Asia

Dear Clients, Please note that this week we are re-publishing a Special Report written by our Emerging Market Strategy team and published on January 7, 2020. The report, authored by Ellen JingYuan He, is an extension of the Special Report published in September 2017 and examines the progress made in China’s “Belt and Road Initiative (BRI)” since its implementation in 2013.  This Special Report concludes that going forward, the Chinese government will likely shift to a stricter regulatory stance in BRI project financing. The shift will lead to a modest pullback in realized BRI investment in 2020. However, given the small size of BRI investments relative to China’s total capital spending, the recovery in Chinese capital goods imports still hinges on the domestic property and infrastructure spending cycle.  I trust you will find this report insightful. In addition, we are closing our long USD/CNH trade, initiated in May 2019 as a currency hedge for our cyclical overweight in Chinese stocks and corporate bonds (denominated in USD terms). As we mentioned in last week’s China Macro and Market Review, upon the signing of the Phase One trade deal on January 15, we expect further modest strengthening in the Chinese currency as China’s economy continues to improve. Therefore, the currency hedge is no longer needed and we recommend that investors favor Chinese stocks and bonds versus the global benchmark in unhedged terms.  Best regards, Jing Sima, China Investment Strategist   Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports ...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth China’s Belt And Road Initiative: Entering A Cooling-Down Phase China’s Belt And Road Initiative: Entering A Cooling-Down Phase Chart I-11BRI Helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports BRI helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Investment Strategy View Matrix Time For A Breather Time For A Breather Receding trade tensions; diminished risks of a hard Brexit; reduced odds of a victory for Elizabeth Warren in the US presidential elections; liquidity injections by most major central banks; and improved sentiment about the state of the global economy all helped push stocks higher late last year. Some clouds have formed over the outlook since the start of the year, however. The December US ISM manufacturing index fell to the lowest level since 2009, while the PMIs in the euro area, UK, and Japan gave up some of their November gains. The conflict between the US and Iran also flared up. Although tensions have abated in recent days, BCA’s geopolitical strategists worry that the détente may not last. The US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. They argue that this could create a dangerous power vacuum in the Middle East. Stock market sentiment is quite bullish at the moment, which makes equities more vulnerable to any disappointing news. While we are maintaining our positive 12-month view on global equities and high-yield credit in anticipation that global growth will rebound convincingly later this year, we are downgrading our tactical 3-month view to neutral. Ho Ho Ho After handing investors a sack of coal last Christmas, Santa was back to his true self this past holiday season. Global equities rose 3.4% in December, finishing the year off with a stellar fourth quarter which saw the MSCI All-Country World index surge by 8.6%. Five forces helped push stocks higher: 1) Receding trade tensions; 2) Diminished risks of a hard Brexit; 3) Reduced odds of a victory for Elizabeth Warren in the US presidential elections; 4) Liquidity injections by the Fed, ECB, and the People’s Bank of China; and arguably most importantly 5) Improved sentiment about the state of the global economy. Tarrified No More Trade tensions subsided sharply after China and the US reached a “Phase One” agreement. The deal prevented tariffs from rising on December 15th on $160 billion of Chinese imports. It also rolls back the tariff rate from 15% to 7.5% on about $120 billion in imports that have been subject to levies since September (Chart 1). Chart 1The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War In addition, the Trump Administration allowed the November 13th deadline on European auto tariffs to lapse. This suggests that the US is unlikely to impose tariffs under the Section 232 investigation of auto imports. The auto sector has been at the forefront of the global manufacturing slowdown, so any good news for that industry is welcome. To top it all off, the US House of Representatives ratified the USMCA, the successor to NAFTA, on December 19th. We expect it to be signed into law in the first quarter of this year. Brexit Risks Fading... Chart 2The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit Boris Johnson’s commanding victory in the UK elections has given him the votes necessary to push a withdrawal bill through parliament by the end of the month. The British government will then seek to negotiate a free trade agreement by the end of the year. A “no-deal” Brexit is unacceptable to the majority of British voters (Chart 2). As such, the Johnson government will have no choice but to strike a deal with the EU. ... While Trump Gains On the other side of the Atlantic, President Trump’s re-election prospects improved late last year despite (and perhaps because of) the ongoing impeachment process. There is an uncanny correlation between the probability that betting markets assign to a Trump victory and the value of the S&P 500 (Chart 3). Chart 3An Uncanny Correlation An Uncanny Correlation An Uncanny Correlation Chart 4Who Will Win The 2020 Democratic Nomination? Time For A Breather Time For A Breather It certainly has not hurt market sentiment that Elizabeth Warren’s poll numbers have been dropping recently (Chart 4). Warren’s best hope was to squeeze out Bernie Sanders as soon as possible, thereby leaving the far-left populist lane all to herself. That dream appears to have been dashed, which suggests that even if Trump loses, a centrist like Joe Biden could emerge as president. An Uneasy Truce It remains to be seen how President Trump’s decision to assassinate General Qassem Soleimani, a top Iranian commander, will affect the election outcome. A YouGov/HuffPost poll taken over the weekend revealed that 43% of Americans approved of the airstrike against Soleimani compared to 38% that disapproved.1 History suggests that the public’s patience for war will quickly wear thin if it results in American casualties or significantly higher gasoline prices. Neither side has an incentive to allow the conflict to spiral out of control. Foreign minister Mohammad Javad Zarif tweeted on Tuesday shortly after Iran lobbed missiles at two US military bases that Iran had “concluded” its retaliatory strike, adding that “We do not seek escalation or war.” Despite claims on Iranian public television that 80 “American terrorists” were killed in the attacks, no US troops were harmed. This suggests that the Iranians may be putting on a show for domestic consumption. The US economy is less vulnerable to spikes in oil prices than in the past. Nevertheless, plenty of things could still go wrong. BCA’s geopolitical team, led by Matt Gertken, has argued that the US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. This could create a dangerous power vacuum in the Middle East. There is also a risk that President Trump overplays his hand. Contrary to the President’s claims, Soleimani was quite popular in Iran (Chart 5). If Trump begins to mock the Iranian leadership’s feeble response, Iran will have no choice but to take more aggressive action. Chart 5Soleimani Was More Popular In Iran Than Trump Claims Time For A Breather Time For A Breather Chart 6US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past One thing that could embolden Trump is that the US economy is less vulnerable to spikes in oil prices than in the past. US oil output reached as high as 12.9 mm b/d in 2019, allowing the country to become a net exporter of oil for the first time in history (Chart 6). Any increase in oil prices would incentivize further domestic production, which would help bring prices back down. The US economy has also become less energy intensive – it takes less than half as much oil to produce a unit of GDP today than it did in the early 1980s. Finally, unlike in the past, the Fed will not need to raise rates in response to higher oil prices due to the fact that inflation expectations are currently well anchored. In fact, as we discuss below, we expect the Fed and other central banks to continue to provide a tailwind for growth over the course of 2020. The Fed’s “It’s Not QE” QE Program The jump in overnight lending rates in mid-September torpedoed the Federal Reserve’s efforts to shrink its balance sheet. Thanks to a steady stream of Treasury bill purchases since then, the Fed’s asset holdings have swelled by over $400 billion, reversing more than half of the decline observed since early 2018 (Chart 7). Chart 7Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Chart 8The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed has insisted that its latest intervention does not amount to a new QE program, stressing that it is buying short-term securities rather than long-dated bonds. In so doing, it is simply creating bank reserves, rather than seeking to suppress the term premium by altering the maturity structure of the private sector’s holdings of government debt. Nevertheless, even such straightforward interventions have proven to be powerful signaling tools. By growing its balance sheet, a central bank is implicitly promising to keep monetary policy very accommodative. It is worth remembering that the run-up in the NASDAQ in 1999 coincided with a significant balance-sheet expansion by the Fed in response to Y2K fears, which came on the heels of three “insurance cuts” in 1998 (Chart 8). Gentle Jay Paves The Way Chart 9Inflation Expectations Remain Muted Inflation Expectations Remain Muted Inflation Expectations Remain Muted In 2000, the Fed moved quickly to reverse the liquidity injection it had orchestrated the prior year. We do not expect such a reversal anytime soon. Moreover, unlike in 2000, when the Federal Reserve kept raising rates – ultimately bringing the Fed funds rate up to 6.5% in May 2000 – the Fed is likely to stay on hold this year. The Fed’s ongoing strategic policy review is poised to move the central bank even closer towards explicitly adopting an average inflation target of 2% over the course of a business cycle. Since inflation tends to fall during recessions, this implies that the Fed will seek to target an inflation rate somewhat higher than 2% during expansions. Realized core PCE inflation has averaged only 1.6% since the recession ended. Both market-based and survey-based measures of long-term inflation expectations remain downbeat (Chart 9). This suggests that the bar for raising rates this year is quite high. More Monetary Easing In The Euro Area And China Chart 10Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out The ECB resumed its QE program in November after a 10-month hiatus. While the current pace of €20 billion in monthly asset purchases is well below the prior pace of €80 billion, the central bank did say it would continue buying assets for “as long as necessary” to bring inflation up to its target. The language harkens back to Mario Draghi’s 2012 “whatever it takes” pledge, this time applied to the ECB’s inflation mandate. Not to be outdone, the People’s Bank of China cut the reserve requirement ratio by 50 basis points last week, a move that will release RMB 800 billion ($US 115 billion) of fresh liquidity into the banking system. Historically, cuts in reserve requirements have led to faster credit growth and ultimately, to stronger economic growth both in China and abroad (Chart 10). The PBOC has also instructed lenders to adopt the Loan Prime Rate (LPR) as the new benchmark lending rate. The LPR currently sits 20bps below the old benchmark rate (Chart 11). Hence, the PBOC’s order amounts to a stealth rate cut. Our China strategists expect further reductions in the LPR over the next six months. In addition, the crackdown on shadow bank lending seems to be subsiding, which bodes well for overall credit growth later this year (Chart 12). Chart 11China: Stealth Monetary Easing China: Stealth Monetary Easing China: Stealth Monetary Easing Chart 12Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing   Rising Economic Confidence Chart 13Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Chart 14The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn   At the start of 2019, nearly half of US CFOs thought the economy would be in a recession by the end of the year. Similarly, two-thirds of European CFOs and four-fifths of Canadian CFOs expected their respective economies to succumb to recession. Professional economists were equally dire (Chart 13). Households also became increasingly worried about a downturn. Google searches for “recession” spiked to near 2009-highs last summer (Chart 14). The mood has certainly improved since then. According to the latest Duke CFO survey, optimism about the economic outlook has increased. More importantly, CFO optimism about the prospects for their own firms has risen to the highest level in the 18-year history of the survey (Chart 15). Chart 15CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late Show Me The Money Going forward, global growth needs to accelerate in order to validate the improved confidence of CFOs and investors alike. We think that it will, thanks to the lagged effects from the easing in financial conditions in 2019, a turn in the global inventory cycle, a de-escalation in the trade war, easier fiscal policy in the UK and euro area, and re-upped fiscal/credit stimulus in China. For now, however, the economic data remains mixed. On the positive side, household spending is still robust across most of the world, a fact that has been reflected in the resilience of service-sector PMIs (Chart 16). Chart 16AThe Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) Chart 16BThe Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) Chart 17US Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Time For A Breather Time For A Breather Chart 18US Housing Backdrop Is Solid US Housing Backdrop Is Solid US Housing Backdrop Is Solid The US consumer, in particular, is showing little signs of fatigue. The Atlanta Fed GDPNow estimates that real personal consumption grew by 2.4% in the fourth quarter, having increased at an average annualized pace of 3% in the first three quarters of 2019. Both a strong labor market and housing market have buoyed US consumption. Payrolls