Monetary
Highlights Lesson 1: Inflation is a non-linear phenomenon. Lesson 2: Beware government interference in monetary policy. Lesson 3: An emerging markets shock is deflationary for developed markets. Lesson 4: The 'Rule of 4' for equities and bonds. Feature We took a much needed holiday last week, hoping that financial markets would enter a midsummer slumber. Our hopes were dashed. The timing of the Turkish lira crisis reminded us of the old adage: time, tide - and financial markets - wait for no man. But on reflection, our summer holiday gave us the time for some, well... reflection: a precious quality in a world that is rapidly neglecting the value of reasoned analysis. The addiction to minute-by-minute commentary and knee-jerk reaction - epitomised by the Twitterati - means that we are 'thinking fast', when we should be 'thinking slow'. So here, after some reflection, are four long-term lessons from the Turkish lira crisis. Lesson 1: Inflation Is A Non-Linear Phenomenon. Turkey's recent experience clearly demonstrates that inflation is non-linear - meaning that inflation doesn't move in a gradual or controlled fashion. Non-linear phenomena experience sudden and explosive phase-shifts (Chart I-2). In Turkey's case, a major cause of its currency crisis was that inflation recently phase-shifted out of a well-established channel to its current 16 percent rate (Chart of the Week). Chart of the WeekTurkish Inflation Experienced A Non-Linearity Chart I-2Inflation Can Experience A Phase-Shift People struggle with the concept of non-linearity because the vast majority of our day to day experiences are linear, meaning the output is proportionate to the input. The speed of our car depends linearly on the pressure on the accelerator pedal; the temperature in our home depends linearly on the thermostat setting; the volume of music in our headphones depends linearly on the volume setting; and so on. Likewise, the vast majority of economic models - including the infamous DSGE inflation models used by central banks - assume linear relationships.1 But some phenomena are non-linear. An example you might relate to is trying to get a small amount of tomato ketchup out of crusted-over squeezy bottle. It is impossible. You squeeze and no ketchup comes out; you squeeze harder and still nothing comes out; and then suddenly you get the explosive phase-shift: the entire bottle empties on your plate! Inflation also experiences violent phase-shifts. The main reason is that people cannot perceive small changes in inflation, making inflation expectations very sticky, which is to say non-linear. The Turkish people might not perceive inflation rising from 8 percent to 10 percent, but they would certainly perceive it rising to 16 percent. Hence, as policymakers squeeze the ketchup bottle, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the whole bottle comes out. The broad money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible (Chart I-3-Chart I-6). So the product MV, which equals nominal GDP, experiences an even sharper non-linearity. Chart I-3The Velocity Of Money... Chart I-4...Is A Non-Linear Phenomenon Chart I-5The Money Multiplier... Chart I-6...Is A Non-Linear Phenomenon This begs the question: when should we worry about a sudden phase-shift in developed market inflation rates? The answer comes from Lesson 2. Lesson 2: Beware Government Interference In Monetary Policy. An economy's broad money supply, M, is dominated by loans. So to expand the broad money supply, somebody has to borrow money. This means that the danger of an inflation phase-shift rises sharply if the government can borrow and spend money at will, with the central bank creating it.2 Over the past few centuries, the British government - by periodically leaving the gold standard - did exactly this to pay for the Napoleonic Wars, the Crimean War and the First World War (Chart I-7). Chart I-7The British Government Created Inflation To Pay For Wars Which answers the question of when to worry. The government has to get into cahoots with the central bank. In other words, the central bank loses its independence and fiscal policy has the scope to become ultra-loose. This describes the situation in Turkey, where President Erdogan has forced the central bank to suppress interest rates, while putting his son-in-law in charge of the Turkish treasury. Could something similar happen in developed economies? President Trump's fiscal stimulus combined with his recent attempt to influence Federal Reserve policy (to more dovish) is a small step in this direction. Nevertheless, the major developed market central banks are on a hawkish path. They are squeezing less on the ketchup bottle. Therefore, the real risk of a phase-shift in developed market inflation will arise not before the next global downturn, but after it - when desperate policymakers might resort to desperate measures. In the near term, we expect developed market inflation to remain contained, and one supporting reason comes from Lesson 3. Lesson 3: An Emerging Markets Shock Is Deflationary For Developed Markets. The slowdown and recent shock in emerging markets has caused the dollar and yen to surge. Even the euro - on a broad trade-weighted basis - has held up very well through the Turkish lira crisis and is up 2 percent in 2018 (Chart I-8). Chart I-8An EM Shock Boosts DM Currencies... Meanwhile, since May, industrial metal prices have plunged 20 percent (Chart I-9) and even the crude oil price is down by 10 percent. Chart I-9...And Depresses Industrial Commodity Prices An emerging market shock also threatens the developed market banking system by impairing its foreign loans. Thereby, it risks stifling domestic credit creation. The combination of stronger currencies, lower commodity prices, and potentially weaker bank credit creation is a disinflationary headwind for developed markets in the near term. Lesson 4: The 'Rule of 4' For Equities And Bonds. If developed market inflation remains contained in the near term, it should also keep a lid on bond yields. This is significant because our non-consensus call is that the main threat to developed market risk-assets comes not from trade wars and/or a global economic slowdown; it comes from rich valuations which will become dangerously unstable if bond yields march much higher. The bond yield that matters is the global long bond yield. Effectively, this is the weighted average of its three main components: the 10-year yields on the U.S. T-bond, the German bund and the Japanese government bond (JGB). But for a useful rule of thumb, just sum the three yields. A sum above 4 - which broadly equates to the global 10-year yield rising above 2 percent - means it is time to go underweight equities. A sum between 3.5 and 4 means a neutral stance to equities. A sum well below 3.5 means an overweight stance to equities - because it would justify even richer valuations. Investment Recommendations Asset allocation: Our 'rule of 4' sum now stands at 3.3, indicating a close to neutral stance to equities. For bonds, we have since May recommended an overweight position in a portfolio of high-quality government 30-year bonds. The recommendation is performing well, and it is appropriate to stick with it for the time being. Sector allocation: Stay overweight the classical defensives versus the classical cyclicals: materials, industrials and banks. This recommendation has fared spectacularly well. Healthcare has outperformed banks by 20 percent since February, so the pressing question is: when to take profits? We anticipate at some point in the fourth quarter. Within the cyclical sectors, prefer banks over oil and gas. Regional and country equity allocation: the geographical allocation of equities follows directly from the sector allocation. Our preferred ranking of sectors necessarily means that our preferred ranking of major equity markets is: S&P500 first, Eurostoxx50 and Nikkei225 second (tied), FTSE100 third. Again, this recommendation has performed extremely well. Currency allocation: Since February, our main currency recommendations have been short EUR/JPY, long EUR/USD, and long EUR/CNY. In effect the recommendations reduce to: long JPY/USD and long EUR/CNY, and this combination has proved to be an excellent 'all-weather' position (Chart I-10). Stick with it for the time being. Chart I-10Long JPY/USD And EUR/CNY Has Been##br## A Good 'All-Weather Combination' Finally, our long-standing short Turkish lira versus South African rand position has returned a mouth-watering 73 percent in four years.3 It is time to close the short Turkish lira position and bank the profits. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Dynamic Stochastic General Equilibrium models. 2 For example, by giving all public sector workers a 50% pay rise! 3 After the cost of carry, based on interest rate differentials. Fractal Trading Model* Market reaction to the Turkish lira crisis caused our two most recent trades to hit their stop-losses, but it has also created new opportunities. The aggressive sell-off in industrial commodities appears technically extended. So this week's recommended trade is an intra-cyclical equity sector pair-trade: long global basic resources, short global chemicals. The profit target is 3.5% with a symmetric stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Just to be clear: The balance of price risks in oil markets remains to the upside - particularly if we see a supply shock resulting from the loss of as much as 2mm b/d of exports from Iran and Venezuela. Neither the supply side nor the demand side in base metals evidence outsized risks, which keeps us neutral ... for now. Still, downside risks for commodities - mostly via threats to trade - loom. In line with our House view, we believe markets are too complacent re the effects of a global trade war.1 However, focusing only on the trade war obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. A strong USD retards EM trade growth, which is particularly bearish for metals and oil (Chart of the Week). Chart of the WeekStronger USD, Slower EM Import Growth##BR##Bearish For Base Metals And Oil An oil-supply shock taking prices above $120/bbl, as one of our scenarios does, would generate a short-term inflationary impulse, and would depress aggregate demand, particularly in EM. Ultimately, it would become a deflationary impulse, as higher energy prices consume a larger share of discretionary incomes, and slow growth. A slowdown in EM trade on the back of a strong USD also would generate a deflationary impulse, as EM income growth slows and aggregate demand falls. Either way, the Fed's rates-normalization policy will be put on hold as current inflation risks morph to deflation risks, if the downside becomes dominant. Highlights Energy: Overweight. The U.S. Strategic Petroleum Reserve (SPR) will release 11mm of oil from its reserves in the October - November period, to allay concerns over the likely loss of 1mm b/d of Iranian exports to U.S. sanctions. We've been expecting this ahead of U.S. mid-term elections, but don't think it will fill the gap in lost exports. Base Metals: Neutral. Union and management leaders at BHP's Escondida mine in Chile averted a strike, after agreeing a contract at the end of last week. Precious Metals: Neutral. Gold rallied more than $35/oz off its lows of last week, as markets took notice of record speculative short positioning, which many view as a bullish contrary indicator. Gold was trading to $1195/oz as we went to press. Ags/Softs: Underweight. The USDA is expected to roll out a $12 billion relief package for farmers on Friday, which includes direct purchases of commodities that were not exported due to tariffs, according to agriculture.com's Successful Farming publication. Feature Overall, the balance of price risks in the industrial commodities are neutral (in base metals) and to the upside (in oil). In the base metals, we think fear of a Sino - U.S. trade war has market participants jittery, and may be getting to the point where it is starting to affect expectations for capex and investment on the production side, and growth on the demand side. Given our expectation EM trade will hold up this year (Chart 2), we continue to expect base metals demand to remain fairly stable, and perhaps pick up as China rolls out modest stimulus measures later this year.2 Chart 2USD Strength Slows EM Trade Growth We remain bullish oil demand - expecting growth of ~ 1.6mm b/d on average in 2018 - 19, and continue to expect a supply deficit next year, which will push Brent prices from $70/bbl on average in 2H18 to $80/bbl next year.3 However, if we see continued strength in the USD beginning to degrade actual EM demand, we will be forced to revise our assessment. Downside Risks To Metals And Oil Loom As mentioned above, we are aligned with our House view, and believe markets are all but ignoring the risk of an all-out trade war, spreading from the well-covered Sino - U.S. standoff to the broader global economy. The global economy already appears to be registering the first signs of a trade slowdown, according to the World Bank's July 2018 global outlook, where it observes "softening demand for imports in advanced economies - with the exception of the United States - and weaker exports from Asia."4 We also are picking it up in our modeling (Chart 2). The Bank also notes the slowdown in trade "is accompanied by rising barriers to trade, moderating growth in China, higher energy prices, and elevated policy uncertainty." A prolonged trade war that spreads globally would be especially devastating to EM economies, as two-thirds of them are commodity exporters of one sort or another.5 Fed Policy Is An EM Growth Risk As important as a trade war is for global growth, focusing too heavily on it obscures growing risks to EM imports and exports arising from the Fed's rates-normalization policy, which is pushing the USD higher. Table 1USD Vs. Fed Policy Variables Per the Richmond Fed's Summary, the Fed is charged by Congress to "promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates."6 One of the models we use to forecast the broad trade-weighted USD is a Fed policy-variables model, which uses lagged U.S. nonfarm payrolls, core PCEPI (the Fed's preferred measure), U.S. 10-year real rates, and U.S. short-term real-rate differentials vs. DM rates as proxies for these policy goals. We throw lagged copper futures prices in to pick up current industrial activity, as well (Table 1). This model highlights the long-term equilibrium between the USD TWIB and the Fed's policy variables going back to 2000.7 We average the output of the policy-variables model with four other models using close-to-real-time variables, and some other proxies for the Fed's policy variables to generate our forecast (Chart 3). Chart 3BCA USD TWIB Forecast The USD TWIB and EM trade volumes form a cointegrated system, as shown in Chart 2. Based on our modeling, we expect EM trade to hold up reasonably well over the next year, with y/y growth remaining positive most of the time. But, as close inspection of the chart reveals, the rate of p.a. growth is slowing as a result of the Fed's rates-normalization policy. This means the rate of growth in EM demand for base metals and oil will slow, although the level of demand will remain high following 20 years of solid growth.8 As a House, we expect the USD TWIB to rise another 5% over the next year, which, given the elasticities in our model, would translate into more than 10% declines in copper and Brent prices, all else equal. The Oil Wildcard As regular readers of this service know, we do not believe "all else equal" applies to commodity markets, particularly oil. We have been highlighting the risks of a confluence of negative supply shocks for months - i.e., the loss of up to 2mm b/d of oil exports from Iran and Venezuela - and the implications of this for prices (Chart 4). This is apparent in our ensemble forecasts, which reflect the physical deficit we expect to the end of 2019 (Chart 5). Chart 4U.S. SPR Release Doesn't Cover Lost Iranian Exports The U.S. government has taken notice of these risks. However, we believe this week's announcement by the Trump administration to release 11mm barrels of crude oil from the U.S. SPR over the October - November period might hold gasoline prices down ahead of the U.S. midterms, but will do next to nothing to make up for the lost export volumes we are expecting in 2019 (Chart 4). Chart 5BCA Continues To Expect Physical Deficits An oil-supply shock taking prices above $120/bbl - the projection from one of our scenarios in Chart 4 - would generate a short-term inflationary impulse in U.S. data the Fed follows. This would depress aggregate demand, particularly in EM, as oil is priced in USD. The Fed likely looks through this spike, but, should it misread the inflation impulse and tighten more aggressively, it would be delivering a double-whammy to EM economies: Higher oil prices and a stronger USD. Many EM governments have relaxed or removed subsidies on fuel prices following the 2015 collapse in oil prices engineered by OPEC. While some governments may re-introduce subsidies, not all will cover all of the price increase in such a shock.9 So, even if some subsidies are re-introduced, a price spike likely would hit EM consumers harder than previous high-price epochs. There is a non-trivial likelihood such an oil-price spike would trigger a recession in the U.S. - and likely in DM and EM economies - per Hamilton's (2011) analysis.10 This would force the Fed to change course and resume its accommodative policies. Ultimately, this would become a global deflationary impulse, as higher energy prices erode discretionary incomes, and slow growth. Bottom Line: An oil-supply shock and slower EM trade growth on the back of a strong USD ultimately produce deflationary impulses. Either way, Fed rates-normalization policy will be put on hold if these downside risks become the dominant theme in industrial commodity markets, and the current inflation risks morph to deflation risks. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "How To Trade A Trade War," published July 13, 2018. It is available at gis.bcaresearch.com. 2 BCA Research's Geopolitical Strategy is expecting policymakers to deploy modest fiscal stimulus and reflationary policies to counter growing threats from the country's trade war with the U.S. This will be supportive, at the margin, for bulks and base metals. Please see "China: How Stimulating Is The Stimulus?" published by our Geopolitical Strategy August 8, 2018. It is available at gps.bcaresearch.com. 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Sailing Close To The Wind," which contains our most recent supply-demand balances and forecasts. It was published August 16, 2018, and is available at ces.bcaresearch.com. 4 Please see The World Bank's Global Monthly, July 2018, p. 2. 5 Please see remarks by World Bank Senior Director for Development Economics, Shantayanan Devarajan, who notes, "two-thirds of developing countries ... depend on commodity exports for revenues." His remarks are in "Global Economy to Expand by 3.1 percent in 2018, Slower Growth Seen Ahead," World Bank press release on June 5, 2018. 6 Please see Steelman, Aaron (2011), "The Federal Reserve's "Dual Mandate": The Evolution Of An Idea," published on the Federal Reserve Bank of Richmond's website. 7 We use a cointegration model to estimate these policy-driven regressions. The output is stout (R2 is greater than 0.95), and it has good out-of-sample results. We use a weighted-average of the five forecasts based on root-mean-square-errors to come up with our USD_TWIB forecast. 8 The World Bank estimates the seven largest EM economies - Brazil, China, India, Indonesia, Mexico, the Russian Federation, and Turkey - accounted for ~ 100% of the increase in metals consumption and close to 70% of the increase in energy demand over the past 20 years. Please see "The Role of Major Emerging Markets In Global Commodity Demand," in the Bank's June 2018 Global Economics Prospects, beginning on p. 61. 9 Please see BCA's Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Scrambles To Reassure Markets," published June 28, 2018. It is available at ces.bcaresearch.com. 10 For an excellent discussion of the correlation between oil-price shocks and recessions, please see Hamilton, James D. (2011), "Historical Oil Shocks," Prepared for the Handbook of Major Events in Economic History. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017
Highlights EM, The USD & Bond Yields: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Feature It's All About The Dollar Chart of the WeekBad Things Happen More Often With A Rising USD The turmoil in Turkey and collapse of the lira has been the latest bout of financial market turbulence seen in 2018. From the VIX shock in early February, to the Italy yield spike in May, to the bear market in Chinese equities, there have been big market meltdowns that seem to come out of nowhere. Yet these are not isolated events. The slowing pace of bond buying by the European Central Bank and the Bank of Japan, in addition to the Fed unwinding its huge balance sheet, have left the global financial system with diminished liquidity. More importantly, the Fed's tightening cycle has turned the U.S. dollar from a weak currency in 2017 to a strong currency in 2018 (Chart of the Week). Yes, U.S.-China trade tensions have compounded matters by raising uncertainties about global growth, but tightening monetary policies and more growth uncertainties have been the true cause of this year's market shocks. Turkey and Italy were questionable credits in 2017, but investors did not care when the dollar was soft and global growth was accelerating. Looking ahead, the key variable to watch will be the U.S. dollar. Many of BCA's strategists have made comparisons between the backdrop today and the late 1990s period that resulted in the 1998 Asian Crisis.1 Those comparisons are valid, given the high level of dollar debt in the emerging markets at a time of Fed tightening and a rising U.S. dollar (Chart 2). A key difference is that, in that late 1990s episode, the Fed was keeping U.S. monetary policy very tight as evidenced by the inverted U.S. Treasury yield curve and a fed funds rate that was well in excess of inflation (and well above what we now know to be the neutral r-star rate). The dollar surged during that period because global growth differentials strongly favored the U.S. Today, the Fed has not yet pushed the funds rate into restrictive territory and the dollar is still well below the peak seen in the late 1990s. With the Fed still not signaling any adjustment to its rate hike plans based on the latest bout of EM turmoil, there is scope for the dollar to continue appreciating over the next 6-12 months. The critical factor that could change this dynamic, however, is the pace of dollar appreciation. The U.S. trade-weighted dollar is now only 5% above the levels of a year ago. Looking back at the 2014/15 surge in the dollar, the peak annual pace of dollar appreciation reached 15% in mid-2015 (Chart 3). That move was big enough, and fast enough, to trigger a sharp U.S. economic growth slowdown, a contraction in U.S. corporate profit growth and a large fall in U.S. inflation (admittedly, helped by collapsing oil prices). It would take a 10% appreciation from current levels (think EUR/USD at 1.04) over the next four months to generate an equivalent pace of dollar appreciation (the black dotted line in all panels). So far, the EM turmoil and dollar strength have not resulted in much turbulence in U.S. financial markets (Chart 4). Corporate credit spreads have stayed well behaved, while U.S. equities are only modestly off the recent highs. Only U.S. Treasury yields have dipped lower from recent highs, even though yields are still contained within the range of the past few months. This is in sharp contrast to the 2015 episode, when U.S. financial markets eventually succumbed to the pressure of the strong dollar and EM selloff - but not without decisive evidence of slowing U.S. growth (top panel). Only then did the Fed finally capitulate and announce a pause after lifting rates just once at the end of 2015, sending Treasury yields sharply lower. Chart 2It's Not 1998##BR##...Yet Chart 3The Pace Of USD Appreciation##BR##Matters A Lot Chart 42015 Redux? Watch##BR##U.S. Growth & Earnings Until there is evidence that the U.S. economy is losing momentum, and that the stronger U.S. dollar and emerging market volatility are a root cause of slowing growth, global bond yields are unlikely to fall much lower on a sustainable basis. The next few readings on the ISM indices, employment growth and small business confidence, along with the third quarter earnings reports starting in October, will be critical in determining if the U.S. economy is falling victim to the "EM Flu". It will likely take more dollar strength before that happens, however. In the meantime, we continue to recommend a below-benchmark overall duration stance, with only a neutral allocation to global corporate bonds versus government debt. We still favor U.S. corporate debt over non-U.S. equivalents until there is evidence of slowing U.S. growth. Bottom Line: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Still Too Much Uncertainty For Rate Hikes One of our highest conviction calls since the start of 2018 has been to stay overweight Australian government bonds. The logic behind the view was simple; it would be very difficult for the Reserve Bank of Australia (RBA) to deliver even a single rate hike over the course of the year. A combination of a fragile consumer, persistent slack in labor markets and softening Chinese demand for Australian exports would all conspire to restrain Australian inflation and keep the RBA on the sidelines. So far, our view has largely come to fruition, to the benefit of Australian government bond performance. Chart 5Massive Australian Bond Outperformance vs USTs The RBA has held the benchmark Cash Rate at the same 1.5% level that has prevailed since August 2016. This has helped the Bloomberg Barclays Australia Treasury index deliver a local currency total return of 2.68% year-to-date. The performance has been even more impressive hedged into U.S. dollars, with an excess return over U.S. Treasuries of 3.95% - surpassing the overall Global (ex U.S.) Treasury index excess return by 85bps. The benchmark 10-year Australian yield has fallen 10bps since the end of 2017, in sharp contrast to the 46bps increase in the 10-year U.S. Treasury yield, with the spread between the two bonds now in negative territory for the first time since 1998 (Chart 5). Obviously, the potential for further outperformance of Australian bonds is diminished after such an impressive run. The Australian Overnight Index Swap (OIS) curve is now only discounting a mere 15bps of rate hikes over the next twelve months, and a move to outright rate cuts will be difficult with the economy still growing above trend and inflation now back to the low end of the RBA's 2-3% target range. Headline unemployment is now down to 5.4%, the lowest level since 2012 and within hailing distance of the 5% level that the RBA believes to be full employment. Yet there are now enough uncertainties regarding the Australian economic outlook to suggest that Australian government bonds should continue to outperform developed market peers over the next 6-12 months. The Biggest Uncertainties: Consumer Spending, Housing & Banks Consumer spending - 60% of Australian GDP, the largest component - has struggled to gain much positive momentum in recent years. Since the end of 2013, the year-over-year growth rate of real consumption has ranged between 2.2% and 3.1%. The lack of spending power has been the biggest problem, with real wage growth averaging a mere 0.2% over the past five years and hours worked remaining stagnant (Chart 6). Anemic income growth means that the household saving rate had to fall from 8% to 2% just to maintain an uninspiring 2.5% average pace of real consumer spending. Both real wage growth and average weekly hours worked have decelerated since the start of 2017, with the former now only at 0.1% and the latter at an all-time low. This has compounded the biggest structural risk to the Australian consumer - high debt. Household debt is now up to a record 190% of disposable income, the fourth highest figure among OECD countries after having shot up thirty percentage points since the end of 2012 (bottom panel). The ability to carry that huge debt load is helped by low interest rates that have helped keep debt service ratios in line with long-run averages. More recently, house prices have been coming off the boil (Chart 7). National house prices were down 2.5% in July on a year-over-year basis, led by declines in the major markets of Sydney (down 5.5% from the July 2017 peak) and Melbourne (down 3% from the November 2017 peak). In the RBA's latest Statement on Monetary Policy released earlier this month, it was noted that even such a modest decline in housing values after years of substantial price gains could have an outsized impact on overall consumption if focused on the more highly indebted or credit-constrained households.2 Yet a cooling of overheated housing values is, as RBA Governor Philip Lowe noted in a speech last week, a "welcome development" after years of unsustainable price gains that greatly diminished housing affordability.3 Homebuyer sentiment and growth in housing approvals have already ticked up in response to the slowing pace of house price appreciation, although both remain well below levels seen during the boom years. One wild card that could short-circuit any rebound in house prices is the availability of credit from Australian banks. The entire Australian banking industry has come under harsh criticism from the findings of the government's Royal Commission on Misconduct in the Banking, Superannuation and Financial Services Industry.4 The Commission was established at the end of 2017, after years of public pressure regarding the questionable business practices of Australian financial firms. Evidence of bribery, forged documents, extending loans to those that could not afford it and even charging fees to dead clients has already come to light. With financial firms on the defensive, there is a risk that banks will raise lending standards for new loans going forward. Australian bank equities have already been underperforming and credit growth is slowing (Chart 8). The bigger concern is the sharp decline in bank deposit growth, which is now contracting modestly on a year-over-year basis. Already, Australian banks are facing some higher funding costs through rising money market rates. Much of that spike seen earlier in 2018 could be attributed to rise in the U.S. bank funding costs, but there is now a notable divergence between LIBOR-OIS spreads in Australia and the U.S., which may be a sign of uniquely Australian funding pressures. Chart 6Poor Fundamentals For##BR##The Australian Consumer Chart 7Weaker Prices =##BR##Stronger Housing Demand? Chart 8An Australian Credit##BR##Crunch Unfolding? The RBA has noted that the absolute levels of bank funding costs (bank debt spreads, deposit rates wholesale lending rates) remain low by historical standards, and that overall financial conditions remain supportive for Australian economic growth. Yet the marginal changes in funding dynamics, combined with the pressure on banks to be more prudent in extending loans, raise downside risks to Australian growth from future credit availability. Other Uncertainties: Capital Spending, Exports & Commodity Prices Australian businesses have ramped up capital spending over the past year, with the annual growth rate of machinery and equipment investment now at the fastest pace since 2012 (Chart 9). An improvement in Australian commodity prices and the overall terms of trade has helped boost corporate profits, helping to fund investment spending. Importantly, the recent pickup in commodity prices has been more broad-based than the iron ore boom in 2010/11, with prices of non-ferrous metals rising even with iron ore prices languishing. Looking ahead, there are increasing risks to the capital spending upturn from growing uncertainties surrounding the outlook for Chinese economic growth, and global trade activity more generally. The NAB business confidence survey, which leads capital spending intentions, has been falling over the past several months (bottom panel). This comes after a significant slowing of Australian export growth, the manufacturing PMI and capacity utilization (Chart 10). Much of that is due to diminished demand from China, which remains Australia's largest export market. Chart 9Capex Upturn At Risk From Global Trade Tensions Chart 10China Is A Big Source Of Uncertainty In Australia China is now undertaking some fresh economic stimulus in response to the growing trade war with the U.S. and the imposition of tariffs. Our colleagues at BCA's China Investment Strategy and Geopolitical Strategy recently penned a Special Report discussing the potential for China's stimulus measures to halt the Chinese growth deceleration seen so far in 2018.5 Their conclusion was that the overall size of the stimulus would be significant, with the surge in fiscal spending potentially equaling the 3% GDP boost seen in 2015/16. This would help support Australia export demand, on the margin, and could potentially boost the prices of Australia's key industrial commodities. However, the overall impact will be less than was seen in 2016/17 given that there will be some offsetting drag from the imposition of tariffs by China and the U.S. The Most Important Uncertainty: How Much Spare Capacity? Chart 11Still Lots Of Slack In The Australian Economy Given all these potential headwinds to Australian growth, the RBA has stated that they are in no hurry to raise interest rates, particularly without any serious threat of an acceleration in inflation. Headline Australian CPI inflation rose to 2.1% in the second quarter of 2018, while core inflation drifted down to 1.8%. Both measures have struggled to breach the lower bound of the RBA's 2-3% target range in recent years (Chart 11). The biggest reason for this is the continued existence of spare capacity in the economy. The IMF estimates that Australia will have a negative output gap of nearly -1% in 2018, unlike most other developed economies where the gap has been closed. Overall wage inflation remains modest, as discussed earlier. While the headline unemployment rate of 5.4% is below the IMF's estimate of the full employment NAIRU of 5.9% (middle panel), the RBA thinks NAIRU is closer to 5%. That implies that there is still slack in the labor market, which is evidenced by the high level of underemployment and the growing share of part-time employment (bottom panel). The RBA anticipates that full employment will not be reached until the end of 2020, even with real GDP growth expected to average 3.25% over the next two years. Both headline and core inflation are projected to rise only to 2.25% by the end of 2020, staying in the lower half of the RBA target band. Unsurprisingly, the RBA has provided guidance stating that it does not expect to raise the Cash Rate before then. Investment Conclusions The Australian OIS curve has now priced out much of the nearly 50bps of rate hikes that were discounted at the start of the year, but there are still 15bps of rate increases expected over the next twelve months. Yet our own Australia Central Bank Monitor has now flipped into negative territory, indicating that fundamental economic and inflation pressures are pointing to the RBA's next move being a rate cut (Chart 12). While that is not our expectation, we think the argument that supported our original investment thesis on Australian government bonds at the beginning of 2018 still holds. Growth uncertainties, ample spare capacity and moderate inflation pressures will ensure that the RBA will struggle to deliver even a single rate hike in 2018 or 2019. Chart 12Stay Overweight Australian Government Bonds The main risk to our view would come from a bigger-than-expected stimulus from China and/or a resolution of the U.S.-China trade war. This would boost Australian economic growth and commodity prices and potentially bring forward the timing of the next RBA hike. We continue to recommend an overweight stance on Australian government bonds in global fixed income portfolios. All positions should be run on a currency-hedged basis, as the Australian dollar is likely to remain under downward pressure from less supportive interest rate differentials. For dedicated Australian bond investors, we recommend a neutral duration stance, as we see yields broadly following the path laid out in the forwards. Bottom Line: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17th 2018, available at fes.bcaresearch.com and gps.bcaresearch.com. 2 https://www.rba.gov.au/publications/smp/2018/aug/pdf/statement-on-monetary-policy-2018-08.pdf 3 https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-17.html 4 https://financialservices.royalcommission.gov.au/Pages/default.aspx 5 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights The Turkish economy is in disarray, ... : The lira's plunge has reminded some investors of the Thai baht's in 1997, but we do not foresee a replay of the Asian Crisis. ... highlighting emerging markets' vulnerability to external factors: EM economies may be on firmer footing than they were 20 years ago, but the vicissitudes of dollar-denominated debt remain their Achilles' heel. Fraught times around the world justify paring back portfolio risk, ... : Increased caution is appropriate in the face of potential EM distress. Multiples are elevated and spreads are tight, leaving stocks and bonds susceptible to a pickup in risk aversion. ... even if domestic data indicate that the U.S. expansion is alive and well: Global concerns did nothing to dim small businesses' rosy outlook, but the dirty little secret within the July NFIB survey is that rising cost pressures will keep the Fed from backing off of its tightening plans. Feature Dear Client, This is our final report for the month of August. We will resume our regular publication schedule the first week of September. We wish everyone an enjoyable rest of the summer. Best regards, Doug Peta, Chief U.S. Investment Strategist What a difference a year makes. If 2017 was all about synchronized global growth, 2018 has been a study in desynchronization. While the list of sputtering international economies grows longer with every passing month, the U.S. economy continues to gather steam. The fact that it is leaving the laggards choking on its exhaust as it speeds by, trampling the conventions of the postwar international order the U.S. itself established, and tightening the screws on dollar borrowers, is bruising feelings from Ankara and Beijing to Ottawa and Brussels. There is nothing on the horizon to indicate that the desynchronization trend is about to end. Surreal as it may be for baby boomers and other pre-millennials, trade barriers are an essential plank in the Republicans' midterm election platform. Our geopolitical strategists caution that there is little reason to expect the anti-trade rhetoric out of Washington to die down before November. The associated headwinds for multinational corporations and economies more reliant on global trade are likely to persist for at least a few more months. The other global policy irritant comes from the Fed. Although it is not blind to the impact of its policies on other economies, its America First mandate is firmly entrenched. Confronted with a domestic economy that is being force-fed stimulus when it is already showing signs of bumping up against supply constraints, the Fed has very little room to relax its vigilance. Investors counting on an "EM put" to alter the course of rate hikes should recognize that that put is way out of the money: it will take a great deal of EM pain for the Fed to back away from its projected course. Turkey's Tenuous Model Before the Asian Crisis, the growth of the Asian Tiger economies was the envy of the world. The formula was simple and effective: take ample supplies of cheap labor, mix with developed-world capital to finance a buildup of manufacturing capacity, and watch eye-popping growth ensue. All was well until too much excitement led to hard-currency-debt-financed investment in overcapacity. When exchange-rate pegs fell, domestic borrowers became unable to meet their obligations and the Asian Miracle imploded. The Turkish lira's plunge has put many investors in mind of the Thai baht's 1997 collapse that set the Asian Crisis in motion. The EM contagion eventually found its way to Russia in the summer of 1998, felling hedge fund titan Long-Term Capital Management (LTCM) and thoroughly rattling several of its Wall Street enablers. Investors would be foolish to ignore the problems in Turkey, which could well ripple out into other EM economies and the developed world. However, our current base-case scenario does not call for anything on the order of the Asian Crisis. Chart of the WeekTurkey Is A Clear Outlier Today ... Chart 2... But It Would Have Been In The Thick Of Things In 1997 Turkey's dependency on external capital flows is reminiscent of the Asian Tigers', but it is an outlier in today's more conservative context (Chart of the Week). On the eve of the Asian Crisis, Turkey's external financing profile, on both a flow (current-account balance as a share of GDP) and a stock (external private debt as a share of GDP) basis, would have placed it squarely within the smart set (Chart 2). In retrospect, the Asian Miracle template of the early and mid '90s was an accident waiting to happen. Currency pegs are seen as a naïve relic, and exporters assiduously build up reserve war chests to prevent currency panics from taking root. Chart 3U.S. Banks Have Modest EM Exposure The key issue for U.S. investors is the potential for contagion to the U.S. banking system and its markets. It is almost impossible to identify an LTCM in advance, but the fact that the banking system is on a much tighter leash following the crisis means that it is far less vulnerable than it was in the late '90s. As our f/x strategists point out,1 European banks (especially Spain's BBVA) have considerably more exposure to Turkey and other fragile EM economies (Chart 3). Sentiment is the most likely transmission mechanism, and U.S. assets would seem to be last in line for multiple de-rating and spread widening, given the strength of the U.S. economy and its comparative remove from the rest of the world. Bottom Line: The magnitude of Turkey's financing excesses is not representative of the entire EM complex. U.S. investors should operate with a heightened sense of caution, but they should not panic. Emerging Markets' Achilles' Heel The magnitude of Turkey's reliance on external financing is unusual, but the direction is common. The vast bulk of the world's wealth is held in developed economies, and EM projects necessarily source capital from DM investors. Over 90% of all EM corporate debt is denominated in hard currency, of which the vast majority is denominated in U.S. dollars. For EM corporates with mainly domestic revenues, moves in the dollar exchange rate exert disproportionate influence over how comfortably they can service their debt. Exchange rates are determined by many factors, but real interest rate differentials are among the most prominent drivers. When the Fed hikes the fed funds rate while other central banks are easing policy or standing pat, the dollar tends to appreciate. A rising dollar pressures EM corporate borrowers, and hasn't been good for EM stock prices, either (Chart 4). If the Fed were to lift the fed funds rate all the way to 3.5% by the end of 2019, as we expect, several EM borrowers could find themselves in the crosshairs. Chart 4Tighter Fed Policy Squeezes EM Equities, Too Meaningful Chinese stimulus could go a long way to offsetting Fed tightening pressures. A more robust Chinese economy would trade more and consume more natural resources. Increased export volumes and higher commodity prices would boost EM exports and commodity prices, helping to support exchange rates. Unfortunately for Asian and Latin American EMs, the jury is still out as to whether or not the Chinese cavalry will ride to the rescue. Our China strategists have observed that a sizable stimulus injection would run counter to policy makers' commitment to reining in shadow banking excesses and cooling off the property market. If the trade war with the U.S. really starts to bite, however, reform may become a lesser priority. The powers that be have been circumspect with stimulus so far (Chart 5), weakening the currency to defend exports (Chart 6) rather than attempting to boost domestic activity via government spending. We will keep a close eye on Chinese policy developments as they unfold. Chart 5Instead Of Helping The EM Bloc With Reflation,... Chart 6...China Has Been Exporting Deflation Bottom Line: Chinese stimulus could help cushion the blow from a stronger dollar, but policy makers have yet to show their hand. Stay tuned. The View From Main Street Despite the global challenges, the July NFIB survey underlined the point that the U.S. economy is flying high. The headline Optimism Index is a single tick below its all-time high (Chart 7, top panel), the Hiring Plans (Chart 7, second panel) and Job Openings components (Chart 7, third panel) are at or near all-time highs, and the Good Time to Expand component is just off the high it set in May (Chart 7, bottom panel). All in all, the view from Main Street is the best it's ever been over the survey's 44-year history. All of the readings in Chart 7 are so good (two-plus standard deviations above the mean), that there is little scope for improvement. Mean reversion may well begin to assert itself, but it is likely to be a slow process. Overall optimism peaks well ahead of downturns, and tends to take its time deteriorating. It lends support to the message from our recession indicator2 that the expansion has at least another year to run. All good things come to an end, however, and the downside to the gangbusters survey results is that they foreshadow the expansion's eventual demise. Respondents' reports of price changes and future intentions to raise them correlate closely with PCE inflation (Chart 8). Record strength in job openings and hiring intentions indicates the labor market is tight enough to squeak, suggesting that firms will soon have to bid up wages to attract new employees. Taken together, the inflation-related measures imply that the Fed will not be able to let up, supporting the house view that the fed funds rate will surprise to the upside. Chart 7A Roaring Economy... Chart 8...Carries The Seeds Of Its Own Demise Bottom Line: The end of the expansion is not at hand, but its strength will eventually compel the Fed to step in to cut it off. Investment Implications Fiscal stimulus and monetary policy still support the expansion and the bull markets in equities and corporate debt, but they will not do so indefinitely. Stimulus is not sustainable from a budgetary standpoint, and gathering inflationary pressures will eventually inspire the Fed to wield its policy tools to bring the curtain down on the business cycle. The shift to restrictive policy will mark an inflection point in risk-asset performance, and investors should pursue more defensive portfolio positioning when it arrives. Although the cyclical inflection point is not yet upon us, the uncertain outcome of trade tensions and emerging market vulnerabilities merit dialing back portfolio risk in the near term. In line with the BCA house view, we recommend overweighting cash and underweighting bonds, while maintaining benchmark positioning in equities. Treasuries will likely outperform if the EM rumblings turn into something more serious, but we would view any decline in yields as a temporary respite from a Treasury bear market that has already been in place for two years. Depending on when, or if, the current global pressures abate, the equity bull market may still have some juice, and we are keeping an open mind about moving stocks back to overweight for the final push. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 17, 2018 Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers," available at fes.bcaresearch.com. 2 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.
Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.