodities prices, China's money and credit impulses and China/EM manufacturing PMI.1 This week we highlight several additional indicators and variables that EM risk assets have diverged from. Chinese H shares - the index that does not contain internet/social media stocks - have decoupled from the Chinese yield curve (Chart I-1). The mainstream press have been focused on inversion in the 10/5-year Chinese yield curve, but we do not find it to be a particularly credible or useful indicator for the economy. Our preference is the 5-year to 3-month yield curve to gauge the cyclical growth outlook. Chart I-1China's Yield Curve Heralds Lower Share Prices Not only has the yield curve been flattening, but it has also recently inverted, suggesting an impending downturn in China's business cycle (Chart I-2). Chart I-2China's Yield Curve Inversion Points To A Growth Slump In China, commercial banks' excess reserves at the People's Bank of China (PBoC) have begun shrinking since early this year, reflecting the PBoC's liquidity tightening (Chart I-3, top panel). Banks' excess reserves are the ultimate liquidity constraint on banks' ability to originate new credit/money and expand their balance sheets. Meanwhile, Chinese commercial banks are stretched and overextended, as illustrated by the record-high ratios of both M2 and commercial banks' assets-to-excess reserves (Chart I-3, bottom panel). These are true measures of the money multiplier, and they have surged to very high levels. Besides, financial/bank regulators are clamping down on speculative activities among banks and other financial intermediaries, and are also forcing banks to bring off-balance-sheet assets onto their balance sheets. Faced with dwindling liquidity (excess reserves), rising interest rates and a regulatory clampdown, banks will slow down credit / money origination. Slower credit growth will cause a considerable slump in capital spending, and overall economic growth will downshift. On a similar note, interest rates lead money/credit growth in China, as evidenced in Chart I-4. Chart I-3China: Dwindling Excess Reserves ##br##Will Cause A Credit Slowdown Chart I-4China: Interest Rates ##br##And Money Growth The considerable - about 200 basis points - rise in Chinese money market and corporate bond yields since November heralds a deceleration in money/credit growth. Historically, interest rates affect money/credit growth and ultimately economic activity with a time lag. There is no reason why this relationship will not hold in China this time around. Given that Chinese companies are overleveraged, credit growth is likely to be more sensitive to rising than falling interest rates. Hence, the lingering credit excesses in China make rising interest rates more dangerous. Industrial commodities prices have reacted to liquidity tightening in China sensibly by falling since early this year (Chart I-5A and Chart I-5B). Chart I-5AWidespread Decline In Commodities Prices (II) Chart I-5BWidespread Decline In Commodities Prices (I) The weakness in commodities prices since early this year is especially noteworthy because it has occurred at a time of U.S. dollar weakness and dissipating Federal Reserve tightening concerns. When and as the U.S. dollar gains ground again, the selloff in commodities will escalate. Outside commodities, there are early signposts that another Chinese slowdown is beginning to unfold - slowing exports in May from Korea and Taiwan to China, being one glaring example (Chart I-6). This chart corroborates our argument that the surge in Chinese imports in late 2016 and the first quarter 2017 was a one-off growth boost, and appeared very strong because of the low base from a year ago. Consistently, Taiwan's manufacturing shipments-to-inventory ratio has rolled over, which correlates well with the tech-heavy Taiwanese stock index (Chart I-6, bottom panel). With respect to the broader EM universe, EM equities and currencies have decoupled from U.S. inflation expectations (Chart I-7). Chart I-6Shipments To China Have Rolled Over Chart I-7EM And U.S. Inflation Expectations: ##br##Unsustainable Decoupling? Historically, falling U.S. inflation expectations have reflected dropping oil prices and caused real rates (TIPS yields) to rise. In turn, lower oil prices and/or rising TIPS yields weighed on EM risk assets. The decline in U.S. Treasurys yields since last December has been largely due to inflation expectations rather than real rates. Such a mixture has historically been ominous for EM risk assets. Notwithstanding, EM risk assets have rallied a lot, despite such a hostile backdrop year-to-date. Finally, the Brazilian and South African exchange rates and their bonds have been among the more stellar performers in the past 12 months. Nevertheless, first quarter GDP releases in Brazil and South Africa have confirmed that there has been little domestic demand recovery in either country. Remarkably, in both countries, agriculture and mining volumes boomed in the first quarter, boosting GDP growth, yet final domestic demand remained shockingly depressed, as illustrated in Chart I-8. This discards the popular EM rally narrative that improving global growth will lift EM economies. Neither a poor domestic growth backdrop and political volatility nor falling commodities prices have prompted a meaningful plunge in either the Brazilian or South African exchange rate. Chart I-9 portends that the BRL and ZAR have historically been correlated with commodities prices but have recently shown tentative signs of decoupling. Chart I-8Not Much Recovery In Brazil ##br##And South Africa's Domestic Demand Chart I-9BRL And ZAR And Commodities Bottom Line: EM financial markets have veered away from many traditional indicators. These constitute important contradictions and raise the question of whether this time is different. We do not think so. What Has Driven This EM Rally: U.S. Rates And The U.S. Dollar The variables that have explained the EM rally in the past six months have been falling U.S. interest rate expectations and a weaker U.S. dollar, as well as the global technology mania. We elaborated on the tech rally in recent weeks,2 and this week re-visit EM's link with U.S. interest rates and the greenback. The main driving force behind EM risk assets, year -to-date, has been U.S. TIPS yields and the greenback (Chart I-10). In short, it has been the carry trade that has transpired since the Fed's meeting on December 15, 2016 - regardless of EM growth dynamics and fundamentals. Going forward, barring a major growth relapse in China/EM growth and an associated U.S. dollar rally, the odds favor a rise in U.S. interest rates in general and U.S. TIPS yields in particular: The U.S. composite capacity utilization gauge (Chart I-11, top panel) - constructed by our Foreign Exchange Strategy team based on the unemployment gap and industrial capacity utilization - is moving above the zero line, denoting that there is little slack in the U.S. economy. Chart I-10U.S. TIPS Yields, Dollar And EM Chart I-11The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? Any time the indicator has moved above the zero line in the past 55 years - the shaded periods on Chart I-11 - inflationary pressures, wages and bond yields have typically risen, and vice versa. The message from this indicator is unambiguous: U.S. inflationary pressures will become evident soon, and interest rates will rise. In this context, U.S. interest rate expectations are too low. Re-pricing of U.S. interest rates will shake off lingering complacency across many financial markets worldwide. Notably, the U.S. mortgage purchase index is surging, job openings are very elevated (Chart I-12), financial and property markets are buoyant and the dollar has been weak. If the Fed does not normalize interest rates now, when will it? Finally, both nominal and inflated-adjusted U.S. bond yields are at their technical support, and will likely bounce from these levels (Chart I-13). Chart I-12Are U.S. Rate Expectations Too Low? Chart I-13U.S. Bond Yields Are At A Critical Juncture Chart I-14U.S. Growth Underperformance Is Late Rising U.S. interest rates will trigger another up leg in the U.S. dollar. Notably, the relative economic surprise index between the U.S. and the G10 is close to its post-crisis lows (Chart I-14). The relative U.S. growth underperformance versus DM is late and will turn around very soon. While it does not always define the fluctuations in the U.S. dollar, we would still expect it to lend some support to the greenback. BCA's Emerging Markets Strategy service believes the broad trade-weighted U.S. dollar is still in a bull market, especially versus EM, DM commodities currencies and Asian currencies. We have less conviction on the magnitude of the downside in the euro, but the latter at minimum will not rally above 1.14 -1.15 for now. Finally, various EM currencies are facing an important technical resistance (Chart I-15A and Chart I-15B). We expect these technical levels to mark their top. Chart I-15AEM Currencies Are Facing Technical Resistance (II) Chart I-15BEM Currencies Are Facing Technical Resistance (I) At the same time, the precious metals index seems to be rolling over at its 200-day resistance level (Chart I-16). A top in the precious metals index would be consistent with a bottom in U.S. TIPS yields and the U.S. dollar. Chart I-16Precious Metals Are Facing ##br##A Major Resistance Bottom Line: U.S. interest rate expectations are too low and are set to rise. Rising interest rates will remove a major support underpinning the EM rally. A Resolution There are three potential scenarios as far as the ongoing EM rally is concerned: The goldilocks scenario of low interest rates in the U.S., a weaker dollar and steady-to-improving growth in EM/China. The markets have already priced in a lot of good news, but the rally could feasibly continue for some time if this scenario transpires. Re-pricing of the Fed. U.S. interest rates will rise and the dollar will get bid up. The rationale is the modest U.S. inflationary pressures will become evident amid solid U.S. growth. This will weigh on EM risk assets, even if EM/China growth does not falter. The basis for this is the EM rally year-to-date has been driven by diminishing U.S. interest rates expectations. Deflation trade redux. China/EM growth will deteriorate meaningfully (for reasons discussed above), causing a considerable downshift in commodities prices and EM risk assets. This could well occur even if U.S. rates stay low. In fact, this is the main plausible reason to bet against a rise in U.S. interest rate expectations from current levels. Investing is about assigning probabilities. We assign much lower probability to the first scenario (no more than 20%), while we see the odds of either the second or third scenarios playing out in the short term at closer to 40%. In the medium term (nine-to 12 months), scenario 3 will be the most prevalent one. If conditions in scenario 2 (rising U.S. bond yields) coincide with a deflationary shock emanating from China, EM financial markets will face a perfect storm. Bottom Line: We continue to recommend a defensive investment strategy for absolute-return investors, and recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, 2017, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?", dated May 17, 2017, and Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, links available on page 19. Argentina: Favor Local Bonds And Sovereign Spreads EM fixed-income portfolio should continue to overweight Argentine local currency bonds and sovereign credit based on the following reasons: Policymakers continue pursuing credible orthodox policies. The central bank has been accumulating foreign exchange as a part of its explicit program to increase international reserves from 10% to 15% of GDP and keep the peso competitive. At the same time, the monetary authorities have partially siphoned off liquidity via reverse repos (Chart II-1). On a net-net basis, monetary stance is rather tight as evidenced by money and credit contraction in real (inflation-adjusted) terms (Chart II-2). Chart II-1Argentina: Rising Reserves ##br##And Reverse Sterilization Chart II-2Argentina: Inflation-Adjusted Money ##br##And Credit Are Contracting Rapid disinflation is proving difficult to achieve due to inflation inertia and high inflation expectations. However, the authorities are holding their position steady in wage negotiations. Wages in both the public and private sectors are contracting in real terms (Chart II-3). Provided wages are a major driver of inflation, employee compensation growing at a slower pace than inflation signals lower inflation ahead. The economy is not yet recovering as evidenced by Chart II-4 and lingering economic stagnation will foster disinflation. Chart II-3Argentina: Lower Wage Growth ##br##Is Critical To Anchor Inflation Chart II-4Argentina: The Economy ##br##Is Still In Doldrums A change in our fundamental view on inflation would require an irresponsible central bank tolerating run away money and credit growth. We find this scenario unlikely and hold the view that the inflation outlook will improve (Chart II-5). Chart II-5Argentina: Inflation Is On The Right Track In regard to the currency, the Argentine central bank will allow the peso to depreciate as maintaining a competitive exchange rate is a major policy priority for them. This is especially true if commodities prices fall and the regional currencies (BRL and CLP) depreciate versus the greenback. The current account and fiscal deficits are large but Argentina is seeing significant FDI and foreign portfolio capital inflows. Hence, funding will not be a problem for some time. The eventual economic recovery and the cheap currency, as well as slow but progressing reforms, will make Argentina a more attractive destination for foreign investors and ensure foreign capital inflows. Overall, there are many challenges, but the outlook for Argentina is much better compared with EM economies in general, and Brazil in particular. Hence, we recommend staying long Argentinian assets on a relative basis versus EM counterparts, particularly Brazil. Specifically, we maintain the following positions: Long ARS versus BRL. We do not expect the currency to depreciate more than what the NDF market is pricing in the next 12 months, and believe it will outperform the BRL on a total return basis (including carry). Stay long Argentine 7-year local currency government bonds. Stay long Argentine / short Brazilian and Venezuelan sovereign credit. Overweight Argentine stocks within the emerging and frontier market universes. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.
Conditions are falling into place for inflation to plunge and monetary easing to progress rapidly. This in combination with structural reforms creates a bullish backdrop for Argentine financial markets. The current economic, structural and political configurations look more promising for Argentina than Brazil. Go long Argentina/ short Brazilian sovereign credit, overweight the Argentine bourse versus the Frontier Markets benchmark and, go long the Argentine Peso versus the Brazilian <i>real</i>.
Markets will remain stuck in a trading range, driven by two policy feedback loops: the Fed's and China's.
Monetary policy at systematically important central banks will determine the winners and losers in global ag export markets going forward. The evolution of fundamentals - supply, demand, and inventories - will remain essential drivers. Mother Nature is the wild card.