Emerging Markets

Highlights Analysis on Brazil is available below. If banks in China are forced by regulators to properly recognize and provision for non-performing assets, large banks would become substantially undercapitalized while many small- and medium-sized banks (SMBs) would have little equity capital left. That would hammer their ability to finance the economy. Provided on aggregate SMBs have actually outgrown larger ones in terms of balance sheet size, the precarious state of the former’s financial health has become a matter of macro significance. The principal danger to shareholders of mainland banks is equity dilution. We reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position. Feature Chinese Banks: A Value Trap Chart I-1Chinese Bank Share Prices Are On Edge Chinese Bank Share Prices Are On Edge Chinese Bank Share Prices Are On Edge Banks are crucial to financing the private sector as well as all levels of government in China. Not only do banks originate a substantial share of credit, but also they account for 82% of purchases of government bonds. That is why today we revisit the fundamentals of the Chinese banking sector. Besides, their equity valuations appear very cheap, and many investors are tempted to buy their shares. Chinese banks’ financial ratios look healthy and valuations appear extremely cheap because they have not recognized and provisioned for non-performing assets. By expanding their balance sheets enormously and not provisioning for bad assets, their profits have mushroomed. Banks have retained a share of these profits, boosting their capital. Yet, their share prices have been flat over the past 10 years. Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner (Chart I-1). We highlight their poor financial health in the section below, where we perform stress tests for both large as well as small and medium sized banks (SMB). The principal danger to shareholders is equity dilution that will continue occurring among mainland banks (Chart I-2). Our bearish view on Chinese bank stocks has not been contingent on a systematic financial crisis but on inevitable and substantial equity dilution. Investment conclusions: Absolute return investors should stay clear of Chinese bank stocks – they are the ultimate value trap. For relative value traders, we reiterate our long U.S. banks/short Chinese bank shares trade, and within the latter our long large/short SMB stocks position (Chart I-3). Chart I-2Beware Of Equity Dilution Beware Of Equity Dilution Beware Of Equity Dilution Chart I-3Our Trades On Chinese Banks Our Trades On Chinese Banks Our Trades On Chinese Banks   Large Versus Small And Medium Banks China’s banking system consists of five large banks (Industrial and Commercial Bank of China, China Construction Bank, Bank of China, Agricultural Bank of China, and Bank of Communications) and about 3150 small- and medium-sized banks (SMBs). All five large banks are publically listed but the central government still holds about 70-80% of their equity. About 36 of the SMBs are also listed but the central authorities in Beijing have a stake in some of the medium-sized banks. Notably, the central government has no equity in any of the small banks. In recent years, SMBs have been playing a greater role in sustaining the credit boom: First, on aggregate SMBs have actually outgrown the five large banks in terms of balance sheet size. The former’s risk-weighted assets1 (RWAs) of RMB 73 trillion exceeds the RMB 65 trillion of large banks (Chart I-4). Recently, investable bank stocks have been lingering around their December lows. Another gap down could be lurking around the corner. The value of RWAs emphasizes banks’ claims on enterprises, non-bank financial institutions and households over holdings of government bonds. Hence, RWAs of banks are a more pertinent measure of non-government financing than total assets. Second, over the past 12 months large banks and SMBs have accounted for 40% and 60% of the rise in the aggregate banking system’s RWAs, respectively (Chart I-5). Therefore, further credit acceleration will be difficult to engineer if – as we discuss below – SMBs begin retrenching under regulatory pressures and amid tighter market financing in the wake of the Baoshang bank failure. Chart I-4SMBs Have Outgrown Large Ones SMBs Have Outgrown Large Ones SMBs Have Outgrown Large Ones Chart I-5SMBs Have Contributed Enormously To The Credit Boom SMBs Have Contributed Enormously To The Credit Boom SMBs Have Contributed Enormously To The Credit Boom   Finally, there has so far been no deleveraging among SMBs. Large banks’ RWAs-to-nominal GDP ratio has been in decline since 2014, but the same ratio for SMBs has not dropped at all (Chart I-6). This chart corroborates that the credit boom between 2015 and 2017 was driven by SMBs, rather than by large banks. In fact, SMBs along with shadow banking are what primarily drove the credit boom that occurred over the past decade. This confirms the thesis that the unprecedented credit bubble has spiraled beyond the central authorities’ control. While China’s entire banking system is in poor health, SMBs are in considerably worse shape than large ones. In particular: SMBs have much more assets classified as equity and other investments than large banks (Chart I-7). Equity and other investments stands for non-standard credit assets that are typically much riskier than loans and corporate bonds. This is the principal reason why in our stress test we use higher ratios of non-performing assets for SMBs than for large banks. Chart I-6No Deleveraging Among SMBs No Deleveraging Among SMBs No Deleveraging Among SMBs Chart I-7SMBs Exposure To Non-StandarD Credit Assets Is Huge SMBs Exposure To Non-StandarD Credit Assets Is Huge SMBs Exposure To Non-StandarD Credit Assets Is Huge Chart I-8Large Banks Versus SMBs Large Banks Versus SMBs Large Banks Versus SMBs Big banks are better capitalized than SMBs. The capital adequacy ratio among big banks is higher compared with the other banks (Chart I-8, top panel). Similarly, the ratio of non-performing loans (NPL) to total loans is considerably lower for large banks than for SMBs (Chart I-8, bottom panel). On the liquidity side, SMBs are more dependent on the wholesale funding market than their larger peers. Interbank transactions account for 10% of SMBs own liabilities. On the other hand, big banks are the main lenders in the interbank market. Bottom Line: SMBs have become more important than large ones in providing financing to companies and households. Yet these SMBs are much more vulnerable. A Stress Test We conducted separate stress tests on large banks and SMBs. Our findings are not optimistic. Some 71% of equity of SMBs will be wiped out if 14% of their RWAs turn sour (Table I-1). 43% of large banks’ equity will be impaired if 12% of their RWAs become non-performing (Table I-2). Chart I- Chart I- The reason we use RWAs rather than loans is because banks have been accumulating claims on enterprises, non-bank financial institutions and households beyond their loan books. Hence, RWAs better captures all credit assets. We use a higher impairment rate for SMBs than for large banks because the former have substantially more non-standard credit assets. Typically, the quality of non-standard credit assets is inferior to those of corporate bonds or loans. We used the following assumptions in our stress tests: For large banks, we assumed non-performing assets (NPAs) ratios of 10% in the optimistic scenario, 12% (baseline), and 14% (pessimistic) (Table I-2). For SMBs, we employed NPAs ratios of 12% (optimistic), 14% (baseline), and 16% (pessimistic) (Table I-1). The magnitude and duration of China’s current credit boom has considerably surpassed that of the 1990s, when Chinese banks held over 25% of non-performing loans (Chart I-9). Therefore, our stress test assumption that the NPAs ratio will rise above 10% is reasonable. Chart I-9China's Credit Booms In Perspective China's Credit Booms In Perspective China's Credit Booms In Perspective We applied a 30% recovery rate on NPAs. The recovery rate on Chinese banks’ NPLs from 2001 to 2005 was 20%. This occurred amid much stronger economic growth. Thus, an assumption of a 30% recovery rate today is realistic. Finally, we calculated overvaluations assuming the fair price-to-book value ratio for all banks is 1. How has it been possible for banks in China to continue expanding their balance sheets aggressively despite such moribund financial health? Banks can operate and expand their balance sheets with zero or even negative de facto equity capital, so long as they obtain liquidity from other banks or the central bank. This is how many Chinese SMBs have been operating in recent years. Barring institutional and regulatory constraints, banks theoretically can expand their balance sheets indefinitely by creating loans and deposits “out of thin air.” We have deliberated extensively in past reports that banks do not intermediate savings or deposits into loans and credit. Rather, they create deposits when they make a loan to or buy an asset from a non-bank entity. Loans and deposits are nothing other than accounting entries on banks’ books. It is regulators’ and shareholders’ forbearance – or lack of it – that allows banks to, or prevents banks from, expanding their balance sheets. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. For example, in April bank regulators released draft rules on how banks should classify all types of assets and provision for them. Over the past several years, many banks have transformed their bad loans into non-loan assets to disguise the true level of their non-performing loans (NPLs). The new regulation, if and when it is adopted and properly executed, will force banks to recognize NPAs and increase their provisions. Although Chinese authorities have been easing both monetary and fiscal policies, they have not completely abandoned their regulatory tightening efforts on banks and shadow banking, or their plans to curb leverage and speculation in the real estate market. Ultimately, this will substantially impair banks’ capital and dampen their ability to originate new credit – both in the form of making loans and buying securities. Consequently, the credit impulse will relapse and the business cycle recovery will be delayed. Bottom Line: If banks in China are forced by regulators to properly recognize and provision for NPAs, large banks would become substantially undercapitalized while many SMBs would have little equity capital left. That would hammer their ability to finance the economy. Investment Ramifications Given the increased importance of SMBs in China, the precarious state of their financial health has become a matter of macro significance. Even if regulators partially reinforce recognition of provisions for NPAs, aggregate credit growth will decelerate. A simple simulation to illustrate this point: If SMBs RWAs growth were to decelerate from 11% currently to 8%, large banks’ RWA annual growth would need to surge from 8% now to 16% for all banks’ RWA growth to accelerate from the current 9.5% to 12%. The latter is probably what is required to promote an economic recovery. Such a ramp-up in large banks’ RWAs is unlikely, given they would also be facing stricter regulatory requirements. The key point is that the positive effects of monetary and fiscal easing continue to be hampered by regulatory tightening on the credit system. The latter will delay a business cycle recovery in China. For now, although the credit plus fiscal spending impulse has picked up, economic growth has not yet revived (Chart I-10, top two panels). The reason has been a declining marginal propensity to spend among households and companies (Chart I-10, bottom two panels). We have discussed this issue at great length in past reports. Consistently, nominal industrial output, car sales and smartphone sales as well as total imports are either very weak or are in outright contraction (Chart I-11). All series in Chart I-11 and I-12 include June data. Chart I-10Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Chart I-11Chinese Economy: No Recovery So Far Chinese Economy: No Recovery So Far Chinese Economy: No Recovery So Far   Chart I-12Chinese Corporate EPS: The Outlook Is Downbeat Chinese Corporate EPS: The Outlook Is Downbeat Chinese Corporate EPS: The Outlook Is Downbeat Importantly, Chinese corporate per-share earnings in RMB are contracting for the MSCI investable universe and will soon be contracting for A-share companies as well (Chart I-12). We maintain our negative outlook for EM risk assets and China-plays globally due to our downbeat view on China’s credit cycle. This differs from BCA’s House View, which is positive on global/Chinese growth.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Brazil: Buy The Rumor, Sell The News? Having surged on the back of Congress’s initial approval of the social security reform, Brazilian financial markets are attempting to break above important technical resistance levels both in absolute and relative terms (Chart II-1 and Chart II-2). If the Bovespa decisively breaks above these technical resistance lines, it would mean it is in a structural bull market. A failure to break out will lead to a sizable setback. Chart II-1Are Brazilian Equities Poised For A Breakout In Absolute Terms… Are Markets Poised For A Breakout In Absolute Terms... Are Markets Poised For A Breakout In Absolute Terms... Chart II-2…And Relative Terms? ...And Relative Terms? ...And Relative Terms?     We upgraded Brazilian equity and fixed-income markets right after the first round of presidential elections on October 7, but then downgraded them in early April. In retrospect, the downgrade was a miscalculation. Presently, investor confidence in Brazil is very high, sentiment is very bullish and markets are overbought. Faced with the choice of chasing the market higher or waiting, we are opting for the latter. Pension Reform: Necessary But Not Sufficient Chart II-3Public Debt-To-GDP Ratio Will Rise Further Public Debt-To-GDP Ratio Will Rise Further Public Debt-To-GDP Ratio Will Rise Further The nation’s pension bill is a very positive and much-needed step in the structural reform process. However, in its current form, it is insufficient to make public debt dynamics sustainable – i.e., halt the rise in the government debt-to-GDP ratio (Chart II-3). Table II-1 illustrates the savings from the social security reform adopted in the lower house. As estimated by the Independent Fiscal Institute, an advisory think-tank of the Senate, the reform would bring only BRL 744 billion of savings over the next decade. Is this sufficient to stabilize the public debt-to-GDP ratio? Chart II- One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years – i.e., the government runs continuous robust primary fiscal surpluses. Yet, the pension bill falls short of achieving this goal. The estimated savings in the first four years will likely be around BRL 130 billion. This amounts to annual savings of BRL 33 billion. Chart II-4 demonstrates that savings from the reform are too small to flip the government’s (often optimistic) projected primary fiscal deficit into a surplus in the forecast period. One way these reforms could contain the rise in the public debt-to-GDP ratio is if the savings generated significantly exceed the primary fiscal deficits over the next several years. Another scenario for stabilizing the public debt-to-GDP ratio is for interest rates to drop meaningfully below nominal GDP growth. Having plummeted amid very benign global and domestic backdrops, local currency bond yields still remain about 100 basis points above current nominal GDP growth (Chart II-5). It remains to be seen whether local currency borrowing costs will drop and stay below nominal GDP in the years to come. Chart II-4Primary Fiscal Balance Will Remain Negative Despite Pension Reform Primary Fiscal Balance Will Remain Negative Despite Pension Reform Primary Fiscal Balance Will Remain Negative Despite Pension Reform Chart II-5Borrowing Costs Remain Above Nominal GDP Growth Borrowing Costs Remain Above Nominal GDP Growth Borrowing Costs Remain Above Nominal GDP Growth   Overall, the pension reform in current form does not guarantee public debt sustainability in Brazil: It is simply insufficient to get the government to run recurring primary fiscal surpluses. Another prerequisite – nominal GDP growth exceeding local bond yields over next several years – is contingent on further reforms as well as on a substantial improvement in confidence among investors, companies and households. It Is All About Confidence The sustainability of public debt, economic growth and financial markets are interlinked, with the common thread being confidence. In a virtuous cycle, financial markets typically rally while the currency stays firm. Subdued inflation will allow the central bank to rapidly reduce interest rates. This will help boost confidence among businesses and consumers, buoying the economy. In turn, lower policy rates could sustain the stampede into domestic bonds, pushing government borrowing costs below rising nominal GDP growth. At that point, the country’s public debt dynamics will become sustainable, the risk premium will continue to fall, and the nation’s financial markets will be in a secular bull market. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. On the contrary, a vicious cycle is possible if there is a negative external or internal shock that prompts the Brazilian real to depreciate by more than 10%. In this case, the central bank cannot slash interest rates. On the contrary, government bond yields – which are presently at record lows – could or will likely rise (Chart II-6 and Chart II-7). These events will hurt confidence and suppress nominal GDP growth below borrowing costs. This could aggravate investors’ anxiety over Brazil’s public debt, leading them to demand a higher risk premium. As a result, a vicious cycle could unfold. Chart II-6Government Bond Yields Are At Historical Lows Government Bond Yields Are At Historical Lows Government Bond Yields Are At Historical Lows Chart II-7Credit Spreads Are Very Tight Credit Spreads Are Very Tight Credit Spreads Are Very Tight   Chart II-8Commodity Prices And The BRL: Positive Correlation Commodity Prices And The BRL: Positive Correlation Commodity Prices And The BRL: Positive Correlation To be clear, we are not presently forecasting the onset of a vicious cycle. Nevertheless, given our negative view on EM risk assets and currencies, we expect a pullback in the Brazilian real and risk assets in the near term. The U.S. dollar is about to rally, as we discussed in detail in last week’s report. Commodities prices will tumble as China’s growth downshift persists. Given that the Brazilian real is a high-beta currency and is often positively correlated with commodities prices (Chart II-8), it could depreciate quite a bit. Patience is especially warranted in the case of Brazilian equities because share prices have decoupled from corporate profits and the business cycle. Stock prices have surged despite plummeting net EPS revisions and contracting profits of non-financial and non-resource companies (Chart II-9) and relapsing economic growth (Chart II-10). Clearly, the rally has been driven by expanding equity multiples due to progress on the social security reform. Chart II-9Stock Prices Are Diverging From Corporate Profits Stock Prices Are Diverging From Corporate Profits Stock Prices Are Diverging From Corporate Profits Chart II-10Domestic Demand Has Stalled Domestic Demand Has Stalled Domestic Demand Has Stalled   Bottom Line: A lot of good news has been priced into Brazilian financial markets. For now, the risk-reward profile is not attractive: investors should wait for a better entry point. This is true for both absolute return investors and dedicated EM equity and fixed-income managers. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. It is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. Usually, different classes of assets have different risk weights associated with them.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations Chart II-

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Current Account Balance Has Improved Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Chart 5 Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. Chart 6 The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. Chart 11 With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Chart 14 Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.

Highlights Analysis on Indonesia starts below. The U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle. Ongoing weakness in the global economy – which is emanating from China/EM – will support the dollar in the coming months. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. A new trade: Long gold / short equal amounts of copper and oil. Feature Chart I-1The Dollar's Technicals Are Still Positive The Dollar's Technicals Are Still Positive The Dollar's Technicals Are Still Positive As we argued in last Week’s Report, emerging markets are facing a make-it-or-break-it moment. The U.S. dollar will serve as a litmus test. If the dollar pushes higher, EM risk assets will sell off. Conversely, if the greenback breaks down, EM risk assets will stage a sustainable cyclical rally. The basis of why the dollar will be a litmus test for EM risk assets is because the greenback is a counter-cyclical currency. It appreciates when global growth is relapsing and depreciates when global growth is reviving. In contrast, EM risk assets are pro-cyclical.  Hence, the negative correlation between EM risk assets and the dollar stems from their opposite-reaction functions to the global business cycle. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. In particular, the dollar’s advance-decline has also been holding above its 200-day moving average (Chart I-1, top panel). Critically, our composite momentum indicator for the broad trade-weighted dollar has not declined below zero (Chart I-1, bottom panel). All of the above affirm the U.S. currency’s relative resilience. When a market exhibits resilience relative to the headwinds it is facing, it is often a bullish sign. Our EM strategy takes its cues from the fact that the greenback has softened but has not broken down. An upleg in the trade-weighted dollar is consistent with our view of a pending relapse in EM risk assets. The Dollar: Review Of Indicators There are a wide range of indicators that herald further U.S. dollar appreciation: Liquidity in the U.S. dollar interbank market has been tightening. The top panel of Chart I-2 demonstrates that the effective fed funds rate has exceeded the interest rate that the Fed pays to banks on excess reserves (IOER) for the first time since 2009 (herein the difference between the two is referred to as the spread). The bottom panel of the same chart illustrates that in the periods when this spread is rising, the dollar tends to appreciate, and when the spread is flat or falling (the shaded intervals), the greenback weakens. Notably, despite plunging U.S. interest rates and the risk-on mode in global financial markets, the dollar has so far held up relatively well. A positive, rising spread reflects a shrinking supply of U.S. dollar liquidity in the interbank market relative to demand. Notably, Chart I-3 illustrates that the dollar - inverted in this chart - is more strongly correlated with U.S. banks’ excess reserves at the Fed than with interest rates. This implies that the argument that lower rates will drive down the value of the greenback is exaggerated. Chart I-2Another Dollar Positive Factor Another Dollar Positive Factor Another Dollar Positive Factor Chart I-3Do U.S. Rates Drive The Dollar? Do U.S. Rates Drive The Dollar? Do U.S. Rates Drive The Dollar? Chart I-4Investors Are Long EM Currencies Vs. Dollar Investors Are Long EM Currencies Vs. Dollar Investors Are Long EM Currencies Vs. Dollar One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback (Chart I-4). Remarkably, various emerging market currencies have rebounded to major technical resistance levels but have not yet broken out, despite a dramatic decline in U.S. interest rates and the risk-on phase in global financial markets (Chart I-5). It remains to be seen whether they can stage a decisive breakout. We have our doubts. Chart I-5AEM Currencies Have Not Yet Broken Out EM Currencies Have Not Yet broken Out EM Currencies Have Not Yet broken Out Chart I-5BEM Currencies Have Not Yet Broken Out EM Currencies Have Not Yet broken Out EM Currencies Have Not Yet broken Out   Finally, one aspect where we differ from the consensus is in terms of currency valuations. The U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value (Chart I-6). Often financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. In aggregate, investors - asset managers and leverage funds - have neutral exposure to DM currencies, such as the Swiss franc, the euro, GBP, JPY, AUD, NZD and CAD versus the U.S. dollar, but they are massively long the liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. Bottom Line: BCA’s Emerging Markets Strategy service maintains that the path of least resistance for the dollar is still up. Global Growth Conditions Are Still Conducive For Dollar Strength As discussed previously, the U.S. dollar is a counter-cyclical currency – it exhibits a negative correlation with the global business cycle (Chart I-7). Meanwhile, it is only loosely correlated with U.S. interest rates, as shown in the bottom panel of Chart I-3 on page 3. Chart I-6The U.S. Dollar Is Only Moderately Expensive The U.S. Dollar Is Only Moderately Expensive The U.S. Dollar Is Only Moderately Expensive Chart I-7The U.S. Dollar Is Counter-Cyclical The U.S. Dollar Is Counter-Cyclical The U.S. Dollar Is Counter-Cyclical   The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. Yet, this scenario would be dollar bullish. In this case the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. The Fed will cut rates by more than what is currently priced in the market only in a scenario of a complete collapse in global growth. So far, neither economic data nor the performance of cyclical segments within financial markets are signaling a meaningful amelioration in the global business cycle: Global cyclical sectors’ relative performance against the global overall equity index is lingering close to its December lows (Chart I-8). This measure of global cyclicals is composed of equal-weighted share prices of global industrials, materials and semiconductors. Further, this global cyclical equity index has not outperformed 10-year U.S. Treasurys (Chart I-9). It is difficult to envision a looming global economic recovery when global cyclical equities are failing to outperform even government bonds. Chart I-8Global Cyclical Sectors Have Not Outperformed Global Cyclical Sectors Have Not Outperformed Global Cyclical Sectors Have Not Outperformed Chart I-9Global Cyclical Sectors Versus U.S. Bonds Global Cyclical Sectors Versus U.S. Bonds Global Cyclical Sectors Versus U.S. Bonds   The Chinese manufacturing PMI import sub-component – a leading indicator of Chinese imports – foreshadows renewed weakness in the EM ex-China, Korea and Taiwan currencies (Chart I-10). In turn, the Korean won and Taiwanese dollar are also vulnerable as China is by far their largest export destination, and their shipments to the mainland continue to shrink rapidly. Further, odds are high that the RMB will depreciate, dragging down the KRW and TWD along with it. Japanese foreign machinery tool orders and German industrial orders are in deep contraction, and have not improved even on a rate-of-change basis (Chart I-11, top and middle panels). Meanwhile, China’s imports of capital goods are contracting at a double-digit pace (Chart I-11, bottom panel). Chart I-10Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies Chinese Imports Are Key To EM Currencies Chart I-11Global Trade Is Shrinking At A Fast Rate Global Trade Is Shrinking At A Fast Rate Global Trade Is Shrinking At A Fast Rate   Chinese auto sales improved dramatically in June, but almost entirely due to hefty price discounts. Such bulky price discounts (up to 50% in certain cases) cannot go on indefinitely. Auto sales will soon tumble as these incentives to purchase expire. While U.S. growth has slowed, it is still holding up better than the rest of the world. Consistently, not only have U.S. large caps been outperforming their global counterparts, but America’s equal-weighted equity index has also been outpacing that of its global peers (Chart I-12). Broad-based U.S. equity outperformance in local currency terms versus the rest of the world denotes U.S. growth outperformance, and heralds another upleg in the greenback. Bottom Line: Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. We continue to recommend a short position in a basket of currencies such as ZAR, CLP, COP, IDR, MYR, PHP and KRW against the dollar. We believe gold has made a major breakout. The biggest risk to our dollar-bullish view is not the dollar’s fundamentals, but China’s decision to diversify away from U.S. dollars and U.S. President Donald Trump’s determination to weaken the greenback. We discussed the latter at great length in our August 30, 2018 Special Report, and will deliberate on the former below. Buy Gold / Short Copper And Oil Despite our positive view on the dollar, we believe gold has made a major breakout (Chart I-13). Pairing a long position in gold with shorts in copper and oil will likely deliver solid returns with low volatility in the next three to six months and beyond (Chart I-14). Chart I-12U.S. Equity Outperformance Heralds A Stronger Dollar U.S. Equity Outperformance Heralds A Stronger Dollar U.S. Equity Outperformance Heralds A Stronger Dollar Chart I-13Gold Is In A Bull Market Gold Is In A Bull Market Gold Is In A Bull Market   Chart I-14Go Long Gold / Short Copper And Oil Go Long Gold / Short Copper And Oil Go Long Gold / Short Copper And Oil The primary reason to buy gold is not global inflation. Rather, it is due to China’s decision to accumulate the yellow metal. Unhappy with U.S. pressures and import tariffs, Chinese authorities have decided to materially reduce the share of dollars in their foreign exchange reserves. The People’s Bank of China (PBoC) holds 62 million ounces of gold. Hence, gold holdings represent only 2.8% of the $3.1 trillion stockpile of the PBoC’s total foreign currency reserves (Chart I-15). In contrast, U.S. assets account for 52%. In this regard, the Russian experience could act as a roadmap for Chinese policymakers. Hit by U.S. and EU economic and financial sanctions following Russia’s seizure of Crimea in 2014, the country decided to accelerate its diversification away from U.S. dollars into gold. Since then, the Russian central bank has continuously boosted its gold holdings, with the yellow metal now accounting for 22% of its foreign currency assets (Chart I-16). Chart I-15Chinese Central Bank's Gold Holdings Chinese Central Bank's Gold Holdings Chinese Central Bank's Gold Holdings Chart I-16Russian Central Bank's Gold Holdings Russian Central Bank's Gold Holdings Russian Central Bank's Gold Holdings   Even if the PBoC accumulates gold at a slower pace than the Russian central bank, the former’s bullion purchases will exert considerable upward pressure on gold prices due to its sheer size. In short, odds are that China’s central bank will be buying gold on any dips. To accommodate such a large buyer, the gold price will need to surge to discourage potential demand from other buyers. In contrast to gold, China’s demand for copper and oil will be subdued from a cyclical perspective. Copper demand will be tame due to weak capital spending growth. Regarding oil, as we argued in our June 21, 2018 report titled, China’s Crude Oil Inventories: A Slippery Slope, the nation has been importing more oil and petroleum products than it has been consuming. As a result, its crude oil inventories have swelled (Chart I-17, top panel). Adding China’s aggregate crude oil inventories to the OECD’s commercial inventories reveals that global inventories have not really declined since 2017 (Chart I-17, bottom panel). Simply put, crude inventories have moved from the OECD to China. Going forward, given both underlying subdued oil demand and elevated crude inventories in China, its oil imports are likely to expand at a slower pace vs. the past five years (Chart I-18). This combined with high net long positions among global investors in crude oil makes us negative on oil prices. This downbeat view on oil differs from BCA’s house view, which is bullish on the commodity. Chart I-17Oil Inventories: China + OECD Oil Inventories: OECD + China Oil Inventories: OECD + China Chart I-18China's Oil Demand China's Oil Demand China's Oil Demand   While we cannot rule out the risk that geopolitical tensions could escalate in the Middle East, we believe the appropriate strategy for investors should be to sell oil on strength. Besides, pairing this strategy with a long position in gold reduces potential drawdowns in the event of an outburst in U.S.-Iran tensions. Bottom Line: We recommend investors initiate the following position: Long gold / short equal amounts of copper and oil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indonesia: Treading On Thin Ice Foreign investors have been rushing into Indonesian financial markets on expectations of the Fed cutting rates. As a result, Indonesian financial markets have been more resilient than we expected. While the Fed’s monetary policy is important for Indonesian financial assets, there are other critical drivers of the Indonesian economy and financial markets that investors should take heed of. Namely, global growth and domestic demand. Both factors are currently negative. Cracks are appearing in the Indonesian property market. Persisting exports contraction will keep the country’s current account deficit wide (Chart II-1). A wide current account deficit entails that the rupiah will remain heavily reliant on volatile foreign portfolio inflows. Lesser known but equally important, Indonesia’s domestic demand is anemic. Particularly, the marginal propensity to spend among businesses and consumers is diminishing (Chart II-2). Truck and passenger car sales are contracting, while motorcycle sales are edging closer to contraction (Chart II-3). Chart II-1Indonesian Exports: Double-Digit Contraction Indonesian Exports: Double-Digit Contraction Indonesian Exports: Double-Digit Contraction Chart II-2Indonesia: Domestic Spending Is Subdued Indonesia: Domestic Spending Is Subdued Indonesia: Domestic Spending Is Subdued   Critically, cracks are appearing in the Indonesian property market. Residential property prices are rising only by 2% from a year ago in local currency terms (Chart II-4). Additionally, domestic cement consumption is shrinking and revenues of two MSCI-listed real estate companies are also contracting.  Chart II-3Indonesia: Vehicle Sales Are Declining Indonesia: Vehicle Sales Are Declining Indonesia: Vehicle Sales Are Declining Chart II-4Cracks In Indonesia's Property Sector Cracks In Indonesia's Property Sector Cracks In Indonesia's Property Sector   Chart II-5Non-Bank Stocks Are Not Rallying Non-Bank Stocks Are Not Rallying Non-Bank Stocks Are Not Rallying Turning to the equity market, Indonesia’s stock market breadth is extremely narrow. The rally of the past several months has been almost entirely led by a few stocks, in particular by Bank Central Asia and Bank Rakyat Indonesia. In fact, these two banks - alone - now account for around 32% of the overall MSCI Indonesia market cap. Meanwhile, the performance of non-financial stocks has been extremely poor (Chart II-5, top panel). As for small cap stocks they are now below their 2016 lows (Chart II-5, bottom panel). This has occurred due to chronically weak profitability among non-financial companies. As for banks, in-line with ongoing deceleration in the real economy, their bad-loan provisions are now rising. Additionally, the aggregate banking system’s net interest margin is still falling. These will hurt banks’ profits. On the whole, the deepening growth slump in Indonesia warrants lower interest rates. Yet, reducing interest rates when faced with a wide current account deficit could trigger currency depreciation. At a certain point – when the frenzy about the Fed’s easing subsides, investors will realize the severity of the ongoing growth downturn in Indonesia and the need for lower rates. When this occurs, the rupiah will depreciate and the currency selloff will spread into equities and bonds. Bottom Line: The risk-reward profile of Indonesian markets is not attractive both in absolute term and relative to their EM peers. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations Chart I-

NOTE: There will be no report on Wednesday, July 17 due to our regular summer break. Highlights Chinese policymakers as well as the People’s Bank of China (PBoC) have historically been reactive, meaning they have typically waited for economic pain to become entrenched before accelerating reflationary measures. The agreement reached at the June G20 Summit to renew trade negotiations with the U.S., while temporary, takes the pressure off the immediate need to further stimulate the economy. While China has the ability to juice the economy, the pain threshold has been raised higher during this cycle, and the country’s leadership has been reluctant to let go of its financial deleveraging campaign. This approach has resulted in a “half measure” stimulus over the past 12 months. The outlook for Chinese stocks is negative over the next three months, as a flip-flop policy approach will increase market volatility.  However, over a cyclical (i.e. six- to 12-month) time horizon, we are maintaining a bullish stance toward Chinese stocks in hedged currency terms. Feature Last week marked the first anniversary of the imposition of tariffs on imports from China by the U.S. – an event that has clearly had a lasting and meaningful impact on global economic activity. Last week was also the first anniversary of a significant monetary easing measure: China’s 3-month interbank repo rate fell 90 basis points on July 3, 2018, 3 days before the first tranche of import tariffs took effect. This decline was just under half of what would ultimately occur (the 3-month repo rate fell from 4.5% in early July to 2.4% in early August), and was taken as a sign by many investors that the PBoC had shifted to a maximum reflationary stance (Chart 1). Chart 1Indecisively Falling Interbank Rate Indecisively Falling Interbank Rate Indecisively Falling Interbank Rate However, several facts underscore that either the PBoC did not, in retrospect, move completely toward a pro-growth stance, or that China’s monetary transmission mechanism is seriously impaired. In our view, it is a combination of both: Despite evidence suggesting it should, the PBoC did not cut its benchmark lending rate. The repo rate declined in the third quarter last year on the back of increased liquidity supply in the interbank market. The weighted average lending rate also fell, but not massively, and not by as much as our model had predicted (Chart 2). A pickup in credit expansion has significantly lagged easing. Excluding local government bonds, the general pickup in credit has been modest. Based on this measure of Total Social Financing, new credit to GDP still remains lower today than at any point during the 2015-2016 downturn (Chart 3). Chart 2Lending Rate: Not Much Easing Lending Rate: Not Much Easing Lending Rate: Not Much Easing Chart 3No Strong Re-Leveraging No Strong Re-leveraging No Strong Re-leveraging With the conclusion of the G20 Summit temporarily halting the trade war escalation and implementation of additional tariffs, these observations raise important questions: Will the PBoC be proactive in easing policy? What does this mean for investors over the coming year? The PBoC Will Be Reactive Rather Than Proactive Chart 4Shadow-Banking Crackdown Continues Shadow-Banking Crackdown Continues Shadow-Banking Crackdown Continues In our view, the PBoC’s policy actions last year can at best be described as half-measures, despite the fact that the central bank was quick to reduce interbank interest rates in last July by cutting the reserve requirement ratio (RRR). The reason is that the PBoC clearly maintained macro-prudential/administrative restrictions on shadow banking activity, despite significantly easing liquidity in the interbank market. Chart 4 shows that shadow-banking credit as a share of total adjusted social financing continued to decelerate rapidly throughout 2018. It now accounts for a mere 12% of the stock of total adjusted social financing, by far the lowest point since 2009. This underscores that the PBoC and policymakers more generally have a deep-seated desire to avoid (further) inflating China’s substantial money and credit excesses – a dynamic that we have discussed in previous reports.1 Looking forward, there are three reasons why the PBoC’s reactive nature is unlikely to change in the near term, in addition to policymakers’ concerns about financial system’s excesses. First, the PBoC has historically been a reactive central bank, in a way that goes beyond the now-typical “data dependent” approach of its developed-market peers. Chart 5 provides a close look at China’s previous economic growth cycles and their corresponding credit expansions. The chart highlights that Chinese policymakers tend to stay behind the curve when it comes to monetary easing: In the previous three growth cycles, the first sign of monetary easing (defined as an RRR and/or benchmark lending rate cut) lagged the peak of nominal GDP growth by an average of four quarters. Rate cuts took place not when economic growth peaked, but once economic activity had already weakened considerably (Chart 6). Chart 5Chinese Policymakers Tend To Stay 'Behind The Curve' Chinese Policymakers Tend To Stay 'Behind The Curve' Chinese Policymakers Tend To Stay 'Behind The Curve' Chart 6More 'Pain' Needed For Massive Easing More 'Pain' Needed for Massive Easing More 'Pain' Needed for Massive Easing The same pattern has applied to other monetary easing tools that the PBoC has deployed in the past, including the Medium Lending Facility (MLF), the Targeted Medium-term Lending Facility (TMLF), the standing Lending Facility (SLF), and the Pledged Supplementary Lending program (PSL) – all of which only took shape after the economy had already shown across-the-board weakness. It will take more widespread and entrenched economic weakness for the PBoC to meaningfully ease further. The local government debt-to-bond swap program was also launched well into the 2015 growth downturn. When widespread and sustained weakness in activity emerged, Chinese policymakers responded by “throwing the kitchen sink” at the economy – by moving forward with multiple rate cuts and often creating new forms of easing in an attempt to catalyze a quick rebound. Since the PBoC has already implemented a series of easing measures, we believe it will take more widespread and entrenched weakness in the real economy for the PBoC to meaningfully ease further. Chart 7Chinese Currency Is Under Pressure Chinese Currency Is Under Pressure Chinese Currency Is Under Pressure Second, the PBoC is likely to be reactive because of the potentially negative effects that proactive rate cuts could cause on sentiment towards the RMB. Chart 7 highlights the close historical correlation between the RRR, interest rate differentials and the USD/CNY. USD/CNY was trading at 7.8 the last time the weighted average RRR was at 11%, which was back in 2007. At the current juncture, interest rate differentials already point to a weaker currency. The PBoC has signaled that USD/CNY at 7 is no longer a line in the sand that must be defended, meaning this level is not a hard constraint that would prevent the central bank from cutting either the RRR or the benchmark lending rates if warranted. In fact, a measured depreciation in the RMB would help mitigate some of the blow from increased tariffs. Nevertheless, in an environment where the currency has already weakened significantly, cutting the RRR or the benchmark lending rates quickly or by a large amount could create self-reinforcing expectations of further depreciation. China has implemented a better counter-cyclical mechanism to defend the RMB than it had in 2015-‘16,2 but the potential for capital outflows remains a serious concern.3 Third, the Trump-Xi meeting at the June G20 Summit in Osaka temporarily averted a further escalation of the trade war and additional tariffs. The agreement to continue trade negotiations lacks tangible progress from either side, and thus the “truce” is likely to be short-lived. Chart 8Markets So Far Unimpressed By Stimulus Markets So Far Unimpressed By Stimulus Markets So Far Unimpressed By Stimulus However, as we pointed out in last week’s report,4 the existence of talks is likely to take some pressure off Chinese policymakers’ immediate need to floor the reflation accelerator. Readouts from recent PBoC leadership meetings indicate that speculative excesses in the financial system remain a top concern for Chinese policymakers. China’s onshore market, after rallying by 2% following the good news from the G20 meeting, has given back all its gain (Chart 8). Given that the onshore equity market is extremely sensitive to China’s credit growth, the short-lived rally since the G20 meeting suggests markets have been unimpressed by the authorities’ reflationary efforts so far. Bottom Line: Chinese policymakers have not fully abandoned their financial deleveraging campaign, which President Xi Jinping initiated two years ago. This implies China’s central bank is likely to maintain its reactive approach in further easing monetary policy, and will likely try to avoid going “all-in” on stimulus for as long as possible. The Reduced Effectiveness Of Monetary Policy The events of the past year have also demonstrated that the effectiveness of Chinese monetary policy has declined relative to past economic cycles. This, in conjunction with the reluctant/reactive nature of the monetary authorities, has clear implications for investors over the coming year. When there is lack of clarity in policy interpretation, Chinese banks tend to stay on the sidelines. Chart 9A Long Delayed Credit Response To Monetary Easing A Long Delayed Credit Response To Monetary Easing A Long Delayed Credit Response To Monetary Easing The PBoC has cut the RRR five times since the second quarter of last year, which has freed up a total of 3.35 trillion yuan of liquidity for the banking system5 and has helped spur significant easing in overall monetary conditions. Yet, as we noted earlier, overall credit growth did not pick up until January of this year, lagging the first rate cut by three quarters (Chart 9). Prior to the economic slowdown in 2015-2016, credit growth used to respond to cuts in the RRR almost immediately. In other words, when banking system liquidity was ample, banks historically lent without hesitation. Post-2015, however, this relationship has changed. The PBoC has increasingly been having trouble channeling new liquidity into actual financing for the real economy. A sharp deterioration in reported bank asset quality that began in 2014 is likely part of the explanation,6 but we suspect that more recent extreme policy contradiction – in particular, repeated flip-flopping among authorities between their desire to support growth and their focus on financial stability – has caused economic agents to wait on the sidelines. While monetary conditions eased and the government urged banks to lend (particularly to the private sector) in the second half of 2018, the “prudent” stance coming from Chinese top leaders was little changed, and tight regulations on financial institutions remained in place. This combination did not give banks the confidence to lend. This changed in the first quarter of this year, when new credit creation-to-GDP surged from 23.6% to 25.6%. The surge occurred shortly after the late-December Central Economic Work Conference (CEWC), which sent a clear message that the central government’s policy focus had shifted to “stabilizing aggregate demand.” Incredibly, the tone shifted again in February, when Premier Li Keqiang and the PBoC publicly disputed whether the January credit spike represented “flood irrigation-style” stimulus, something Premier Li made clear was to be avoided.7 Charts 10 and 11 highlight how these shifts impacted credit growth: The first quarter was clearly on track for a 2015-2016-magnitude outcome, whereas April and May saw the path of credit growth return back to a moderate re-leveraging scenario. Chart 10 Chart 11 To get back on track for a 2015-2016 magnitude reflation, we will need to see June’s credit creation at or above 5 trillion yuan – equivalent to January’s credit numbers (Chart 12). Chart 12'Credit Binge' In June Unlikely Credit Binge' in June Unlikely Credit Binge' in June Unlikely As we go to press, the number for June’s total social financing has not been officially released yet. But the official reading from the total local government bond issuance in June (including both general bond and special-purpose bond issuance), a key component of our adjusted total social financing series, came in at 900 billion yuan. This is three times more than local government bonds issued in May and twice the size of January’s. Nevertheless, January’s bank lending, particularly short-term lending, was unusually large; an episode highly criticized by Chinese leadership as we mentioned above. As PBoC stated in its defense to this criticism, January is “traditionally the biggest month of the year for bank loans due to seasonal factors”. Therefore, without a clear shift in policy signal from China’s top leadership, we do not expect June’s bank lending number to be a repeat of January’s. Instead, June’s total credit impulse will likely put the cumulative progress in credit growth closer to our 27% of nominal GDP assumption (assuming an 8% nominal GDP growth for the remainder of 2019). This would fall into our “half-strength” credit cycle scenario relative to past reflationary episodes. Bottom Line: Ultimately, we do not doubt that Chinese policymakers will be able to engineer a significant re-acceleration in economic activity should they choose to do so. But in order for policymakers to achieve this goal, policy ambiguity and inconsistency will have to be meaningfully reduced.  Investment Implications Over a cyclical time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms. From our perspective, neither policymakers’ bias towards reluctance nor the reduced effectiveness of monetary policy convincingly argue against our bullish stance towards Chinese stocks over a cyclical (i.e. six- to twelve-month) time horizon, but the tactical implications are clearly negative. Over a cyclical horizon, one of two scenarios is likely to unfold: Either downside risk brought on by current tariffs and weakness in domestic demand is contained enough such that Chinese economic activity does not materially decelerate, or the trade dispute escalates into a full-tariff scenario of 25% on all U.S. imports from China that dramatically impacts Chinese growth. In the first scenario, policymakers will likely to continue providing half-measured responses, and unconstrained “across-the-board” easing will not occur. But Chart 13 highlights that Chinese stocks, particularly the investable market, are priced for a much worse economic outcome, suggesting Chinese relative equity performance would trend higher in these circumstances. Chart 13Chinese Stocks Priced In For A Worse Economic Outlook Chinese Stocks Priced In For A Worse Economic Outlook Chinese Stocks Priced In For A Worse Economic Outlook Chart 14Bullish On A Cyclical Horizon, Bearish In The Near Term Bullish On A Cyclical Horizon, Bearish In The Near Term Bullish On A Cyclical Horizon, Bearish In The Near Term In the second scenario, Chinese business and consumer sentiment is likely to collapse and policymakers will be facing high odds of a substantial slowdown in economic activity. This will create the political will necessary for unconstrained “across-the-board” easing, similar to what occurred in 2015-2016. The sharp re-acceleration in economic activity that would result from broad-based stimulus would clearly be positive for listed Chinese earnings per share (Chart 14), meaning the cyclical outlook for Chinese stocks would likely be even more positive than in the first scenario. However, the near-term equity market outlook of the second scenario would be extremely negative, as a financial market meltdown in of itself would likely be required to build the political will necessary to ultimately ease. Bottom Line: For investors with a time horizon of less than three months, we would not recommend a long position in Chinese stocks, neither in absolute terms nor relative to the global benchmark. However, over a strictly cyclical (i.e. six- to 12-month) time horizon, we recommend staying long/overweight Chinese stocks in hedged currency terms.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      Please see Geopolitical Strategy Special Report, “China: How Stimulating is The Stimulus?”, dated August 8, 2018, available at cis.bcaresearch.com 2      A series of countercyclical measures China implemented in 2016-2017 includes: tightening controls on capital outflows, reducing offshore RMB liquidity supply, raising offshore RMB borrowing costs, and setting a firmer daily reference point for the RMB’s trading band. 3      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 4      Please see China Investment Strategy Weekly Report, “China Macro and Market Review”, dated July 4, 2019, available at cis.bcaresearch.com 5      According to PBoC announcements. 6      Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 7      Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. Cyclical Investment Stance Equity Sector Recommendations