have risen by an average of 200K per month for the past six months, double what is necessary to keep up with labor force growth. This week’s strong ADP release – which featured a 29K jump in jobs in goods-producing industries in December, the best since April – suggests that today’s jobs report will remain healthy. In addition, wage growth has picked up, particularly at the bottom of the income distribution (Chart 17). Residential construction has also been strong. Homebuilder sentiment reached the best level since June 1999 (Chart 18). Global Manufacturing: Too Early To Call The All-Clear The outlook for manufacturing remains the biggest question mark in the global economy. The US ISM manufacturing index dropped to 47.2 in December, its lowest level since June 2009. The composition of the report was poor, with the new orders-to-inventory ratio dropping close to recent lows. Chart 19Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM We would discount the ISM report to some extent. The regional Fed manufacturing indices have not been nearly as disappointing as the ISM (Chart 19). The Markit PMI, which tracks US manufacturing activity better than the ISM, clocked in at a respectable 52.4 in December, down only slightly from November’s reading of 52.6. Nevertheless, it is hard to be excited about the near-term outlook for US manufacturing, especially in light of Boeing’s decision to suspend production of the 737 Max temporarily. Most estimates suggest that the production halt will reduce real US GDP growth by 0.3%-to-0.5% in the first quarter. The euro area manufacturing PMI gave up some of its November gains, falling to 46.3 in December. While the index is still above its September low of 45.7, it has been under 50 for 11 straight months now. The UK and Japanese PMI also retreated. Chinese manufacturing has shown clearer signs of bottoming out. Despite dipping in December, the private sector Caixin manufacturing PMI remains near its 2017 highs. The official PMI published by the National Bureau of Statistics is less upbeat, but still managed to come in slightly above 50 in December. The production subcomponent reached the highest level since August 2018. Reflecting the positive trend in the Chinese economy, Korean exports to China rose by 3.3% in December, the first positive growth rate in 14 months (Chart 20). Taiwan’s exports have also rebounded. The manufacturing PMI rose above 50 in both economies in December. In Taiwan’s case, this was the first time the PMI moved into expansionary territory since September 2018. On balance, we continue to expect global manufacturing to recover in 2020. This is in line with our observation that global manufacturing cycles typically last three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 21). That said, the weakness in European and US manufacturing (at least judged by the ISM) is likely to give investors pause. Chart 20Some Positive Signs Emerging From Korea And Taiwan Time For A Breather Time For A Breather Chart 21A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle   Investment Conclusions We turned bullish on stocks in late 2018, having temporarily moved to the sidelines during the summer of that year. Global equities have gained 25% since our upgrade. We see another 10% of upside for 2020, led by European and EM bourses. Despite its recent gains, the real value of the MSCI All-Country World Index is only 3% above its prior peak in January 2018. The 12-month forward PE ratio of 16.3 is still somewhat lower than it was back then. The valuation picture is even more enticing if we compare equity earnings yields with bond yields, which is tantamount to computing a rough equity risk premium (ERP). The global ERP remains quite high by historic standards, especially outside the US where earnings yields are higher and bond yields are generally lower (Chart 22). Chart 22The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US Chart 23Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish   Nevertheless, sentiment is quite positive towards stocks at the moment (Chart 23). Elevated bullish sentiment, against the backdrop of ongoing uncertainty about the outlook for global manufacturing and an uneasy truce between the US and Iran, poses a near-term headwind to risk assets. As such, while we are maintaining our positive 12-month view on global equities and high-yield credit, we are downgrading our tactical 3-month view to neutral for the time being. We do not regard this as a major realignment of our views; we will turn tactically bullish again if stocks dip about 5% from current levels.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Ariel Edwards-Levy, “Here's What Americans Think About Trump's Iran Policy,” TheHuffingtonPost.com (January 6, 2020).   MacroQuant Model And Current Subjective Scores   Time For A Breather Time For A Breather Strategic Recommendations Closed Trades

Highlights An analysis on Indonesia is available below. We intend to maintain our long EM stocks position, initiated on December 19, as long as the MSCI EM equity index does not break below our stop point of 6% below current levels. Global trade will improve on a rate-of-change basis. Nevertheless, both money and bank asset impulses in China have already rolled over, and the credit impulse could relapse in the first half of 2020. As a result, the staying power of China’s recovery remains doubtful. For now, we continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Feature Chart I-1Investors Are Very Bullish On US Stocks Investors Are Very Bullish On US Stocks Investors Are Very Bullish On US Stocks EM share prices and currencies are at a crossroads. On one hand, some green shoots have recently emerged in Asia’s business cycle. On the other hand, global stocks are overbought and investor sentiment is very bullish, as evidenced by the record large net long position held by asset managers and leveraged funds in US equity indices futures (Chart I-1). The clash between these forces will define trading in EM risk assets in the coming weeks. If EM share prices and currencies consolidate their recent gains without a major relapse, it will signal that a sustainable rally lies ahead. Alternatively, if EM stocks and exchange rates drop considerably, it will indicate that improving investor sentiment and flows (technicals) rather than a durable recovery in corporate profitability (fundamentals) are what produced the recent rebound. We initiated a long position in EM stocks on December 19 and intend to maintain it unless the MSCI EM equity index breaks below our stop point of 1050, which is 6% below current levels. Green Shoots In Asia There are a number of green shoots beginning to emerge in Asia. December data point to a budding recovery in Asia’s business cycle: manufacturing PMIs rose in December in Korea, Taiwan and Singapore (Chart I-2). The measure was flattish in China and slightly down in Japan (Chart I-2, bottom two panels). Korean exports have begun recovering on a rate-of-change basis (Chart I-3, top panel). What’s more, the average of new and backlog orders rose for Chinese NBS and Taiwanese manufacturing PMIs in the past couple of months (Chart I-3, middle and bottom panels). Chart I-2Green Shoots In Asia Green Shoots In Asia Green Shoots In Asia Chart I-3Asian Exports To Improve On A Rate-Of-Change Basis Asian Exports To Improve On A Rate-Of-Change Basis Asian Exports To Improve On A Rate-Of-Change Basis   Chart I-4DRAM And NAND Prices Have Improved Post December 15 Memory Prices Still Signal Sluggish Semiconductor Demand DRAM And NAND Prices Have Improved Post December 15 Memory Prices Still Signal Sluggish Semiconductor Demand DRAM And NAND Prices Have Improved Post December 15 Finally, following the announcement of the US-China phase one trade deal on December 13, semiconductor NAND and DRAM prices rose (Chart I-4). It seems that the phase one trade deal has boosted sentiment not only among investors worldwide but also among business executives in Asia. Even though US ISM and European PMI manufacturing data remain lackluster, we continue to emphasize that what matters for – and is an indication of – EM growth is China’s and emerging Asia’s manufacturing cycles. In a nutshell, we put much more weight on Asian rather than DM manufacturing data when gauging trends in EM stocks and currencies. The marginal improvement in Asian manufacturing provides veracity to the recent rally in EM equities and currencies. Chart I-5China: Credit And Fiscal Versus Broad Money Impulses China: Credit And Fiscal Versus Broad Money Impulses China: Credit And Fiscal Versus Broad Money Impulses China’s credit and fiscal impulse continues to point up (Chart I-5, top panel), also supporting the notion that global trade will be improving on a rate-of-change basis. In addition, we have entered the second year of the global trade/manufacturing contraction, and the base effects are much more benign – Asian exports started shrinking in late 2018. Hence, odds are that global trade will be contracting at a reduced pace from a year ago, and by mid-2020 may even post slightly positive growth. Looking beyond the near term, however, the Chinese money and bank asset impulses have already rolled over (Chart I-5, middle and bottom panels). Given that they have often led the credit and fiscal spending impulse, odds are that the latter will roll over in the coming months. If this is indeed the case, the improvement in China’s growth will be short-lived. What does it all mean? Investors should play this EM rally with tight stop points. The near-term growth outlook is benign, but the sustainability of this recovery is not yet assured. Having rebounded in recent months, EM financial markets could soon start looking through the current improvement in economic conditions in China and could become preoccupied with its growth outlook in the second half of 2020. Market Signals Are Mixed Apart from China’s money and credit impulses, we are watching numerous market signals to corroborate or reject the hypothesis of a durable recovery in both China’s business cycle and global trade. Several of these market signals have not yet confirmed this hypothesis. Chinese and Korean government bond yields have drifted lower in recent weeks, a phenomenon that is typically associated with weakening growth in China and global trade (Chart I-6). Apart from semiconductor stocks, global cyclical sectors have not outperformed the global equity index. Specifically, global industrials, materials, autos, as well as freight and logistics, have been flat to down versus the global aggregate stock index (Chart I-7). Chart I-6Yellow Flags From Bond Yields In China And Korea Yellow Flags From Bond Yields In China And Korea Yellow Flags From Bond Yields In China And Korea Chart I-7Global Cyclicals Have Not Outperformed Yet Global Cyclicals Have Not Outperformed Yet Global Cyclicals Have Not Outperformed Yet Chart I-8No Breakout In Industrial Metals Prices No Breakout In Industrial Metals Prices No Breakout In Industrial Metals Prices Industrial metals in general – and copper prices in particular – have not yet broken out (Chart I-8). Correspondingly, the broad trade-weighted US dollar has corrected sharply but has not yet broken down. So far, the greenback’s retrenchment is more consistent with a correction rather than a bear market. A breakout in industrial metals prices and a breakdown in the broad trade-weighted dollar would confirm that China’s growth and global trade have entered a period of lasting expansion. Finally, our Risk-On/Safe-Haven currency ratio1 has so far been inconclusive. This ratio strongly correlates with the EM equity index (Chart I-9). Barring a major breakout in this indicator, the medium- and long-term outlook for EM stocks will remain opaque. Chart I-9Cyclical Versus Safe-Haven Currencies And EM Stocks Cyclical Versus Safe-Haven Currencies And EM Stocks Cyclical Versus Safe-Haven Currencies And EM Stocks Bottom Line: While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. In the coming weeks, price actions in EM financial markets will reveal if EM stocks and currencies have entered a genuine and lasting bull market or if their recent rebound has been driven by euphoria surrounding the US-China trade deal. Asset Allocation: EM Versus DM We recommended buying EM stocks on December 19 but we stopped short of outright upgrading EM versus DM stocks. We are seeking confirmation from the market signals listed above before upgrading our allocation to EM within a global equity portfolio from underweight to overweight. While some global growth-sensitive markets have broken out, signposts from other markets are not yet flashing green. First, EM per-share earnings (EPS) continue to underperform DM EPS in both local and common currency terms (Chart I-10). So long as EM EPS lag DM peers, EM equities, currencies and credit markets will trail their DM counterparts. Second, growth woes in EM are not limited to China or global trade. Domestic demand in many EM economies outside China, Korea and Taiwan continues to slump (Chart I-11, top and middle panel). Besides, core inflation has fallen to a record low, dampening corporate profits (Chart I-11, bottom panel). Chart I-10EM EPS Continues To Lag DM EM EPS Continues To Lag DM EM EPS Continues To Lag DM Chart I-11EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak EM Ex-China, Korea and Taiwan: Domestic Demand Is Very Weak Chart I-12EM Ex-China, Korea And Taiwan: Need Lower Lending Rates EM Ex-China, Korea And Taiwan: Need Lower Lending Rates EM Ex-China, Korea And Taiwan: Need Lower Lending Rates Even though EM central banks have reduced interest rates, in many economies lending rates in real, inflation-adjusted terms have risen rather than declined (Chart I-12). The basis is that inflation has dropped more than lending rates. High lending rates explain why credit demand is poor. In a nutshell, many EM economies require much more easing to recover. Third, EM equity valuations are not more attractive than DM ones. While EM stocks are cheaper compared to their US counterparts, they are more expensive versus euro area equities. Overall, EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts (Chart I-13). In short, there is no strong valuation case for favoring EM versus DM. Finally, we have been speculating since March 2019 that the absolute and relative performance of EM stocks is more likely to resemble their profiles in 2011-14 rather than in 2016-17. This thesis has so far been playing out. Chart I-14 illustrates an overlay of share prices in EM and DM as well as EM’s relative equity performance to DM. The overlay compares the period from 2017 to present with the one from 2011-14. Chart I-13EM Equities Command Neutral Valuations EM Equities Command Neutral Valuations EM Equities Command Neutral Valuations Chart I-14EM And DM Stocks Are Tracking Their 2012 Profiles EM And DM Stocks Are Tracking Their 2012 Profiles EM And DM Stocks Are Tracking Their 2012 Profiles   DM share prices rallied substantially in 2011-14 but EM equities, currencies and credit markets as well as commodities prices have been flat to down. As a result, EM massively underperformed DM during that global bull market (Chart I-14, bottom panel). EM equities command a neutral valuation both in absolute terms and relative to their DM counterparts. That occurred because EM domestic fundamentals were poor back in 2011-14 and China’s growth stabilized but failed to stage a meaningful recovery (please refer to the bottom panel of Chart I-2 on page 2). Bottom Line: We continue to recommend underweighting EM equities, currencies and credit markets versus their DM counterparts. Review Of Some Of Our Open Positions We are closing the following strategic position: short EM equities / long US 30-year Treasurys. In the past 10 years, US bonds have done much better than EM equities on a total return basis in common currency terms (Chart I-15). This position had been profitable till October but our gains have evaporated since then and we are closing it flat. We are booking a 8.3% gain on long Asian / short US semiconductor stocks, a position initiated on June 13, 2019. Asian semis stocks have already rallied a lot and potential weakness in the US dollar will help US semis while cap upside in Asian semis stocks. We are reiterating the long gold / short oil and copper trade recommended on July 11, 2019 (Chart I-16). In any feasible global macro scenario, gold will continue outperforming oil and copper. The basis is that global real interest rates will stay low. Chart I-15Close Short EM Equities / Long US 30-Year Treasurys Position Close Short EM Equities / Long US 30-Year Treasurys Position Close Short EM Equities / Long US 30-Year Treasurys Position Chart I-16Stay With Long Gold / Short Oil And Copper Trade Go Long Gold / Short Copper And Oil Stay With Long Gold / Short Oil And Copper Trade Go Long Gold / Short Copper And Oil Stay With Long Gold / Short Oil And Copper Trade   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Struggling Under High Real Rates Indonesian commercial banks have been the only leg holding up the Indonesian stock market (Chart II-1). However, their cyclical outlook is uninspiring as their share prices risk selling off. The critical issue is that lending rates in the Indonesian economy are too high for borrowers. Hence, banks are facing a lose-lose dilemma: Either bank lending rates will have to drop, squeezing Indonesian commercial banks’ net interest rate margins, or non-performing loans (NPL) will mushroom as debtors cannot afford such high borrowing costs. In both cases, bank profits will suffer. Both of these scenarios are bearish for commercial banks’ share prices. Given that banks account for 47% of the overall MSCI Indonesia stock market capitalization and the rest of the equity market has been struggling due to worsening corporate profitability, the outlook for this bourse is downbeat. We continue recommending underweighting Indonesian stocks within an EM equity portfolio. The Indonesian economy is facing strong deflationary pressures. Both headline and core consumer price inflation have dropped to the bottom of the central bank’s inflation target band (Chart II-2, top panel). Meanwhile, corporate pricing power as measured by the GDP deflator has weakened significantly (Chart II-2, bottom panel). Chart II-1Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Indonesia: Financials Are The Only Sector Rallying Chart II-2Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting Indonesia: Inflation Is Undershooting   Disinflationary forces have caused the nation’s nominal GDP growth to plummet dangerously below bank lending rates (Chart II-3). This makes it more difficult for borrowers to service their debt and will ensure rising NPL in the banking system. Crucially, it also discourages new credit demand. The top panel of Chart II-4 shows that bank loan growth is decelerating. Chart II-3Borrowing Costs Are Excessive Borrowing Costs Are Excessive Borrowing Costs Are Excessive Chart II-4Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates Policy Rate Cuts Did Not Translate To Much Lower Bank Lending Rates     Although the central bank has cut its policy rate by 100 basis points in 2019, bank lending rates dropped by only 17 basis points and currently stand at 10.2% in nominal terms (Chart II-4, middle panel). In real (inflation-adjusted) terms, bank lending rates remain very elevated (Chart II-4, bottom panel). Consistent with excessive borrowing costs, both the consumer and business sectors are struggling: Retail sales (excluding vehicles) volume growth is hovering around zero (Chart II-5, top panel). Retail sales of specific items are contracting (Chart II-5, middle panel). Meanwhile, motorcycle and car unit sales are shrinking (Chart II-5, bottom panel). Industrial activity is also lackluster. Freight traffic is very weak, capital goods imports are contracting and domestic cement consumption remains anemic (Chart II-6). Consistently, EBITDA of non-financial publically-listed companies is flirting with contraction (Chart II-7). Chart II-5A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector A Major Deceleration In The Consumer Sector Chart II-6Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued Indonesia: Industrial Activity Is Subdued   Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. The government is focused on keeping the budget deficit in check and no major fiscal stimulus should be expected. Therefore, monetary policy/lower interest rates should be the only source of stimulus. Overall, the Indonesian economy needs much lower lending rates and a fiscal boost. With rate cuts by the central bank failing to translate into much lower bank lending rates, the sole viable option for authorities is to force commercial banks to reduce their lending rates. This strategy appears to be already in place, as demonstrated by President Joko Widodo’s November speech where he explicitly encouraged commercial banks to lower their lending rates. Such moral suasion or regulatory push by the authorities will likely intensify in the coming months. Doing so, however, will squeeze commercial banks’ net interest rate margins and hit banks’ profits (Chart II-8). Alternatively, if banks refuse to drop their lending rates meaningfully, their NPL will proliferate, damaging their profits.  Chart II-7Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Indonesia: Corporate Profits Are About To Contract Chart II-8Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall Commercial Banks' Net Interest Margins Will Fall   Importantly, Indonesian commercial banks are expensive with a PBV ratio of 2.7; therefore, banks’ share prices will be extremely sensitive to negative news regarding their profit growth outlook. Investment Recommendations Chart II-9Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Indonesian Stocks Relative To The EM Equity Benchmark Equity investors should continue underweighting this bourse. Chart II-9 shows that relative equity performance versus EM is teetering. Our short position in the rupiah versus the US dollar remains in place but we are instituting a stop point at 13500 USD/IDR to manage risks. The basis for rupiah depreciation is as follows: In an economy that is facing unbearable high real borrowing costs and no willingness or ability to stimulate fiscally, the currency will likely serve as an adjustment valve. It will probably depreciate to boost exports and encourage import substitution as well as generate inflation. Critically, when the economy is stumbling due to excessive real interest rates, the latter do not typically engineer currency appreciation. In fact, the currency tends to depreciate rather than appreciate in cases when the return on capital is below borrowing costs. Indonesia fits this profile very well. Consistent with our expectations for currency depreciation, we continue underweighting Indonesian domestic bonds and sovereign credit within their respective EM benchmarks. We will alter this stance if our stop on the rupiah is triggered. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1    Average of CAD, AUD, NZD, BRL, MXN, RUB, CLP & ZAR total return indices relative to average OF JPY & CHF total return indices. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Incoming economic data suggests that China’s economy is in the process of bottoming, but also that the intensity of a recovery is likely to be more muted than it has been during past economic cycles. Recent Chinese equity market performance is consistent with a bottoming in the economy: cyclicals are outperforming defensives, and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark. However, there is more potential upside for investable than domestic stocks, and the gains in both markets may be front loaded in the first half of the year. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, several indicators now suggest that China’s economy is in the process of bottoming, but these indicators also imply that the intensity of a recovery in economic activity is likely to be more muted than it has been during past economic cycles. We see this as consistent with the views presented in our December 11 Weekly Report,1 which laid out four key themes for China and its financial markets for 2020. 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 Within financial markets, recent developments are also consistent with the view that Chinese economic activity will modestly accelerate and that a Sino-American trade truce will last until the US presidential election in November 2020. Chinese stocks have rallied both in absolute terms and relative to global equities over the past month, and cyclical stocks are clearly outperforming defensives on an equally-weighted basis in both markets. The RMB has also appreciated modestly, with USD-CNY having now durably fallen back below the 7 mark. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark, with the caveat that we expect more potential upside for investable than domestic stocks and the gains in both markets may be front loaded in the first half of the year. We expect modest further gains in the RMB over the coming few months, as we see the PBoC is unwilling to allow rapid appreciation. In reference to Tables 1 and 2, we provide several detailed observations below concerning developments in China’s macro and financial market data: Chart 1A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway On a smoothed basis, the Bloomberg Li Keqiang index (LKI) rose in November, driven largely by an improvement in electricity output (Chart 1). While our alternative LKI is weaker than Bloomberg’s measure, we see the improvement in the latter as a sign of a bottoming process for growth that is now underway (Bottom panel, Chart 1). Our leading indicator for the Li Keqiang index was essentially flat in November, with the large gap that has persisted between the degree of monetary accommodation and money & credit growth still present. There was a notable improvement in the Bloomberg Monetary Conditions Index (MCI) in November, but this can be attributed to a surge in headline inflation (which depressed real interest rates). This underscores that the ongoing uptrend in our LKI leading indicator is modest, and that an improvement in economic activity this year is thus unlikely to be sharp or intense. With the pace of pledged supplementary lending (PSL) injections and Tier 1 housing price appreciation as exceptions, all of the housing market data series that we track in Table 1 deteriorated in November. On a smoothed basis, residential housing sales rose at a slower pace and the previous surge in housing construction waned, in line with our expectation (Chart 2). House prices have continued to deviate from housing sales; deteriorating affordability and tight housing regulations have contributed to this divergence. Although funding from the PBoC’s PSL program improved in November, even further funding assistance is likely necessary in order to expect a strong uptrend in housing sales given the affordability and regulatory headwinds (Bottom panel, Chart 2). Both China’s Caixin and official manufacturing PMIs continue to signal positive signs for Chinese economic activity. While the Caixin PMI fell slightly in December, it stayed in expansionary territory for the fifth consecutive month. The official PMI also provided positive signs: the overall index remained above 50 for the second month, the production component rose further into expansionary territory, and the new export orders moved above the 50 mark. All told, China’s PMI data now clearly suggests that a bottoming in China’s economic growth is underway. Although the overall PMI data is sending a positive signal, Chart 3 highlights two series that are somewhat less positive. First, while the import component of the official PMI is rising, it is lagging other key sub-components and remains below 50. In addition, the PMI for small enterprises, which led the early phase of the 2016 recovery in the official PMI, has not meaningfully changed over the past few months. For now, these series suggest that a recovery in growth is likely to be muted compared with previous episodes over the past decade. Chart 2More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales Chart 3Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery In USD terms, China’s equity markets (both investable and domestic) have rallied more than 8%-9% in absolute terms over the past month. In relative terms, both investable and A-share markets have also outperformed the global benchmark. It is notable that the relative performance trend of Chinese investable stocks has broken clearly above its 200-day moving average, which is the first time since the trade talks collapsed in May of last year (Chart 4A). The strong rally in China’s stock prices over the past month, particularly in the investable market, largely reflect the likely signing of a trade truce between the US and China. In our view, more accommodative monetary and fiscal support in 2020, as well as an ongoing truce, provide a sound basis to overweight China’s stocks within a global equity portfolio over both a tactical and cyclical horizon. However, we expect that China’s investable market has more upside potential than its domestic peer, given how much further the former fell in 2019.    From an equity sector perspective, the most notable development over the past month is that cyclical sectors have outperformed defensives in both the investable and domestic markets and have broken above their respective 200-day moving averages (Chart 4B). Among cyclical sectors, industrials, energy, consumer discretionary, especially materials and telecommunication services, have all contributed to cyclical outperformance over the past month. The outperformance of cyclical sectors is strongly consistent with continued outperformance of Chinese stocks versus the global average, and strengthens our conviction that investors should be overweight Chinese markets within a regional equity portfolio. China’s 3-month repo rate fell meaningfully over the past week, in response to a 50 bps cut in the reserve requirement ratio (RRR). The decline has merely returned the repo rate back to the level that prevailed on average in 2019, but it does underscore the PBoC’s desire to modestly ease liquidity on a net basis. We will be presenting a Special Report on China’s government bond market later this month, but for now, our view remains that easier monetary policy is unlikely to materially impact Chinese government bond yields this year, unless the PBoC decides to target sharply lower interbank repo rates (which is not our expectation). Chart 4AThe Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal Chart 4BThe Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery China’s onshore corporate bond spread has risen slightly over the past month alongside falling corporate yields. Despite persistent concerns of rising defaults on China’s onshore corporate bonds, the overall default rate remains quite low compared with those in developed economies, and China’s corporate bond market will benefit from even a modest improvement in economic growth this year. As such, we expect a continued uptrend in China’s onshore corporate bond total return index, and would favor onshore corporate over duration-matched Chinese government bonds. Chart 5A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely The RMB has gained more than 1.35% versus the U.S. dollar over the last month, which caused USD-CNY to durably break below 7 (Chart 5). The rise was clearly in response to news that the US and China will agree to a trade truce, and we expect a further modest downtrend in USD-CNY as China’s economy continues to improve. Investors should note that we are likely to close our long USD-CNH trade (currently registering a gain of 1%) following the signing of the Phase One deal on Jan 15, given that we opened the trade as a currency hedge for our overweight towards Chinese stocks (denominated in USD terms). As such, upon the signing of the deal, we would recommend that investors favor Chinese stocks versus the global benchmark in unhedged terms.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Feature Recommended Allocation Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Since BCA published its 2020 Outlook,1 and the December GAA Monthly Portfolio Update,2 nothing has happened to make us fundamentally change our views. We see the global manufacturing cycle rebounding over the coming quarters, but major central banks remaining dovish. This combination of accelerating growth and easy monetary policy should be positive for risk assets. We accordingly continue to recommend an overweight on equities versus bonds, prefer the more cyclical euro zone and EM equity markets over the US, and selectively like credit (particularly the riskier end of the US junk bond universe). In the 2020 Outlook, we laid out a series of milestones that would indicate how our scenario is playing out: whether we need to reconsider it, or whether we should be adding further to risk (Table 1). Here is how those milestones are progressing. Table 1Milestones For The 2020 Outlook Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Chinese growth. Total Social Financing picked up in November (CNY1.75 trillion versus CNY619 billion the previous month) and the most recent hard data (notably retail sales and industrial production) showed improvement. But the momentum of credit creation and activity generally remain weak (Chart 1). We expect that Chinese growth will begin to accelerate in early 2020, due to the lagged effect of monetary stimulus in the first half of last year, and easier fiscal policy. Moreover, December’s annual Central Economic Work Conference pointed to greater government emphasis on growth stability.3 The clampdown on shadow banking also seems to be easing (Chart 2). However, we need to see further signs of Chinese growth accelerating before, for example, we become more bullish on Emerging Markets and commodities. Chart 1Chinese Credit And Activity Remain Weak Chinese Credit And Activity Remain Weak Chinese Credit And Activity Remain Weak Chart 2Clampdown On Shadow Banking Easing? Clampdown On Shadow Banking Easing? Clampdown On Shadow Banking Easing? Trade war. The last-minute agreement to cancel the December 15 rise in US tariffs on Chinese imports represents the “ceasefire” we expected, rather than “phase one” of a more profound agreement. It is still unclear whether previous tariffs will be rolled back (Chart 3). China’s supposed promise to increase imports of US agricultural products from $10 billion a year to $40 billion-$50 billion seems unrealistic. Progress on more fundamental topics such as China’s subsidies for state-owned companies seems far off. For now, President Trump has done enough to minimize the negative impact on the US economy in an election year. But there remains a possibility that trade war reemerges as a risk during 2020. Chart 3How Far The Rollback? How Far The Rollback? How Far The Rollback? Progress against these milestones suggests that our current asset allocation recommendation structure – moderately risk-on, but with hedges against downside risk – is appropriate for now. Global growth. Data confirming the rebound in the manufacturing cycle remain mixed. Economic surprises have generally been positive in the euro zone, but have slipped in the US and Japan, and remain soft in the Emerging Markets (Chart 4). In Germany, the manufacturing PMI slipped back to 43.7 in December, but the Ifo and ZEW surveys both rebounded (Chart 5). There is, however, still little sign that the weakness in manufacturing is spilling over into consumption and services. In Germany, unemployment remains at a record low and wages are strong. In the US, wage growth continues to trend up, and there is no indication in the weekly initial claims data that companies are starting to lay off workers at more than the seasonally normal pace (Chart 6). Market indicators of the cycle are also showing some positive signs. Among commodities, the price of copper – the most cyclical metal – has begun to rise. Chinese cyclical stocks are outperforming defensives. But the US dollar has not yet showed any significant depreciation (Chart 7). Chart 4Economic Surprises Mixed Economic Surprises Mixed Economic Surprises Mixed Chart 5Germany Showing Signs Of Bottoming Germany Showing Signs Of Bottoming Germany Showing Signs Of Bottoming   Chart 6No Problems In The Labor Market No Signs Of Weakening Labor Market No Problems In The Labor Market No Signs Of Weakening Labor Market No Problems In The Labor Market Chart 7Some Positive Signs From The Markets Some Positive Signs From The Markets Some Positive Signs From The Markets     US politics. President Trump’s approval rating has picked up slightly – we warned that its slipping might cause him to get aggressive on trade or foreign policy (Chart 8). Markets might worry at the possibility of “President Warren” given her focus on increased regulation of industries such as finance, energy, and technology. But she has fallen a little in the polls. Even in liberal California (where the primary will be unusually early next year – March 3), she is only level with Biden and Sanders in opinion polls. Our geopolitical strategists see US politics as one of the key geopolitical risks this year,4 but the risk seems subdued for now. Chart 8Trump’s Approval Rating Stable To Rising Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones Fed tightening. Expansions usually end when inflation rises, either causing the Fed to raise rates to choke it off, or with the Fed ignoring the inflation and allowing debt and asset bubbles to form. Any signs, therefore, that inflation, or inflation expectations, are rising would signal that we are truly in the “end game”. For now, there are no such signs. US inflation is likely to soften over the next six months, as a result of the economic slowdown and strong dollar. And TIPS breakevens imply the market believes the Fed will miss its inflation target by an average of 80-90 BPs a year over the next decade (Chart 9). The Fed is likely to sound very dovish over the coming year. The review of its monetary policy framework, probably to be announced in July, may result in some sort of “catch-up” policy: under this, if inflation undershoots the Fed’s target, the target automatically rises the following year.5 Its efforts to support the repo market, including short-term Treasury securities purchases of $60 billion a month, will increase the Fed’s balance-sheet, and represent a “mini-QE” (Chart 10). The Fed is likely to be reluctant to turn more hawkish ahead of the presidential election. These dovish moves – and continued accommodative policies from the ECB and Bank of Japan – mean that monetary policy will be supportive for risk assets throughout 2020. Chart 9Inflation Remains Subdued Inflation Expectations Driven By Oil Inflation Remains Subdued Inflation Expectations Driven By Oil Inflation Remains Subdued These milestones suggest, therefore, that our current asset allocation recommendation structure – moderately risk-on, but with hedges (long cash and gold) against downside risk – is appropriate for now. Chart 10A "Mini-QE"? A Mini-"QE"? A Mini-"QE"? Equities: We shifted last month to an underweight on US equities, with an overweight on the euro zone, and neutral on Emerging Markets. The US tends to underperform during upswings in the global manufacturing cycle (Chart 11). Europe looks attractive because of its heavy weighting in sectors we like such as Financials, Autos and Capital Goods. Europe’s returns will also be boosted by the appreciation in the euro and pound that we expect (our equity recommendations assume no currency hedging). For EM, we would turn more positive if we saw a clear pickup in Chinese credit and economic growth. Chart 11US Underperforms When Growth Picks Up US Underperforms When Growth Picks US Underperforms When Growth Picks Chart 12Fed Won't Cut As The Market Expects Fed Won't Cut As The Market Expects Fed Won't Cut As The Market Expects   Fixed Income: Our positive view on global growth implies that long-term rates will rise. We see the US Treasury 10-year yield reaching 2.5% by mid-2020. The market still expects the Fed to cut rates once over the next 12 months. If it stays on hold, as we expect, that slight hawkish surprise would be compatible with a moderate rise in rates (Chart 12). Core euro zone rates might rise by a little less, perhaps by 30-40 BPs, and Japanese government bond yields by 10-15 BPs. We, therefore, continue to recommend a small underweight on duration and an overweight on TIPS which look particularly cheaply valued. Within credit, our preferences are for European investment grade (not as expensive as in the US, and with the ECB buying corporate debt again) and the lower end of the US junk-bond universe (since CCC-rated bonds missed out on 2019’s rally). In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued, and with speculative positions long the dollar. Currencies: In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued (Chart 13), and with speculative positions long the dollar (Chart 14). But its performance is likely to vary depending on the currency pair. Our FX strategists expect the dollar to weaken to 1.18 against the euro and 1.40 against the pound over the next 12 months, and even more against currencies such as the NOK, SEK, and AUD.6 But the dollar is likely to strengthen against the yen (an even more counter-cyclical currency) and against currencies in EM, where central banks will continue to cut rates and inject liquidity aggressively to support their economies. Chart 13Dollar Looks Expensive... Dollar Looks Expensive... Dollar Looks Expensive... Chart 14...And Speculators Are Long Monthly Portfolio Update: Counting The Milestones Monthly Portfolio Update: Counting The Milestones     Commodities: Supply in the oil market remains tight, with OPEC deepening its production cuts to 1.7 million barrels/day. The crude oil price was held down in 2019 by weakening demand, which should recover along with the cycle in 2020 (Chart 15). Our energy strategists expect Brent to average $67 a barrel in 2020 (compared to $66 now), with WTI $4 lower. Metal prices could rise in 2020 as Chinese growth recovers and the US dollar depreciates – the two most important factors that drive them (Chart 16). Given the uncertainty over both, we remain neutral for now, but would turn more positive (including on commodity-related assets, such as Australian or EM equities) if we see clear signs of their moving in the right direction. We see gold as a good downside hedge in a world of ultra-low interest rates, especially since central banks may allow inflation to overshoot over the coming years. Chart 15Supply/Demand Balance Points To Higher Oil Price Markets Will Tighten In 2020 Supply/Demand Balance Points To Higher Oil Price Markets Will Tighten In 2020 Supply/Demand Balance Points To Higher Oil Price Chart 16Metals Are Driven By The Dollar And China Metals Are Driven By The Dollar And China Metals Are Driven By The Dollar And China   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   Footnotes 1 Please see "Outlook 2020: Heading Into The End Game," dated 22 November 2019, available at bca.bcaresearch.com. 2 Please see "GAA Monthly Portfolio Update: How To Position For The End Game," dated 2 December 2019, available at gaa.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Year-End Tactical Upgrade," dated 18 December 2019, available at cis.bcaresearch.com 4 Please see Geopolitical Strategy "Strategic Outlook: 2020 Key Views: The Anarchic Society," dated 6 December 2019, available at gps.bcaresearch.com 5 For example, if the Fed's inflation target is 2% but inflation is only 1.7% one year, the target would automatically rise to 2.3% the following year. 6 Please see Foreign Exchange Strategy, "2020 Key Views: Top Trade Ideas," dated December 13, 2019, available at fes.bcaresearch.com GAA Asset Allocation