Emerging Markets

Dear Client, In lieu of our regular report next week, we are sending you a Special Report from my colleague Chester Ntonifor, Foreign Exchange Strategist. Chester will share his outlook on the Hong Kong Dollar. I hope you will find his report insightful. Please note that next week’s report will be published on Friday, August 21. Best regards, Jing Sima, China Strategist   Highlights President Trump's ban of China-based apps marks a new front in the Sino-US tech war. There is no change in our strategic views. The impact on both China’s aggregate economic growth outlook and the financial markets should be limited on a cyclical basis. Consider overweight Chinese offshore ex-TMT stocks and onshore semiconductor stocks within a global equity portfolio, against a backdrop of escalating hostilities in the tech sphere. Feature Chart 1Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Geopolitical risks again stirred up volatility last week in China’s equity markets. President Trump issued two executive orders to take effect in 45 days, banning US transactions with the Chinese-owned social media apps TikTok and WeChat. Shares in Tencent, the China-based Internet giant that owns WeChat, have plummeted by 11% in China’s offshore market following the ban announcement (Chart 1). The event underscores that technology is at the root of a power struggle between the US and China. The struggle will likely be exploited by Trump as the US presidential election nears and Trump’s polling numbers lag. However, we remain constructive on Chinese stocks over the next 6 to 12 months.  Although the latest development remains highly fluid, the tensions should not have a material impact on the cyclical outlook for China’s aggregate economy or financial markets. This will be the case as long as the situation does not degenerate into an outright tariff increase on Chinese export goods or other strategic actions with the potential to cause major economic damage.  Given rising downside risks to Chinese tech company stocks in the near term, we recommend investors hold a neutral position on Chinese tech giant company equities versus their global peers. Instead, investors should overweight Chinese “old economy” stocks as well as sectors that are greatly benefited from policy support. We initiate two trades today: long MSCI China ex-TMT versus MSCI Global ex-TMT;1 and long domestic semiconductor stocks versus global semiconductor benchmark. A New Front In Tech War It is likely that the US will implement the ordered bans in some way. Banning TikTok wasn’t a surprise because the US had amply signaled its displeasure with the app in preceding months. The social media company has rapidly gained US market share and hence access to American users’ data. Its parent company ByteDance is based in Beijing and therefore subject to China’s cybersecurity laws, a major source of bilateral tensions. The company originated in a Chinese acquisition of an American company, another irritant for the Trump administration. The US is now pressuring TikTok’s US operations to sell the app to an American-based company such as Microsoft. Regarding Trump’s executive order on WeChat and Tencent, it is not clear what “transactions” with Tencent will be disallowed from the US market.2 Additionally, US officials later appeared to backpedal and limit the scope of the executive order on Tencent to only the WeChat app. We have a few preliminary observations on the evolving situation: It is unknown how far the executive action will go regarding Tencent. The Internet titan gets less than 5% of its revenues from outside China, according to its 2019 financial statement.  However, Tencent has many prominent investments in the US gaming and music industries. The US Commerce Department has 45 days to interpret and enforce the directive. The vague language in the executive order provides the US with enough legal space to deprive Tencent of US technologies in those sectors, and would severely curtail Tencent’s online gaming business, which is its main engine of growth. The bans underscore the US administration’s intention to extend tech hostilities with China by denying Chinese tech companies the access to compete and expand globally. Last week, Secretary of State Mike Pompeo announced a five-pronged “Clean Network” initiative that would scrub Chinese companies from US telecommunications networks entirely.3 China, for its part, has been progressively banning US social media giants since 2009. China has not announced any retaliatory actions since the executive orders were issued. Top Chinese policymakers seem to have shifted gears from a tit-for-tat retaliation to a carefully calibrated diplomatic reaction that does not ramp up tensions further. Moreover, there is a sizeable contingent of top Chinese policymakers pushing for reconciliation with the US. We think that China’s senior leaders prefer to dial down the current conflict and take a wait-and-see approach until after the US presidential election in November. Nevertheless, the next two to three months will be unpredictable as the election nears and Trump’s polling numbers lag behind his rival Joe Biden. Bottom Line: China’s leading Internet and tech companies are embroiled in a US-China feud. Pressures will likely intensify with other tech companies potentially also targeted. For now, stay neutral on leading Chinese tech company stocks within a global equity portfolio. Stick With The Knowns Chinese tech company stock prices will likely be extremely volatile in the short run. Nevertheless, we are staying the course with our constructive cyclical view on overall Chinese stocks and we do not recommend any one-way bets on the market during the next two to three months. China’s financial markets have been shaken by negative surprises relating to frictions with the US.  However, investors cheer on even the slightest easing of tensions between the two countries. Last Friday’s volatile trading was a good example: initial confusion over the ban’s scope in Trump’s order led to a more than 10% plunge in Tencent stock during morning trading in the Hong Kong market, but the losses were cut in half after the US indicated the ban only affected the WeChat app. Chart 2Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Economic policy support from the Chinese government and “national team” can also distort the short-term price trend in tech equities. These stocks have risen by more than 20% in both the onshore and offshore markets since the beginning of 2018, despite the deteriorating US-China relationship (Chart 2). While we are neutral on tech company stocks, we recommend overweight Chinese “old economy” stocks and remain constructive on domestic sectors that are beneficiaries of government policy support. We are initiating two trades: long MSCI China ex-TMT versus MSCI Global ex-TMT; and long domestic semiconductor stocks versus global semiconductor benchmark. The reflationary efforts since early this year facilitated a strong rebound in China’s industrial sector activities and profits (Chart 3). In turn, China’s ex-tech "old economy" stocks have outperformed relative to their global peers. Even though the handful of tech titans account for roughly 35% of the investable market capitalizations, MSCI China stock prices excluding tech titans have decisively broken out of their 200-day moving average, which suggests there is still sufficient support to our constructive view on the overall investable index (Chart 4). Chart 3Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Chart 4Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Our cyclical overweight view on China’s domestic stocks also remains unchanged. The domestic market is much more sensitive to the trend in monetary conditions, credit growth and economic cycles than the investable market. As we pointed out in last week’s report,4 monetary conditions are accommodative and credit and economic growth remain in an uptrend. This underscores that China’s domestic stocks have more upside potential than investable stocks, even in an escalating geopolitical risk environment. Chart 5Chinese Semis Are On Fire Chinese Semis Are On Fire Chinese Semis Are On Fire Lastly, more pressure from the US and the West to curb the advancement of Chinese technology will only encourage the leadership to double down on supporting state-led technology programs. This argues for a more bullish view on Chinese tech companies that focus on the domestic market, at least on a cyclical basis (Chart 5). Last week the State Council updated its policy, supporting two strategically important sectors: integrated circuits and software. The central government has had policies in place to support these two sectors since 2000 and updates its support policies every decade or so. Last week's updated version will allow chip companies to enjoy even more tax exemptions and favorable financing than the first set of support policies. China has clearly stepped up its promotion of self-sufficiency and redoubled  its efforts to thwart any pressures meant to restrain its technological progress.  As pointed out by our Geopolitical Strategy team,5 the U.S. and its allies control 95% of the global semiconductor market (Chart 6). Nonetheless, China is the world’s largest importer, accounting for about one-third of global semiconductor sales, making it the largest consumer of semiconductors (Chart 7). Chart 6China’s Chip Makers Are Still Small Fry Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 7China Accounts For 60% Of Global Semiconductor Demand Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 8Made In China 2025 Targets Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War In brief, China relies a lot on imported semiconductors and is working to mitigate this dangerous vulnerability. The Made in China 2025 program estimates that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Bottom Line: China’s domestic industrial sector will continue to recover in the next 6 to 12 months. The nation’s semiconductor industry will get a boost from recently shored-up government policy supports. Overweight these sectors in the face of expanding tensions from the US tech war against China.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1TMT stocks include information technology prior to December 2018, and include media & entertainment and internet & direct marketing retail sectors after December 2018. 2Please see the orders: https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-tiktok/ and https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-wechat/ 3https://www.state.gov/announcing-the-expansion-of-the-clean-network-to-safeguard-americas-assets/ 4Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated August 5, 2020, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations