China
Highlights Chart 1European Policy Uncertainty Down Macron remains on target to win the French election, but Italy looms as a risk ahead; Fade any relief rally after South Korean elections; Russia is not a major source of geopolitical risk at present; Stay underweight Turkey and Indonesia within the EM universe. Feature The supposed pushback against populism is emerging as a theme in the financial industry. The expected defeat of nationalist-populist Marine Le Pen in the second round of the French election on May 7 has reduced Europe's economic policy uncertainty, despite continued elevated levels globally (Chart 1). We are not surprised by this outcome. A year ago, ahead of both the Brexit referendum and the U.S. election, we cautioned investors that it was the Anglo-Saxon world, not continental Europe, which would experience the greatest populist earthquake.1 The middle class in the U.S. and the U.K. lacks the socialist protections of large welfare states (Chart 2), leading to frustrating outcomes in terms of equality and social mobility (Chart 3). In other words, the gains of globalization have not been redistributed in the two laissez-faire economies. Hence the Anglo-Saxon world got Trump and Brexit while the continent got market-positive outcomes like Rajoy, Van der Bellen, Rutte, and (probably) Macron. Chart 2Given The Qualities Of The##br## Anglo-Saxon Economy ... Chart 3...Brexit And Trump ##br##Should Not Be A Surprise Looking forward, we agree with the consensus that Marine Le Pen will lose, as we have been stressing with high conviction since November.2 Despite a poor start to the campaign, Macron remains 20% ahead of Marine Le Pen with only four days left to the election (Chart 4). Could the polls be wrong? No. And not just because they were right in the first round. Polls are likely to be right because French polls have an exemplary track record (Chart 5) and there is no Electoral College to throw off the math. Chart 4Le Pen Unlikely To Bridge This Gap Chart 5French Polls Have Strong Track Record As we go to press, the two candidates are set to face off in an important televised debate. Given Le Pen's post-debate polling performance in the first round (Chart 6), we doubt she will perform well enough to make a change. Next week, we will review the second round and its implications for the legislative elections in June and French politics beyond. Overall, we think Europe's policy uncertainty dip is temporary, as the all-important Italian election risk looms just ahead in 2018.3 For now, we are sticking with our bullish European risk asset view, but will look to pare it back later in the year. Chart 6Debates Have Not Helped Le Pen Chart 7Commodity Currencies Suggest Global Trade Is At Risk... What about emerging markets? With investors laser-focused on developed market political risks - Trump's policies and protectionism, European elections, Brexit, etc - have EM political risks fallen by the wayside? Chart 8...And Commodities Are At Risk Too Chart 9China's Growth To Decelerate Again We don't think so. According to BCA's Emerging Market Strategy, the recent performance of the commodity currency index (an equally weighted average of AUD, NZD, and CAD) augurs a deceleration of global growth in the second half of this year (Chart 7) and a top in the commodity complex (Chart 8).4 At the heart of the reversal is the slowdown in China's credit and fiscal spending impulse (Chart 9).5 Given China's critical importance as the main source of EM final demand (Chart 10), the slowdown in money and credit growth is a significant risk to EM growth in the latter part of the year (Chart 11).6 Chart 10EM Is Leveraged To China Much More Than DM Chart 11China: Money/Credit Growth Is Slowing At the heart of China's credit slowdown are efforts by policymakers to cautiously introduce some discipline in the financial sector. Chinese interbank rates have risen noticeably, which should have a material impact on credit growth (Chart 12). Given that the all-important nineteenth National Party Congress is six-to-seven months away, we doubt that the tightening efforts will be severe. But they may foreshadow a much tighter policy in 2018, following the conclusion of the Congress, when President Xi has full reign and the ability to redouble his initial efforts at reform, namely to control the risks of excessive leverage to the state's stability. With both the Fed and PBoC looking to tighten over the next 12-18 months, in part to respond to improvements in global inflation expectations (Chart 13), highly leveraged EM economies may face a triple-whammy of USD appreciation, Chinese growth plateauing, and easing commodity demand. In isolation, none is critical, but as a combination, they could be challenging. Chart 12Chinese Policymakers End The Credit Party? Chart 13Global Tightening Upon Us? In this weekly report, we take an around-the-world look at several emerging economies that we believe are either defying the odds of political crisis or particularly vulnerable to growth slowdown. South Korea: Here Comes The Sunshine Policy, Part II South Korea's early election will be held on May 9. The victory of a left-wing candidate has been likely since April 2016, when the two main left-wing parties, the Democratic Party and the People's Party, won a majority of the 300-seat National Assembly. It has been inevitable since the impeachment of outgoing President Park Geun-hye in December - whose removal was deemed legal by the Constitutional Court in March - for a corruption scandal that split the main center-right party and decimated its popular support after ten years of ruling the country.7 The only question was whether Moon Jae-in, leader of the Democratic Party and erstwhile chief of staff of former President Roh Moo-hyun, would finally get his turn as president, or whether Ahn Cheol-soo, an entrepreneurial politician who broke from the Democratic Party to form the People's Party, would defeat him. At the moment, Moon has a significant lead in the polls, while Ahn has lost the bump in support he received after other candidates were eliminated through the primary process (Chart 14). Moon's lead has grown throughout the recent spike in saber-rattling between the United States and North Korea, which suggests that Moon is most likely to win the race. The debates have also hurt Ahn. Moon leads in every region, among blue collar and white collar voters, and among centrists as well as progressives. Also, the pollster Gallup Korea has a solid track record for presidential elections going back to 1987, with a margin of error of about 3%, so Moon is highly likely to win if polls do not change in Ahn's or Hong's favor. The key difference between Moon and Ahn boils down to this: Moon is the established left-wing candidate and has mainstream Democratic Party machinery backing him, a clear platform, and experience running the country from 2003-8. Ahn does not have experience in the executive branch (Blue House) and his policy platform is less clear. His party is a progressive offshoot of the Democratic Party, yet he is bidding for disenchanted center-right voters, a contradiction that has at times given him the appearance of flip-flopping on important issues. Thus Ahn's election would bring greater economic policy uncertainty than Moon's, though Ahn is more business-friendly by preference. Regardless, the new president will have to work with the opposing left-wing party in the National Assembly if he intends to get anything accomplished. The combined left-wing vote is 164, yielding only a 13-seat majority if the two parties work together. Differences between them will cause problems in passing legislation. It would be easier for Moon to legislate with his party's 119-seat base than for Ahn with his party's 40-seat base, unless Ahn can steer his party to cooperate with the center right like he is trying to do in the presidential campaign. Markets may celebrate the election regardless of the victor because it sets the country back on the path of stable government. The Kospi bottomed in November when the political crisis reached a fever pitch and has rallied since December 5, when it became clear that the conservatives in the assembly would vote for Park's impeachment. This suggested an early government change to restore political and economic leadership. The market rallied again when the Constitutional Court removed Park, which pulled the presidential elections forward to May and cut short what would otherwise have been another year of uncertainty until the original election date in December 2017 (Chart 15). Chart 14South Korea: Moon In The Lead Chart 15Korean Stocks Cheered Impeachment Investors can reasonably look forward to an increase in fiscal thrust after the election, particularly if Moon is elected. Table 1 compares the key policy initiatives of the top three candidates - both Moon and Ahn are pledging increases in government spending. Note that South Korean fiscal thrust expanded in the first two years of the last left-leaning government, i.e. the Roh Moo-hyun administration (Chart 16). Table 1South Korean Presidential Candidates And Their Policy Proposals Chart 16Left-Wing Leaders Drive Up Fiscal Spending Beyond any initial relief rally, however, investors may experience some buyer's remorse. South Korea is experiencing a leftward swing of the political pendulum that is not conducive to higher growth in corporate earnings. This is the implication of the April legislative elections and the collapse of President Park's support prior to the corruption scandal; it will also be the takeaway of either Moon's or Ahn's election win over a discredited conservative status quo (both fiscal and corporate). The leftward shift is motivated by structural factors, not mere political optics. Average growth rates have fallen since the Great Recession, yet South Korea lacks the social amenities of a slower-growing developed economy. The social safety net is comparable to Turkey's or Mexico's and wages have been suppressed to maintain competitiveness (Chart 17). Inequality has grown dramatically (Chart 18). Chart 17Keeping Labor Cheap Chart 18Fueling The Populist Fire Therefore the policies to come will emphasize redistribution, job security, and social benefits. Moon's policies, in particular, are aggressive. He has pledged to require the public sector to increase employment by 5% per year and add 810,000 jobs by 2022, and to expand welfare for the elderly regardless of their income level. This will swell the budget deficit and public debt, especially over time, given South Korea's demographic profile, which is rapidly graying (Chart 19). Moon also intends nearly to double the minimum wage, require private companies to hire 3-5% more workers each year, depending on company size, and give substantial subsidies to SMEs that hire more workers. He supports a hike in corporate taxes, though the details of any tax changes have yet to be disclosed. Chart 19Society Turning Gray Ahn's policy preferences are more focused on productivity improvements than social welfare. While Moon panders to middle-aged workers concerned about job security - among whom he leads Ahn by 30 percentage points - Ahn panders to the youth, who are currently battling an unemployment rate of 11%. He would pay subsidies to young workers while they look for jobs immediately after graduation ($266 per month) and for the first two years of their employment at an SME ($532 per month). He would direct budgetary funds to research and development, high-tech industries, and job training. The SME policies speak to the general dissatisfaction with the cozy relationship between large, export-oriented industrial giants - the chaebol - and the political elite. Both Moon and Ahn will attempt to remove subsidies and privileges from the chaebol, potentially forcing them to sell or spin-off branches that are unrelated to their core business, and will seek to incentivize SMEs. Chaebol reform is a long-running theme in South Korean politics with very little record of success, but the one thing investors can be sure of on this front is greater uncertainty regarding policies toward the country's multinationals. Bottom Line: South Korea is experiencing a swing of the political pendulum to the left regardless of who wins the presidential race on May 9. What About Geopolitics? Internationally, Moon, if he wins, will attempt to improve relations with China and North Korea at the expense of the U.S. and Japan. His voter base came of age during the democracy movement of the 1980s and is friendlier toward China and less hostile toward North Korea than other age groups (Chart 20 A&B). Ahn may attempt a similar foreign policy adjustment, but he is less willing to confront the United States. His attempt to woo the youth will constrain any engagement with Pyongyang, since young South Koreans feel the least connection with their ethnic brethren to the north. Given that a Moon presidency would be paired with that of Trump, it would likely precipitate tensions in the U.S.-Korean relationship. News headlines will announce that South Korea is "pivoting" toward China, much in the way that U.S. ally the Philippines was perceived as shifting toward China after President Rodrigo Duterte's election in 2016. This will be an exaggeration, since Koreans still generally prefer the U.S. to China and view North Korea as an enemy (Chart 21). Nevertheless, there is potential for real, market-relevant disagreements. Chart 20Moon's Middle-Aged Constituency Chart 21Constraints On The Sunshine Policy In the short term, the risk is to trade, given the South Korean Left's strain of opposition to the U.S.-Korea free trade agreement (KORUS) and Trump's intention to renegotiate it, or even impose tariffs. Trump is bringing a protectionist tilt to U.S. trade policy - at very least - and he is relatively unconstrained on trade so we consider this a high-level risk over his four-year term in office. Trade tensions could become consequential if South Korea breaks with the U.S. over North Korea, angering the Trump administration. At the same time, South Korea's trade with China (Chart 22) is a risk due to China's secular slowdown, protectionism, and intention to move up the value chain and compete with South Korea in global markets. Chart 22South Korea's Twin Trade Risks In the short and long term, Moon's attempt to revamp Kim Dae-jung's "Sunshine Policy" of economic engagement and denuclearization talks with North Korea could create serious frictions with the U.S. What Moon is proposing is to promote economic integration so that South Korea has more leverage over the North, which is increasingly reliant on China, and also to reduce military tensions via negotiations toward a peace treaty (the 1950-3 war ended with an armistice only). The idea is to launch a five-year plan toward an inter-Korean "economic union." This would begin by re-opening shuttered cooperative projects like the Kaesong Industrial Complex and Mount Kumgang tours and later establish duty-free agreements, free trade zones, and multilateral infrastructure projects that include Russia and China.8 The problem is that any new Sunshine Policy - which is ostensibly a boon for the region's security - will clash with the Trump administration's attempt to rally a new international coalition to tighten sanctions on North Korea to force it to freeze its nuclear and ballistic missile programs. North Korea will want to divide the allies and thus will be receptive to China's and South Korea's offers of negotiations; the U.S. and Japan will not want to allow any additional economic aid to the North without a halt to tests and tokens of eventual denuclearization. How will this tension be resolved? Trump is preparing for negotiations and over the next couple of years the U.S. and Japan are highly likely to give diplomacy at least one last chance, as we have argued in recent reports.9 Eventually, if the U.S. becomes convinced of total collaboration between China and South Korea with the North (i.e. skirting sanctions and granting economic benefits), while the North continues testing capabilities that would enable it to strike the U.S. homeland with a nuclear weapon, some kind of confrontation is inevitable. But first the U.S. will try another round of talks. The "arc of diplomacy" could extend for several years, as it did with Iran (Chart 23), if the North delays its missile progress or appears to do so. Chart 23The 'Arc Of Diplomacy' Can Last For Several Years Despite our belief that the North Korean situation will calm down as diplomacy gets under way, South Korea is seeing rising geopolitical headwinds for the following reasons: Sino-American tensions: U.S.-China competition is growing over time, notwithstanding the apparently friendly start between the Trump and Xi administrations.10 Trump's North Korea policy: The Trump administration has signaled that the U.S. does not accept a nuclear-armed North Korea and the need to maintain the credibility of the military option will keep tensions at a higher level than in recent memory.11 Japanese re-armament: Japanese tensions with China and both Koreas are rising as Japan increases military expenditures and maritime defenses and moves to revise its constitution to legitimize military action.12 The costs of peace: If diplomacy prevails, South Korean engagement with the North still poses massive uncertainties about the future of the relationship, the North's internal stability amid liberalization, whether the transition to greater economic integration will be smooth, and whether the South Korean economy (and public finances) can absorb the associated costs. This is not even to mention eventual unification. Bottom Line: The current saber-rattling around the Korean peninsula is not over yet, but tensions are soon to fall as international negotiations get under way. Still, geopolitical risks for South Korea are rising over the long run. Investment Conclusions The currency will be the first to react to the election results and will send a signal about whether the fall in policy uncertainty is deemed more beneficial than the impending rise in pro-labor policies. Beyond that, the won has been strong relative to South Korea's neighbors and competitors (Chart 24). The Korean central bank is considering cutting rates at a time when fiscal policy is set to expand substantially, a negative for the currency. Chart 24Won Strength, Yen Weakness Therefore we remain short KRW / long THB. Thailand, another U.S. ally, is running huge current account surpluses, is more insulated from U.S.-China geopolitical conflicts, and has navigated tensions between the two relatively well. We expect a relief rally in stocks due to resolution of the campaign and the likelihood of an easing in trade tensions with China. However, this is the only reason we are not yet ready to join our colleagues in the Emerging Markets Strategy in shorting Korean stocks versus Japanese. We will look to put on this trade in future. We do not have high hopes for Korean stocks over the long run due to the headwinds listed above. As for bonds, both Moon's and Ahn's agendas, particularly Moon's, will be bond bearish because they will increase deficits and debt. At the short end of the curve, yields may have reason to fall; but the long end should reflect looser fiscal policy, the worsening debt and demographic profile, and increasing geopolitical risk, whether from conflicts with the U.S. and North Korea, or from the rising odds of a greater future burden from subsidizing (or even merging with) North Korea. Therefore we recommend going long 2-year government bonds / short 10-year government bonds. Russia: Defying Odds Of A Political Crisis Russia has emerged from the oil-price shocks scathed, but unbowed.13 Its textbook macro policy amid a severe recession over the past two years has been exemplary: The government has maintained constant nominal expenditure growth and substantially cut spending in real terms (Chart 25). The fiscal deficit is still large at 3.7%, but it typically lags oil prices (Chart 26). Hence, the recovery in oil prices over the past year should lead to a notable improvement in the budget balance. For 2017, the budget is conservative, as it assumes $40/bbl Urals crude. Chart 25Russia Has Undergone##br## Through Real Fiscal Squeeze... Chart 26...Which Is##br## Now Over Early this year, the Ministry of Finance adopted a new fiscal rule where it will buy foreign currency when the price of oil is above the set target level of 2700 RUB per barrel (the price of oil in rubles at the $40 bbl Urals) and sell foreign exchange when the oil price is below that level (Chart 27). The objective of this policy is to create a counter-cyclical ballast that will limit fluctuations in the ruble caused by swings in oil prices. Chart 27Oil Price Threshold For New Fiscal Rule Chart 28Forex Reserves Have Stabilized The recovery of oil prices and strict macroeconomic policy has allowed Russia to stabilize its foreign exchange reserves (Chart 28), although they remain at a critical level as a percent of broad money supply. However, the GDP growth recovery will be tepid and fall far short of the high growth rates of the early part of the decade (Chart 29). Chart 29Russia: ##br##Recovery Is At Hand Chart 30Inventories Remain Far ##br##Above Average Levels Russian policymakers should be cautiously optimistic. On one hand, they have been able to withstand a massive decline in oil prices. On the other, the situation is still precarious and warrants caution given the delicate situation in oil markets. OECD oil inventories remain elevated and could precipitate an oil-price collapse without OPEC's active oil-production management (Chart 30). From this macroeconomic context, we would conclude that: Russia will abide by the OPEC 2.0 production-cut agreement: While the new budget rule will go a long way in insulating the ruble from swings in oil prices, Russia is still an energy exporter. As such, we expect Russia to play ball with Saudi Arabia and continue to abide by the conditions of the OPEC deal. Thus far, Russia has been less enthusiastic in cutting production than the Saudis, but still going along (Chart 31). Russia will not destabilize the Middle East: While Russia will continue to support President Bashar al-Assad of Syria, its involvement in the civil war will abate. Moscow already began to officially withdraw from the conflict in January. While part of its forces will remain in order to secure Assad's government, Russia has no intention of provoking its newfound OPEC allies with geopolitical tensions. Russia will talk tough, but carry a small stick: Shows of force will continue in the Baltics and the Arctic, but investors should fade any rise in the geopolitical risk premium (Chart 32). It is one thing to fly strategic bombers close to Alaska or conduct military exercises near the Baltic States; it is quite another to act on these threats. In fact, Russia has been doing both since about 2004 and its bluster has amounted to very little with respect to NATO proper. This is because Russia depends on Europe for almost all of its FDI and export demand and it is only in the very early innings of replacing European demand with Chinese (Chart 33). As long as Russia lacks the pipeline infrastructure to export the majority of its energy production to China, it will be reluctant to confront Europe. Chart 31Moscow Will Play ##br##Ball With OPEC Chart 32Fade Any Spike ##br##In Geopolitical Risk Chart 33Russia Relies On Europe;##br## China Not A Replacement As we have posited in the past, energy exporters are emboldened to be aggressive when oil prices are high.14 When oil prices collapse, energy exporters become far more compliant. Nowhere is this dynamic more true than with Russia, whose military interventions in foreign countries have served as a sure sign that the top of the oil bull market is at hand! Bottom Line: We do not expect any serious geopolitical risk to emanate from Russia, despite the supposed souring of relations between the Trump and Putin administrations due to the U.S. cruise-missile strike against Syria.15 And we also do not expect President Putin to manufacture a geopolitical crisis ahead of Russia's March 2018 presidential elections, given that his popularity remains high and that the opposition is in complete disarray. While Russia may continue to talk tough on a number of fronts, investors should fade the rhetoric as it is purely for domestic consumption. Turkey: Deceitful Stability Turkey held a constitutional referendum that dramatically expands the powers of the presidency on April 16.16 The proposed 18 amendments passed with a 51.41% majority and a high turnout of 85%. As with all recent Turkish referenda and elections, the results reveal a sharply divided country between the Aegean coastal regions and the Anatolian heartland, the latter being a stronghold of President Recep Tayyip Erdogan. Is Turkey Now A Dictatorship? First, some facts. Turkey has not become a dictatorship, as some Western press allege. Yes, presidential powers have expanded. In particular, we note that: The president is now both head of state and government and has the power to appoint government ministers; The president can issue decrees; however, the parliament has the ability to abrogate them through the legislative process; The president can call for new elections; however, he needs three-fifths of the parliament to agree to the new election; The president has wide powers to appoint judges. What the media is not reporting is that the parliament can remove or modify any state of emergency enacted by the president. In addition, overriding a presidential veto appears to be exceedingly easy, with only an absolute majority (not a super-majority) of votes needed. As such, our review of the constitutional changes is that Turkey is most definitely not a dictatorship. Yes, President Erdogan has bestowed upon the presidency much wider powers than the current ceremonial position possesses. However, the amendments also create a trap for future presidents. If the president should face a parliament ruled by an opposition party, he would lose much of his ability to govern. The changes therefore approximate the current French constitution, which is a semi-presidential system. Under the French system, the president has to cohabitate with the parliament. This appears to be the case with the Turkish constitution as well. Bottom Line: Turkish constitutional referendum has expanded the powers of the presidency, but considerable checks remain. If the ruling Justice and Development Party (AKP) were ever to lose parliamentary control, President Erdogan would become entrapped by the very constitution he just passed. Is Turkey Now Stable? The market reacted to the results of the referendum with a muted cheer. First, we disagree with the market consensus that President Erdogan will feel empowered and confident following the constitutional referendum that gives him more power. This is for several reasons. For one, the referendum passed with a slim majority. Even if we assume (generously) that it was a clean win for the government, the fact remains that the AKP has struggled to win over 50% of the vote in any election it has contested since coming to power in 2002 (Chart 34). Turkey is a deeply divided country and a narrow win in a constitutional referendum is not going to change this. Chart 34Turkey's Ruling Party Struggles To Get Over 50% Of The Vote Second, Erdogan is making a strategic mistake by giving himself more power. It will focus the criticism of the public on the presidency and himself if the economy and geopolitical situation surrounding Turkey gets worse. If the buck now stops with Erdogan, it means that all the blame will go to him in hard times. We therefore do not expect Erdogan to push away from populist economic and monetary policies. In fact, we could see him double down on unorthodox fiscal and monetary policies as protests mount against his rule. While he has expanded control over the army, judiciary, and police, he has not won over the major cities on the Aegean coast, which not only voted against his constitutional referendum but also consistently vote against AKP rule. Events in Turkey since the referendum have already confirmed our view. Despite rumors that the state of emergency would be lifted following the referendum, the parliament in fact moved to expand it by another three months. Furthermore, just a week following the plebiscite, the government suspended over 9,000 police officials and arrested 1,120 suspects of the attempted coup last summer, with another 3,224 at large. This now puts the total number of people arrested at around 47,000. Investors are confusing lack of opposition to stability. Yes, the opposition to AKP remains in disarray. As such, there is no political avenue for opposition to Erdogan. The problem is that such an arrangement raises the probability that the opposition takes the form of a social movement and protest. We would therefore caution investors that a repeat of the Gezi Park protests from 2013 could be likely, especially if the economy stumbles. Bottom Line: The referendum has not changed the facts on the ground. Turkey remains a deeply divided country. Erdogan will continue to feel threatened by the general sentiment on the ground and thus continue to avoid taking any painful structural reforms. We believe that economic populism will remain the name of the game. What To Watch? We would first and foremost watch for any sign of protest over the next several weeks. Any Gezi Park-style unrest would hurt Erdogan's credibility. May Day protests saw police scuffle with protesters in Istanbul, for example. Given his penchant for equating any dissent with terrorism, President Erdogan is very likely to overreact to any sign that a social movement is rising in Turkey to oppose him. It is not our baseline case that the constitutional referendum will motivate protests, but it is a risk investors should be concerned with. Next election is set for November 2019 and the constitutional changes will only become effective at that point (save for provisions on the judiciary). Investors should watch for any sign that Erdogan's or the AKP's popularity is waning in the interim. A failure to secure a majority in parliament could entrap Erdogan in an institutional fight with the legislature that creates a constitutional crisis. Chart 35Turkey Constrained By European Ties Relations with the EU remain an issue as well. Erdogan will likely further deepen divisions in the country if he goes ahead and makes a formal break with the EU, either by reinstituting the death penalty or holding a referendum on the EU accession process. Erdogan's hostile position towards the EU should be seen from the perspective of his own insecurity as a leader: he needs an external enemy in order to rally support around his leadership. We would recommend that clients ignore the rhetoric. Turkey depends on Europe far more than any other trade or investment partner (Chart 35). If Turkey were to lash out at the EU by encouraging migration into Europe, for example, the subsequent economic sanctions, which we are certain the EU would impose, would devastate the Turkish economy and collapse its currency. Nonetheless, Ankara's brinkmanship and anti-EU rhetoric will likely continue. It is further evidence of the regime's insecurity at home. Bottom Line: The more that Erdogan captures power within the institutions he controls, the greater his insecurities will become. This is for two reasons. First, he will increase the risk of a return of social movement protests like the Gezi Park event in 2013. Second, he will become solely responsible for everything that happens in Turkey, closing off the possibility to "pass the buck" to the parliament or the opposition when the economy slows down or a geopolitical crisis emerges. As such, we see no opening for genuine structural reform or orthodox policymaking. Turkey will continue to be run along a populist paradigm. Investment Conclusions BCA's Emerging Market Strategy recommends that clients re-instate short positions on Turkish assets, specifically going short TRY versus the U.S. dollar and shorting Turkish bank stocks. The central bank's net liquidity injections into the banking system have recently been expanded again (Chart 36). This is a form of quantitative easing and warrants a weaker currency. To be more specific, even though the overnight liquidity injections have tumbled, the use of the late liquidity money market window has gone vertical. This is largely attributed to the fact that the late liquidity window is the only money market facility that has not been capped by the authorities in their attempt to tighten liquidity when the lira was collapsing in January. The fact remains that Turkish commercial banks are requiring continuous liquidity and the Central Bank of Turkey (CBT) is supplying it. Commercial banks demand liquidity because they continue growing their loan books rapidly. Bank loan and money growth remains very strong at 18-20% (Chart 37). Such extremely strong loan growth means that credit excesses continue to be built. Chart 36Liquidity Injections Reaccelerating Chart 37Money And Credit Growth Strong Besides, wages are growing briskly - wages in manufacturing and service sector are rising at 18-20% from a year ago (Chart 38, top panel). Meanwhile, productivity growth has been very muted. This entails that unit labor costs are mushrooming and inflationary pressures are more entrenched than suggested by headline and core consumer price inflation. It seems Turkey is suffering from outright stagflation: rampant inflationary pressures with a skyrocketing unemployment rate (Chart 38, bottom panel). The upshot of strong credit/money and wage growth as well as higher inflationary pressures is currency depreciation. Excessive credit and income/wage growth are supporting import demand at a time when the current account deficit is already wide. This will maintain downward pressure on the exchange rate. The currency has been mostly flat year-to-date despite the CBT intervening in the market to support the lira by selling U.S. dollars (Chart 39). Without this support from the CBT, the lira would be much weaker than it currently is. That said, the CBT's net foreign exchange rates (excluding commercial banks' foreign currency deposits at the CBT) are very low - they stand at US$ 12 billion and are equal to 1 month of imports. Therefore, the central bank has little capacity to defend the lira by selling its own U.S. dollar. Chart 38Turkish Stagflation Chart 39Turkey Props Up The Lira We also believe there is an opportunity to short Turkish banks outright. The currency depreciation will force interbank rates higher (Chart 40, top panel). Chart 40Weak Lira Will Push Interbank Rates Higher Historically, currency depreciation has always been negative for banks' stock prices as net interest margins will shrink (Chart 40, bottom panel). Surprisingly, bank share prices in local currency terms have lately rallied despite the headwinds from higher interbank rates and the rollover in net interest rate margin. This creates an attractive opportunity to go short again. Bottom Line: We are already short the lira relative to the Mexican peso. In addition, we are recommending two new trades based on the recommendations of BCA's Emerging Market Strategy: long USD/TRY and short Turkish bank stocks. Dedicated EM equity as well as fixed-income and credit portfolios should continue underweighting Turkish assets within their respective EM universes. Indonesia: A Brief Word On Jakarta Elections President Joko "Jokowi" Widodo saw his ally, Basuki Tjahaja Purnama (nicknamed "Ahok"), badly defeated in the second round of a contentious gubernatorial election on April 19. Preliminary results suggest that Ahok received 42% against 58% for his contender, Anies Baswedan, a technocrat and defector from Jokowi's camp whose own party only expected him to receive 52% of the vote. This was a significant setback. Jokowi's loss of the Jakarta government is a rebuke from his own political base, a loss of prestige (since he campaigned to help Ahok), and a boost to the nationalist opposition party Gerindra and other opponents of Jokowi's reform agenda. Ahok is a Christian and ethnic Chinese, which makes him a double-minority in Muslim-majority Indonesia, which has seen anti-Chinese communal violence periodically and has also witnessed a swelling of Islamist politics since the decline of the oppressive secular Suharto regime in 1998. Ahok fell under popular scrutiny and later criminal charges for allegedly insulting the Koran in September 2016 by casting doubt on verses suggesting that Muslims should not be governed by infidels. Mass Islamist protests ensued in November. Gerindra exploited them, as did political forces behind the previous government of Susilo Bambang Yudhoyono and trade unions opposed to the Jokowi administration's attempt to regularize minimum wage increases.17 Ahok's sound defeat shows that the opposition succeeded in making the race a referendum on him versus Islam. Despite the blow, Jokowi's popularity remains intact (Chart 41). The latest reliable polling is months out of date but puts Jokowi 24% above Prabowo Subianto, leader of Gerindra, whom he has consistently led since defeating him in the 2014 election. Jokowi remains personally popular, maintains a large coalition in the assembly, and is still the likeliest candidate to win the 2019 election. Jokowi's approval ratings in the mid-60 percentile are comparable to those of former President Yudhoyono at this time in 2007, and the latter was re-elected for a second term. Moreover Yudhoyono slumped at this point in his first term down to the mid-40 percentile in 2008 before recovering dramatically in 2009, despite the global recession, to win re-election. In other words, according to recent precedent, Jokowi could fall much farther in the public eye and still recover in time for the election. However, Jokowi will now have to shore up his support among voters with a strong Muslim identity, which is a serious weak spot of his, as indicated in the regional electoral data in Table 2. Jokowi relies on two key Islamist parties in the National Assembly. He cannot afford to let opposition grow among Muslim voters at large (notwithstanding Gerindra's own problems working with Islamist parties). Chart 41Jokowi Still Likely To Be Re-Elected In 2019 Table 2Islamist Politics A Real Risk For Jokowi He clearly faces a tougher re-election bid now than he did before. Risks to China and EM growth on the two-year horizon are therefore even more threatening than they were. And since a Prabowo victory would mark the rise of a revanchist and nationalist government in Indonesia that would upset markets for fear of unorthodox economic policies, the political dynamic will be all the more important to monitor. These election risks also suggest that traditional interest-group patronage is likely to rise at the expense of structural economic reform over the next two years. Bottom Line: We remain bearish on Indonesian assets. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com. 5 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Toward A Desynchronized World?" dated April 26, 2017, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017; and Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, all available at gps.bcaresearch.com. 8 Please see "Moon Jae-in's initiative for 'Inter-Korean Economic Union," National Committee on North Korea, dated August 17, 2012, available at www.ncnk.org. 9 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 10 For our latest feature update on what is one of our major themes, please see BCA Geopolitical Strategy and EM Equity Sector Strategy, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 11 Please see footnote 7 above. 12 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 13 Please see BCA Emerging Markets Strategy and Geopolitical Strategy Special Report, "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat'," dated April 7, 2017, available at gps.bcaresearch.com. 16 An original version of this analysis of Turkey appeared in BCA Emerging Market Strategy Weekly Report, "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com. 17 Please see "Indonesia: Beware Of Excessive Wage Inflation" in BCA Emerging Markets Strategy Special Report, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, available at ems.bcaresearch.com.
Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Chart I-6A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower Table I-1Export To China And U.S. In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs Chart II-1BHigh Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Despite cooperating to reduce oil production and drain global oil inventories, the Kingdom of Saudi Arabia (KSA) and Iran still compete at every level for dominance of the Gulf region's economic and geopolitical order. We have maintained that KSA's aggressive push to privatize (or de-nationalize) its state oil company - ARAMCO - is an extension of this battle. Now that a state-led Chinese consortium has emerged as a potential cornerstone investor in the $100 billion Saudi Armco initial public offering (IPO) expected next year, we believe a key element of KSA's strategy in the Persian Gulf's "security dilemma" is falling into place.1 Energy: Overweight. We are long the Dec/17 Brent $65/bbl calls vs. short the Dec/17 Brent $45/bbl puts at a net premium of -$0.47/bbl. This new recommendation was down 46.8%, which we initiated last week following our assessment of OPEC 2.0's strategy to reduce global oil inventories. We remain long the Dec/17 Brent vs. short Dec/18 Brent, which is up 94.7%. Our long GSCI position is down 4.5%; we have a 10% stop on this position. Base Metals: Neutral. Copper registered a 51k metric ton physical surplus in January, according to estimates from the International Copper Study Group. Precious Metals: Neutral. Gold retreated going into French elections over the weekend, indicating investors were not as fearful as some pundits. Our long volatility position is down 43.8%. Ags/Softs: Underweight: Reuters reported the Brazilian government will provide up to 500 million reals (~$159mm) to market this year's corn crop. An expected record harvest and weak export volumes prompted the action.2 Feature By aggressively courting Chinese investors for its potential record-breaking Aramco IPO next year, KSA doesn't just secure funding to pursue its goal of becoming the largest publicly traded vertically integrated oil company in the world. It tangibly expands the number of powerful interests in the world with a deep economic stake in its execution of Vision 2030, the grand plan to diversify away from its near-total dependence on oil revenues. China, too, benefits from this arrangement: By expanding its financial and economic commitments to KSA, it pursues its global investment and technology strategy, and gradually its standing as a "Great Power" with a vested interest in protecting those investments. These states jointly benefit from Aramco's expansion of its refining business into the Asian refined-product markets, which will remain the most heavily contested space in the oil market. It also does not hurt China, where crude oil production has been falling since June 2015 (Chart 1), to be financially invested in a petro-super-state like KSA, which has been supplying on average 14% of its imports over the same period (Chart 2). China's product demand will breach 12mm b/d this year, with gasoline demand growing some 300k b/d, according to the IEA. Overall product demand will grow close to 345k b/d, keeping China the premier growth market in the world for refined products. Investing in the refining system meeting this consumption - and Asia's other growing markets - therefore is attractive to Chinese companies on numerous fronts. Chart 1Chinese Oil Production Falling ... Chart 2... And Imports From KSA Steady Iran has yet to execute on its apparent strategy to attract FDI to its oil and gas sector, where the resource potential is of the same order of magnitude as KSA's. When combined with the development potential of Iraq, a neighboring petro-state, the potential of OPEC's "Shia Bloc" is enormous. Iran has the largest natural gas reserves in the world, and Iraq's oil endowment is second only to KSA's in terms of the vast low-cost, high-quality resource available for development. Yet Iran's success in lining up the investment and technical expertise required to develop its resource endowment as it approaches critical post-sanctions elections next month has been halting at best.3 Aside, that is, from deepening its relationship with Russia, which also is seeking desperately needed FDI in the wake of the oil-price collapse brought about by OPEC's market-share was during 2015 - 16. The KSA-Iran Security Dilemma In Context Chart 3Saudi Profligacy Has Continued In 2017 Before we get into the intricacies of energy geopolitics, a brief recap is in order.4 Prior to the lifting of nuclear-related sanctions against Iran beginning in 2015, KSA and OPEC benefited from an undersupplied oil market that kept oil prices above $100/bbl which allowed these states to increase domestic and military spending massively while experiencing few problems in oil exports or development. This can be seen in the evolution of KSA's fiscal breakeven oil prices, which increased dramatically in the lead-up to the 2014 price collapse (Chart 3), as production grew more slowly than spending. As the Saudi Manifa field came online in early 2014, global production expanded from various quarters, and it became apparent that sanctions against Iran would be lifted, KSA led OPEC into a market-share war. Oil prices fell from $100/bbl before OPEC's November 2014 meeting to below $30/bbl by the beginning of 2016. This strategy turned out to be a complete failure.5 We correctly predicted the failed market-share strategy would force an alliance between OPEC and non-OPEC petro-states - led by KSA and Russia, respectively - to cut production in the face of considerable market skepticism in the lead-up to OPEC's November 2016 Vienna meeting and in consultations with the Russian-led non-OPEC petro-states shortly thereafter.6 We remain convinced that this coalition, which we've dubbed OPEC 2.0, will extend its production cuts to the end of this year.7 As a result, OECD commercial inventories will decline by 10% or so, despite rising in Q1.8 Petro-State Balance Sheets Still Under Pressure The oil-price evolution described above buffeted petro-state budgets, particularly KSA's and Russia's. The pressures generated by this evolution hold the key to understanding where oil prices will go next. Finances: While both Saudi Arabia and Russia have managed to weather the decline in oil prices, the pain has been palpable. BCA's Frontier Market Strategy has detailed Saudi fiscal woes in detail.9 Based on their estimates, Saudi authorities will have enough reserves to defend the country's all-important currency peg for the next 18-24 months (Table 1). Without the peg, prices of imports would skyrocket. Table 1Saudi Arabia: Projected Debt Levels And Foreign Reserves Given that Saudi Arabia imports almost all of its consumer staples, such a price shock could lead to social unrest. Beyond the next two years, the government will have to rely on debt issuance to fund its deficits and focus its remaining foreign exchange resources on maintaining the peg. The problem is that this strategy will leave the country with just $350 billion in reserves by the end of 2018, lower than local currency broad money (Chart 4). At that point, confidence among locals and foreigners in the currency peg could shatter, leading to even greater capital flight than is already underway (Chart 5). Chart 4KSA: Forex Reserves Depleting Chart 5KSA: Capital Outflows Persist While Russia has weathered the storm much better, largely by allowing the ruble to depreciate, its foreign exchange reserves are down to 330 billion, the lowest figure since 2007 (Chart 6). OPEC 2.0's shale-focused strategy: The market strategy behind the OPEC 2.0 agreement is complex. The roughly 1.8 mm b/d of coordinated production cuts is supposed to draw down global storage by ~ 300 mm bbls by the end of 2017. This should lead to forward curves backwardating - a process that is clearly under way (Chart 7). According to BCA's Commodity & Energy Strategy, a backwardated forward curve is critical in slowing down the pace of tight oil production in the U.S. given the reliance of shale producers on hedging future production prices to lock in minimum revenue.10 Geopolitics: Countries with an unlimited resource like oil tend to be authoritarian regimes (Chart 8). This phenomenon is referred to as the "resource curse," and is well documented in political science. Chart 6Russia: Forex Reserves Depleting Chart 7Backwardation Under Way What does it have to do with geopolitics? Basically, it suggests that the main national security risk to energy-producing regimes is not each other but their own populations. In countries where the political leadership generates its wealth from the sale of natural resources, the citizenry becomes a de facto "cost center" requiring social benefits and security expenditures to ensure the unemployed remain peaceful. By contrast, manufacturing nations benefit from an industrious citizenry that is a "profit center" for government coffers. In this paradigm, energy-producing states face a primary security risk that is not external, but rather derives from their own under-utilized or restless populations. Thus, when the "unlimited resource" is re-priced for lower demand or greater global supply, the real risk becomes domestic unrest. At that moment, expensive geopolitical imperatives take a back seat to domestic stability. This explains the current détente between, on one side, Russia and the OPEC "Shia Bloc" (Iran and Iraq), and on the other, Saudi Arabia and its OPEC allies. Even with this détente, Saudi Arabia, its allies, and the "Shia Bloc" are finding it difficult to maintain fiscal spending that funds their still-massive social programs with prices trading in the low- to mid-$50/bbl range (Chart 9). Saudi's fiscal breakeven oil price is estimated to be $77.70/bbl this year by the IMF. Iran and Iraq require $60.70/bbl and $54/bbl, respectively, putting them in slightly better shape than their Gulf rival, but still in need of higher prices to sustain the spending required to quell social unrest.11 Chart 8Unlimited Resources Undermine Democracy Chart 9Oil Prices Too Low For National Budgets Chart 10Support For Putin Holding Up Given Russia's relatively superior domestic economic situation and political stability (Chart 10), we suspect that Moscow cares a little less about oil market rebalancing than Saudi Arabia. President Vladimir Putin will face reelection in less than a year, but he is unlikely to face a serious challenger. Even so, Russia still feels the pain of lower energy prices. Oil and gas revenues constituted 36% of state revenues last year, down from 50% in 2014, when prices were trading above $100/bbl. This pushed Russia's budget deficit out to more than 3% of GDP in 2016. According to The Oxford Institute for Energy Studies, "even with planned spending cuts (the deficit) will still be more than 1% of GDP by 2019 ... Russia's Reserve Fund could be exhausted by the end of 2017, on the government's original forecast of an oil price of $40/barrel in 2017."12 Oil-Market Rebalancing Critical For KSA's Aramco IPO For Saudi Arabia, however, rebalancing is critical, which explains why it has over-delivered on the promised production cuts, while Russia and the "Shia Bloc" have dragged their feet (Chart 11 and Chart 12). Not only is the currency peg non-negotiable, but Riyadh's clear interest is oil-price stability in the lead-up to its Aramco IPO. It is not enough to attract a mega investor from China; the entire oil-investment community has to be convinced they are not pouring money into an enterprise that could lose value close on the heels of the IPO. Chart 11Saudis Cut Production More Than Russians ... Chart 12... Or The "Shia Bloc" To attract foreign capital at reasonable prices for Aramco's massive privatization, KSA must prove it can exert some control over the oil price "floor." As such, the Kingdom's motivation to stick to the OPEC 2.0 agreement is serious. In a joint report done by BCA's Geopolitical Strategy and Commodity & Energy Strategy last January, we argued that three factors are critical to this IPO:13 Moving downstream: Saudi Arabia intends to become a major global refiner with up to 10 million b/d of refining capacity (an addition of about 5 mm b/d of capacity). If realized, this volume of refining capacity would rival that of ExxonMobil's 6 mm+ b/d, the largest in the world. Because OPEC does not set quotas for refined-product exports, Saudi Arabia's shift downstream would allow it to capture higher revenues from international sales of gasoline, diesel, jet fuel, and other refined products. This could eventually mean that Saudi Arabia would fly above ongoing crude oil market-share wars. Instead, it could rely on its access to short-haul domestic supplies and state-of-the-art technology - Aramco's principal endowments - to command massive crack spreads, or the difference between the price of input, crude oil, and output, refined product. FDI wars: With estimates of its value hovering ~ $100 billion, the Aramco IPO expected next year will be the largest ever executed. It is likely to divert FDI that Iraq and Iran desperately need to revitalize their production, transportation, and refining infrastructure. This is a crucial long-term goal for Saudi Arabia. At the moment, its oil production dwarfs that of its "Shia Bloc" OPEC rivals. However, Iran and Iraq are projected to close the gap and potentially export even more oil than the Kingdom in future (Chart 13). Bringing China into the region: The U.S. deleveraging from the Middle East continues. President Donald Trump may have ordered cruise missile strikes against Syria, but he is not interested in getting bogged down in another land war in the region. Chart 14 speaks for itself. As such, Saudi Arabia is largely on its own when facing off against Iran, its regional rival. Appeals to Chinese state energy companies are therefore designed to give Beijing a stake in Saudi energy infrastructure. This would force China to start caring more about what happens to Saudi Arabia, as with Iraq, where it is heavily invested, and Iran, where it has long flirted with investing more. Chart 13"Shia Bloc" Gaining On KSA Chart 14U.S. Has Deleveraged From Middle East When we first penned our report, we were speculating on the China link. Since then, Beijing has created a consortium consisting of state-owned energy giants Sinopec and PetroChina and banks, led by the country's sovereign wealth fund, to compete in the expected $100 billion equity sale.14 Given the financial, economic, and geopolitical importance of the Aramco IPO, we continue to expect that Saudi Arabia will push to extend the OPEC 2.0 production cut when the group meets in Vienna on May 25. Judging by the commitments to the cuts thus far, the deal appears to be an agreement for Saudi Arabia and its Gulf allies to continue to cut and for Russia and the "Shia Bloc" (Iran and Iraq) not to increase production.15 (Both of the latter states still have a lot of "skin in the game," so to speak.) As such, an extension of the deal is in the interests of KSA, Russia, and their respective allies. And, importantly, it will continue to provide a floor to oil prices. Meanwhile, downside and upside risks to supply continue. In terms of supply increase, the usual suspects -Libya and Nigeria - are working to increase production. In terms of supply decrease, we continue to worry about the dissolution of Venezuela as a functioning state and the potential that supply disruptions may occur. Bottom Line: Geopolitical drivers still support the continuation of OPEC 2.0's efforts to restrain production and draw down global oil stockpiles. As such, our positioning recommendations for an expected backwardation - i.e., long Dec/17 Brent vs. short Dec/18 Brent - and our fade of the option-market skew favoring put - the long Dec/17 $65/bbl Brent calls vs. short Dec/17 $45/bbl Brent puts - remain intact. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 A "security dilemma" refers to a situation in which a state's pursuit of "security" through military strength and alliances leads its neighbors to respond in kind, triggering a spiral of distrust and tensions. Please see BCA Commodity & Energy Strategy and Geopolitical Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com and gps.bcaresearch.com. NB: The $100-billion figure often attached to the estimated size of the IPO, which will seek to float 5% of Aramco, is a placeholder for the moment. There is considerable disagreement over the level at which the market will value Aramco, which some estimates significantly below the value assumed by the $100-billion estimate. We will be examining this in future research. 2 Please see "Brazil readies $159 million in corn subsidies amid record crop," Reuters, April 19, 2017, available at Reuters.com. 3 The New York Times provided an excellent summary of post-sanctions development recently in "Even Bold Foreign Investors Tiptoe in Iran," March 31, 2017. 4 For a summary of BCA Commodity & Energy Strategy recommendation performance, please contact your relationship manager. 5 Please see "The Game's Afoot, But Which One," for the consequences of OPEC's market-share war. It was published April 6, 2017, in BCA Research's Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 7 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC-Russia Oil Deal On Track To Deliver," dated February 9, 2017, available at ces.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, available at ces.bcaresearch.com. 9 Please see BCA Frontier Market Strategy Special Report, "Saudi Arabia: Short-Term Gain, Long-Term Pain," dated February 1, 2017, available at fms.bcaresearch.com. 10 Contango markets - where prices for prompt delivery are less than prices for deferred delivery - favor shale producers when the front of the WTI forward curve is ~ $50/bbl, and - all else equal - incentivizes them to hedge forward so as to lock in future revenues and maximize the number of rigs they deploy. In backwardated markets, however, the number of rigs a shale operator is able to deploy is lower, all else equal, which means the revenue they can lock in by hedging forward is lower. Please see BCA Commodity & Energy Strategy Weekly Report, "North American Oil Pipeline Buildout Complicates Price And Storage Expectations," dated February 16, 2017, available at ces.bcaresearch.com. 11 Please see the IMF, Regional Economic Outlook: Middle East and Central Asia, October 2016, Table 5. 12 Please see "Russia Oil Production Outlook to 2020," Oxford Institute for Energy Studies, February 2017. 13 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Desperate Times, Desperate Measures: Aramco And The Saudi Security Dilemma," dated January 14, 2016, available at ces.bcaresearch.com. 14 Please see "Exclusive: China gathers state-led consortium for Aramco IPO - sources," Reuters, dated April 19, 2017, availableat reuters.com. 15 In "OPEC 2.0 Cuts Will Be Extended Into 2017H2; Fade The Skew And Get Long Calls Vs. Short Puts," dated April 20, 2017, we noted, "Without pulling storage down to more normal levels, inventories remain too close to topping out, which puts markets at higher risk of the sort of price collapse seen in 2015-16. At the beginning of 2016, global oil markets were close to pricing in the approach of a full-storage event. In such an event, as global inventories approach capacity, prices trade below the cash-operating costs of the most expensive producers, until enough supply is forcibly knocked off line to drain excess stocks. This is an extremely high-risk scenario for states like KSA, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. After the last such event at the beginning of 2016, these states were left reeling, as fiscal spending was slashed, projects were canceled and governments burned through foreign reserves in an effort to make up for lost revenue." This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016
Highlights China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Continued demand strength in DM will not prevent a relapse in EM/China growth. EM is much more leveraged to China than to DM. Higher bond yields in DM, a stronger U.S. dollar and weak China/EM domestic demand are bearish for commodities and EM risk assets. A new equity trade: short KOSPI / long Nikkei. Feature In our recent reports1 we have argued that China's growth is likely to relapse again in the second half of this year based on its aggregate credit and fiscal impulse. Chart I-1 illustrates that this impulse leads Korean, Taiwanese, Japanese, German and U.S. aggregate exports to China by six months, and this indicator is reinforcing the message that shipments from these economies to the mainland have peaked and will stumble. Consistently, the bottom panel of Chart I-1 reveals that Chinese imports of capital goods are set to decelerate significantly and probably contract anew by the end of this year or early 2018. If markets are forward looking, they should begin discounting a potential growth slump very soon. Chart I-2 demonstrates that there is a tight correlation between each of these countries' shipments to China and the mainland's credit and fiscal impulse. Chart I-1Chinese Imports To Relapse Chart I-2Exports To China To Weaken In this context, a relevant question is whether the expansion of U.S. and European imports will be sufficient to safeguard the recovery in EM and global trade as China's imports tumble. Our analysis substantiates that domestic demand strength in the U.S. and Europe will boost these economies but will likely not preclude another downturn in EM/Chinese growth and global trade. In brief, China/EM growth will decouple (to the downside) from the business cycle in developed markets (DM). Our basis is that EM and China trade much more with one another, and as such the DM business cycle has become a less important driver. If DM demand holds up as China's imports tumble anew, EM share prices and currencies will underperform their DM counterparts. In this context, our negative view on EM is contingent on a deceleration in China's business cycle rather than a major relapse in DM domestic demand. In the near term, higher bond yields in DM due to strong domestic demand combined with weakness in EM/Chinese growth will reverse the EM rally. EM Is Much More Leveraged To China Than To DM Chart I-3EM Is Leveraged To China Much More Than DM Chart I-3 shows that the relative performance of EM versus DM stocks typically fluctuates with the relative import volume trend between China and DM. This supports our thesis that the EM world is much more leveraged to China than DM. The following considerations certify China's greater importance for EM economies compared to the U.S. and Europe: Table I-1 shows the share of exports going to China and to the U.S. for individual EM countries. The mean for exports to China is 14.6% of total, and 11.3% for shipments to the U.S. These numbers corroborate the fact that developing countries sell more to China than to the U.S. Chart I-4 is constructed using the numbers from Table I-1. It demonstrates that Korea, Taiwan, Chile and Peru are more exposed to China while India, Turkey, and the Philippines are more leveraged to the U.S. We did not include Mexico and central Europe in this chart because the former trades with the U.S. and the latter predominantly with European countries due to their geographical proximity. Table I-1Export To China And U.S. Chart I-4Exposure To China And Exposure To The U.S. Chinese demand is critical for commodities, particularly for industrial metals prices. China consumes 6-7-fold more industrial metals than the U.S. Unsurprisingly, the mainland's credit and fiscal impulse leads industrial metals prices (Chart I-5). At this moment, we are negative on both metals and oil prices, as we view the 2016 rally as a mean-reverting rally in a structural bear market. As commodities prices drop again, commodities-producing nations will suffer from a negative terms-of-trade shock. This is regardless of which countries they export commodities to. There is one global price for each commodity, and when it deflates commodity producing nations are the ones that get hurt - irrespective of whether they sell that commodity to China, the U.S., Europe or the rest of the world. Countries like Korea and Taiwan do not sell commodities, but their largest export destination is still China (Chart I-6). The latter accounts for 25% of Korean and 27% of Taiwanese exports Chart I-5China's Credit And Fiscal##br## Impulse And Industrial Metals Chart I-6Korea And Taiwan: The ##br##Composition Of Exports. Even if we assume that 30% of goods exported to China by Korea and Taiwan are assembled and then re-exported to other countries, the mainland's domestic absorption of Korean and Taiwanese goods is still considerable. Notably, the recovery in Korean, Taiwanese and Japanese exports has been driven more by China than the rest of the world (Chart I-7). Therefore, China's business cycle is also important for some non-commodity producing countries like Korea, Taiwan and others in Asia. China itself has become much more reliant on its credit origination and fiscal spending than on exports in general and exports to DM in particular (Chart I-8). Chart I-7Asia's Exports Recovery Has Largely ##br##Been Driven By China's Demand Chart I-8China Has Become Reliant ##br##On Stimulus Not Exports Finally, Table I-2 exhibits the product structure of Chinese imports. By and large, China imports three categories of goods: various commodities, capital goods and some luxury goods. All three are at risk of a slowdown because they are leveraged to the nation's credit cycle. Table I-2Composition Of Chinese Imports Bottom Line: China's imports are critical not only for commodity producers (Latin America, Russia, Africa, the Middle East and Indonesia) but also for non-commodity economies in Asia. Altogether this comprises most of the EM universe. EM/China's Importance In Global Trade EM/China account for much larger global trade flows than advanced economies. In short, global trade will relapse again if global shipments to China and the rest of the EM universe slump. EM including Chinese imports (but excluding the mainland's imports for re-exports) in U.S. dollars are equal to imports by the U.S., EU and Japan combined (Chart I-9). Chinese imports for processing - imports that are used to manufacture goods for exports - are excluded from the calculation of this chart. Only Chinese imports for domestic consumption are accounted for. Also, this EM aggregate excludes Mexico and central European countries because their manufacturing is intertwined with the ones in the U.S. and EU. Exports to EM countries account for 25%, 28% and 17% of German, Japanese and U.S. exports, respectively. As a share of GDP, exports to vulnerable EM economies stand at 2%, 5% and 5% of U.S., German and Japanese GDP, respectively (Chart I-10). Chart I-9EM Imports Are Equal To Combined##br## Imports Of U.S., EU And Japan Chart I-10Japan And Germany Are More ##br##Exposed To EM Than The U.S. Japan and Germany are much more vulnerable to an EM/China slowdown than the U.S. and the rest of Europe (Europe ex-Germany). China's exports are exposed more to EM than DM. Chart I-11 shows that 45% of Chinese exports are shipped to Asia ex-Japan, 18% to Latin America, Russia, the Middle East, Africa, Australia and Canada and only 18% to the U.S. and 16% to the EU. Capital spending in China and EM ex-China makes up 5% and 5% (together 10%) of global GDP in real terms (Chart I-12). By comparison, EU and U.S. capital expenditures are 5% and 4.5% of world GDP in real terms. Hence, EM and especially China's investment outlays are big enough to matter for the global economy. Chart I-11China Sells More To EM Than DM Chart I-12EM/China Capex Is Large As Chart I-1 indicates, China's imports of industrial goods will soon tumble. Capital goods imports for EM ex-China have revived, but as their bank loan growth slumps the recovery in capital goods imports is likely to be short lived. Bottom Line: Two-pronged trade flows between EM and China are considerable for their own economies as well as global trade flows. Continued demand strength in DM countries will not prevent a relapse in EM/China growth. Market Observations And Conclusions Our conviction is that China's imports are set to dwindle in the second half of this year. This is bearish for commodities producers and Asian economies selling to China. If markets are forward looking, they should begin discounting this now. Moreover, bank deleveraging in EM/China has further to run. Altogether, this leads us to maintain the strategy of underweighting EM risk assets relative to their DM counterparts, and maintaining a negative stance on EM in absolute terms. Furthermore, it appears the U.S. dollar and U.S. bond yields have recently bounced from their technical support levels, and odds are they will rise further (Chart I-13). DM bond yields will move higher for now before the EM/China slowdown becomes visible later this year. For the time being, rising U.S. bond yields and a stronger greenback (versus EM, Asian and commodities currencies) will weigh on EM risk assets. Remarkably, Chinese interest rates are rising and corporate bond prices are plunging as the People's Bank of China continues along a gradual tightening path (Chart I-14). Chart I-13The U.S. Dollar And U.S. Bond Yields To Rise Chart I-14China: Borrowing Costs Are Rising As long as economic data from China and DM remain positive, financial regulators in Beijing are determined to curb leverage and speculative activities in China's credit system. Higher interest rates and regulatory tightening amid the lingering credit bubble are bound to cause meaningful stress in China's financial system and lead to a deceleration in credit growth. EM risk assets are very complacent about this risk. Interestingly, the commodities currencies index - an equal-weighted average of the Australian, New Zealand and Canadian dollars - has already halted its rally and begun depreciating even versus safe-haven currencies like the Swiss franc (Chart I-15). Such poor showing by commodities currencies should be taken seriously because it has occurred at a time when the U.S. dollar has been soft and global share prices have been well bid. As such, we read this message from the commodities currencies as a harbinger of a major top in commodities prices and EM risk assets. There is no reason why EM ex-China currencies should diverge from the commodities currency index this time around (Chart I-16). Chart I-15Commodities Currencies Versus ##br##Safe-Haven Currency Chart I-16EM Currencies ##br##To Tumble In short, we are reiterating our bearish strategy on EM currencies and recommend shorting a basket of the following currencies: ZAR, TRY, BRL, CLP, COP, MYR and IDR versus the U.S. dollar or a basket of the U.S. dollar and the euro. The main risk to our downbeat view on EM risk assets is not EM/China fundamentals but the rally in DM share prices. That said, DM stocks and credit markets were well bid in 2012-2014 yet EM stocks and currencies did very poorly during that period. This could be repeated again in the next couple of months before fundamental problems/weaker growth in China/EM become evident and stem the rally in DM equities too, as occurred in 2015. A New Equity Trade: Short KOSPI / Long Nikkei We have identified a tactical opportunity for a relative equity trade: short Korean / long Japanese stocks, currency unhedged. The Korean won is overvalued versus the Japanese yen, according to the relative real effective exchange rate based on unit labor costs (Chart I-17). This will provide a competitive advantage to Japanese manufacturers and will dent performance of the KOSPI versus the Nikkei. Even though the won could still appreciate versus the yen, equity prices in Japan will still fare better than their Korean counterparts in common currency terms. Japan's more competitive positioning is also reflected in its manufacturing PMI, which is much stronger than Korea's (Chart I-18). This should lead to outperformance of Japanese manufacturers versus their Korean peers. Chart I-17The Korean Won Is Expensive ##br##Versus The Yen Chart I-18Manufacturing PMI: ##br##Korea And Japan Korea is much more exposed to China than Japan. Exports destined to China make up 25% and 18% of Korean and Japanese exports, respectively. In the meantime, combined exports to the U.S. and EU account for 22% of Korea's total exports and 31% of Japan's total exports (Chart I-19). Provided our view that China's growth will disappoint relative to U.S. and EU growth pans out, Japan is in better position than Korea. Japanese policymakers continue to be much more aggressive in reflating their economy than Korean policymakers. Bank loan growth is accelerating in Japan but is slowing in Korea, albeit from a higher level (Chart I-20). Finally, the technical profile of relative performance between Korean and Japanese share prices favors the latter (Chart I-21). Chart I-19Japan And Korea: Structure Of Exports Chart I-20Bank Loan Growth Is Stronger In Japan Than Korea Chart I-21Short KOSPI / Long Nikkei Bottom Line: Short KOSPI / long Nikkei, currency unhedged. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports titled, "A Time To Be Contrarian", dated April 5, 2017, "Signs Of An EM/China Growth Reversal", dated April 12, 2017 and "EM: The Beginning Of The End", dated April 19, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations