Emerging Markets

Special Report

Highlights The chance of a U.S.-China trade agreement is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities. Feature “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart 1). Chart 1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart 2) – an actual recession would consign him to the dustbin of history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart 3). This leaves him less room for maneuver going forward. Chart 3China's Gradual Stimulus Yet To Revive Global Economy Chart 4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart 4).   Q4 may be Trump’s last chance to save the business cycle and his presidency. The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart 5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart 6). Chart 5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. Chart 7Trump's Fiscal Policy Undid His Trade Policy In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart 7). The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop, given that its economy is still closely linked to the rest of the world (Chart 8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart 8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.1 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,2 and will the outcome derail the trade talks? Bottom Line: Global economic growth is fragile and President Trump has only tentatively retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table 1). Many of these concessions have been postponed as a result of Trump’s punitive measures. Table 1China’s Offers Thus Far In The Trade War It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “balance” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. The threat of a divorce from the U.S. is a danger to China’s economy and the Communist regime. Chart 9China's Ultimate Economic Constraint Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart 9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart 10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Chart 10Creative Destruction In China Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart 11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart 11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram 1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Diagram 1The South China Sea As The World’s Traffic Roundabout Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart 12A & 12B). A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart 13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart 14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart 14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. Chart 15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart 15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart 16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart 17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart 18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature. Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart 19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time. While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart 20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart 21). This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Taiwan has a lot more dry powder for a political crisis than Hong Kong. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart 22). A deterioration in this region has global consequences. Chart 22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward. Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 2 Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory.

Analyses on the Philippines, Colombia and Argentina are available below. Highlights Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, U.S. bonds are overbought and technical factors might exert upward pressure on them in the near term. Our ubiquitous premise remains that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. There are no signs of investor capitulation that mark a major bottom in EM risk assets. Feature Given the recent plunge in bond yields around the world, we are devoting this week’s report to discussing the implications of low U.S. bond yields on EM risk assets. Our key takeaway is that lower U.S. bond yields are not a reason to be long EM risk assets and currencies. Low Bond Yields: Reflective Or Stimulative? With respect to ultra-low bond yield, investors and commentators generally subscribe to one of the following two arguments: Bond yields are reflective – i.e. they are indicative of an upcoming economic calamity and thereby signal a bearish outlook for equity and credit markets; The current low levels of bond yields signify a dovish monetary policy stance and hence are bullish for global risk assets. In our opinion, it is not a certainty that the bond market always has perfect foresight of the economic outlook. At the same time, falling global bond yields and easing central banks do not automatically ensure a pickup in global economic activity. Hence, low bond yields do not justify a bullish stance on global stocks and credit markets. Like any other financial market, bonds are driven by time-varying forces. In certain times, bond yields signal a correct trajectory for growth, inflation and monetary policy. At other times, bond prices are driven by investor sentiment and momentum-chasing trading strategies. In times where the latter is occurring, the bond market can send the wrong signal on growth and inflation, as well as misprice the future path of interest rates. U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing.  Presently, we have the following observations and reflections on U.S. bond yields: U.S. bond yields are presently correct in signaling that global growth continues to decelerate. This is corroborated by many other indicators that we have been publishing. However, this does not imply that U.S. bond yields will be a reliable leading indicator at the bottom of this business cycle. The basis is that U.S. bond yields did not lead at the top of the cycle. On the contrary, U.S. bond yields lagged the global business cycles by a considerable margin in both 2015-‘16 and in 2018-’19, when the growth slowdown emanated from China/EM. Chart I-1 illustrates that Chinese nominal manufacturing output and import volume growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. In recent years, U.S. bond yields have also lagged the global manufacturing PMI index by about six to nine months (Chart I-2, top panel). Chart I-1China’s Business Cycle Led U.S. Bond Yields Chart I-2Global Manufacturing And EM Stocks Led U.S. Bond Yields   Remarkably, EM financial markets have been leading U.S. bond yields in recent years, not the other way around (Chart I-2, bottom panel). For some time we have held the view that the ongoing growth slump in China would culminate into a global manufacturing and trade recession that would be negative for the rest of the world, especially for EM, Japan, commodities producers, and Germany. This theme has been the main reason for our negative view on global stocks, especially cyclicals, as well as our positive stance on safe-haven bonds and bullish view on the dollar.  Understanding the origins of this global manufacturing and trade downtrend is critical to gauging the evolution of the business cycle. China is the epicenter of this global trade and manufacturing recession. In turn, the root cause of the mainland’s growth slump is money/credit tightening that has occurred in China in both 2017 and early 2018. ​​​​Money and credit growth remain lackluster in the Middle Kingdom, despite ongoing fiscal and monetary policy easing (Chart I-3). Notably, domestic credit growth and its impulse have been muted, especially when issuance of government bonds is excluded (Chart I-4). The aggregate credit and fiscal stimulus have so far been insufficient to engineer a recovery. Chart I-3China: Fiscal Deficit And Broad Money Growth Chart I-4China: Private Sector Credit Growth Is Weak Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. U.S. domestic demand has not been the source of the ongoing global manufacturing and trade recession. U.S. final domestic demand was robust until Q4 2018 and has so far downshifted only modestly (Chart I-5, top panel). Corroborating this, U.S. manufacturing was the last shoe to drop in the global manufacturing recession (Chart I-5, bottom panel). Accordingly, the Federal Reserve’s policy tightening was not the reason behind the current worldwide manufacturing recession. It follows that lower U.S. interest rates might not be essential to instigate a global economic recovery. Critically, the latest plunge in EM currencies and widening in EM credit spreads has occurred amid falling U.S. bond yields and Fed easing. Chart I-5U.S. Economy And Bond Yields Have Lagged In This Cycle Chart I-6U.S. Bond Yields And EM: No Stable Correlation We have long argued against the consensus view that EM equities, credit markets and currencies are much more sensitive to U.S. interest rates than to the global business cycle. Chart I-6 reveals that there has been no stable correlation between U.S. bond yields and EM credit spreads and currencies. Therefore, a bottom in EM currencies and risk assets will occur when global trade and Chinese demand ameliorate rather than as a result of Fed policy. An important question is whether low bond yields are going to support global share prices. Our hunch is that it is not likely.1  First, if U.S. bond yields had not dropped by as much as they have, global equity prices would be lower. In short, reduced long-term interest rate expectations have led investors to pay higher multiples, especially for non-cyclical and growth stocks. The U.S. equity rally since early this year has been due to multiples expansion, especially among non-cyclical and growth stocks. Chart I-7Global Ex-U.S. Share Prices: No Bull Market Here The latter has allowed the S&P 500 to reach new highs recently at a time when global ex-U.S. share prices are not far from their December lows (Chart I-7). Second, falling interest rates are positive for share prices when profits are growing, even if at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Going forward, U.S. equities remain at risk due to a potential profit contraction. We do not foresee a recession in U.S. household spending. However, America’s corporate earnings will be under pressure from a stronger dollar and shrinking profit margins due to rising unit labor costs (Chart I-8), notwithstanding the manufacturing recession that is taking hold. Chart I-8U.S. Corporate Profits Are At Risk From Margins One popular narrative attributes exceptionally low bond yields to excess savings over investments. Yet this is not always accurate. Box I-1 below explains why bond yields have little relation to savings and investments in any economy. Chart I-9U.S. Bonds Are High-Yielders Among DM Finally, some investors wonder if the low/negative bond yields in DM ex-U.S. could push U.S. Treasury yields lower. Our take is that it is possible. The spread of U.S. Treasury yields over DM ex-U.S. is very wide, which could entice foreign fixed-income investors to purchase Uncle Sam’s bonds (Chart I-9). ​​​​​​What is preventing foreign fixed-income investors from piling into Treasuries is exchange rate risk. If for whatever reason a consensus emerges among global fixed-income investors that the greenback is not going to depreciate in the next 12-18 months, there could be a stampede of foreign investors into U.S. Treasuries, pushing yields considerably lower. In our opinion, the odds are that the broad trade-weighted dollar will stay firm for now and could make new cycle highs. In such a scenario, investor expectations of U.S. currency depreciation will diminish. This could trigger a stampede of foreign fixed-income investors into U.S. bonds. This is not a forecast but a consideration that bond investors should take into account. Bottom Line: Global growth conditions, especially outside the U.S., remain bond friendly. Nevertheless, bonds are overbought and technical factors discussed in Box I-1 below might exert upward pressure on U.S. bond yields in the near term. Implications For EM  We explore three scenarios for the direction of U.S. bond yields in the coming weeks and months and the corresponding potential dynamics for EM risk assets and currencies. Scenario 1: U.S. bond yields continue to fall as the global trade and manufacturing recession endures, suppressing global growth. Outcome: EM currencies will depreciate and EM risk assets will suffer more. Scenario 2: U.S. Treasury yields increase because U.S. domestic demand firms up, even if the global trade contraction persists.  Outcome: EM currencies will weaken and EM risk assets will sell off further. Scenario 3: U.S. bond yields rise because the global manufacturing recession abates and a recovery in China leads to a global trade revival. Outcome: EM currencies will appreciate and risk assets will rally considerably. Please note that Scenario 3 is not our baseline scenario. The ubiquitous premise in these deliberations is that EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. EM currencies and EM risk assets are primarily driven by cycles in global trade and the Chinese economy rather than U.S. growth and interest rates. Chart I-10Stay With Short EM Equities / Long 30-Year U.S. Bonds Strategy To capitalize on our view of weaker global growth emanating from China/EM, we have been recommending the following strategy: short EM stocks / long U.S. 30-year Treasuries. This recommendation has panned out nicely, delivering a 21.5% gain since its initiation on April 10, 2017 (Chart I-10). Barring Scenario 3 above, this trade has more upside. EM Financial Markets: No Capitulation So Far Major bottoms in financial markets typically occur after investor capitulation has already taken place. Having reviewed various financial market variables, we conclude that signposts of capitulation in EM risk assets and global equities are absent: The S&P 500 SKEW index is very low. This index reflects the probability that investors are assigning to downside risk in share prices. The SKEW index is currently at one of its lowest readings of the past 30 years (since its existence), which suggests that investors are not hedging themselves against large price swings (Chart I-11). This usually occurs prior to a heightened period of volatility. Chart I-11Are U.S. Equity Investors Complacent? The volatility measures for EM and commodity currencies are still very subdued (Chart I-12). The same is true for EM equity volatility (Chart I-12, bottom panel). Even though EM and commodities currencies as well as EM share prices have fallen substantially, the price of buying insurance is still low – meaning investors are still not particularly worried. This habitually is a sign of complacency. Chart I-12Cyclical Risk Markets: Implied Volatility Remains Low Chart I-13No Capitulation Among EM Equity And Currency Investors Finally, Chart I-13 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures were still elevated as of August 15. Bottom Line: There are no signs of investor capitulation that often mark a major bottom in risk assets.   BOX 1 Do Bond Yields Equilibrate Savings And Investment? Mainstream economic theory regards bond yields as the interest rate that balances desired savings and desired investment. According to mainstream theory, when desired savings rise relative to desired investment, bond yields drop. The latter induces less savings and more investment equilibrating the system. Conversely, when desired investment increases relative to desired savings, bond yields climb, discouraging investment and incentivizing more savings. The fundamental shortcoming of this economic model stems from the misrepresentation of banking. When a commercial bank buys any security from a non-bank, it originates a new deposit “out of thin air.” The bank does not allocate someone’s deposit into bonds. Diagram I-1 below exhibits this point. When a U.S. bank purchases a dollar-denominated bond from a pension fund, it does not use someone’s deposit to do so. Rather, a new deposit in the U.S. banking system (often at another bank) is created “out of thin air” as a result of the transaction. The amount of bonds commercial banks can purchase is limited only by regulatory norms, liquidity provision by the central bank as well as its management’s willingness to do so. Nobody needs to save for a bank to buy a bond or make a loan.  We have written in past reports on money, credit and savings that deposits in the banking system have no relationship with national or household savings. When an individual or company saves, the amount of deposits in the banking system does not change. All in all, banks do not intermediate savings/deposits into credit/loans. They create new deposits “out of thin air” when they originate a loan to or buy any security from a non-bank. Provided that banks do not utilize national savings or existing deposits to acquire bonds, fluctuations in bond yields do not reflect changes in national savings. Holding everything else constant, bond yields could drop if commercial banks buy bonds en masse. The opposite also holds true. Chart I-14 demonstrates that U.S. commercial banks have been augmenting their purchases of various types of bonds. This partially explains why bond yields have plunged (bond yields shown inverted on this chart). If U.S. banks’ bonds purchases mean revert, as they often do, U.S. bond yields could rise. Chart I-14Are U.S. Banks' Purchases Of Bonds Driving Bond Yields? This along with more bond issuance by the U.S. Treasury to refill its Treasury’s General Account at the Fed as well as the existing overbought conditions in government bonds could produce a pick-up in yields. Such a rebound in bond yields would be technical and would not signal fundamental changes in the U.S. or global business cycles, or in the savings-investment balance.  Closing Some Positions Long Latin American / short emerging Asian equity indexes. This position has generated a 6% loss since its initiation on October 11, 2018 and we have low confidence that it will generate positive returns going forward. Long Chinese small cap / short EM small-cap stocks. Our bet has been that Chinese private sector companies trading in Hong Kong and represented in the MSCI small-cap index will perform better than the average EM small cap. This strategy has not worked out and has produced a 4.4% loss since its recommendation on November 20, 2013. We are downgrading Colombian equities from neutral to underweight. Please refer to pages 17-20 for a detailed analysis. Instead, we are upgrading the Peruvian bourse from underweight to a neutral allocation within an EM equity portfolio. Our view remains that gold prices will continue outperforming oil.2 Peru benefits from higher gold and silver prices while Colombia is largely an oil play. Consistently, the Peruvian currency will depreciate less than the Colombian peso. These justify this allocation shift between these two bourses.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Philippines: The Currency Holds The Key Government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Chart II-1Philippine Current Account Deficit Funded By Volatile Portfolio Flows Declining U.S. interest rates coupled with slumping oil prices have supported Philippine financial markets. However, the country’s balance of payments dynamics are still precarious. In particular, Philippine’s wide current account (CA) deficit will need to be funded by volatile foreign portfolio inflows as the basic balance – the sum of CA balance and net FDI – has turned negative (Chart II-1). Critically, the already wide current account deficit is set to balloon even further: First, the 2019 fiscal spending was back-loaded because a Congress impasse delayed the government budget approval to April. Hence, government expenditures, in general, and infrastructure investment, in particular, will rise meaningfully in the next few months. Higher infrastructure spending will drive imports of capital goods higher (Chart II-2). The latter accounts for 32% of total imports. Second, Philippine export growth is likely to contract anew as global trade is not recovering (Chart II-3). Chart II-2Philippine Government Infra Spending Will Accelerate Chart II-3Philippine Exports Will Contract We continue to expect broad portfolio capital outflows from EM. Potential for foreign outflows from the Philippines is large. Foreign ownership of local equities is high at 42%. As to foreign ownership of local currency bonds, it stands at around 13%. A renewed decline in the peso will drive away portfolio flows reinforcing additional currency depreciation. The falling peso will prevent the central bank from reducing interest rates further. Even if the central bank does not hike rates to support the peso, market-driven local rates could rise for a period of time. This is bad news for property stocks – which account for about 27% of the MSCI Philippines index. Having rallied considerably, they are at major risk as local interest rates rise. In addition, these stocks have benefited from strong real estate demand emanating from the Philippine Offshore Gaming Operators (POGO) sector – which itself has been largely driven by Chinese capital flows. Both the Chinese and Philippine authorities have begun cracking down fiercely on these operations because they are link to capital flight out of China. This crackdown will curtail capital flows into these areas and depress revenues of Philippine real estate companies. This will occur at a time when the residential market is experiencing weak demand. We continue to recommend shorting/underweighting property stocks. Finally, small cap stocks are in a bear market and are sending an ominous signal (Chart II-4). Furthermore, this bourse is neither attractive in absolute terms nor relative to EM (Chart II-5). Chart II-4Small-Cap Stocks Are In A Bear Market Chart II-5Philippine Equities Are Expensive Bottom Line: We continue recommending to short the Philippine peso against the U.S. dollar. Overall, EM dedicated investors should continue underweighting the Philippine equity, fixed income and sovereign credit markets within their respective EM universes. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Colombia: A Top In The Business Cycle? Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening   Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates.   Juan Egaña, Research Associate juane@bcaresearch.com   Argentina: Do Not Catch A Falling Knife The latest rout in Argentine markets has brought fears of another sovereign debt default or restructuring. Are conditions right for buying Argentine markets? Politics complicate the assessment of a debt restructuring and we do not recommend bottom fishing in Argentine financial markets. Looking at the profile of past financial crises and debt defaults, there might be more downside in Argentine asset prices. Sovereign U.S. dollar bond prices remain well above their 2002 and 2008 lows (Chart IV-1). Compared with previous EM financial crises, Argentine stocks might still have considerable downside in U.S. dollar terms (Chart IV-2). Chart IV-1Things Could Get Worse Chart IV-2Historical Patterns Suggest More Downside In Bank Stocks The equity market index has relapsed below its 2018 lows in dollar terms, which technically qualifies as a breakdown and entails fresh lows ahead (Chart IV-3). Chart IV-3A Technical Breakdown In Argentine Equities In addition to political uncertainty and rising possibility of a left-wing run government, the nation’s ability to service its foreign currency debt has deteriorated with the currency plunging to new lows. Specifically, the country has large foreign debts of $275 billion. Foreign obligation payments in the next 12 months are about $40 billion. The government lacks foreign currency reserves and export revenues necessary to service its external debt. The central bank’s net foreign exchange reserves (excluding FX swaps and gold) are about $17 billion. The country’s annual exports are $77.5 billion. With agricultural commodities prices falling, exports will likely shrink. By and large, our downbeat stance from April remains intact. Bottom Line: Investors should continue avoiding and underweighting Argentine financial markets.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com   Footnotes 1      Please note this is the view of BCA’s Emerging Markets Strategy service and is different from BCA’s house view. Clients can read the debate between various BCA strategists in the report What Goes On Between Those Walls? BCA’s Diverging Views In The Open. Please click on the link to access it. 2    We recommended the long gold / short copper and oil trade on July 11, 2019 and this position remains intact. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

Special Report

Highlights So What? Maintain a cautious stance on Turkish currency and risk assets. Why? Following the AKP’s defeat in Istanbul, Erdogan has doubled down on unorthodox economic policies. Improvements in the current account balance are temporary. Unless investor sentiment is meaningfully repaired, the lira will resume its decline in 2020. In the meantime, tensions with the West – especially the U.S. – will remain elevated. The imposition of secondary sanctions from the U.S. is likely. Feature U.S. President Donald Trump is wavering in the trade war, which is ostensibly positive news for global risk assets that are selling off dramatically amid very gloomy expectations about the near future. The question is whether the delay is too little, too late to halt the slide in financial markets in the near term. The reason to be optimistic is that interest rates have fallen and the global monetary policy “put” is fully in effect. Moreover, it is irrefutable now that President Trump is sensitive to the negative financial effects of the trade war. He is delaying new tariffs on some of the remaining $300 billion worth of imports from China not simply because consumer price inflation has ticked up but more fundamentally because the tightening of financial conditions increases the risk of a recession. A president can survive a small increase in inflation but not a big increase in unemployment. The reason to be pessimistic is that global economic expectations are threatening the crisis levels of 2008 (Chart 1) and Trump’s tariff delay offers cold comfort. His administration has not delayed all the tariffs, and the delay lasts only three months. Rather than renew the license for U.S. companies to do business with Chinese telecom giant Huawei, his Commerce Department has deferred any decision – leaving uncertainty to fester in the all-important tech sector. Chart 1Global Economic Expectations Near Crisis Levels Chart 2More China Stimulus Needed To Prevent EM Breakdown Beneath the surface is the fact that China’s money-and-credit growth faltered in July, suggesting that negative sentiment is still suppressing credit demand and preventing policy stimulus from having as big of a bang as in 2015-16. The late-July Politburo meeting signaled a more accommodative turn in policy, as we have expected, and BCA’s China strategist Jing Sima expects more fiscal stimulus to be announced after the October 1 National Day celebration. But high-beta economies and assets will suffer in the meantime – especially emerging market assets (Chart 2). Emerging markets are also seeing geopolitical risks rise across the board – and with the exception of China and Brazil, these risks are underrated by markets: Greater China: Beijing is getting closer to intervening in Hong Kong with police or military force. Such a crackdown will increase the odds of a confrontation with Taiwan and a backlash across the region and world, meaning that East Asian currencies in particular have more room to break down. India: The escalation in Kashmir is not a “red herring.” A single terrorist attack in India blamed on Pakistan could trigger a dangerous military standoff that hurts rather than helps Indian equities, unlike the heavily dramatized standoff ahead of the election earlier this year. Russia: Large-scale protests, overshadowed by Hong Kong, highlight domestic instability amid falling oil prices. These developments bode ill for Russian currency and equities. We will return to these risks in the coming weeks. This week we offer a special report on Turkey, where political risk is becoming extremely underrated as the lira rallies despite a further deterioration in governance (Chart 3). Chart 3Political Risks Are Underrated In Turkey Too Early To Write Off Erdogan “Whoever wins Istanbul, wins Turkey … Whoever loses Istanbul, loses Turkey.” President Recep Tayyip Erdogan Turkey’s ruling Justice and Development Party (AKP) has had a tough year. The March 31 local elections – especially the rerun election for mayor of Istanbul – dealt the party its biggest electoral losses since it emerged as the country’s dominant political force in 2002 (Chart 4). The elections came to be seen as a referendum on President Recep Tayyip Erdogan and thus raise the question of whether the party’s strongman leader is in decline – and what that might mean for emerging market investors. Erdogan’s grip on power has long been overrated – it is his vulnerability that has driven him to such extremes of policy over the past decade. The Gezi Park protests of 2013 and the attempted military coup of 2016 revealed significant strains of internal opposition in the aftermath of the Great Recession. With each case of dissent, the AKP responded by stimulating the economy and tightening state control over society (Chart 5). But this strategy faltered last year when monetary policy finally became overextended, the currency collapsed, and the country slid into recession. The opposition finally had its moment. The AKP is less a source of unity. As a consequence, the AKP is less a source of unity among Turkish voters. Both its share of seats in parliament and the overall level of party concentration in the Turkish parliament have declined since 2002 (Chart 6). Were it not for its coalition partner, the Nationalist Movement Party (MHP), the AKP would not have gained a majority in the 2018 parliamentary election. The AKP’s popular base consists of conservative, rural, and religious voters. This bloc is losing influence in parliament relative to centrist and left-wing parties (Chart 7). Moreover, the share of Turks identifying with political Islam, while still the largest grouping, is declining. Those who identify with more secular Turkish nationalism are on the rise (Chart 8). Does this shift entail a major turn in national policy? Will a new party emerge to challenge the AKP at last? Chart 8Secular Nationalism Is On The Rise There has long been speculation that former AKP leaders such as former Turkish president Abdullah Gul, former prime minister Ahmet Davutoglu, and former deputy prime minister Ali Babacan might form a political alternative. The latter resigned from the AKP on July 8, reviving speculation that a rival party could emerge that is capable of combining disillusioned AKP voters with the broader opposition movement at a time when Erdogan’s vulnerability has been made plain. However, the opposition is likely getting ahead of itself. The ruling party still has many tools at its disposal. Its share of seats in parliament is more than double that of the main opposition party, the Republican People’s Party (CHP). It is also viewed favorably in rural areas, and support for Erdogan there will not shift easily. Moreover, despite the negative electoral trend, the AKP has a lot of enthusiasm among its supporters – it is the party with the highest favorability among its own voters (Chart 9). The March election served as a wakeup call for the AKP – a warning not to take its power for granted. Erdogan can still salvage his position. The next election is not due until June 2023, leaving the party with four years to recuperate. While polls for the 2023 parliamentary election paint an ominous sign (Chart 10), they are very early, and the key will be whether Erdogan can divide the opposition and reconnect with his voter base. Above all, this will depend on what changes he makes to economic policy. Chart 10Erdogan Needs To Reconnect With Voter Base Bottom Line: Erdogan’s and the AKP’s popularity is waning, but it is too soon to write them off. The key question is how Erdogan will handle economic policy now that there are chinks in his armor. Doubling Down On Erdoganomics The fluctuation in the lira “is a U.S.-led operation by the West to corner Turkey … The inflation rate will drop as we lower interest rates.” President Recep Tayyip Erdogan Erdogan needs to see the economy back to recovery in order to secure his success in the next election. A survey conducted early this year reveals that Turks view unemployment, the high cost of living, and the depreciation of the lira as the most significant problems facing Turkey, with 27% of respondents indicating that unemployment is the most important problem facing the country (Chart 11). More importantly, Turks do not have much confidence in the government’s ability to manage this pain – only one-third of respondents viewed economic policies as successful, a 14pp decline from the previous year. This highlights the need for Erdogan to revive confidence in Turkey’s policymaking institutions and to deliver on the economic front.     The key is how Erdogan will handle economic policy. However, it is still too early to call for a sustainable improvement in the Turkish economy as many of the same fundamental imbalances continue to pose risks. While the current account has improved significantly – even registering a surplus in May – the improvement will not endure (Chart 12). On the one hand, the weaker lira has made exports more attractive relative to global competition. However, the improvement in the external balance is in large part due to weaker imports which are now more expensive for Turkey’s residents and have fallen by 19% y/y in 1H2019. Shrinking imports also reflect weak domestic demand which has been weighed down by tight monetary conditions (Chart 13). Chart 12Current Account Improvement Will Not Endure Chart 13Tight Monetary Conditions Weighed On Domestic Demand What is more, portfolio inflows which in the past were necessary to offset the large current account deficit, have collapsed (Chart 14). Were it not for the improvement in the trade balance, the central bank of the Republic of Turkey (CBRT) would have experienced a pronounced decline in its foreign reserves, and currency pressures would have been significant. A meaningful improvement in investor sentiment – which will remain cautious on the back of economic and geopolitical risks – is a necessary precondition for the return of these inflows. Nevertheless, the current account deficit will likely remain narrow in the second half of the year as the trade balance improves on the back of a weak lira and imports remain depressed due to soft domestic demand. This will keep the lira supported over this period. Although risks from a wide current account deficit have been temporarily put off, years of foreign debt accumulation are a hazard to a sustainable improvement in the lira. Foreign debt obligations (FDO) due over the coming 12 months are extremely elevated at $167 billion (Chart 15). It is not clear that they can be paid off. While the FDO figure is overly pessimistic as some of these debts will be rolled over, net central bank foreign exchange reserves can cover only 2.7% of these obligations. This poses downside risks on the lira at a time when inflows have not yet recovered.1 Moreover, unorthodox economic policies will eventually reverse any improvement in the currency. Chart 14Financial Account Does Not Lend Support Chart 15FDO Pose A Risk To The Currency While the 4 years between now and the next election could be an opportunity to embark on unpopular structural reforms that will improve the outlook by the time voting season rolls in, Erdogan has instead doubled down on his current strategy. Less than two weeks after the results of the Istanbul election rerun, CBRT governor Murat Cetinkaya was removed by presidential decree. A month later, key CBRT staff were dismissed.2 At his first monetary policy committee meeting as governor on July 25, Murat Uysal slashed the one-week repo rate by 425bps. Given Erdogan’s outspoken distaste for high interest rates, the president’s consolidation of power over economic decision making implies that the outlook for easier monetary policy is now guaranteed. However, the ramifications of this dovish shift will be concerning for voters. The depreciating lira was singled out as the most important economic problem facing Turkey by the largest number of survey respondents (Chart 16). Erdogan’s pursuit of dovish policies despite popular opinion shows that he is doubling down on unorthodox policy despite popular opinion. Monetary easing threatens to unwind the current account improvement and ultimately de-stabilize the lira. Assuming that the banking sector does not hold back the supply of credit to the private sector, lower rates will generate a pickup in demand which will raise imports and widen the current account deficit. Unless there is a marked improvement in investor sentiment – which will remain tainted by the erosion of central bank independence and increased tensions with the West – a return in portfolio inflows to pre-2018 levels is unlikely. As a consequence the lira will begin to soften anew in 2020. The lira will soften anew in 2020. While inflation will subside as the lira stabilizes this year, it will likely remain elevated relative to pre-2018 levels – in the 10% to 15% range. Contrary to Erdoganomics, traditional economic theory postulates that interest rate cuts pose upside pressure on prices. The resurgence in domestic demand will occur against a backdrop of rising wages (Chart 17). Chart 17Price Pressures Will Persist With foreign currency reserves running low, the CBRT recently adopted several measures to discourage locals from exchanging their liras for foreign currency. These efforts reflect attempts to mitigate the negative impact of monetary easing on the lira, and to ensure FX reserves are supported: A 1-percentage point increase in the reserve requirement ratio for foreign currency deposits and participation funds. A 1-percentage point reduction in the interest rate on dollar-denominated required reserves, reserve options and free reserves held at the bank. An increase in the tax on some foreign exchange sales to 0.1% from zero. These measures make it more expensive for banks to hold foreign currency, incentivizing lira holdings instead. They also raise the CBRT’s foreign reserves highlighting the downside risks on these holdings and the lira. However, given that these measures boost CBRT reserves only superficially – rather than mirroring an improvement in the underlying economic conditions – they highlight that need for policy tightening to defend the lira, even as the CBRT officially pursues an accommodative path. Bottom Line: The Turkish economy will be extremely relevant to Erdogan’s fate in 2023. However with large foreign debt obligations, a rate cutting cycle underway, and foreign investors who remain uneasy, the case for Turkey’s economic recovery – especially amid turbulent global conditions – is weak. In the meantime, Erdogan will continue to blame external factors for the nation’s malaise. Don’t Bet On Trump-Erdogan Friendship “Being Asian and in Asia is as important as being European and in Europe for us.” Turkish Foreign Minister Melvut Cavusoglu For several years Erdogan has attempted to distract the populace from the country’s economic slide by adopting an aggressive foreign policy, particularly toward the West. The immediate cause is Syria, where Turkey has fundamental security interests that clash with those of the U.S. and Europe. But tensions also stem from Erdogan’s economic and political instability. This aggressive foreign policy has not changed in the wake of the AKP’s electoral loss. Erdogan is continuing to test the U.S.’s and EU’s limits and the result is likely to be surprise events, such as U.S.-imposed sanctions, that hurt Turkey’s economy and financial assets. Erdogan clashes with the West both because of substantive regional disagreements and because it plays well domestically. Turks increasingly see the U.S. and other formal NATO allies as a threat, while looking more favorably upon American rivals like Russia, China, Iran, and Venezuela (Chart 18). The U.S., meanwhile, is expanding the use of “secondary sanctions” to impose costs on states that make undesirable deals with its rivals, and Turkey is now in its sights. The reason is Erdogan’s decision to purchase the S400 missile defense system from Russia. This decision exemplifies the breakdown in the U.S.-Turkish alliance and Turkey’s search for alternative partners and allies. The arms sale is likely – eventually – to trigger secondary sanctions under the U.S. International Emergency Economic Powers Act and especially the Countering America’s Adversaries Through Sanctions Act (CAATSA). Washington has already imposed sanctions on China for buying the same weapons from Russia. Erdogan recently accepted the first delivery of components for the S400s, which are supposed to go live by April 2020. He stuck with this decision in disregard of Washington’s warnings. He has a solid base of popular support across political parties for this act of foreign policy and military independence from the U.S. (Chart 19). But the full consequences have not yet been felt. President Trump’s response is muted thus far. He banned Turkish pilots from the U.S. F-35 program and training but has not yet imposed sanctions due to his special relationship with Erdogan and ongoing negotiations over Syria. Syria is the root of the breakdown in Turkish-American relations since 2014. Washington and Ankara have clashed repeatedly over their preferred means of intervening into the Syrian civil war and fighting the Islamic State. The U.S. relies on the Syrian Democratic Forces, led by the Kurdish People’s Protection Units (YPG), which are affiliated with the Kurdistan Workers’ Party (PKK). The PKK is based in Turkey and both the U.S. and Turkey designate it as a “terrorist organization” due to its militant activities in its long-running struggle for autonomy from Turkey. Turkey has intervened in Syria west of the Euphrates River and has repeatedly threatened to conduct deeper strikes against the Kurds. The latter would put U.S. troops in harm’s way and could result in lost leverage for Western forces seeking to maintain their YPG allies and force an acceptable settlement to the Syrian conflict. There is a basis for a deal between Presidents Trump and Erdogan that could keep sanctions from happening. Trump is attempting to wash its hands of Syria to fulfill a promise of limiting U.S. costs in wars abroad. Meanwhile an aggressive intervention in Syria is not a popular option in Turkey, which is why Erdogan has not acted on threats to seize a larger swath of territory (Chart 20). As a result, the U.S. and Turkey recently formed a joint operation center to coordinate and manage “safe zones” for Syrian refugees. If they can manage the gray area on the Turkish-Syrian border, the Trump administration can continue to prepare for withdrawal while preventing Erdogan from taking too much Kurdish territory. The tradeoff is clear, but similar agreements have fallen apart. First, the U.S. Congress is ready to impose sanctions over the S400s and Trump is under pressure to punish Turkey for undermining NATO and dealing with the Russians. Second, the Trump administration has not found an acceptable solution to the Syrian imbroglio that makes full withdrawal possible. If Trump becomes convinced that the risks of a total and rapid withdrawal from Syria are greater than the rewards (as many of his GOP allies staunchly believe), then he has less incentive to protect Erdogan. Meanwhile Erdogan could still decide he needs to plunge deeper into Syria to counteract the YPG. Or he could retaliate against any sanctions over the S400s and provoke a broader tit-for-tat exchange. He has threatened to cancel orders for Boeing aircraft worth $10 billion. Clearly U.S. sanctions will cause the lira to fall and send Turkey into another bout of financial turmoil. In the meantime Turkey’s relations with Europe also pose risks. While the refugee crisis has abated, in great part due to Turkish cooperation, other disagreements are still problematic: The EU is not upgrading Turkey’s customs union and both sides know that Turkey is not eligible for EU membership anytime soon. In response to what the EU has deemed as illegal drilling for oil and gas off the coast of Cyprus, the EU called off high-level political meetings with Turkey and suspended EUR 145.8 million in pre-accession aid. EU foreign ministers have also put off talks on the Comprehensive Air Transport Agreement between the two parties which would have led to an increase in passengers using Turkish airports as a transit hub. In addition, EU ministers asked the European Investment Bank to review its lending activities in Turkey, which amounted to EUR 358.8 million last year. Erdogan is taking a bolder approach to Cyprus. He has decided to send a fourth ship to drill for natural gas in Cyprus’s Exclusive Economic Zone in the Eastern Mediterranean. The purpose is to rally support for his government by calling on the public’s strong allegiance to Turkish Cypriots (Chart 21). The problem is that a confrontation sought as a domestic distraction could provoke negative policy reactions from the EU (or the U.S., which is reconsidering its arms embargo on the Greek Cypriot side). Relations with the West would get worse. Chart 22... But Turkey Cannot Afford To Flout The EU Turkey cannot afford to flout the U.S. and EU. Its economy is dependent on Europe (Chart 22). And the U.S. still underwrites Turkey’s NATO membership and access to the global financial system. The problem is that Erdogan is an ambitious and unorthodox leader and he has clearly wagered that he can rally domestic support through various confrontations with Western policies. This means that for the immediate future the country is more likely to clash with Western nations than it is to recognize its own limits. Political risks are frontloaded and investors should be cautious before trying to snap up the depressed lira or Turkish government bonds. Bottom Line: Tensions with the West – especially the U.S. – will likely lead to economic sanctions. While there is a basis for Presidents Trump and Erdogan to avoid a falling out, it is not reliable enough to underpin a constructive investment position – especially given Erdogan has not changed course in the wake of this year’s significant electoral loss. Investment Conclusions Chart 23Optimism On Lira Amid Unresolved Risks The lira has rallied by 3.6% since the Istanbul election. It has risen 0.3% since the replacement of CBRT Governor Murat Cetinkaya and rallied further despite the sacking of the central bank’s chief economist and other high-level staff (Chart 23). Given that the market knows that the central bank reshuffle entails interest rate cuts, is this a clear signal that the lira has hit a firm bottom and cannot fall further? Turkey is more likely to clash with Western nations.  We doubt it. First, Erdogan’s doubling down on unorthodox policy threatens the recovery in the currency and risk assets and his aggressive foreign policy raises the risk of sanctions and further economic pain. Second, although Turkey is not overly exposed to China, it is heavily exposed to Europe, which is on the brink of a full-fledged recession and depends heavily on the Chinese credit cycle – which had another disappointment in July. German manufacturing PMI has been sinking further below the 50 boom-bust mark since the beginning of the year, and the economy contracted in 2Q2019 (Chart 24). Chart 24Global Backdrop Not Yet Supportive Chart 25Improvement In Spread Will Be Fleeting Given these domestic and global economic risks and geopolitical tensions, we expect any improvement in the sovereign spread to be fleeting (Chart 25). While the lira may experience temporary improvement, pressures will re-emerge in 2020 as the lagged impact of Erdogan’s pursuit of growth at all costs re-emerge. Stay on the sidelines as any improvement in the near term is fraught with risk.     Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Emerging Markets Strategy Weekly Report, “Country Insights: Indonesia, Turkey, And The UAE” May 2, 2019, ems.bcaresearch.com. 2 Among those removed are the central bank’s chief economist Hakan Kara as well as the research and monetary policy general manager, markets general manager, and banking and financial institutions general manager.

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well Chart I-13German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Chart II-3No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations