Asia

Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Rising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals ...And Offshore Cyclicals ...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps.  The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic  assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock.  In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel).    While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured.  Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B).  In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... When Interest Rates Rise... When Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance ...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8).  In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5  As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Monetary Tightening ≠ Lower Stock Prices Monetary Tightening ≠ Lower Stock Prices Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year.  A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Stay Invested In Chinese Stocks Stay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Cyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth,  2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper.  5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far The Rally Has Been Too Fast, And Gone Too Far The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated Investor Expectations Are Very Elevated Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Low SKEW Signifies That Investors Are Not Ready For Tail Risks Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper Investors Are Very Long Copper Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Peak Fiscal Stimulus In China? Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China? Peak Credit Growth In China? Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving China's Business Cycle Will Continue Improving China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse US Household Income Surged Amid Economic Collapse US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Credit Standards At US Banks Are Tight Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Poor Breadth In EM Equities Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks A Warning Signal for EM Stocks A Warning Signal for EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Red Flags For EM Equities and Currencies Red Flags For EM Equities and Currencies Chart I-13Are Commodities In A Soft Spot? Are Commodities In A Soft Spot? Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets A Message From Emerging Asian Credit Markets A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Current Account Balance Is In Surplus Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Philippine Exports Are Recovering Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth Decelerating Bank Loan Growth Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Chart II-1Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Current Account Balance Is In Surplus Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Philippine Exports Are Recovering Philippine Exports Are Recovering   On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth Decelerating Bank Loan Growth Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com

Dear Client, Next week I will present our outlook on China’s economic recovery, the direction of economic policy and financial markets for the rest of the year and beyond in two live webcasts. The webcasts will take place next Wednesday, October 14 at 10:00AM EDT (English) and Friday, October 16 at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). Best regards, Jing Sima, China Strategist   Feature We have changed the format of our monthly China Macro And Market Review to deliver our messages more concisely and effectively. This week’s report consists of charts that are the most market relevant. Many charts are either self-explanatory or convey a message with brief comments. These charts present macro fundamentals as well as price signals and valuation profiles of China’s financial markets. Our key observations and investment conclusions are as follows: Recent economic data points to a broadening economic recovery in China. The demand side continues to accelerate, and its pace has outstripped production for three consecutive months. Both external and domestic demand measures jumped to above the 50 boom-bust threshold in September’s manufacturing PMI. Service PMI saw the largest monthly uptick since 2013. Credit expansion remained robust through August. Medium- and long-term bank loans to corporates have partially offset the dwindling short-term loans since May, suggesting that near-term liquidity constraints among corporates may be easing. Moreover, an improving bank loan structure will help to boost corporates’ Capex investments. As noted in last month’s China Macro and Market Review,1 the consistent outperformance in production recovery relative to demand in H1 this year has led to an inventory buildup. The ongoing inventory destocking has impeded China’s imports of major commodities and led to a weakening of commodity prices in the past two weeks. The continued destocking of commodities suggests that China’s demand for commodities will remain soft into Q4. Beyond Q4, however, the acceleration in both domestic and external demand should provide solid support to the ongoing economic recovery. Local governments still hold a substantial amount of unspent proceeds from special-purpose bonds issued earlier this year; the funds must be invested in infrastructure projects. We expect China’s imports of industrial raw materials to bounce back in Q1 2021 once the current inventory destocking runs its course. We remain overweight Chinese domestic and investable stocks in a global portfolio in the coming six to nine months. Even though Chinese share prices have run ahead of the country’s business cycle and have priced in an earnings recovery, they are still less overbought than their global peers. China’s economic recovery remains solid compared with other economies, thanks to its successful containment of the domestic COVID-19 outbreak. In absolute terms, we think Chinese stocks still have ample upside potential, as both monetary and fiscal stances remain historically accommodative and the economic recovery is accelerating. Recent setbacks in onshore and offshore stocks were due to the ripple effects from global equity selloffs. Escalating Sino-US frictions have had a very limited effect on China’s overall market because US sanctions are mostly targeted at individual technology companies. There is an elevated risk of a near-term correction in global equity prices, particularly in the next four weeks leading up to November’s US presidential election. In our view, these corrections will provide good buying opportunities. Both Chinese government bonds and onshore corporate bonds remain attractive in a global fixed-income portfolio, based on their higher yields and better risk-reward profile relative to their global peers. Within China’s onshore bond portfolio, returns on corporate bonds have consistently outperformed their duration-matched government bonds. We continue to recommend onshore corporate bond positions in the next 6-12 months.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Chart 1A Widening Economic Recovery A Widening Economic Recovery A Widening Economic Recovery Chart 2Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021 Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021 Credit Expansion Will Likely Peak In October, But Its Impetus For The Economic Recovery Will Continue Through 1H2021   Chart 3ALocal Governments Still Have Plenty Of Unspent Fiscal Firepower Local Governments Still Have Plenty Of Unspent Fiscal Firepower Local Governments Still Have Plenty Of Unspent Fiscal Firepower The divergence between total social financing and M2 growth during the past two months was mainly due to the lack of synchronization between government bond issuances and fiscal spending. Bond issuances are included in social financing and have pushed up fiscal deposits. Fiscal deposits do not derive M2 until they are eventually transferred into fiscal spending. Therefore, we expect that M2 growth will catch up in a few months. Most of the proceeds from government bond issuance have not been dispensed. Local governments have more than enough firepower to continue to support infrastructure spending in the next two quarters. Chart 3BChina's Bank Loan Structure Is Improving China's Bank Loan Structure Is Improving China's Bank Loan Structure Is Improving Chart 3CLoan Demand And Loan Approvals Have Revitalized Loan Demand And Loan Approvals Have Revitalized Loan Demand And Loan Approvals Have Revitalized Chart 4AChina's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... China's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... China's Resilient And Competitive Export Sector Has Performed Well During The Pandemic-Induced Global Recession... Chart 4B...And Will Benefit From A World-wide Economic Recovery ...And Will Benefit From A World-wide Economic Recovery ...And Will Benefit From A World-wide Economic Recovery Chart 5Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Ongoing Inventory Destocking Will Likely Continue To Impede China's Imports Of Commodities Into Q4 Chart 6A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector A Faster Recovery In Demand In Downstream Industries Should Help To Revive The Manufacturing Sector   Chart 7AMounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Mounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Mounting Post-Pandemic Demand In The Property Market Has Invited Tighter Scrutiny From Chinese Authorities... Chart 7B...But Near-Term Real Estate Construction Should Still Hold Up ...But Near-Term Real Estate Construction Should Still Hold Up ...But Near-Term Real Estate Construction Should Still Hold Up As noted in last month’s China Macro And Market Review,2 recently tightened financing regulations on real estate development3 are not game changers. Historically, the government’s financial rules and land sales have not had a strong positive correlation with real estate investment growth. So far, Chinese authorities have kept property policies flexible, allowing most local governments to have their own housing policies. We expect property restrictions will tighten on tier-one and tier-two cities that are facing upward pressure on housing prices. Housing demand in smaller cities, however, remains soft and may see increased policy support next year.  Chinese policymakers will continue to keep an eye on real estate speculation. In the near term, however, real estate developers need to complete their existing projects, which will support construction activities into H1 next year.   Chart 8AHousehold Consumption Continues To Recover Household Consumption Continues To Recover Household Consumption Continues To Recover Chart 8BRising Employment Should Further Lift Consumption Rising Employment Should Further Lift Consumption Rising Employment Should Further Lift Consumption   Chart 9AChina's Offshore And Onshore Forward Earnings Have Ticked Up China's Offshore And Onshore Forward Earnings Have Ticked Up China's Offshore And Onshore Forward Earnings Have Ticked Up Chart 9BValuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme Valuations In A Shares Are Not Too Extreme   Chart 9CChinese Stocks Are Not Expensive Compared With Global Benchmarks Chinese Stocks Are Not Expensive Compared With Global Benchmarks Chinese Stocks Are Not Expensive Compared With Global Benchmarks Chart 10AChina's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China's Cyclical Stocks Are Advancing Against The Backdrop Of Improving Economic Fundamentals China offshore cyclical stock prices have been driven by hefty valuations since 2016, mostly because investable cyclicals are heavily weighted in high-flying tech stocks. Chinese tech stock prices will likely be extremely volatile in the next one to three months. We expect a tougher stance on China from the US in the next four weeks leading up to the presidential election. Furthermore, even if Trump does not get reelected, the “lame duck” President may still impose sanctions on China before he leaves the White House in January 2021. We are staying the course with our constructive cyclical view on Chinese stocks, even though the market will be more volatile during the next few months. Chinese tech company stocks have been shaken by negative surprises relating to frictions with the US.  However, investors also cheer on even the slightest easing of tensions between the two countries.4 We expect this risk-on and -off sentiment to intensify through Q4. Onshore cyclical stocks have consistently underperformed defensives, driven by a downtrend in relative earnings per share. However, improvements in economic fundamentals of late suggest that the uptick in domestic cyclicals may be strengthening. We remain long on onshore and offshore consumer discretionary and materials relative to their respective broad market indexes. The investment calls are in place until policy dividends on those sectors subside, which we expect in mid-2021. Chart 10BChina's Equity Sectors In Perspective China's Equity Sectors In Perspective China's Equity Sectors In Perspective Chart 10CChina's Equity Sectors In Perspective China's Equity Sectors In Perspective China's Equity Sectors In Perspective Chart 11AA Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors A Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors A Solid Economic Recovery, A Relatively Stable Currency Exchange Rate And Higher Yields, All Have Made China's Stocks and Bonds Attractive To Foreign Investors Chart 11BChinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Chinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Chinese Bonds Offer A Better Risk-Reward Profile In An Ultra-Low Yield Global Environment Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review   Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated September 9, 2020, available at cis.bcaresearch.com 3China's widely circulated but unofficial "three red lines" policy sets limits on bank borrowings: a 70% ceiling on a developer’s debt-to-asset ratio after excluding advance receipts; a 100% cap on the net debt-to-equity ratio; and a requirement that short-term borrowing does not exceed cash reserves, according to S&P Global Ratings. 4Please see China Investment Strategy Weekly Report "Sticking With Chinese “Old Economy” Stocks In A Widening Tech War," dated August 12, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Please note that yesterday we published a Special Report titled Global Supply Chain: Moving Away From China? Please click on it to access it. Highlights Thailand has entered a phase of precarious, turbulent and potentially lasting political turmoil. Thailand’s governance system has largely favored the public sector and business elites over ordinary citizen. Political protests are therefore here to stay. Meanwhile, the pandemic has thrown the economy into a “knockout” and it will take a long time for it to recover. We are downgrading Thai equities from overweight to neutral for dedicated EM equity portfolios. Fixed income portfolios should maintain an overweight position on Thai local currency government bonds and sovereign credit. Feature Chart 1Thai Equities: Absolute And Relative To EM Performance Thai Equities: Absolute And Relative To EM Performance Thai Equities: Absolute And Relative To EM Performance Thailand has entered a phase of precarious, turbulent and potentially lasting political turmoil. These circumstances will weigh negatively on consumer and business confidence. Already the economy is unable to generate a strong recovery following the severe recession caused by the pandemic. As such, our overweight stance in Thai equities has been significantly challenged. We are recommending investors downgrade the allocation to Thai equities from overweight to neutral within a dedicated EM equity portfolio (Chart 1). Entering A Phase Of Persistent Political Volatility… Insistent Protestors And An Unresponsive Government A new wave of anti-establishment protests has gripped Thailand. In February of this year, the Constitutional Court and the Election Commission banned the progressive Future Forward Party – a youthful opposition party – triggering protests early in the year. The demonstrations then quickly dissipated as the COVID-19 pandemic broke out to then return with more momentum in July/August. The pro-democracy movement is demanding the resignation of Prime Minister Prayut Chan-o-cha and his military-backed government. It is also calling for the dissolution of parliament and the drafting of a new constitution. For the first time, protesters have violated a powerful taboo and have entered uncharted territory in their demand for the reformation of the monarchy. This reformation includes removing Section 112 of the Penal Code (which enshrines “lèse majesté” laws that criminalize any form of criticism of the monarchy), as well as reducing King Vajiralongkorn’s powers over national assets and the army. Finally, protesters are demanding that opposition parties be allowed more freedom to participate in the electoral system. The country’s political and economic systems have grossly favored the ruling military-monarchy nexus and the business elite class. Meanwhile, Prime Minister Prayut Chan-o-cha and his military-backed government seem unwilling to compromise in any serious way. Not only has the Prime Minister failed to engage with the protestors but is instead dangerously downplaying the gravity and depth of the problem with little acknowledgement of public anger. Please refer to Appendix 1 on page 14 for a more detailed assessment of the political situation in the Kingdom. Chart 2Share Of Employees' Income Is Smaller In Thailand Than In The US Share Of Employees' Income Is Smaller In Thailand Than In The US Share Of Employees' Income Is Smaller In Thailand Than In The US The Origins Of Thailand’s Public Anger The root cause of discontent in Thailand lies in deep structural issues related to the country’s governance system. The country’s political and economic systems have grossly favored the ruling military-monarchy nexus and the business elite class. National income and prosperity have not benefited broader social groups, and income inequality has grown. As such, a large section of the Thai population has experienced poor income growth, scarce job opportunities, and must contend with an inadequate social safety net: Income and wealth inequality: Income and wealth inequality gaps are at an extreme in Thailand. According to the 2018 Global Wealth Report, published by Credit Suisse, Thailand ranked as the most unequal country among the countries surveyed in the report. Over the last two years that same report has continued to assign this rank to Thailand, along with Russia and India.  Other indicators show similar trends on the income inequality front. For example, Chart 2 shows that the labor share of income in Thailand sits at 40%, much lower than corporate profits, entrepreneur and rental income. The latter two are income sources available to high-income households. By comparison, in the US, wages and salaries make up 56% of GDP, while total corporate profits and entrepreneur and rental income amount to just 24%. Private-sector wages in Thailand are also 30% lower than public sector wages (Chart 3). This is unsurprising given the preferential status that government and public sector employees get in Thailand. Stagnating incomes for middle and low-income employees: Not only is the share of income for middle- and lower-income workers small, but income growth for this class has stagnated as well. Chart 4 illustrates that private-sector wage growth has been very weak in the past few years and is beginning to contract in real (inflation-adjusted) terms.  Chart 3Thailand: Public Wages Are Substantially Higher Than Private Ones Thailand: Public Wages Are Substantially Higher Than Private Ones Thailand: Public Wages Are Substantially Higher Than Private Ones Chart 4Thailand: Workers' Average Real Wage Have Stagnated Thailand: Workers' Average Real Wage Have Stagnated Thailand: Workers' Average Real Wage Have Stagnated   Overall, real GDP per capita growth has been unimpressive in Thailand. In particular, it averaged only 3% annually from 2010 till 2019 inclusive versus 6% from the 1980s to 1997 (Chart 5). The key reason for stagnating real per capita incomes is lower labor productivity growth over the past decades as Thai businesses have not been investing (Chart 6). The lack of investment has undermined productivity growth, and with it, real income growth. Chart 5Thailand: Real GDP Per Capita & Productivity Thailand: Real GDP Per Capita & Productivity Thailand: Real GDP Per Capita & Productivity Chart 6Thai Businesses Have Not Been Investing Thai Businesses Have Not Been Investing Thai Businesses Have Not Been Investing   Worryingly, small and medium businesses (SMEs) have also not deployed any capital expenditures either. Chart 7 illustrates how commercial bank lending to non-financial SMEs has been stagnating and has most recently been devastated by the COVID-19 pandemic. SMEs are the backbone of the Thai economy as they employ 80% of the labor force and their investments are critical to generating labor productivity gains in Thailand. While not financing SMEs, Thai commercial banks provided funding to consumers which is an unproductive form of credit versus loans for business investment (Chart 8). Chart 7Thailand's SMEs Have Been Starved From Credit Thailand's SMEs Have Been Starved From Credit Thailand's SMEs Have Been Starved From Credit Chart 8Thailand's Commercial Banks Have Mostly Lent To Consumers Thailand's Commercial Banks Have Mostly Lent To Consumers Thailand's Commercial Banks Have Mostly Lent To Consumers   High youth unemployment: Youth in Thailand – which are currently leading the anti-establishment movement – are struggling to find job opportunities. According to the Youth Employability Scoping Study report published by Thailand Development Research Institute & UNICEF, fewer Thais have jobs today than a decade ago. Indeed, youth unemployment is much higher than those aged 35 to 60+ (Chart 9). Chart 9Thai Youth Unemployment Is A Major Problem Thai Youth Unemployment Is A Major Problem Thai Youth Unemployment Is A Major Problem Moreover, higher education is not translating to jobs in Thailand. University graduates are much less likely to find jobs than those with a primary education. The unemployment rate for university graduates stands at 17.2% versus 2.4% for those with a primary education. Not surprisingly, the recent protests have been initiated and led by students. Absence of a social safety net: According to the International Labor Organization, Thailand lacks a proper social safety net to protect its most vulnerable citizens. Central government spending on social protection is low at 3% of GDP according 2018 data from the IMF’s Government Finance Statistics. This compares to 15% in Brazil, 11% in Turkey, 6% in Chile, and 5% in South Africa. Indeed, Thailand’s government spending is very low even by EM standards (Chart 10, top panel). Thailand’s public debt to GDP is also too small and at par with that of Chile (Chart 10, bottom panel). Chile itself lacks a proper social safety net and has been going through its own socio-political turmoil. Furthermore, not only is Thailand’s overall government budget spending small, but just a tiny 11% share of its already small budget gets allocated to social benefits, while 45% gets allocated to government employee compensation and the purchases of goods and services (Chart 11). Chart 10Thai Government Spending Is Too Small… Thailand Challenged Thailand Challenged Chart 11...And Favors Government Employees ...And Favors Government Employees ...And Favors Government Employees   Finally, existing social benefits mostly apply to formal employees in Thailand. Yet informal employment accounts for 50% of the entire work force. This leaves a large chunk of workers with minimal or no social protection at all. As to Thailand’s tourism industry, it is now virtually frozen. Bottom Line: Thailand’s governance system has largely favored the public sector and business elites. In turn, a large share of the population has experienced stagnant incomes for the past 15-20 years, faced poor employment prospects and suffered under an inadequate social security system. Protests are therefore here to stay and the nation is entering another phase of social and political instability. Crucially, the addition of the monarchy on the list of reforms by protestors is taking Thailand into uncharted and highly uncertain territory. Odds of slipping into periodic violence are also high. …Amid Crumbling Domestic Growth Not only is Thailand going through deep structural issues resulting from its poor public governance, but the nation is also suffering from its worst recession since the Asian Crisis. In turn, the confluence of these disturbing structural and cyclical dynamics will be weighing on the Thai economy. Worryingly, Thailand’s auto and tourism sectors – two critical segments of the Thai economy – have been devastated by the pandemic. Chart 12 illustrates that auto production, sales and exports – which were all distressed even before the pandemic began – have collapsed and will unlikely recover to pre-pandemic levels for some time. As to Thailand’s tourism industry, it is now virtually frozen. Tourist revenues collapsed to zero in July and August (Chart 13, top two panels). Hotel occupancy rates fell and sit at a timid 14% (Chart 13, bottom panel). Tourism brings in around $50-60 billion annually (about 10% of GDP) into Thailand and employs 12% of the Thai labor force. Chart 12Thailand's Auto Industry Is In The Doldrums Thailand's Auto Industry Is In The Doldrums Thailand's Auto Industry Is In The Doldrums Chart 13Thai Tourism Collapsed Thai Tourism Collapsed Thai Tourism Collapsed   The Thai government promptly unleashed a large fiscal stimulus back in March and April worth about 14% of GDP to prop up domestic demand. Yet while the stimulus was large on paper, it does not seem to have been successful. Chart 14Government Spending Has Been Offset By A Negative Credit Impulse Government Spending Has Been Offset By A Negative Credit Impulse Government Spending Has Been Offset By A Negative Credit Impulse For example, the monthly handout scheme failed to reach half of Thailand’s informal workers (its targeted recipients). The scheme ended quickly on July 31. Moreover, only 15% of small business owners have utilized the government’s soft loans scheme (the government’s most important stimulus item). It seems that access to the government’s stimulus programs has been limited. Particularly, a few stimulus programs were implemented via third-party channels such as banks and utility companies with no clear procedures in place. This vague administrative structure ended up rejecting many applicants. Meanwhile, actual spending by the government was modest and was more than offset by the weak overall bank credit impulse (Chart 14). Provided that Thai commercial banks remain unwilling to lend, the credit impulse will remain negative and, accordingly, will continue to weigh on domestic demand. Finally, the new Finance Minister, Predee Daochai, resigned after just 26 days on the job due to jockeying inside the ministry over senior roles. This suggests that government economic policy is in disarray and will weigh on business confidence delaying investment and hiring. As to monetary policy, the Bank of Thailand (BoT) has been ultra-accommodative. The BoT has been purchasing government bonds and injecting liquidity into commercial banks (Chart 15, top). Meanwhile commercial banks have been buying government bonds en masse (Chart 15, bottom). The BoT has also slashed its policy by 125 BPs since January 2019. Yet it seems that Thai commercial banks are adamant about not passing lower interest rates aggressively to borrowers because they want to protect their high net interest rate margins at a time when they are set to face mounting losses from rising NPLs (Chart 16). Chart 15Public Debt Monetization By Central And Commercial Banks Public Debt Monetization By Central And Commercial Banks Public Debt Monetization By Central And Commercial Banks Chart 16Commercial Banks Prime Lending Rates Are Still Too High Commercial Banks Prime Lending Rates Are Still Too High Commercial Banks Prime Lending Rates Are Still Too High Chart 17Commercial Banks Net Interest Rate Margins Are Elevated Commercial Banks Net Interest Rate Margins Are Elevated Commercial Banks Net Interest Rate Margins Are Elevated As a result, the real economy’s borrowing rates – although have fallen by 85 basis points – are still too elevated at 5.4% given the collapse that has occurred in nominal GDP growth (Chart 17). In brief, a 85 basis points drop in lending rates will not be enough to restore household debt servicing capacity at a time when their incomes have been devastated. Thailand’s household debt to their disposable income ratio sits at a particularly elevated level of 120% (Chart 18, top panel). If household nominal income contracts further, a debt deflation spiral may follow. Falling nominal income at a time of elevated household debt burden and relatively high lending rates will result in consumer defaults and/or reduced spending. Rising NPLs at banks will lead to less bank lending and falling consumption feeding into lower employment and wages. All of these will heighten price and income decline pushing up the real value of debt and real lending rates (Chart 18, bottom panel). Worryingly, the Thai economy is already dangerously close to deflation territory (Chart 19). Chart 18Elevated Real Lending Rates Amid High Consumer Indebtedness Elevated Real Lending Rates Amid High Consumer Indebtedness Elevated Real Lending Rates Amid High Consumer Indebtedness Chart 19The Thai Economy Is Dangerously Close To Deflation The Thai Economy Is Dangerously Close To Deflation The Thai Economy Is Dangerously Close To Deflation   Bottom Line: The pandemic has thrown the economy into a “knockout” and it will take a long time for it to recover. The stimulus has been insufficient or poorly administrated to revive the economy quickly and meaningfully.  Investment Recommendations Chart 20Thai Equities Are Not Cheap Thai Equities Are Not Cheap Thai Equities Are Not Cheap Equities: We are downgrading Thai equities from overweight to neutral for dedicated EM equity portfolios. The reason why we are reluctant to move to underweight is because the currency will outperform other EM currencies and share prices have already underperformed the EM benchmark dramatically. The poor outlook for corporate and bank profits is the main rationale behind our downgrade. The business cycle recovery will be very subdued and will take longer in Thailand than in other EM economies. Besides, political uncertainty will weigh on both business and investor confidence. In the meantime, Thai equities are not cheap at all. The forward price-to-earnings ratios stands at 18 for Thailand versus 15 for EM (Chart 20). Absolute return investors should stay put on the Thai bourse. We expect equities to continue underperforming local bonds.  EM local currency bond portfolios should maintain an overweight position on Thai local currency government bonds. The currency will not sell off a lot as the current account balance is in a large surplus of 5.5% and is unlikely to change any time soon. Meanwhile, the Thai central bank has been accumulating FX reserves in an attempt to weaken the baht. Without the central bank’s interventions, the Thai baht would have been much stronger. Importantly, political turmoil in Thailand does not typically lead to major sell offs in local government bonds and currency. EM credit managers should continue overweighting Thai sovereign credit too (US dollar government bonds). Thailand has a very low public debt to GDP ratio and its fiscal dynamics will not deteriorate as much as in other EM countries. An 85 basis points drop in lending rates will not be enough to restore household debt servicing capacity at a time when their incomes have been devastated. APPENDIX 1 Thailand’s Political Dynamics: An Uncharted Territory It is impossible to predict each twist and turn in Thailand’s politics. What is certain is that Thailand is again entering another precarious multi-year phase of social and political instability that will occasionally turn violent. In the near term, the revival of unrest will weigh the already fragile Thai economy and share prices: Neglecting the protestors: Prime Minister Prayut’s government seems unwilling to compromise with the protestors in any serious way which risks fueling public anger. For instance, Prayut has been using rising COVID-19 cases and the dire impact the former has on the economy as reasoning to discourage Thais from protesting. Prayut also warned that protests could cause the nation to be “engulfed in flames,” harkening back to previous periods of chaos, such as 2006-14. Prayut also unleashed 8,000 police officers in one of the recent protests as a signal to pro-democracy protestors to tread carefully. Furthermore, the parliament voted on September 24 to delay until November a decision on whether to amend the constitution. Such lack of sympathy on the part of the government is fueling public anger and will likely push pro-democracy protestors to escalate their stance. Some really love the king: The pro-democracy/anti-establishment movement is demanding the reformation of the monarchy. Thailand however is still a deeply religious and conservative society with parts of the population – mostly elders and persons living in the southern regions – who deeply love and respect the monarchy. This part of Thai society is enraged by protestor demands for reform. Therefore, the anti-establishment protestors will face counter-protests – even if smaller in number – from royalists. Already the latter group gathered in Bangkok’s sports arena on August 30 to show support for King Vajiralongkorn. This group could gain momentum in the coming months and years, increasing chances of the two camps clashing and giving the authorities a pretext to forcefully and violently intervene. Threat of force: Prayuth’s government maintains military backing and shares a mutual interest with the palace in suppressing the populist democratic movement. Prayuth will limit the use of force against protesters only for a time and he will resort to force if protests start to affect critical infrastructure and business. If protesters also persist in criticizing the monarchy, it will enable the regime to divide the opposition, since the traditional opposition players will refrain from violating royal taboos. Importantly, because the king lacks the moral authority of his predecessor, the royal succession cannot be said to be “finished” from the point of view of the royalist establishment. The emerging protests are the first major challenge to the new order and the military-backed government will defend it with force. Where Is Thailand Headed: As of yet, there is no basis for believing that the royal and military establishment will be fundamentally shaken. However, in the coming years they could be forced to cede some powers in the wake of this full-fledged socio-economic crisis. The critical question is, when the crisis point is reached, whether the new king will successfully play the role of arbiter and peacemaker in settling the dispute. If he fails to do so, then polarization will escalate, setting Thailand on a very uncertain path with no clear roadmap to follow. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations