China
The Sino-U.S. trade war is heating up further. After veiled threats of curtailing rare earth shipments to the West, Chinese policymakers are now announcing their preparation of a blacklist of “unreliable” entities. While the content of the list remains…
Highlights Global equities face near-term downside risks from the trade war, but should be higher in 12 months’ time. Its claims to novelty notwithstanding, Modern Monetary Theory is basically indistinguishable from standard Keynesian economics except that MMT assumes that changes in interest rates have no discernible effect on aggregate demand. This straightforward but unrealistic assumption allows MMT’s proponents to argue that the neutral rate of interest does not exist, that crowding out is impossible, and that while fiscal deficits do matter (because too much government spending can stoke inflation), debt levels do not. Despite its many shortcomings, MMT’s focus on financial balances and the role of sovereign-issued money is laudable. A better understanding of these concepts would have made investors a lot of money during the past decade. Today, most economies are still running large private-sector financial surpluses. This surplus of desired savings relative to investment has kept interest rates low, which have allowed governments to finance their budgets at favorable terms. As these surpluses decline, inflation will rise. Feature Greetings From Down Under I have been meeting clients in Australia and New Zealand this week. The mood has been generally negative on the outlook for both the domestic and global economies. As one might imagine, the brewing China-U.S. trade war has been a hot topic of discussion. We went tactically short the S&P 500 on May 10th, a move that for the time being effectively neutralizes our structurally overweight stance on global equities. As we indicated when we initiated the hedge, we will take profits on the position if the S&P 500 drops below 2711. Despite the darkening clouds hanging over the trade war, we still expect a detente to be reached that prevents a further escalation of the conflict. Both sides would suffer from an extended trade war. For China, it is no longer just about losing access to the vast U.S. market. It is also about losing access to vital technology. The blacklisting of Huawei deprives China of critical components needed to realize its dream of becoming a world leader in AI and robotics. The trade war will not harm the U.S. as much as it will China, but it has still raised prices for American consumers, while lowering the prices of key agricultural exports such as soybeans. It has also hurt the stock market, which Trump seems to view as a barometer for his own success as president. If a trade detente is eventually reached, market attention will shift back to the outlook for global growth. We expect the combination of aggressive Chinese fiscal/credit stimulus and the palliative effects of falling global bond yields over the past seven months to lift growth in the back half of the year. As a countercyclical currency, the U.S. dollar is likely to weaken when global growth starts to strengthen. This will provide an opportune time to go overweight EM and European equities as well as the more cyclical sectors of the stock market. Are You Now Or Have You Ever Been A Member Of The MMT Movement? Last week’s report1 argued that a global deflationary ice age is unlikely to transpire because politicians will pursue large-scale fiscal stimulus to preclude this outcome. We noted that many countries are easing fiscal policy at the margin, partly in response to populist pressures. Even in Japan, the likelihood that the government will raise the sales tax this year has diminished, while structural forces will continue to drain savings for years to come. This will set the stage for higher inflation in Japan, something the market is not at all anticipating. Somewhat controversially, we contended that larger budget deficits are unlikely to imperil debt sustainability, at least for countries that are able to issue debt in their own currencies. This implies that any government with its own printing press should simply ease fiscal policy until long-term inflation expectations reach their target level. MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. A number of readers pointed out that our analysis sounded suspiciously supportive of Modern Monetary Theory (MMT). Are we really closet MMT devotees? No, we are not. Our approach shares some commonalities with MMT (so if you want to call me a “MMT sympathizer,” go ahead). However, it also differs from MMT in a number of important respects. As we discuss below, these differences have significant implications for market outcomes, particularly one’s views about the long-term direction of government bond yields. MMT: A “Special Case” Of Keynesian Economics Modern Monetary Theory is not nearly as novel as its backers claim. In fact, MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. Outside of liquidity trap conditions, most economists believe that monetary policy is an effective aggregate demand management tool. MMT’s supporters reject this. In their view, changes in interest rates have no impact on spending. In the technical parlance of economics, MMT is basically the Hicksian IS/LM model but with a vertical IS curve and an LM curve that intersects the IS curve at an interest rate of zero (Chart 1). This seemingly small variation on the traditional Keynesian framework has far-reaching consequences. For one thing, it renders meaningless the entire concept of the neutral rate of interest. If changes in interest rates have no effect on aggregate demand, then one cannot identify an equilibrium level of interest rates that is consistent with full employment and stable inflation. Given their leftist roots, it is not surprising that most MMTers favor keeping rates low, preferably near zero. Higher rates shift income from borrowers to lenders. The latter tend to be richer than the former. Why reward fat cats when you don’t have to? Low rates also allow the government to spend more without putting the debt-to-GDP ratio on an unsustainable trajectory. If the interest rate at which the government borrows stays below the growth rate of the economy, the government can run a stable Ponzi scheme, perpetually issuing new debt to pay the interest on existing debt (Chart 2). In such a world, budget deficits only matter to the extent that too much fiscal stimulus can stoke inflation. The level of debt, in contrast, never matters. Interest Rates Do Affect Aggregate Demand Chart 3Mortgage Rate Swings Matter For The Housing Market Despite MMT’s efforts to deny any role for monetary policy in stabilizing the economy, the empirical evidence clearly shows that changes in interest rates do affect consumption and investment decisions. Housing activity, in particular, is very sensitive to movements in mortgage rates. The recent drop in mortgage rates bodes well for U.S. housing activity during the remainder of the year (Chart 3). The dollar, like most currencies, is also influenced by shifts in interest rate differentials (Chart 4). Changes in the dollar affect net exports, and hence overall employment. Once we acknowledge that interest rates affect aggregate demand, we are back in a world of trade-offs between monetary and fiscal policy. One can have easy monetary policy and tight fiscal policy, or tight monetary policy and easy fiscal policy. But outside of liquidity trap conditions, one cannot have both easy monetary and fiscal policies for a prolonged period of time without tolerating higher and rising inflation. Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials The Perils Of Accounting Identities MMT proponents love accounting identities. They are particularly fond of saying that government deficits endow the private sector with additional wealth in the form of government bonds or cash. Unfortunately, the penchant to “argue by accounting identity” is almost always a recipe for disaster since such arguments usually fail to identify the causal forces by which one thing affects the other. For example, no competent economist would deny that an increase in the fiscal deficit must tautologically imply an increase in the private sector’s financial balance (the difference between the private sector’s income and spending). What MMT adherents fail to appreciate is that private-sector savings can increase either if incomes rise or spending falls. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. When an economy is depressed, fiscal stimulus is likely to increase employment. In such a setting, rising payrolls will boost incomes, leading to a larger private-sector surplus. In contrast, when the economy is operating at full employment, any increase in the private-sector surplus must come about through a decline in private-sector spending. That is to say, if the government consumes more of the economy’s output, the private sector has to consume less. There is a huge difference between the two cases. MMTers tend to gloss over this distinction because they do not really have a theory for why the private-sector financial balance moves around in the first place. To them, private-sector spending is completely exogenous. It is determined by such things as animal spirits that the government has no control over. The government’s only job is to adjust the fiscal balance to ensure that it is the mirror image of the private-sector’s balance. Budget deficits cannot crowd out private-sector spending in this context because the government plays no role in determining how much the private sector wishes to spend. Investment Conclusions Economics gets a bad rap these days. Although most people would not go as far as Nassim Taleb who once mused about running over economists in his Lexus, it is fair to say that there is a lot of disillusionment towards the economics profession. Ostensibly heterodox theories like MMT help fill an intellectual void for those hoping to rewrite the economics textbooks for the 21st century. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. Shortly after the financial crisis, when the world was still mired in a deep slump, Keynesian economics predicted that large budget deficits would not push up interest rates and that QE would not lead to runaway inflation. In contrast, Taleb said in early February 2010, when the 10-year Treasury yield was trading at around 3.6%, that Ben Bernanke was “immoral” and that “Every single human being should short Treasury bonds. It’s a no-brainer.” The study of financial balances is not unique to MMT, nor is MMT’s approach to thinking about financial balances the best one. Even so, a basic understanding of the concept would have prevented Taleb and countless others from making the mistakes they did. The fact that MMT has brought the discussion of financial balances, along with related concepts such as the role of sovereign-issued money in an economy, back into the spotlight is its greatest virtue. Today, most economies are still running large private-sector financial surpluses (Chart 5). Given that interest rates are so low, it is difficult to argue that budget deficits are crowding out private spending. This may change over time, however. Falling unemployment is boosting consumer confidence, which will bolster spending. U.S. wage growth has already accelerated sharply among workers at the bottom end of the income distribution (Chart 6). These are the workers with the highest marginal propensity to consume. Chart 5AMost Major Countries Run Private-Sector Surpluses (I) Chart 5BMost Major Countries Run Private-Sector Surpluses (II) Meanwhile, baby boomers are leaving the labor force. More retirees means less production, but not necessarily less consumption. Once health care spending is added to the tally, consumption actually increases in old age (Chart 7). If production falls in relation to consumption, excess savings will decline and the neutral rate of interest will rise. Chart 7Savings Over The Life Cycle When this happens, will governments tighten fiscal policy, as the MMT prescription requires? In a world where entitlement programs are politically sacrosanct, that seems unlikely. The end result is that economies will overheat and inflation will rise. Will central banks tighten monetary policy in response to higher inflation? That depends on what one means by tighten. Central banks will undoubtedly raise rates, but in a world of high debt levels, they will be loath to push interest rates above the growth rate of the economy. Interest rates will rise in nominal terms, but probably very little or not at all in real terms. In such an environment, investors should maintain below-benchmark duration exposure in their fixed-income portfolios, while favouring inflation-linked bonds over nominal bonds. Owning traditional inflation hedges such as gold would also make sense. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Ice Age Cometh?” dated May 24, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades
Highlights So What? U.S.-China relations are still in free fall as we go to press. Why? The trade war will elicit Chinese stimulus but downside risks to markets are front-loaded. The oil risk premium will remain elevated as Iran tensions will not abate any time soon. The odds of a no-deal Brexit are rising. Our GeoRisk Indicators show that Turkish and Brazilian risks have subsided, albeit only temporarily. Maintain safe-haven trades. Short the CNY-USD and go long non-Chinese rare earth providers. Feature The single-greatest reason for the increase in geopolitical risk remains the United States. The Democratic Primary race will heat up in June and President Trump, while favored in 2020 barring a recession, is currently lagging both Joe Biden and Bernie Sanders in the head-to-head polling. Trump’s legislative initiatives are bogged down in gridlock and scandal. The remaining avenue for him to achieve policy victories is foreign policy – hence his increasing aggressiveness on both China and Iran. The result is negative for global risk assets on a tactical horizon and possibly also on a cyclical horizon. A positive catalyst is badly needed in the form of greater Chinese stimulus, which we expect, and progress toward a trade agreement. Brexit, Italy, and European risks pale by comparison to what we have called “Cold War 2.0” since 2012. Nevertheless, the odds of Brexit actually happening are increasing. The uncertainty will weigh on sentiment in Europe through October even if it does not ultimately conclude in a no-deal shock that prevents the European economy from bouncing back. Yet the risk of a no-deal shock is higher than it was just weeks ago. We discuss these three headline geopolitical risks below: China, Iran, and the U.K. No End In Sight For U.S.-China Trade Tensions U.S.-China negotiations are in free fall, with no date set for another round of talks. On March 6 we argued that a deal had a 50% chance of getting settled by the June 28-29 G20 summit in Japan, with a 30% chance talks would totally collapse. Since then, we have reduced the odds of a deal to 40%, with a collapse at 50%, and a further downgrade on the horizon if a positive intervention is not forthcoming producing trade talks in early or mid-June (Table 1). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 We illustrate the difficulties of agreeing to a deal through the concept of a “two-level game.” In a theoretical two-level game, each country strives to find overlap between its international interests and its rival’s interests and must also seek overlap in such a way that the agreement can be sold to a domestic audience at home. The reason why the “win-win scenario” is so remote in the U.S.-China trade conflict is because although China has a relatively large win set – it can easily sell a deal at home due to its authoritarian control – the U.S. win set is small (Diagram 1). Diagram 1Tiny Win-Win Scenario In U.S.-China Trade Conflict The Democrats will attack any deal that Trump negotiates, making him look weak on his own pet issue of trade with China. This is especially the case if a stock market selloff forces Trump to accept small concessions. His international interest might overlap with China’s interest in minimizing concessions on foreign trade and investment access while maximizing technological acquisition from foreign companies. He would not be able to sell such a deal – focused on large-scale commodity purchases as a sop to farm states – on the campaign trail. Democrats will attack any deal that Trump negotiates. While it is still possible for both sides to reach an agreement, this Diagram highlights the limitations faced by both players. Meanwhile China is threatening to restrict exports of rare earths – minerals which are critical to the economy and national defense. China dominates global production and export markets (Chart 1), so this would be a serious disruption in the near term. Global sentiment would worsen, weighing on all risk assets, and tech companies and manufacturers that rely on rare earth inputs from China would face a hit to their bottom lines. Chart 1China Dominates Rare Earths Supply Over the long haul, this form of retaliation is self-defeating. First, China would presumably have to embargo all exports of rare earths to the world to prevent countries and companies from re-exporting to the United States. Second, rare earths are not actually rare in terms of quantity: they simply occur in low concentrations. As the world learned when China cut off rare earths to Japan for two months in 2010 over their conflict in the East China Sea, a rare earths ban will push up prices and incentivize production and processing in other regions. It will also create rapid substitution effects, recycling, and the use of stockpiles. Ultimately demand for Chinese rare earths exports would fall. Over the nine years since the Japan conflict, China’s share of global production has fallen by 19%, mostly at the expense of rising output from Australia. A survey of American companies suggests that they have diversified their sources more than import statistics suggest (Chart 2). Chart 2Import Stats May Be Overstating China’s Dominance The risk of a rare earths embargo is high – it fits with our 30% scenario of a major escalation in the conflict. It would clearly be a negative catalyst for companies and share prices. But as with China’s implicit threat of selling U.S. Treasuries, it is not a threat that will cause Trump to halt the trade war. The costs of conflict are not prohibitive and there are some political gains. Bottome Line: The S&P 500 is down 3.4% since our Global Investment Strategists initiated their tactical short on May 10. This is nearly equal to the weighted average impact on the S&P 500 that they have estimated using our probabilities. Obviously the selloff can overshoot this target. As it does, the chances of the two sides attempting to contain the tensions will rise. If we do not witness a positive intervention in the coming weeks, it will be too late to salvage the G20 and the risk of a major escalation will go way up. We recommend going short CNY-USD as a strategic play despite China’s recent assurances that the currency can be adequately defended. Our negative structural view of China’s economy now coincides with our tactical view that escalation is more likely than de-escalation. We also recommend going long a basket of companies in the MVIS global rare earth and strategic metals index – specifically those companies not based in China that have seen share prices appreciate this year but have a P/E ratio under 35. U.S.-Iran: An Unintentional War With Unintentional Consequences? “I really believe that Iran would like to make a deal, and I think that’s very smart of them, and I think that’s a possibility to happen.” -President Donald Trump, May 27, 2019 … We currently see no prospect of negotiations with America ... Iran pays no attention to words; what matters to us is a change of approach and behavior.” -Iranian Foreign Ministry spokesman Abbas Mousavi, May 28, 2019 The U.S. decision not to extend sanction waivers on Iran multiplied geopolitical risks at a time of already heightened uncertainty. Elevated tensions surrounding major producers in the Middle East could impact oil production and flows. In energy markets, this is reflected in the elevated risk premium – represented by the residuals in the price decompositions that include both supply and demand factors (Chart 3). Chart 3The Risk Premium Is Rising In Brent Crude Oil Prices Tensions surrounding major oil producers ... are reflected in the elevated risk premium – represented by the residuals in the Brent price decomposition. Already Iranian exports are down 500k b/d in April relative to March – the U.S. is acting on its threat to bring Iran’s exports to zero and corporations are complying (Chart 4). Chart 4Iran Oil Exports Collapsing What is more, the U.S. is taking a more hawkish military stance towards Iran – recently deploying a carrier strike group and bombers, partially evacuating American personnel from Iraq, and announcing plans to send 1,500 troops to the Middle East. The result of all these actions is not only to reduce Iranian oil exports, but also to imperil supplies of neighboring oil producers such as Iraq and Saudi Arabia which may become the victims of retaliation by an incandescent Iran. Our expectation of Iranian retaliation is already taking shape. The missile strike on Saudi facilities and the drone attack on four tankers near the UAE are just a preview of what is to come. Although Iran has not claimed responsibility for the acts, its location and extensive network of militant proxies affords it the ability to threaten oil supplies coming out of the region. Iran has also revived its doomsday threat of closing down the Strait of Hormuz through which 20% of global oil supplies transit – which becomes a much fatter tail-risk if Iran comes to believe that the U.S. is genuinely pursuing immediate regime change, since the first-mover advantage in the strait is critical. This will keep markets jittery. Current OPEC spare capacity would allow the coalition to raise production to offset losses from Venezuela and Iran. Yet any additional losses – potentially from already unstable regions such as Libya, Algeria, or Nigeria – will raise the probability that global supplies are unable to cover demand. Going into the OPEC meeting in Vienna in late June, our Commodity & Energy Strategy expects OPEC 2.0 to relax supply cuts implemented since the beginning of the year. They expect production to be raised by 0.9mm b/d in 2H2019 vs. 1H2019.1 Nevertheless, oil producers will likely adopt a cautious approach when bringing supplies back online, wary of letting prices fall too far. This was expressed at the May Joint Ministerial Monitoring Committee meeting in Jeddah, which also highlighted the growing divergence of interests within the group. Russia is in support of raising production at a faster pace than Saudi Arabia, which favors a gradual increase (conditional on U.S. sanctions enforcement). Both the Iranians and Americans claim that they do not want the current standoff to escalate to war. On the American side, Trump is encouraging Prime Minister Shinzo Abe to try his hand as a mediator in a possible visit to Tehran in June. We would not dismiss this possibility since it could produce a badly needed “off ramp” for tensions to de-escalate when all other trends point toward a summer and fall of “fire and fury” between the U.S. and Iran. If forced to make a call, we think President Trump’s foreign policy priority will center on China, not Iran. But this does not mean that downside risks to oil prices will prevail. China will stimulate more aggressively in June and subsequent months. And regardless of Washington’s and Tehran’s intentions, a wrong move in an already heated part of the world can turn ugly very quickly. Bottom Line: President Trump’s foreign policy priority is China, not Iran. Nevertheless, a wrong move can trigger a nasty escalation in the current standoff, jeopardizing oil supplies coming out of the Gulf region. In response to this risk, OPEC 2.0 will likely move to cautiously raise production at the next meeting in late June. Meanwhile China’s stimulus overshoot in the midst of trade war will most likely shore up demand over the course of the year. Can A New Prime Minister Break The Deadlock In Westminster? “There is a limited appetite for change in the EU, and negotiating it won’t be easy.” - Outgoing U.K. Prime Minister Theresa May Prime Minister Theresa May’s resignation has hurled the Conservative Party into a scramble to select her successor. While the timeline for this process is straightforward,2 the impact on the Brexit process is not. The odds of a “no-deal Brexit” have increased but so has the prospect of parliament passing a soft Brexit prior to any new election or second referendum. The odds of a “no-deal Brexit” have increased. Eleven candidates have declared their entry to the race and the vast majority are “hard Brexiters” willing to sacrifice market access on the continent (Table 2). Prominent contenders such as Boris Johnson and Dominic Raab have stated that they are willing to exit the EU without a deal. Table 2“Hard Brexiters” Dominate The Tory Race Given that the average Tory MP is more Euroskeptic than the average non-conservative voter or Brit, the final two contenders left standing at the end of June are likely to shift to a more aggressive Brexit stance. They will say they are willing to deliver Brexit at all costs and will avoid repeating Theresa May’s mistakes. This means at the very least the rhetoric will be negative for the pound in the coming months. A clear constraint on the U.K. in trying to negotiate a new withdrawal agreement is that the EU has the upper hand. It is the larger economy and less exposed to the ramifications of a no-deal exit (though still exposed). This puts it in a position of relative strength – exemplified by the European Commission’s insistence on keeping the current Withdrawal Agreement. Whoever the new prime minister is, it is unlikely that he or she will be able to negotiate a more palatable deal with the EU. Rather, the new leader will lead a fractured Conservative Party that still lacks a strong majority in parliament. The no-deal option is the default scenario if an agreement is not finalized by the Halloween deadline and no further extension is granted. However, Speaker of the House of Commons John Bercow recently stated that the prime minister will be unable to deliver a no-deal Brexit without parliamentary support. This will likely manifest in the form of a bill to block a no-deal Brexit. Alternatively, an attempt to force a no-deal exit could prompt a vote of no confidence in the government, most likely resulting in a general election.3 Chart 5British Euroskeptics Made Gains In EP Election While the Brexit Party amassed the largest number of seats in the European Parliament elections at the expense of the Labour, Conservative, and UKIP parties (Chart 5), the results do not suggest that British voters have generally shifted back toward Brexit. In fact, if we group parties according to their stance, the Bremain camp has a slight lead over the Brexit camp (Chart 6). Thus, it is not remotely apparent that a hard Brexiter can succeed in parliament; that a new election can be forestalled if a no-deal exit is attempted; or that a second referendum will repeat the earlier referendum’s outcome. Chart 6Bremain Camp Still Dominates Bottom Line: While the new Tory leader is likely to be more on the hard Brexit end of the spectrum than Theresa May, this does not change the position of either the European Commission or the British MPs and voters on Brexit. The median voter both within parliament and the British electorate remains tilted towards a softer exit or remaining in the EU. This imposes constraints on the likes of Boris Johnson and Dominic Raab if they take the helm of the Tory Party. These leaders may ultimately be forced to try to push through something a lot like Theresa May’s plan, or risk a total collapse of their party and control of government. Still, the odds of a no-deal exit – the default option if no agreement is reached by the October 31 deadline – have gone up. In the meantime, the GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. GeoRisk Indicators Update – May 31, 2019 Last month BCA’s Geopolitical Strategy introduced ten indicators to measure geopolitical risk implied by the market. These indicators attempt to capture risk premiums priced into various currencies – except for Euro Area countries, where the risk is embedded in equity prices. A currency or bourse that falls faster than it should fall, as implied by key explanatory variables, indicates increasing geopolitical risk. All ten indicators can be found in the Appendix, with full annotation. We will continue to highlight key developments on a monthly basis. This month, our GeoRisk indicators are picking up the following developments: Trade war: Our Korean and Taiwanese risk indicators are currently the best proxies to measure geopolitical risk implications of the U.S.-China trade war, as they are both based on trade data. Both measures, as expected, have increased more than our other indicators over the past month on the back of a sharp spike in tensions between the U.S. and China. Currently, the moves are largely due to depreciation in currencies, as trade is only beginning to feel the impact. We believe that we will see trade decline in the upcoming months. Brexit: While it is still too early to see the full effect of Prime Minister May’s resignation captured in our U.K. indicator, it has increased in recent days. We expect risk to continue to increase as a leadership race is beginning among the Conservatives that will raise the odds of a “no-deal exit” relative to “no exit.” EU elections: The EU elections did not register as a risk on our indicators. In fact, risk decreased slightly in France and Germany during the past few weeks, while it has steadily fallen in Spain and Italy. Moreover, the results of the election were largely in line with expectations – there was not a surprising wave of Euroskepticism. The real risks will emerge as the election results feed back into political risks in certain European countries, namely the U.K., where the hardline Conservatives will be emboldened, and Italy, where the anti-establishment League will also be emboldened. In both countries a new election could drastically increase uncertainty, but even without new elections the respective clashes with Brussels over Brexit and Italian fiscal policy will increase geopolitical risk. Emerging Markets: The largest positive moves in geopolitical risk were in Brazil and Turkey, where our indicators plunged to their lowest levels since late 2017 and early 2018. Brazilian risk has been steadily declining since pension reform – the most important element of Bolsonaro’s reform agenda – cleared an initial hurdle in Congress. While we would expect Bolsonaro to face many more ups and downs in the process of getting his reform bill passed, we have a high conviction view that the decrease in our Turkish risk indicator is unwarranted. This decrease can be attributed to the fact that the lira’s depreciation in recent weeks is slowing, which our model picks up as a decrease in risk. Nonetheless, uncertainty will prevail as a result of deepening political divisions (e.g. the ruling party’s attempt to overturn the Istanbul election), poor governance, ongoing clashes with the West, and an inability to defend the lira while also pursuing populist monetary policy. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Footnotes 1 Please see BCA Research Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 2 The long list of candidates will be whittled down to two by the end of June through a series of votes by Tory MPs. Conservative Party members will then cast their votes via a postal ballot with the final result announced by the end of July, before the Parliament’s summer recess. 3 A vote of no confidence would trigger a 14-day period for someone else to form a government, otherwise it will result in a general election. Geopolitical Calendar
Highlights In the political economy of oil, an awareness of the speed at which policy in systematically important states can change can restrain risk taking and investment. This can keep markets in an agitated state of anticipation, awaiting the next policy shift – or the fallout from earlier decisions – and can separate prices from fundamentals. Crude oil markets are in such an agitated state. Fundamentally, oil markets are tight and likely will get tighter, as backwardations in benchmark forward curves indicate (Chart 1). Oil demand continues to grow, with EM growth offsetting DM declines (Chart 2). Production is being restrained by OPEC 2.0, and could remain so in 2H19. U.S. shale-oil producers appear to be taking capital discipline seriously, and prioritizing shareholder interests, which likely will keep production growth within the limits dictated by free cash flow. Chart of the WeekBackwardations In Brent & WTI: Evidence Of Tight Oil Markets Chart 2EM Continues To Lead Global Oil Demand Growth The combination of these fundamentals will keep supply growth below demand growth this year, which means balances will remain tight (Table 1 below). This will drain inventories and keep forward curves backwardated (Chart 3). Globally, monetary policy will remain largely accommodative. However, policy risks – chiefly Sino – U.S. trade tensions and rising U.S. – Iran tensions – are taking their toll, increasing uncertainty re demand growth, and raising concerns over the security of oil supply from the Persian Gulf, which accounts for ~ 20% of global output. The combination of these policy-risk factors is putting a bid under the USD, which creates a demand headwind by raising the cost of oil ex-U.S.1 This is, in our view, keeping Brent prices below $70/bbl, vs. the $75/bbl we expect this year. Chart 3Commercial Oil Inventories Will Resume Drawing Highlights Energy: Overweight. U.S. National Security Adviser John Bolton declared Iran was responsible for naval mines attached to oil tankers off the coast of the UAE earlier this month, which damaged four ships, two of them belonging to Saudi Arabia. Bolton also said the Iranian naval operation was connected to a drone attack on the Saudi East – West pipeline two days later, and an unsuccessful attack on the Saudi Red Sea port of Yanbu.2 Base Metals: Neutral. Global copper markets continue to tighten: Fastmarkets MB’s Asian treatment and refining charges (TC/RC) weekly index dropped to its lowest level since it was launched June 2013 at the end of last week – to $58.30/MT, $0.0583/lb. Lower TC/RC charges reflect lower raw ore supplies available for refining. Global inventories remain low – down 22% y/y at the LME, COMEX, SHFE and Chinese bonded warehouses – and a threatened strike at on of Codelco's Chilean mines could tighten supplies further. We are re-establishing our tactical long July $3.00/lb Comex copper vs. short $3.30/lb Comex copper call spread at tonight’s close, expecting continued tightening in markets. Precious Metals: Neutral. Gold prices appear supported on either side of $1,280/oz, as trade, foreign and monetary policy risks remain elevated. Ags/Softs: Underweight. Heavier-than-expected rains are hampering plantings in the U.S. Midwest, which is driving grain prices higher. Corn, wheat, oats and beans surged Tuesday as markets re-opened from a long holiday weekend in the U.S. Feature Within the context of the political-economy framework we use to frame our analysis of oil markets, foreign policy and trade policy – particularly in the U.S. and China – are dominating fundamentals. Indeed, absent the threat of war in the Persian Gulf between Iran and the U.S., and their respective allies, and an uncertainty surrounding an expanded Sino – U.S. trade war, Brent crude oil would be trading above $75/bbl in 2H19, based on our modeling. As things stand now, we believe markets are under-pricing the risk of war in the Persian Gulf, and are over-estimating the short-term effects of the Sino – U.S. trade war. The longer-term consequences of a deeper and more protracted Sino – U.S. trade war, however, continue to be under-estimated. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) U.S. – Iran War Risk Is Under-priced We have noted in the past the risk of an escalation in the military confrontation in the Persian Gulf remains acute for global oil markets, most recently in our latest balances report.3 In particular, we believe the risk of this scenario is not fully priced, given market participants’ mark-down of the probability of the price of Brent for December 2019 delivery exceeding $75/bbl and $80/bbl from 39% to 26% and 25% to 16% over the past month in options markets. The probability of Brent for March 2020 delivery exceeding $75/bbl and $80/bbl has similarly been marked down from 38% to 28% and 26% to 19% (Chart 4). An escalation of attacks on soft targets – specifically Saudi and UAE oil shipping and pipeline networks, as occurred earlier this month – likely would provoke a U.S. response against Iran or its proxies, given U.S. National Security Adviser John Bolton’s declaration this week re Iran, which we noted above. A direct attack on the U.S. military presence in the Gulf would be met with extreme force, according to U.S. President Donald Trump.4 A shooting war in the Gulf would, once again, raise the odds of a closing of the Strait of Hormuz, which has been threatened in the past by Iran. Some 20% of the world’s oil supply transits the Strait daily.5 A credible attack against shipping in the Strait would send oil prices sharply higher. If Iran were to succeed in blocking transit through the Gulf, an even sharper move in prices – above $150/bbl – could be expected. Markets Too Sanguine Re Sino – U.S. Trade War Commodity markets are not fully pricing the recent escalation of Sino – U.S. trade war, which were dialled up recently when Chinese President Xi Jinping declared China is embarking on a “New Long March” at a domestic political visit.6 The size of the tariffs thus far imposed by the U.S. against China and the EU are trivial in the context of global trade flows of ~ $19.5 trillion this year (Chart 5).7 According to the WTO, the USD value of merchandise trade rose 10% last year to $19.5 trillion, partly on the back of higher energy prices, while the value of services increased to $5.8 trillion, an 8% gain. Against this, U.S. tariffs of 25% on $250 billion worth of goods imported from China remain trivial. U.S. tariffs so far on EU imports by the U.S. are de minimis. Trade concerns do matter, however, in the longer run. Our geopolitical strategists make the odds of a no-deal outcome 50%, vs. a 40% chance of a deal being reached, and a 10% chance trade talks extend beyond the G20 talks scheduled for June. If markets become convinced the current Sino – U.S. trade war will evolve into a larger standoff between the U.S. and China – military or economic – capex and global supply chains will undergo profound changes. Globally, states likely will find themselves in the orbit of one of these powers, which will fundamentally alter investment flows and, ultimately, the profitability of global businesses. A full-blown trade war could become a Cold War, in other words, which would re-order global supply chains.8 Should this occur, an increase in demand for oil, bulks like iron ore, and base metals could ensue, as China ramps its fiscal and monetary stimulus, and the U.S. and others in its sphere of influence bid up commodity prices as they are forced to pay for other higher-cost alternatives for once-cheaper goods and services.9 USD Will Remain A Short-Term Headwind Globally, central banks remain accommodative, which will support aggregate demand domestically. However, the combination of rising U.S. – Iran tensions and the prospect of a widening Sino – U.S. trade war have put a bid under the USD in the short term. Our FX strategists expect the USD will appreciate another 2 – 3% before cresting and heading lower later in the year. In the short term, USD strengthening is a headwind for oil prices. A stronger dollar translates into higher prices in local currencies ex U.S., which reduces demand, all else equal. On the supply side, a stronger dollar lowers local production costs, which stimulates supply ex U.S. at the margin. Together, these militate against higher oil prices. Assuming the USD does weaken later in the year, as our FX strategists expect, oil prices could pick up a slight tailwind. However, policy risk and supply-demand fundamentals will continue to drive oil prices for the balance of the year. Bottom Line: Oil prices are being restrained by policy risk – particularly U.S. and Chinese trade policy and U.S. foreign policy in the Persian Gulf. We believe markets are under-estimating the odds of Brent prices being above $75/bbl for barrels delivering in December 2019, and in March 2020. A resolution of Sino – U.S. trade tensions is less likely than a no-deal outcome (40% vs. 50%), with the odds of trade talks continuing beyond next month’s G20 meeting being very slim (10%). A deepening of the Sino – U.S. trade war will have longer-term consequences for commodity demand – possibly positive in the wake of Chinese fiscal and monetary stimulus. Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see BCA’s Foreign Exchange Strategy Weekly Report titled“President Trump And The Dollar”, dated May 9, 2019, available at fes.bcaresearch.com. 2 Please see “Iranian naval mines likely used in UAE tankers attacks: Bolton,” published by reuters.com on May 29, 2019. See also BCA’s Commodity & Energy Strategy Weekly Report titled “Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity”, dated October 25, 2018, and BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report “U.S.-Iran: This Means War?”, dated May 3, 2019, both available at ces.bcaresearch.com. 3 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled“Policy Risk Sustains Oil’s Unstable Equilibrium” , dated May 23, 2019, available at cesbcaresearch.com. 4 Please see Trump issues harsh warning to Iran, tweeting it would meet its "official end" if it fights U.S. posted by cbsnews.com on May 20, 2019. 5 Please see BCA’s Geopolitical Strategy and Commodity & Energy Strategy Special Report titled “U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic”, dated July 19, 2018, available at ces.bcaresearch.com. 6 For an excellent discussion of these developments, please see BCA’s Geopolitical Strategy Weekly Report titled “Is Trump Ready For The New Long March?”, dated May 24, 2019, available at gps.bcaresearch.com. The “New Long March” is a reference to the 8,000-mile retreat of Chinese Communist Party fighters so they could regroup and ultimately prevail in their civil war in 1934-35. In recalling the Long March, “President Xi … told President Trump to ‘bring it on,’ as he apparently believes that a conflict with the U.S. will strengthen his rule,” according to Matt Gertken, BCA Research’s Chief Geopolitical Strategist. 7 Please see “Global trade growth loses momentum as trade tensions persist,” published by the WTO April 2, 2019. The World Trade Organization expects the growth in merchandise trade volume to drop from 3% last year to 2.6% in 2019, with a slight improvement next year back to 3% growth. Importantly, the WTO notes this is “dependent on an easing of trade tensions.” 8 The odds of a “hot war” between the U.S. and China also are rising, particularly in the South China Sea, according to Adm. James Stavridis (USN, Retired). Please see Collision course in the South China Sea published by the Nikkei Asian Review May 22, 2019. 9 Please see BCA’s Commodity & Energy Strategy Weekly Report titled“Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals” dated May 9, 2019, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades
In our recent research, we have highlighted that our confidence in our constructive cyclical equity view has been shaken. There is budding evidence that the global growth recovery anticipated for the back half of the year could be pushed out to Q1/2020. In China, apparent diesel demand is adding insult to injury and warns that the ongoing Chinese easing has not translated into rising economic activity. Importantly, despite being collected prior to President Trump’s May 5th tweet, this data signals that global growth will likely remain downbeat in the coming months. Moreover, it underscores that more equity market pain lies ahead (see chart), as historically, Chinese diesel consumption growth and SPX momentum have been joined at the hip. Granted, there is a caveat as Beijing has been clamping down on highly polluting diesel fuel, suggesting that part of the recent plunge in apparent diesel consumption might have been exacerbated by the ongoing smog crackdown. Nonetheless, as it still powers trucking freight and infrastructure activity, Chinese diesel demand is telling us something about the weakness in domestic activity. Bottom Line: Stay cautious on the broad equity market.
The top panel shows that while the 7-day repo rate rose in late-2016 and 2017, the rise was fairly small (on the order of 60 basis points). By contrast, the 3-month repo rate surged, which appears to have been caused by macro-prudential policy changes aimed…
Instead of aggressive and broad-based bank lending, this policy push will likely have to come in the form of quasi-fiscal spending, e.g. a significant increase in infrastructure-oriented local government bond issuance (which we include as “credit” in our…
Highlights A financial market riot point remains likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail. The near-term outlook is bearish for China-related assets, but investors should stay cyclically bullish in anticipation of a strong reflationary response. It is not clear whether further monetary easing will occur over the coming year, given that monetary conditions have already eased substantially. But an RRR cut coupled with a benchmark lending rate cut is now a real possibility, and would signal that the monetary policy dial has been turned to “maximum stimulus”. Monthly credit growth needs to be approximately 2.8-3 trillion RMB per month in May and June in order to be consistent with a 2015/2016-magnitude policy response. May’s number may fall short of this, but that would set up June as a make-it or break-it month for credit creation. Chinese credit growth surged in 2012, but economic activity did not significantly accelerate. A repeat of this scenario is a risk to our cyclically bullish stance, but three reasons suggest it is not likely to occur. Investors should stay long USD-CNH over the cyclical horizon despite warnings from Chinese policymakers not to short the RMB. Feature Tensions between China and the U.S. have worsened materially over the past two weeks, in line with our view that an actual trade agreement this year (not just continued negotiations) is much less likely. The Huawei blacklist, stalled negotiations, a sharp escalation in preparatory nationalist rhetoric in China, and President Xi Jinping’s declaration in a Jiangxi province speech that the country is embarking on a new “Long March”1 significantly diminishes the possibility of a deal that addresses the U.S.’ structural concerns. Chart 1A Market Riot Point Is Coming This implies that any agreement would require President Trump to capitulate and accept a temporary deal relating simply to the balance of trade between the two countries. It is possible that this occurs over the coming 6-12 months (in time for Trump to attempt a declaration of victory before the 2020 election), but it is not likely to occur before real economic (and thus financial market) pain arrives. This supports our view that a major financial market riot point is likely over the coming few months to force policymakers, including those in China, to address the economic weakness that a full-tariff scenario will entail (Chart 1). Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight Chinese stocks (in hedged currency terms) on the basis that policymakers will ultimately respond as needed, lest they face an unstable deceleration in economic activity that may become difficult to stop. In this week’s report we address the following three questions facing China-exposed investors over the coming year, before concluding with a brief note about the RMB: Can the PBOC provide more of a reflationary impulse if needed, and if so, how? How can investors tell whether policymakers are stimulating as required from the monthly credit data? What are the odds that China will stimulate aggressively and the economy does not meaningfully reaccelerate? How Can The PBOC Ease Further? We argued in our May 15 Weekly Report that a 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome.2 In our view, this response, instead of aggressive and broad-based bank lending, will likely have to come in the form of quasi-fiscal spending, e.g. a significant increase in infrastructure-oriented local government bond issuance (which we include as “credit” in our adjusted total social financing calculation). However, we have received several questions from clients asking about the outlook for monetary policy in a full-tariff scenario, particularly the question of what the PBOC can do to provide even more of a reflationary response. Most investors would simply assume that the PBOC would cut interest rates even further, and this is certainly a possible outcome over the coming year. But even if the PBOC were to cut interest rates, it is not always clear to investors what rate should or will be cut. Confusion surrounding China’s monetary policy landscape has been high ever since the PBOC established an interest rate corridor system in 2015, and a review of what has occurred over the past 2½ years is warranted in order to better understand the implications of future policy decisions. A 2015/2016-magnitude policy response will again be required in order for policymakers to be confident that the upcoming trade shock will be overcome. Chart 2The Simple (But Incomplete) View Of China's New Monetary Regime Chart 2 outlines how China’s new monetary regime is officially described by the PBOC. The benchmark lending rate, China’s “old” policy rate that established a base regulated rate for banks to price their loans, was replaced in 2015 with a corridor system. The target rate in this system is the 7-day interbank repo rate, which can be seen in Chart 2 is often at the low end of the corridor. However, we explained in a February 2018 Special Report why Chart 2 is only half of the story.3Charts 3 - 5 show the other half: Chart 3 shows that while the 7-day repo rate rose in late-2016 and 2017, the rise was fairly small (on the order of 60 basis points). By contrast, the 3-month repo rate surged, which appears to have been caused by macro-prudential policy changes aimed at severely curtailing the issuance of wealth management products by non-depository financial institutions. Chart 4 highlights that there is a strong (and leading) relationship between changes in China’s 3-month interbank repo rate and 1) changes in the percentage of loans issued above the benchmark rate and 2) changes in the gap between the weighted-average interest rate and the benchmark rate. Chart 5 shows that China’s weighted average interest rate can be successfully modelled by a regression on the benchmark lending rate and the 3-month interbank repo rate. Chart 3The 3-Month Repo Rate Has Been More Important Than The 7-Day Chart 4A Strong Link Between 3-Month Repo Rates And Economy-Wide Rates The relationships shown in Charts 3 - 5 are weaker if the 3-month repo rate is replaced with the 7-day rate, highlighting that while the latter is the new de jure policy rate in China, the former has been the de facto policy and market-driven lending rate among banks and non-financial institutions over the past 2½ years. Chart 5The Benchmark Lending And 3-Month Repo Rates Explain Effective Lending Rates Our framework for examining China’s monetary policy environment leads us to conclude that there are three things the PBOC can do to meaningfully ease further, were they to decide to do so: The most impactful action that the PBOC could take is to cut the benchmark lending rate. While banks in China are no longer required to price loans in reference to the benchmark rate, in practice many still do. Roughly 2/3rds of loans in China have been priced at an interest rate above the benchmark over the past year, and Chart 5 noted that the weighted average interest rate is a direct function of the benchmark rate. As such, a cut to the benchmark rate is likely to feed directly into lower lending rates. Chart 3 showed that the substantial spread between the 3-month and 7-day repo rates that prevailed from late-2016 to mid-2018 has all but disappeared, implying that the PBOC cannot lower interest rates much further by dialing back on macro-prudential regulation. Instead, if it wants interbank rates to fall meaningfully, lowering the corridor around the 7-day rate by cutting the floor (the PBOC’s 7-day reverse repo rate) will likely be required. This would be carried out with further reductions to the reserve requirement ratio (RRR). Third, while Chart 5 showed that our model for the weighted average lending rate has done a very good job over the past few years, it is clear that a gap has opened up between the actual rate and that predicted by the model. The most likely explanation of this gap is that it is due to a risk premium applied by banks, possibly in response to the re-orientation of riskier funding demands that had previously been fulfilled by the shadow banking sector to on-balance sheet loans from depository institutions. It is not clear what policy tools are at the PBOC’s disposable to reduce the gap, but doing so has the potential to lower average interest rates by a non-trivial amount. The relative easiness of monetary conditions is the key difference between today and 2012. It is not clear yet which option the PBOC will pursue over the coming year or whether further monetary easing will occur, but an RRR cut coupled with a benchmark lending rate cut is now a real possibility. If it happens, it would be a clear signal for investors that the monetary policy dial has been turned to “maximum stimulus”. Inferring Reluctance Or Capitulation From Monthly Credit Growth The second issue that investors will be wrestling with over the coming few months relates to the question of whether the month-to-month pace of credit growth is consistent with the magnitude of the reflationary response that we believe will be required. To the extent that significantly more monetary easing occurs over the coming year, it is likely to have happened because policymakers were overly reluctant to green-light a renewed and substantial re-acceleration in credit growth and were then forced to fight a destabilizing slowdown in the economy. Chart 6A Strong Credit Response Will Be Required In Response To A Full Tariff Scenario We have used the metric of new credit to GDP as the primary method to judge the relative size of previous credit booms, and have argued that a return to 30% on this measure will likely be required in response to a full 25% tariff scenario (Chart 6). Unfortunately, China’s unique seasonality patterns and the lack of official seasonally adjusted data make it difficult for investors to judge whether incoming credit data is consistent with the required policy response. Previously, we have shown seasonally adjusted measures of credit using a simple application of X12 ARIMA, the statistical seasonal adjustment program used by the U.S. Census Bureau. But Charts 7 and 8 present a different approach. The charts show the average cumulative amount of adjusted total social financing as the calendar year progresses, along with a ±0.5 standard deviation band, based on the 2010 to 2018 period. The thick black line in both charts shows the progress in new credit creation this year, assuming an 8% annual nominal GDP growth rate for the remainder of the year. Chart 7 shows the cumulative progress in credit assuming a 27% new credit to GDP ratio for the year (corresponding to a half-strength credit cycle relative to past episodes), whereas Chart 8 assumes 30%. In our view, these charts are revelatory. First, Chart 7 provides evidence that policymakers have been reluctant to allow credit growth to surge. The chart shows that credit growth ran well above a half-strength credit cycle pace in the first quarter of the year; following this, through either administrative controls or jawboning, policymakers lowered the pace of credit growth in April such that it moved back within the range. By contrast, Chart 8 highlights that the pace of Q1 credit growth was exactly right in a 30% new credit to GDP scenario, and that April fell short. In order to be back within the range by June, Chart 8 suggests that monthly credit growth needs to be on the order of 2.8-3 trillion RMB per month in May and June, just a slightly slower pace than what investors observed in March. It is quite possible that May’s credit number will fall short of 2.8-3 trillion RMB, given that the increase in the second round tariffs only occurred on May 10 and that Chinese policymakers have so far seemed reluctant to pull the trigger. But this also heightens the risk of a serious near-term selloff in the domestic equity market, and would set up June as a make-it or break-it month for credit creation. Stimulus Without A Recovery? Revisiting The 2012 Scenario Chart 9The 2012 Scenario: Strong Credit, But A Modest Improvement In Activity A final question facing investors this year is whether it is possible that the Chinese economy fails to respond to strong efforts by policymakers to stimulate the economy. Chart 9 shows that a similar situation occurred in 2012; while the surge in new credit to GDP did stabilize economic activity and caused a modest uptrend, the economic improvement was much smaller than what the relationship shown in the chart would imply. In our view, there are three reasons to believe that a 2012 scenario will not repeat itself: First, Chart 10 shows that the Q1 rebound in new credit to GDP appears to have halted the decline in investment-relevant Chinese economic activity. There is no basis to suggest that an uptrend in activity has begun, but the fact that the economy has even started to respond to the pickup in credit growth is a positive sign. Second, Chart 11 highlights one important difference between 2012 and today. The chart shows that our leading indicator for China’s economy did not rise as much as new credit to GDP, and that this occurred because monetary conditions remained relatively tight from the beginning of 2012 all the way through to early-2015. This relative tightness in monetary conditions occurred because of fairly elevated interest rates, and due to a persistent rise in the real effective exchange rate. However, the collapse in the weighted average lending rate following the 2015/2016 economic slowdown has eased monetary conditions in a lasting way, suggesting that a similar rise in new credit to GDP should have a strongly positive effect on Chinese economic growth. This also underscores our earlier point: monetary policy has already largely returned to 2015/2016 levels, meaning that it is fiscal/administrative action to boost credit growth that is missing. Third, Chart 12 highlights that the pace of inventory accumulation represents another key difference between the current economic environment and that of 2012. The chart shows that the change in China’s level of industrial inventories relative to exports (both measured in value terms) rose sharply in 2011 and 1H 2012, only to slow significantly over the following year (which may have weighed on the rebound in activity in 2012 and 2013). In contrast, the chart shows that inventories have recently been contracting at their fastest pace relative to exports since 2011, implying that the drag on production from potential destocking may be minimal. Chart 10A (Very) Tentative Sign Of Stabilization Chart 11Monetary Conditions Are Considerably Easier Today There are, however, two caveats to the above analysis. First, on the inventory front, Chart 12 shows that the level of industrial inventories to exports is fractionally higher than it was in 2012, even though it has declined significantly from its 2017 high. The level of inventories has been rising relative to exports for some time, and thus the “equilibrium” level is not clear. But to the extent that a prolonged trade war with the U.S. requires meaningfully lower inventory levels in China, then destocking may become more of a drag than we expect. Second, Chart 11 shows that while monetary conditions are much easier today than they were in 2012, money growth is much weaker. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, although we cannot reasonably envision an outcome where credit growth surges and growth in the money supply does not. A Brief Note On The RMB We noted in our May 15 Weekly Report4 that a significant rise in new credit to GDP and a meaningful decline in the currency would be required to stabilize China’s economy if the U.S. proceeds with 25% tariffs on all imports from China. Consequently, we recommended that investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade, with the expectation that a break above 7 in the coming weeks was likely (Chart 13). Chart 12Inventories Have Been Meaningfully Reduced Chart 13In A Full Tariff Scenario, A Defense Of 7 Is Only A Near-Term Event Recently, Xiao Yuanqi, the spokesman for the China Banking and Insurance Regulatory Commission, was quoted as saying that “those who speculate and short the yuan will [surely] suffer heavy loss[es]”,5 which many investors took to mean that China will defend USD-CNY = 7 at all costs. In our view this may be true in the short-term, but is unlikely to occur over a 6-12 month time horizon in a full 25% tariff scenario. Policymakers have become much more attuned to sharp declines in the currency after the major episode of capital flight that occurred in 2015 and 2016, and are keen to ensure that any movements in the exchange rate are orderly. However, complete currency stability in the face of a major shock to the export sector means that the required rise in the “macro leverage ratio” to stabilize the economy will be even higher, highlighting that an orderly depreciation in the currency is the lesser of two evils. As such, we interpret these recent comments from policymakers as an attempt to prevent a breach in USD-CNY = 7 over the short-term, and an attempt to control the pace of decline over the longer term in a full-tariff scenario. The conclusion for investment strategy is that China-exposed investors should stay long USD-CNH over the cyclical horizon, but should limit the leverage of the position and should expect frequent short-term reversals. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, “Seven Questions About Chinese Monetary Policy,” dated February 22, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com. 5 Reuters News, “China’s top banking regulator says yuan bears will suffer ‘heavy losses’,” dated May 25, 2019. Cyclical Investment Stance Equity Sector Recommendations
Highlights The view that the world will sink into a deflationary “ice age” hinges on the assumption that policymakers will make a colossal mistake by failing to do what is in their own best interest. Contrary to popular belief, governments always have a tool to increase inflation, even when an economy has fallen into a liquidity trap: It’s called sustained fiscal stimulus. Japan could have avoided its deflationary epoch if the authorities had eased fiscal policy more aggressively. Ironically, bigger budget deficits probably would have caused the government debt-to-GDP ratio to rise less than it did. The U.S. and China are unlikely to repeat Japan’s mistake. Actually, looking ahead, Japan may not repeat Japan’s mistake. The euro area is a tougher call given the region’s political and institutional constraints; but even there, a reflationary outcome is more likely than not. An intensification of the trade war will cause government bond yields to fall a bit further in the near term. However, yields are likely to be higher one year from now. Global equities will follow the same path as bond yields: Down in the near term, but up over a 12-month horizon. Feature I feel more confident than ever that the next phase of the Ice Age will soon be upon us. Much of the thesis has come from learning the hard deflationary lessons from Japan. Most commenters now accept the Japanification of mainland Europe has occurred, but they just cannot conceive that the same thing might happen with the US. My biggest conviction call is that US 10y bond yields will converge with Japanese and German yields in the next recession at around minus 1% (and US 30y yields will fall to zero or below) and that markets will panic as outright deflation takes an icy grip. - Albert Edwards, Société Générale (May 2019) Fire Or Ice? If you were to ask most central bankers today whether it is better to err on the side of too much or too little inflation, chances are they would say the former. Their rationale would surely be as follows: If inflation rises to uncomfortably high levels, they can simply raise interest rates in order to cool the economy. In contrast, if inflation gets too low, and interest rates are already close to zero, monetary policy loses potency. It is better to have more control over the economy than less. This reasoning is correct on its own terms, but if one stands back and thinks about it, it is rather perverse to argue that deflation, which generally stems from a lack of aggregate demand, should be more difficult to overcome than inflation, which is usually the result of too much demand. After all, people like to spend money. Getting someone to work and produce should, in principle, be more difficult than getting them to consume. Inflation should be a bigger problem than deflation. So why do so many economists think otherwise? The Paradox Of Thrift There actually is a very good reason for this bias, one which John Maynard Keynes articulated more than 80 years ago. Keynes observed that when unemployment is rising, people are likely to try to save more due to fear of losing their jobs. Since one person’s spending is another’s income, this could create a vicious cycle where falling spending leads to lower aggregate income, and so on. Unfortunately, it is hard to save if you do not have a job. Thus, the decision by all individuals to save more could result, ironically, in a decline in aggregate savings.1 Keynes called this the paradox of thrift. At the heart of the paradox of thrift lies a deep-seated coordination problem. During an economic downturn, everyone would be better off if everyone else spent more money. However, since the spending of any one person only has a negligible effect on aggregate demand, no one has an incentive to spend more than is absolutely necessary. Keynes’ seminal insight was that a government could overcome this coordination problem by acting as a spender of last resort. Keynes argued that if the private sector decides to save more, the public sector should save less by running a bigger budget deficit. The result would be the preservation of full employment. Debt And Deliverance A common objection to the idea that governments should run bigger budget deficits to compensate for inadequate private-sector demand is that this will cause public-sector debt levels to swell to the point that a fiscal crisis becomes inevitable. The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. For countries such as Italy, this is a legitimate concern. If a country does not have a central bank that can serve as a buyer of last resort of government debt, it can end up facing a pernicious feedback loop where rising bond yields increase the likelihood of default, leading to even higher bond yields. These countries can, and often do, face speculative attacks on their bond markets (Chart 1). For countries that issue debt in their own currencies, this concern does not exist. This is because their governments can print money to pay for goods and services. Since the cost to the government of printing a $100 bill is negligible, the government can always conjure up demand out of thin air. Of course, there is a risk that the government will manufacture too much demand and inflation will rise. But if the goal is to prevent deflation, this is a feature not a bug. Once demand increases enough, the government can just pull the plug on further fiscal stimulus, and everyone can live happily ever after. Japan’s Experience Chart 2The 1990s Japanese Example Didn’t Japan try this approach and fail? No. Japan suffered the mother of all financial shocks in the early 1990s when the real estate and stock market bubbles simultaneously burst. This happened just as the working-age population was peaking, which made businesses even less eager to expand domestic capacity. The result of all this was a massive increase in excess private-sector savings. The government did loosen fiscal policy, but not by enough. Consequently, deflation eventually set in. As inflation expectations fell, real rates rose (Chart 2). Rising real rates put upward pressure on the yen and increased the government’s real debt financing costs. To make matters worse, falling prices made it more difficult for private-sector borrowers to pay back their loans. This further depressed spending. Ironically, had the Japanese government eased fiscal policy more aggressively to begin with, it probably would have been able to trim deficits later on. Nominal GDP would have also increased more briskly. As a consequence, the government debt-to-GDP ratio would have ended up rising less than it did. Today, Japan remains mired in a deflationary mindset. Twenty-year CPI swaps, a proxy for long-term inflation expectations, are trading at 0.3%, nowhere close to the Bank of Japan’s 2% target. Interest rates are stuck near zero, reflecting the fact that the economy continues to suffer from excess savings. Japan Needs Fiscal Stimulus, Not Austerity The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. Given Japan’s pathetically low fertility rate, a sensible strategy would be to offer subsidized housing and baby bonuses to any couple that has three or more children. It is impossible to know how big a budget deficit will be required to reset inflation expectations to a higher level. If people believe that the government is serious about easing fiscal policy by enough to get inflation up to target, real rates will collapse, the yen will fall, and private demand will rise. In the end, the government may not need to raise the budget deficit that much. Even if the Japanese government did have to increase the budget deficit substantially, this would not endanger the economy. As long as the interest rate at which the government borrows is below the growth rate of the economy, any budget deficit, no matter how large, will produce a stable debt-to-GDP ratio in the long run (Chart 3).2 Since there would be no need to ease fiscal policy by so much that the Bank of Japan is forced to lift interest rates above the economy’s growth rate, there is little risk that the debt-to-GDP ratio will end up on an unsustainable trajectory. Chart 4Japanese Excess Savings Are Starting To Recede Will the Japanese government heed this advice? While Q1 GDP growth surprised on the upside, this was mainly because of a strong contribution from net exports and inventories. Final domestic demand remains underwhelming. Stronger global growth will help Japan later this year, but we think there is still a 50/50 chance the planned VAT hike will be postponed. Looking ahead, the exodus of Japanese workers from the labor market into retirement will reduce private-sector savings. The household savings rate has already fallen from nearly 20% in the early 1980s to around 4% in recent years. The ratio of job openings-to-applicants has risen to a 45-year high (Chart 4). Falling private-sector savings will raise the neutral rate of interest, thus giving the BoJ more traction over monetary policy. Japan’s deflationary ice age may be coming to an end. Stimulus With Chinese Characteristics Like Japan, China has struggled to consume enough of what it produces. In the days when China had a massive current account surplus, it could export that excess savings abroad. It cannot do that anymore, so the government has consciously chosen to spur fixed-investment spending in order to prop up employment. Since a lot of investment is financed through credit, debt levels have risen (Chart 5). Much of China’s debt-financed investment spending has been undertaken by local governments and state-owned enterprises. This has made credit and fiscal policy virtually indistinguishable. While the general government fiscal deficit stands at a moderate 4.1% of GDP, the augmented deficit, which includes a variety of off-balance sheet expenditures, has swollen to 10.7% of GDP, up more than six percentage points since 2010 (Chart 6). Chart 5China: From Exporting Savings To Investing Domestically And Building Up Debt As we discussed a few weeks ago in a report entitled “Chinese Debt: A Contrarian View”, there is little preventing the Chinese government from further ramping up credit/fiscal stimulus.3 The fact that the trade negotiations are on the ropes only strengthens the case for additional easing. The government knows full well that it will gain negotiating leverage over the U.S. if the Chinese economy is humming along despite higher tariffs on Chinese imports. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Europe: Turning Japanese? Judging from the fact that German bund yields have fallen to Japanese levels, one might conclude that the Japanification of Europe is complete. There is, however, at least one key macro difference between the two regions: While long-term inflation expectations in the euro area have declined, they are still well above Japanese levels (Chart 7). As a result, real yields are quite a bit lower in core Europe, which gives countries such as Germany and France some cushion of support. Chart 7Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower In Germany Than Japan Chart 8Italian Bond Yields Are Still Worryingly High Bond yields remain elevated in Italy, though still below the levels seen last October, and far below their peak during the euro crisis in 2011 (Chart 8). Short of the creation of a pan-euro area fiscal union, Italy’s best hope is that Germany takes steps to reflate its own economy. The conventional wisdom is that the German psyche, ever focused on fiscal discipline, would never permit that to happen. This view, however, forgets that Germany had no trouble violating the Maastricht Treaty’s deficit cap of 3% of GDP in the early 2000s. Germany today sees little need to significantly loosen fiscal policy because years of wage repression, and more recently, a weak euro, have caused its current account surplus to swell to 9% of GDP. However, the country’s ability to push out its excess production to the rest of the world may become more limited in the future. The gap in unit labor costs between Germany and other euro area members has narrowed steadily in recent years. This development has coincided with a decline in Germany’s trade surplus with the rest of the euro area (Chart 9). If the common currency starts to appreciate and wage growth in Germany continues to outpace the rest of the region, the German government may have no choice but to loosen the fiscal screws. Chart 9Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Chart 10U.S.: Federal Discretionary Spending Has Been Gaining Steam U.S.: Ice Age Vs. Green New Deal While Trump’s tax cuts have gotten a lot of attention, an equally important development in recent years has been the rapid acceleration in federal government spending. From a contraction of 7% in 2013, real discretionary outlays are set to grow by 3% in 2019 (Chart 10). There is little reason to think that the U.S. budget deficit will shrink anytime soon. Taxes may go back up if the Democrats take control of the White House and sweep Congress next year. However, even in that scenario, any increase in tax rates is likely to be neutralized by higher social welfare spending – yes, including partial implementation of the green new deal. Meanwhile, government outlays on Social Security and health care programs such as Medicaid are on track to rise by 5.4% of GDP over the next thirty years (Chart 11). So far, an overstimulated U.S. economy has not produced much in the way of inflation. But with the unemployment rate down to a 49-year low, that could change over the next few years. Recent communications from FOMC members suggest a growing tolerance for a modest inflation overshoot of the 2% target. An outright increase in the Fed’s inflation target is unlikely in the near term, but could become a viable option if realized inflation moves above the Fed’s current comfort zone of 2%-to-2.5% for long enough. If that were to happen, raising the inflation target could turn out to be politically more expedient than engineering a deep recession in an effort to bring inflation back down. It will also help alleviate the rising real debt burden that will ensue from high deficits. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. The Fed is already facing political pressure from the Trump administration to keep rates low. Politics in the U.S. and in many other countries is moving in a more populist direction. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Historically, there is a clear inverse correlation between central bank independence and inflation (Chart 12). Investment Conclusions On the question of whether we are heading for a deflationary ice age or a period of inflationary global warming, we would put higher odds on the latter. Many of the structural factors that have produced lower inflation over the last few decades are in retreat. Globalization has stalled, and may even reverse course if the trade war intensifies (Chart 13). The ratio of workers-to-consumers globally is starting to shrink as the post-war generation leaves the labor force (Chart 14). Central bank autonomy is under attack, while fiscal policy is turning more expansionary. Chart 13The Age Of Globalization Is Over Chart 14The Worker-To-Consumer Ratio Has Peaked Globally To believe that politicians will not dial up fiscal stimulus in the face of a chronic shortfall of aggregate demand is to believe that they will act incompetently. Not incompetent in the low-IQ sort of way. Incompetent in the sense that they will act against their own self-interest. Voters want more employment. In the age of populism, it seems unlikely that politicians with ready access to the printing press will fail to deliver what the people want. We declared “The End Of The 35-Year Bond Bull Market” on July 5, 2016. As luck would have it, this was the very same day that the U.S. 10-year Treasury yield hit an all-time low of 1.37%. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. Right now, we are witnessing a countertrend rally in bond prices. Yields could fall a bit further in the coming weeks if the trade war heats up. However, yields will be higher in 12 months’ time, provided that China and the U.S. begrudgingly reach a trade truce and global growth reaccelerates, as we expect. Global equities are likely to follow the same pattern as bond yields. Trade tensions could push stocks down about 5% from current levels (we are presently positioned for this by being tactically short the S&P 500 against an underlying structural overweight position). However, equities will move to fresh highs over a 12-month horizon as global growth picks up. The recent stock market correction caused our long European bank trade to be stopped out for a loss of 7%. We will re-enter the trade once we conclude that global equities have found a bottom. The dollar will probably strengthen a bit more in the near term, but as a countercyclical currency, the greenback will weaken in the second half of this year. This will provide a good opportunity to go overweight EM and European stocks in common-currency terms. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1 Another way to see this point is to recall that business spending normally declines when the economy weakens. Investment spending tends to move in lockstep with national savings (indeed, at the global level, the two must be exactly equal to each other). Thus, if consumer spending falls in response to the decision by households to try to save more, and this leads to lower investment, it will also lead to lower aggregate savings. 2 Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 3 Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades