Asia

Highlights Odds are that the recently improved access to financing will allow property developers to boost construction volumes modestly in the coming months. Yet, the outlook for new credit origination and government tolerance of another credit binge is highly uncertain. For now, the completion of previously launched projects will help construction-adjacent industries in the short run. However, these activities will consume real estate developers’ cash augmenting both their liquidity needs and financial vulnerability. That is a basis to underweight the Chinese real estate sectors within both the Chinese MSCI investable universe and the onshore A-share indexes. Feature The emergent divergence among Chinese property sales, starts and completions constitutes an exceptionally bizarre phenomenon. The gaps between these three indicators are currently unprecedented (Chart I-1). Understanding these divergences is critical to correctly gauging the outlook for the Chinese real estate market. This report aims to assess the growth outlook of these three variables. Odds are that these gaps will narrow going forward. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions (Chart I-2). Chart I-1An Unprecedented Divergence… The Unprecedented Divergence The Unprecedented Divergence Chart I-2…But A Convergence Looms Convergence Ahead Convergence Ahead   In terms of the strength of construction activity in the Chinese property market, the real estate developers’ access to funding has been and remains the key. Over the next three to six months, the Chinese property market is likely to be characterized by a contraction in floor space sold, a considerable relapse in floor space starts, and a rebound in floor space completions. For now, we reckon the improved access to financing in recent months should help property developers to boost construction volumes modestly in the coming months (Chart I-3). Chart I-3Construction Activity Will Modestly Improve In The Coming Few Months Further Credit Easing Will Likely Lead To Rising Construction Activity Further Credit Easing Will Likely Lead To Rising Construction Activity That said, the current round of credit stimulus has probably been front-loaded in the first quarter, and property developers’ access to funding will begin to deteriorate again going forward. This will weigh on their ability to raise construction volumes materially. Understanding The Construction Cycle In China Floor space sold, starts and completions generally move in tandem. Specifically, strong sales lead rising starts, which then with a time lag result in increased completions. However, over the past 15 months, the growth rate of property starts has accelerated to over 20%, while sales have mildly contracted and floor space completions have been shrinking dramatically (Chart I-2). The key reason for these divergences has been the considerable financing difficulties facing property developers. Tighter monetary policy and credit beginning in late 2016 severely impaired developers’ ability to raise funds. This made Chinese real estate developers desperate for any source of possible revenue or financing. Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell and get cash at a time when credit was tight.  Property developers were also aiming to conserve cash flow amid tight credit. After investing 25% of the total investment required for a property project (excluding the value of the land), they received a presale permit from the authorities. The permits allowed them to sell housing units in advance. Home-buyers had to pay at least 30% of the total property value at the time they signed the presale contract. This way, developers were able to obtain both deposits and advance payments1 (Chart I-4). This was a welcome addition to scarce financing last year. After this phase, property developers then slowed their investment in construction, installation and equipment purchases – because these would consume precious, limited cash. This depressed construction activity has resulted in a material contraction in floor space completed (Chart I-5). Chart I-4Developers’ Funding Has Improved Due To Deposits & Advanced Payments Rising Funding From Deposits And Advance Payments Rising Funding From Deposits And Advance Payments Chart I-5   Bottom Line: Launching new projects and pre-selling housing units while shrinking construction enabled Chinese real estate developers to stay afloat last year amid tight access to credit. What Does This Mean? There are two important implications related to this unprecedented divergence among property sales, starts and completions. The first is that raising funds via launching property starts along with shrinking completions has resulted in a significant increase in Chinese property developers’ liabilities. This is a form of borrowing money for property developers, and it has been occurring on top of very poor financial health. Specifically, Chinese real estate developers’ debt-to-equity ratio is currently above 4, and continues to surge (Chart I-6). Further, in 2018, 54 out of 131 Chinese property developers had negative free cash flow. This scheme of raising funding via new launches along with postponing building and completions is becoming unsustainable. The divergence between surging property starts and contracting completions suggests that real estate developers have raised funds through selling more uncompleted buildings instead of completed properties (Chart I-7, top panel). Chart I-6Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chinese Property Developers Are Very Leveraged Chart I-7A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings A Big Increase In Sales Of Uncompleted Buildings   Specifically, some 87% of total residential floor space sold in the past 12 months has been sold in advance, much higher than the approximate 77% total recorded in the years prior to 2018 (Chart I-7, bottom panel). The second important implication is that property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. Chinese real estate developers are facing massive funding requirements this year. Developers need considerable amounts of funding this year to speed up their construction activities on delayed projects (launched but not completed ones). It generally takes about two years for real estate developers to complete a construction project and deliver the presold properties. Developers had already slowed their construction progress last year. They must accelerate the pace this year to ensure deliveries are made on time. Developers also need to roll over or repay significant amounts of debt coming due in 2019. On the whole, they have issued nearly RMB3.9 trillion of bonds so far, with most in the three- to five-year duration. Chart I-3 on page 2 shows that further improvements in credit flows in the economy will likely lead to ameliorating construction activity. Credit easing has allowed developers to raise funds through bank loans, bond issuances (both domestic and overseas) and other forms of borrowing (Chart I-8). Property developers’ ability to raise financing will determine the strength of property construction activities in China going forward. As a result, real estate investment in construction, installation and equipment purchases have all ameliorated in recent months (Chart I-9). This reflects a true pickup in real estate construction activities since the beginning of this year. Chart I-8Marginal Credit ##br##Easing Marginal Credit Easing Marginal Credit Easing Chart I-9   However, whether or not this latest improvement develops into full-fledged recovery is contingent on credit flows in the economy in general, and property developers’ access to financing in particular. If the overflow of credit decelerates after the massive binge that took place in the first quarter, it will weigh on construction activity. If the first-quarter credit binge persists, Chinese property developers will likely be able to raise sufficient funds to speed up property completions and roll over their maturing debt this year. In this scenario, construction activity will gather speed, facilitating a recovery in the overall economy.  At the current juncture, it is impossible to make a definite conclusion. The outlook for new credit flows and government tolerance of another credit binge is highly uncertain. On the one hand, the Politburo last month reiterated that China will push forward structural deleveraging and prevent speculation in the property market. Preliminary credit flow numbers for April appear to be very weak, not confirming blockbuster credit in the first quarter. Besides, the banking regulator has renewed pressure on banks to recognize non-performing loans and provision for them.2 This will curb banks’ ability to originate new loans and buy corporate bonds. On the other hand, an escalation of tensions between China and the U.S. and the uncertainty it is instilling in the economy and financial markets could lead the authorities to keep the credit taps open for longer, allowing credit to flow into the broader economy. Bottom Line: Real estate developers are extremely leveraged and lack cash to complete launched projects. Hence, property developers’ ability to raise financing holds the key in terms of the strength of property construction activities in China. Further easing in credit will likely lead to rebounding property completions and rising construction activity, and vice versa. What About Chinese Property Demand? Easy credit may alleviate the financing stress facing Chinese real estate developers and lift construction activity temporarily. However, the most important and sustainable source of funding for real estate developers is property sales. Chart I-10 shows that funding from property sales, including deposits, advance payments and mortgages assumed by property buyers, contributes nearly half of the sources of funds raised in that year. Chart I-10 Self-raised funds are the second-largest component of the source of funds, with a share of 34%. One major component of self-raised funds – retained earnings – are also closely related to property sales. The other major component is equity and bond issuance. Bank loans and foreign investment (including direct equity injections, sales of bonds and equity, and borrowing from foreign banks) together account for only about 15%. Even though there has been some credit easing for Chinese real estate developers, the bad news is that property sales are still in a structural downtrend. Chart I-11Slower PSL Injections Will Negatively Impact Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand Diminishing PSL Scheme Will Be Negative To Property Demand As discussed in our previous reports,3 China’s property market is currently facing structural impediments. Low affordability, slowing rural-to-urban migration, demographic changes, the promotion of the housing rental market and the government’s continuing emphasis on clamping down speculation are together generating strong structural headwinds for property demand in China. Importantly, surging property demand between late 2015 and 2017 was mainly driven by the Chinese central bank’s direct lending to the real estate sector, which is not sustainable. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the Pledged Summary Lending (PSL) facility designed for slum area reconstruction.4 Indeed, the central bank’s PSL injections have already decelerated considerably since last year (Chart I-11). This has resulted in contracting overall property sales. Late last month, the authorities significantly cut their slum-area reconstruction target by more than one-half – from 6.4 million units last year to 2.85 million units this year. This suggests the amount of PSL injections will decline correspondingly (Chart I-12). Chart I-12 Besides the diminishing PSL scheme, some other factors are also signaling a dismal outlook for Chinese property demand. A deep and long contraction in property demand in rich provinces indicates demand saturation (Chart I-13). Sales outside eastern provinces track PSL injections very closely, as per Chart I-11, and are facing headwinds. Chinese households are more leveraged than U.S. ones, with the former’s debt-to-disposable income ratio having surpassed that of the latter (Chart I-14). Chart I-13Demand Is Saturated In China’s (Richer) Eastern Provinces Demand Saturation In Rich Eastern Provinces Demand Saturation In Rich Eastern Provinces Chart I-14China’s Household Debt Burden Is Very Elevated Escalated Household Debt In China Escalated Household Debt In China   Chart I- In addition, mortgage rates in China have not dropped much, despite monetary policy easing in the past 12 months. Recent data shows the average mortgage rate paid by first-time homebuyers has fallen from 5.71% last November to 5.56% this March, a still-high number. With respect to the ability to service mortgage payments, on a 90-square-meter house with a 30% down payment, our calculations show that annual interest costs account for about 27% of average household disposable income levels (Table I-1). Overall, poor affordability for Chinese homebuyers will constrain property demand in the coming years. Finally, the government is quite determined to implement its property tax in a few years. Local governments’ financing needs will become more acute as revenue from land sales decline substantially. China’s property market is on the way to becoming the market dominated by second-hand properties instead of new buildings – similar to many developed countries. Critically, the progress in establishing property tax laws in China seems to be accelerating. There have been more high-level meetings and discussions about the property tax law, and these meetings/discussions are becoming more detailed and concrete. Bottom Line: Chinese housing demand will be in a structural downtrend, weighing on construction activity beyond any near-term rebound. Investment Implications Based on the above findings, we draw the following investment strategy conclusions: It is reasonable to expect a slight pickup in real estate construction activity in China over the next few months. This will be marginally positive for construction-related commodities demand. Consequently, construction-related commodities markets (steel, cement, and glass) may be supported in the near term (Chart I-15). However, over the longer term, we remain fundamentally negative on construction activity within China’s property markets, as property sales will be in a structural downtrend. BCA’s Emerging Market Strategy service recommends equity investors underweight Chinese property developers within the Chinese equity indexes (Chart I-16). Chart I-15Construction-Related Commodities May Marginally Benefit From A Pickup In Activity Contraction Commodities Prices May Marginally Benefit Contraction Commodities Prices May Marginally Benefit Chart I-16Underweight Real Estate Stocks Relative To The Domestic And Investable Benchmarks Underweight Real Estate Stocks Within Respective Chinese Investable Universes Underweight Real Estate Stocks Within Respective Chinese Investable Universes   The completion of previously launched projects will help construction-related industries. Yet, these activities will consume real estate developers’ cash augmenting their liquidity needs and amplifying their financial vulnerability. This is a basis for our recommendation to underweight property stocks, especially following their significant outperformance in the past six months.  Further, property stocks respond to marginal changes in financing conditions rather than housing sales or construction activities. The basis is that they are extremely leveraged, and access to funding is key. In the coming months, if credit conditions tighten at a time when real estate developers must commit cash to complete previously launched projects, their cash flow will deteriorate. This will be reflected in their share prices, which will underperform the Chinese broader onshore and offshore indexes. This is likely to occur regardless of the absolute performance of Chinese stocks. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Chinese real estate developers could also slow the construction activity after completing 50% of a property project, which allows them to receive at least 60% of the presold property value from house buyers. 2      https://www.bloomberg.com/news/articles/2019-05-06/china-is-said-to-imp… 3      Please see Emerging Markets Strategy Special Report “China Real Estate: A Never-Bursting Bubble?” dated April 6, 2018 and China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 4      Please see China Investment Strategy Special Report “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese housing market with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Ellen’s previous housing report was extremely well received,1 and clients should look forward to tomorrow’s update. Chart 1A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook A Full Trade War: Clear Near-Term Risk, But An Uncertain Cyclical Outlook Turning to the financial markets, investors have been squarely focused this week on the sudden escalation in tension between the U.S. and China, caused by President Trump’s renewed threat on May 5 to heighten tariffs on Chinese imports at the end of this week. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. The financial market reaction was swift: Chinese A shares fell nearly 6% on Monday, and USD-CNY surged nearly half a percent (Chart 1). Chinese stocks fared better on Tuesday, but may come under pressure again later in the week as China’s trade delegation returns to the U.S. for talks on Thursday & Friday. Despite this week’s volatility, we would not yet recommend any portfolio strategy changes to investors who are positioned in favor of Chinese stocks or China-related assets more generally. First, we still see the combined odds of a deal or a further extension in talks as being as high as 60%, and investors would view an agreement to extend the negotiations in a positive light after this week’s selloff. At a minimum, investors are likely to get a better chance to sell in such a scenario. Second, over that past year we have steadfastly maintained that China’s economy and its earnings cycle are driven by monetary conditions, money, and credit growth, and two of these three drivers are clearly now pointing to improving economic activity over the coming year. Certainly, the imposition of a 25% import tariff on all Chinese goods would represent a new, negative shock to the Chinese economy, but in this scenario Chinese policymakers would also substantially dial up their reflationary response. As such, while the near-term response in the equity market is likely to be very negative if President Trump follows through with his threat, the cyclical (i.e. 6-12 month outlook) for Chinese relative equity performance is not yet clear. This is only true in local currency (i.e. hedged) terms, however, as we agree that there is meaningful downside potential for the RMB in a full tariff scenario. So while we are likely to advise investors to wait and assess the likely reflationary response if a 25% “second round” tariff rate is imposed this week before changing their equity stance, we would recommend a long USD-CNY/CNH position in the interim as a hedge against a potentially substantial decline in the RMB. Stay tuned.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1      Please see BCA Research’s China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?,” published September 13, 2018. Available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Feature The U.S.-China trade talks have not yet collapsed but they appear to be reaching a “make it or break it” moment. President Donald Trump renewed his threat of heightening tariffs on Chinese imports on May 5, in the interim between two weeks of shuttle diplomacy in Beijing and next in Washington that have been billed as the final round of negotiations. Chinese officials responded to Trump’s new tariff remarks by threatening to pull out of the talks. The status of the Chinese delegation due in Washington this week is unclear as we go to press. Specifically, President Trump has claimed that he would increase the current 10% tariff rate on $200 billion worth of Chinese imports to 25%, a move that was originally due on March 1, but was delayed to extend the talks and seek a better agreement. Trump also threatened to raise tariffs on the remaining $325 billion of Chinese imports that are so far untouched. This is the most significant escalation in rhetoric since before the tariff truce agreed on December 1 between Trump and Chinese President Xi Jinping in Buenos Aires. True, the threat to increase the tariffs is a last-minute pressure tactic tied to the administration’s attempt to make this week “the final week” of the talks. American advisers have said that at the end of these two weeks they would make a recommendation to the president either to sign a deal or walk away. For this reason, it is not certain that Trump will follow through with the increase. However, we consider the threat credible. The costs of trade war are not prohibitive to the U.S. or China considering the strategic interests at stake in their great power competition (Chart 1). And since December 1, we have argued that a relapse into trade war and rising tariffs was a substantial risk at 30% odds; this threat increases those odds. Chart 1The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over The Era Of U.S.-China Detente Is Over Talks have been deteriorating for the past month at least. First, the trade grievances at the root of the trade war with China – namely corporate espionage, hacking, forced technology transfer, intellectual property theft, and the American-allied restrictions on Chinese telecoms firm Huawei – were always going to be extremely difficult to settle. These are apparently weighing on the ability of Washington and Beijing to close an agreement. Second, tensions have recently flared across the entire range of U.S.-China strategic disagreements, including most importantly North Korea and Iran. In late April, the U.S. demanded that China halt all imports of Iranian oil by the end of May in order to avoid secondary sanctions that, in theory, could affect China’s central bank and other banks. Meanwhile North Korea has conducted two minor but provocative weapon tests (including short-range missiles on May 4) since the failed summit between Trump and Kim Jong Un in Hanoi. Washington expects Beijing to keep North Korea in check and involved in diplomacy as part of the broader strategic negotiation. Taiwan and the South China Sea are also simmering due to U.S.-Taiwan diplomacy and arms sales, Chinese military drills, and the U.S. decision to treat China’s “maritime militia” like its navy. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40%. As a result of these developments, and the dragging on of talks, we put the odds of a trade deal by the end of June at 50% in our April 10 report. Trump’s latest threat reduces the chances of an extension of the talks beyond June to 10%, while raising the odds of a collapse in talks and escalation of trade war to 40% (Table 1). Table 1Updated Trade War Probabilities (May 2019) U.S. And China Get Cold Feet U.S. And China Get Cold Feet From the Chinese point of view, Trump’s threat makes it harder to clinch a deal. Trump’s use of sweeping, unilateral tariffs on national security grounds has forced China into an awkward position. It is politically and ideologically toxic for Beijing to appear to capitulate to coercion, i.e. nineteenth-century-style tactics of gunboat diplomacy and western imperialism. The tariff truce in Buenos Aires minimized the appearance that China is negotiating under duress, giving Xi Jinping the ability to negotiate and make concessions without losing face. While China is in the weaker position economically, and therefore would prefer a deal, it will batten down the hatches and fight a trade war if forced to do so. The risk of other executive decisions disruptive to markets is going up. The implication for investors is threefold. First, the USD and U.S. equities will continue to outperform global counterparts as trade policy uncertainty shoots back up (Chart 2). The American economy is more insulated from global trade and the dollar is counter-cyclical. But as U.S. equities have rallied and volatility will go up, U.S. equities may simply fall less rapidly than Chinese and others. Chart 2U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty U.S. Will Outperform On Rising Trade Uncertainty Second, our view that China’s economic stimulus will surprise to the upside is reinforced by this development, as Beijing cannot afford to withdraw or pause stimulus when it still faces such a severe external risk to its manufacturing sector and employment (Chart 3). This will counteract the negative impact to global sentiment and manufacturing expected from any additional tariffs, creating more volatility in commodity and emerging market assets. Third, as we recognized in the case of Trump’s renewed “maximum pressure” tactic on Iran, the president is apparently not concerned with minimizing risks to the economy ahead of the 2020 election. His risk appetite remains voracious. Therefore the risk of other executive decisions disruptive to markets is going up. For instance, our 35% chance that Trump will impose Section 232 tariffs on auto and auto part imports, particularly from Europe, is rising toward 50% (Chart 4). Chart 3China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus China Cannot Afford to Withhold Stimulus Chart 4   Bottom Line: The odds of a re-escalation of the trade war have risen to 40%. American equities should outperform global, while safe-haven assets, such as a portfolio hedge of Swiss bonds and gold, should catch a bid. We are closing out our long copper trade for a loss of 3.58% as well as our long Chinese equities ex-tech trade for a gain of 6.59%. Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains A Sign Of Liquidity Strains A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot NPLs Will Rise A Lot NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Improving UAE Economy Improving UAE Economy Chart III-2Rising Oil Output Rising Oil Output Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The March data brought the first signs of a stabilization in China’s “hard” economic data, albeit from a weak level. The April PMIs disappointed, but they remained in expansionary territory; this is in addition to a continued significant improvement in the trade-related subcomponents of the official survey. Chinese credit growth is unlikely to relapse over the coming year, despite recent investor concerns that Chinese policymakers may dial back their stimulus efforts. The pace of growth may moderate, but halting the uptrend in growth this year would constitute a major policy mistake that we do not expect. Chinese stocks may trend flat-to-down in the very near term as investors await a signed trade deal with the U.S. and further signs of a recovery in activity. Over the next 6-12 months, however, an overweight stance is warranted, barring a major relapse in our leading indicator. 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, March’s data brought the very first (albeit modest) signs of stabilization in actual Chinese economic activity. While the April manufacturing PMIs released earlier this week disappointed, the trade related components of the official survey continued to improve meaningfully, which implies that an improvement in domestic demand is still early. This conclusion is not particularly surprising given that the first green shoots in the actual data are emerging from a depressed level of activity. Credit growth has only recently picked up, implying that actual activity will strengthen over the coming 6-12 months followed a signed trade deal and a continued (modest) uptrend in credit. 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, the most significant recent development has been that Chinese stocks have sagged somewhat due to concerns that policymakers may meaningfully dial back their stimulus efforts over the coming year. In our view, recent statements from policymakers, as well as the fact that the recovery in activity is only now beginning, underscores that credit growth is unlikely to relapse over the coming year. It may not grow at the breakneck pace observed in the first quarter, but beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1 highlights that March brought the first sign of a stabilization in actual Chinese economic activity. When measured on a smoothed basis, the Li Keqiang index itself weakened further in March, but total import growth moved sideways and nominal manufacturing output ticked higher. We noted in our last Macro & Market review that future changes in activity measures were now more likely to reflect actual changes in underlying economic circumstances given that the previously beneficial tariff front-running effect had probably washed out of the data. March’s data confirms this view, and underscores that activity will pickup in the second half of the year. Chart 1The First (Albeit Tentative) Sign Of Economic Stabilization The First (Albeit Tentative) Sign Of Economic Stabilization The First (Albeit Tentative) Sign Of Economic Stabilization Chart 2 shows that the uptrend in our leading indicator for Chinese economic activity is so far modest, but also that it is now at a 2-year high relative to its 12-month moving average. The indicator is being weighed-down by weak money growth (M2 and our definition of M3), even though monetary conditions remain easy and our measures of credit growth picked up sharply in Q1. We doubt that the trend in Chinese money and credit growth can sustainably decouple in a scenario where the latter is sustainably improving, as it would imply that all of the credit improvement was originating from non-bank financial institutions. As such, we expect money growth to catch up to credit growth in the coming months. The annual change in the PBOC’s pledged supplementary lending injection remained in negative territory in March, and both floor space started and sold decelerated modestly further. Construction and sales activity continue to diverge, with the latter still pointing to a further slowdown in the former. We will be updating our Chinese housing outlook in a Special Report next week. April’s Caixin and official manufacturing PMI disappointed, but this overshadowed a continued significant improvement in the new export orders and import components of the official PMI (Chart 3). In our view, this is consistent with a stabilization in the export outlook, but implies that Chinese domestically-oriented manufacturing activity is not yet booming. Nonetheless, a signed trade deal, improving importer/exporter sentiment, and an uptrend in credit growth still implies that activity will pick up meaningfully later in the year. Chart 2Our Leading Indicator Is Now Modestly Trending Higher Our Leading Indicator Is Now Modestly Trending Higher Our Leading Indicator Is Now Modestly Trending Higher Chart 3Trade-Related Components Of The Official PMI Continue To Rise Trade-Related Components Of The Official PMI Continue To Rise Trade-Related Components Of The Official PMI Continue To Rise   Over the past month, Taiwanese and domestic Chinese stocks have been the best performers within “Greater China”, relative to the MSCI Hong Kong index, the MSCI China index, and the Hang Seng China Enterprises index. The latter in particular has lagged other Chinese equity indexes since late-March (Chart 4), and may be due for a catch-up. Over the nearer-term, Chinese stocks, especially the domestic market, have sagged due to concerns that Chinese policymakers may meaningfully dial back their stimulus efforts over the coming year. We discussed this risk in our April 17thWeekly Report,1 and noted that while we expected credit growth to moderate somewhat, a more meaningful slowdown, particularly if coupled with signals from policymakers that a much slower pace of growth is desired, could pose a risk to our overweight equity stance. The April manufacturing PMIs disappointed, but the trade-related components of the official survey continued to improve meaningfully. In our view, recent statements from policymakers, particularly from PBOC Deputy Governor Liu Guoqiang,2 underscores that credit growth is unlikely to relapse over the coming year; it will simply not be growing at the breakneck pace observed in the first quarter. Beyond the near-term jitters that this may introduce into the equity market, we do not see it as a threat to an overweight stance towards Chinese stocks over the coming 6-12 months. Chart 5 highlights that Chinese consumer stocks have been the clear winners since the beginning of the year, particularly in the domestic market. Consumer stocks, including staples, sold off substantially in 2H2018 as investors responded to shockingly weak consumer spending data. Stimulus measures targeted to Chinese households, along with a meaningful improvement in some measures of consumer spending, has helped restore investor confidence in consumer stocks (which had previously been viewed as a bullish “no-brainer” structural trade). Chart 4Is An H-Share Catchup##br## Looming? Is An H-Share Catchup Looming? Is An H-Share Catchup Looming? Chart 5Chinese Consumer Stocks Have Been On Fire Chinese Consumer Stocks Have Been On Fire Chinese Consumer Stocks Have Been On Fire   The sharp rise in the 7-day interbank repo rate in April fed concerns among equity investors that Chinese policymakers might be in the process of paring back their stimulus efforts. However, as Chart 6 shows, China’s 7-day repo rate is extraordinarily volatile, and is affected by a variety of seasonal and technical factors. The chart shows that a 1-month moving average of the 7-day repo rate is broadly in line with the level that has prevailed over the past 9 months. In addition, the 3-month repo rate (which we have argued has been a more informative predictor of China’s monetary policy stance) remains well on the low end of its range over the past year. In short, despite investor concerns, Chinese interbank repo rates are not signaling a change in China’s monetary policy stance. Tighter monetary policy is not in the cards for this year. After having risen noticeably in late-March, Chinese onshore corporate bond spreads have fallen back to the low end of their trading range over the past 8 months. We continue to recommend that domestic investors hold a diversified portfolio of SOE corporate bonds, on the basis that actual bond defaults over the coming 6-12 months are likely to be materially lower than what investors are pricing in even though they are indeed likely to rise. Chart 7 shows that USD-HKD has eased somewhat over the past month from the top end of the band, and now trades closed at 7.845. This modest appreciation in HKD appears to have been catalyzed by a further reduction in the supply of interbank liquidity by the HKMA. While the appreciation in HKD is some modest good news for Hong Kong’s monetary authority, it remains reluctant to reduce liquidity in the system given how extremely weak loan growth is in Hong Kong. This implies that, barring a meaningful upturn in credit, a significant appreciation in HKD is not likely in the cards. Chart 6Interbank Repo Rates Are Not Trending Higher Interbank Repo Rates Are Not Trending Higher Interbank Repo Rates Are Not Trending Higher Chart 7A Modest Appreciation In HKD (Which Is Not Likely To Continue) A Modest Appreciation In HKD (Which Is Not Likely To Continue) A Modest Appreciation In HKD (Which Is Not Likely To Continue)   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      Please see China Investment Strategy Weekly Report “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem,” dated April 17, 2019, available at cis.bcaresearch.com 2      During a PBOC briefing on April 25, Deputy Governor Guoqiang noted that “no one can bear it if policy swings back and forth between tightening and loosening many times a year”. Cyclical Investment Stance Equity Sector Recommendations