Protectionism/Competitive devaluation
Highlights Investors who are betting on a quick resolution to the U.S./China trade war following the "new NAFTA" deal and the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months. Consequently, we are closing our long ESG leaders / short benchmark trade. Feature September's PMI releases, both official and private, confirm that China's export outlook is deteriorating rapidly. Chart 1 highlights that the Caixin PMI is about to fall below the boom/bust line, and the new export orders component of the official PMI has sunk to a 2 ½ year low. Somewhat oddly, investors do not seem to be responding negatively to the de-facto announcement of a 25% rate on the second round of U.S. import tariffs against China. Chart 2 shows that domestic infrastructure stocks have actually been rising relative to global stocks since mid-September, and our BCA China Play Index appears to have entered a (so far very modest) uptrend. Chart 1The Export Shock Is Coming... Chart 2...But Investors Have Been Incrementally Upbeat One possible explanation for this is that investors are doubling down on the idea that China will have to aggressively stimulate in response to the shock. We have leaned against this narrative, by arguing in past reports that China's policy response to the upcoming export shock is not likely to be heavily credit-based, and that increases in fiscal spending today will involve more "soft infrastructure" than in the past.1 Chart 3 certainly shows no evidence of a spike in broad money or total credit; adjusted total social financing growth barely accelerated in August, against the backdrop of promises to front-run planned fiscal spending over the coming year. Chart 3No Major Acceleration In Credit Growth Evident Yet Chart 4Americans Support A Tough Stance Against China But a second explanation of recent investor behavior, one that we have been hearing more loudly from some market participants, is that China is waiting until after the midterm elections in the U.S. to make a deal, in anticipation that Republican losses in Congress will weaken Trump and change the political reality in terms of trade policy towards China. There are three reasons why investors holding this view are likely mistaken, and have been taken in by false hope: In the U.S., the actual implementation of tariffs lies within the control of the Presidency. Congress has delegated substantial authority to the president that would take time to be clawed back. Moreover, the president controls the execution of tariffs, and has a general prerogative over national security issues, which certainly includes the trade war with China. Democratic control of the House or Senate may cause President Trump to act even more forcefully against China, as trade will be among the few relatively unfettered policy options left to him. Chart 4 highlights that a sizeable majority of the American public views Chinese trade policy towards the U.S. as unfair, unlike the U.S.' other major trade partners. Reflecting this point, Democrats themselves maintain a hawkish stance on trade with China. This suggests that Trump will have a strong mandate to continue to demand major concessions from China even after the elections. We agree that Chinese stocks have already priced in a sizeable earnings decline, but we would still characterize buying now as an ill-advised case of trying to catch a falling knife. We highlighted in our September 19 Weekly Report that during the 2014-2016 episode Chinese stocks bottomed several months after stimulus began to take effect,2 because of a delayed decline in forward earnings. A similar situation would appear to be developing this time around: the third round of tariffs against China will likely soon be announced, the shock to Chinese export growth will soon manifest itself in the data, and yet Chinese forward earnings have only fallen 5-6% from their June peak. Bottom Line:Investors who are betting on a resolution to the U.S./China trade war following the U.S. midterm elections have likely been taken in by false hope. Stay neutral China relative to global stocks, and overweight low-beta sectors within the investable equity universe. Recent Sector Performance: A Beta Story, And A New Trade Idea Chart 5Last Week We Closed One Of Our Most Successful Calls We recommended closing one of our most successful trades of the past year in a brief Special Report last week.3 The report outlined major changes to the global industry classification standard (GICS) that took effect this week, as well as the implications for China's stock market. One key change is that Alibaba, one of the "BATs", is now part of the consumer discretionary sector and makes up roughly 60% of its market capitalization. Given this fundamental shift in the risk/reward profile of the position, we recommended closing our long MSCI China Consumer Staples / short MSCI China Consumer Discretionary trade for a profit of 47% (Chart 5). With the goal of identifying new trade ideas that are likely to outperform within the context of a trade war, Chart 6 presents the alpha and beta characteristics of 23 industry groups in the MSCI China index (the investable benchmark) from mid-June to the end of September. The x-axis of the chart represents the group's beta versus the benchmark, whereas the y-axis shows standardized alpha over the period. The chart also distinguishes between out/underperforming sectors. Chart 6Since Mid-June, Sector Performance Has Largely Been Beta-Driven Several points are notable: Largely speaking, the relative performance of Chinese industry groups since mid-June has been determined by their beta characteristic (with almost all low-beta industry groups outperforming). This supports our existing position of favoring low-beta sectors within the MSCI China index, a trade that we initiated on June 27.4 Four industry groups that belong to traditionally cyclical sectors have outperformed since mid-June and have had a beta less than 1: energy, capital goods, banks, and consumer durables and apparel. Energy and capital goods have been particularly notable, having outperformed by 24% and 15%, respectively. Technology-related industry groups have underperformed, including the pharma, biotech, and life sciences industry group within health care. Consumer services and retailers have significantly underperformed, due to the heavy influence of travel-related businesses in both indexes. Among the top performing industry groups over the past three months, Chinese energy stocks look like the most compelling trade in absolute terms. While we are normally reluctant to chase performance, several factors support an outright long position: BCA's Commodity & Energy Strategy service is bullish on oil prices, and recently increased their 2019 Brent price forecast to $95/bbl based on both supply and demand factors.5 Despite the recent outperformance of Chinese energy companies within the investable universe, they remain cheap versus global energy companies based on cash flow-based valuation metrics (Chart 7). This is true even after accounting for the fact that they are typically discounted relative to their global peers due to heavy state ownership. Chinese energy companies look reasonably priced relative to the value of global oil production (Chart 8). Chinese energy companies largely receive their revenue in U.S. dollars, which is an attractive hedge in an environment where CNY-USD may decline further. Chart 7Chinese Energy Stocks Are Cheap Versus Their Global Peers... Chart 8...And Versus The Value Of Global Oil Production Given this, we are updating our trade book and recommend that investors initiate an outright long position in Chinese energy stocks as of today. Chart 9Despite Outperforming, Absolute Capital Goods Performance Has Been Lackluster What about Chinese capital goods companies? For now, we are content with relative rather than absolute exposure, which (surprisingly) exists in our low-beta sectors trade. Capital goods companies account for almost 70% of the Chinese industrial sector, and industrial stocks have been less volatile than the broad market over the past year, in large part because they underperformed so significantly in 2017. Given this, they have been included in our low-beta sectors portfolio, despite being typically pro-cyclical. In absolute terms, though, it is far from clear that Chinese capital goods stocks will trend higher (Chart 9). Some investors are hopeful that capital goods producers will benefit from a significant acceleration in infrastructure spending but, as we noted above, the bar is high for the type of stimulus that investors have come to expect. In addition, potential weakness in property construction could be a drag, and could offset gains from a pickup in infrastructure investment.6 We recommend that investors stick with a relative position, until compelling signs of a stimulus overshoot emerge. Bottom Line: The relative performance of Chinese industry groups since mid-June has been almost entirely determined by their beta characteristic, with almost all low-beta industry groups outperforming. Energy stocks have been among the top outperformers within the Chinese equity universe, and several factors support our recommendation that investors initiate an outright long position. A Pause In Broad "Reform" As An Investment Theme Following last November's Communist Party Congress, we noted that China was likely to step up its reform efforts in 2018, and would take meaningful steps to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth Slow or halt leveraging in the corporate/financial sector Eliminate corruption and graft We argued that Chinese policymakers would have to set the pace of reforms to avoid a significant slowdown in the economy, but we noted that a policy mistake (moving too aggressively) could not be ruled out. We introduced the BCA China Reform Monitor as a way of tracking the intensity of the reforms, which was calculated as an equally-weighted average of the four "winner" sectors that emerged in the month following the Party Congress (energy, consumer staples, health care, and technology) relative to an equally-weighted average of the remaining seven sectors (Chart 10). In particular, we argued that a rise in the monitor that was driven by the underperformance of the denominator would be a warning sign that reforms had become too aggressive for the economy to withstand. Chart 10Reform, As A Broad Theme, Will Be Less Relevant In The Year Ahead Chart 10 highlights that the reform monitor rose for the first half of the year, driven by the gains of the numerator rather than losses in the denominator. The message of a sustainable pace of reforms, even against the backdrop of brewing trade tension, was consistent with the relative performance of Chinese stocks and was part of the reason we recommended staying overweight versus the global benchmark in Q1 and the majority of Q2.7 Since mid-June, however, the reform theme has been thrown into reverse: our reform monitor has declined, alongside absolute declines in both "winner" and "loser" sectors. The timing of this inflection point is clearly aligned with President Trump's announcement of the second round of tariffs. Given this, and our view that the U.S./China trade war is likely to get worse over the coming 6-12 months, it is likely that broad "reform" as an investment theme will be less relevant for the foreseeable future, at least relative to policymaker efforts to stabilize the economy. However, for several reasons, we view this as a pause in the theme, rather than an end: On the environmental front, Chart 11 highlights that China continues to pursue a clean air policy, at least in large population centers. Anti-pollution efforts are a signature policy of President Xi Jinping. They affect quality of life and ultimately the legitimacy of the regime, so they cannot be postponed entirely or indefinitely. Chart 11China Continues To Clamp Down On Air Quality Shifting China's growth model away from primary and secondary industry remains a long-term goal of policymakers. Chart 12 highlights that tertiary industry has already risen non-trivially as a share of GDP. This trend is also clearly visible in the electricity consumption data, which shows that residential and tertiary industry consumption has risen quite materially over the past several years. Chinese policymakers will clearly ease up on the brake over the coming year in terms of deleveraging, but it is far from clear that they will aim for another wave of aggressive private sector debt growth. We highlighted one key reason for this in a recent Special Report: comparing adjusted state-owned enterprise (SOE) return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative for these firms (Chart 13). This implies that further aggressive leveraging of SOEs could push them into a debt trap. In fact, if policymakers do refrain from promoting a major private sector credit expansion over the coming year, that restraint will directly reflect the reform agenda. Chart 12Policymakers Continue To Emphasize A Transition Towards Services Chart 13SOEs Now Appear To Have A Negative Financial Gain From Debt Chart 14 highlights that while anti-corruption cases involving gifts and the improper use of public funds are off of their high from early this year, they remain elevated and are not trending lower. As a final point, Chart 15 shows that our long MSCI China environmental, social, and governance (ESG) leaders / short MSCI China trade has been negatively impacted by the pause in reform as an investment theme. While MSCI's ESG indexes aim to generate low tracking error relative to the underlying equity market of each country, technology companies are typically overrepresented in ESG indexes because of the low emissions nature of their business model. In China's case, we noted above that technology industry groups have fared poorly since mid-June, and panel 2 of Chart 15 shows that the underperformance of Chinese investable technology companies since mid-June lines up with the latest leg of ESG underperformance. Chart 14China's Anti-Corruption Drive Is Still In Effect Chart 15Favor ESG Leaders Again When The Reform Theme Reasserts Itself It remains unclear how much of tech's underperformance has been due to rich multiples versus concerns that the U.S. crackdown on Chinese technology transfer and intellectual property theft will negatively impact the market share of China's tech companies (via an opening of the market and a rise in the market share of foreign competitors). But we believe that the latter is a factor, and we recommend closing our long ESG leaders / short benchmark trade until "reform", both environmental and otherwise, reasserts itself as a driving factor for the Chinese equity market. Bottom Line: While it is likely paused rather than stalled, broad "reform" as an investment theme will be less relevant over the coming 6-12 months relative to policymaker efforts to stabilize the economy. We are closing our long ESG leaders / short benchmark trade at a loss of 5.5%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Special Report "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Investing In The Middle Of A Trade War", dated September 19, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report "GICS Sector Changes: The Implications For China", dated September 26, 2018, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com. 5 Pease see Commodity & Energy Strategy Weekly Report "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at ces.bcaresearch.com. 6 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 7 The rapidly escalating trade war between China and the U.S. caused us to recommended putting Chinese stocks on downgrade watch at the end of March, and we recommended that investors cut their exposure to neutral on June 20. Pease see China Investment Strategy Weekly Report "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, and China Investment Strategy Special Report "Downgrade Chinese Stocks To Neutral", dated June 20, 2018, both available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. We have a contrarian view about Chinese corporate bonds, and recommend holding a long but diversified position over the coming 6-12 months. Feature Chart 1The RMB Is Acting As A "Panic Barometer" ##br##For Domestic Stocks The Trump administration finally announced its decision this week on the second round of tariffs on Chinese imports, essentially applying a 25% rate. While the rate will initially start at 10%, it will rise to 25% by the end of the year, and the administration has threatened to immediately seek public consultation on tariffs on all remaining imports from China if the country retaliates against the second round (which was announced yesterday). With news reports having suggested that China would reject new trade talks merely if the second round moves forward, the prospect of a breakthrough in negotiations seems dim, at best. We have highlighted in past reports that the RMB has acted as a panic barometer for domestic equities (Chart 1), as evidenced by the recent spike in the correlation between the two. During this period, the percent decline in CNY-USD seems to have closely followed the magnitude of proposed tariffs as a percent of Chinese exports to the U.S., as would be implied in a simple open economy model with flexible exchange rates. Based on this framework, Chart 2 suggests that the RMB may come under considerable further market pressure, even if investors only assume a 10% rate on the third round of tariffs. A break above the psychologically-important level of 7 for USD-CNY appears likely barring a major intervention from the PBOC, suggesting that a meaningful uptick in Chinese financial market volatility is forthcoming. Chart 2USDCNY = 7 Is Likely To Be Breached Barring Strong Action From The PBOC Stimulus To The Rescue? Given that Chinese policymakers have signaled their willingness to stimulate in response to a negative external environment, some investors have argued that China is actually about to enter a mini-cycle upswing. For now, two points suggest that this conclusion is premature: A 10% tariff rate on all remaining imports from China would imply close to $90 billion in tariffs collected, once the second round rate rises to 25%. As noted above, a simple equilibrium exchange rate framework would imply material further weakness in the RMB to counter protectionism of this magnitude. Besides heralding a further selloff in Chinese stocks, this could lead to competitive currency devaluation amongst China's largest trading partners, a "beggar-thy-neighbor" policy that tends to exacerbate rather than alleviate shocks to aggregate demand. As we have noted numerous times over the past year, China's old economy was slowing in the lead up to the U.S./China trade war, and it is not yet clear whether the announced stimulus will generate enough "lift" to convince investors that the low in economic activity is behind them. Chart 3 shows that the August rise in adjusted total social financing as a share of GDP was extremely muted, and that there is no sign yet of a pickup in government spending. Even if China ramps up its stimulus efforts in response to this week's decision from the Trump administration, Chart 4 highlights an important point for investors: there was a considerable lag between a policy response and the low in stock prices during the 2014-2016 episode (a lag that may re-occur today). The chart shows that despite an ongoing depreciation in the RMB and a rebound in our BCA leading indicator for the Li Keqiang index, Chinese stock prices continued to decline for several months. This gap was caused by a lagged decline in earnings, and underscores that investors may ignore the current efforts by policymakers to stabilize the economy until clarity on the stability of earnings presents itself. Chart 3No Sign Yet Of##br## Major Stimulus Chart 4History Suggests Investors Need Both ##br##Stimulus And Earnings Clarity And for now, several signs point to potentially material downside risk for earnings: While the now considerably larger shock from U.S. tariffs has yet to impact the Chinese economy, trailing earnings growth has already peaked and has recently fallen below its trend (Chart 5, panel 1). Despite the recent deceleration in trailing earnings growth and the sharp decline in stock prices, analysts' 12-month forward growth estimates remain quite elevated (Chart 5, panel 2). This suggests that forward earnings could be vulnerable to a decline above and beyond what occurs to trailing earnings, as a full 1/3rd of the increase in the former since late-2015 has been due to very significant shift in growth expectations. The rise in trailing earnings over the past few years appears to be stretched, based the trend in profit margins (Chart 6). The chart highlights that 12-month trailing earnings have well surpassed sales since late-2016, causing margins to rise to their highest level on record and raising the risk of a significant mean-reversion in response to a meaningful economic shock. Net earnings revisions have done a good job at predicting inflection points in forward earnings growth over the past decade, and have recently fallen into negative territory (Chart 7). Chart 5Lofty Earnings Growth Expectations ##br##Are A Risk To Stocks Chart 6The Earnings Recovery Has Been Partly ##br##Reliant On A Margin Expansion Chart 7Earnings Revisions Herald ##br##Slowing Earnings Momentum It is true that some of the above-average levels for profit margins and 12-month forward growth expectations can be explained by the substantial rise in the share of the tech sector in the MSCI China index, whose constituents are significantly more profitable than ex-tech stocks, may have better longer-term growth prospects, and may be more immunized from the trade war with the U.S. Still, Chart 8 illustrates the high earnings hurdle rate for tech stocks over the coming year. Bottom-up analysts continue to expect tech stocks to grow their earnings more than 20% over the next 12 months, despite: Chart 8Are Chinese Tech Stocks Going To Be##br## Able To Grow Earnings 20+%? A poor economic outlook that is likely to impact consumer spending (even if households "outperform" the business sector), and The fact that tech sector net earnings revisions have fallen deeply into negative territory (panel 2). How should investors allocate capital within China in the middle of a trade war with the U.S? First, despite the fact that Chinese stocks have already fallen significantly from their early-January high, it is clearly too early to bottom fish either domestic or investable stocks. Stay neutral China, at best, relative to global stocks. Second, investors should certainly favor low-beta sectors within the Chinese equity universe. Currently, our low-beta equity portfolio includes industrials, telecom services health care, utilities, and consumer staples, but we update the portfolio weights at the end of every month. Third, as discussed below, investors should ignore the very bearish narrative towards Chinese corporate bonds, and hold a long but diversified position over the coming 6-12 months. Bottom Line: The Trump administration's decision to effectively tariff the second round of imports at 25% materially raises the odds of another significant uptick in Chinese financial market volatility. Even if China ramps up its stimulus efforts in response, the lesson of the 2014-2016 episode is that investors are likely to wait for earnings clarity before buying stocks aggressively. Stay neutral China, at best, relative to global stocks, and overweight low-beta sectors within the investable equity universe. Chinese Corporate Bonds: A Contrarian Long Our analysis of the earnings risk facing equities suggests that it is probably still too early to buy Chinese stocks, but in our (contrarian) view there is still one pro-cyclical asset that investors should favor: Chinese corporate bonds. Headlines about defaults in China's corporate bond market continue to appear in the financial press, with concerns most recently focused on low recovery rates of defaulted issues.1 We last wrote about Chinese corporate bonds in June,2 and took a contrarian (i.e. optimistic) stance towards the market. In the meantime, our long China onshore corporate bond trade has continued to gain ground, and an analysis of the inferred credit rating of the market actually strengthens our conviction to stay long. One key element of the bearish narrative towards Chinese corporate bonds is the fact that investment-grade issues in the market are trading like junk. Table 1 highlights that this is largely true: the table presents the spread-inferred credit rating of the four major rating categories of the ChinaBond Corporate Bond Index, and shows that AAA bonds are trading on the border of equivalent maturity investment- and speculative-grade bonds in the U.S. Bonds rates AA+/AA/AA- in China are trading between lower-B and high-CAA, which is firmly in speculative-grade territory. However, in our view market participants are making a mistake when they assume that de-facto junk ratings on Chinese corporate bonds will translate into U.S. junk-style default rates on bonds over the coming 6-12 months (or, frankly, beyond). Chart 9 presents an estimate of the market-implied default rate for the four rating categories shown in Table 1, and suggests that investors are pricing in roughly a 1% default rate for AAA-rated corporate bonds and a 4-5% default rate for AA+/AA/AA-. Table 1Chinese Corporate Bonds Are Trading##br## Like Speculative-Grade Issues Chart 9Allowing Market-Implied Default Rates##br## To Occur Would Be A Huge Policy Error There are two important factors to consider when gauging the validity of these expectations: Based on Moody's most recent Annual Default Study, the market's current expectations for Chinese corporate bond defaults are actually above the average historical one-year default rates for their inferred credit ratings. Average default rates almost never actually occur over a given 12-month period. Chart 10 highlights that default rates in the U.S. have a binary distribution that is almost entirely determined by whether the economy is in recession (not just slowing down). The late-1980s and the post-2015 environment have been exceptions to this rule, which in large part can be explained by industry-specific events (namely, a surge of energy-sector defaults due to a collapse in the price of oil). But the key point is that investors are likely to overestimate the actual default rate over a given 12 month period when assuming an average historical rate, unless the economy shifts from an expansion to an outright recession over the period. From our perspective, the combination of the market's default expectations and the fact that China is easing suggests an outright long position in Chinese corporate bonds is warranted over the coming year. In our judgement, there is simply no way that policymakers can allow default rates on the order of what is being priced in to occur, as it would constitute an enormous policy mistake that would risk destabilizing the financial system at a time when officials are attempting to counter the looming shock to the export sector. In fact, we doubt that China's typical policy of gradualism when liberalizing its economy and financial markets would allow default rates to rise from 0% to 5% over a year in any economic environment, particularly the current one. As a final point, Chart 11 highlights why a significant rise in the default rate is required in order for investors to lose money on Chinese corporate bonds. The chart shows the 12-month breakeven spread for the ChinaBond AA- Corporate Bond index, unadjusted for default. The breakeven spread represents the rise in yields that would be required for investors to lose money over a 12-month horizon (i.e. the yield change that exactly erases the income return from the position), assuming no defaults. Chart 10"Average" Default Rates ##br##Do Not Really Occur Chart 11A 2% Rise In Yields From Tighter Policy Is Not##br## Going To Occur Over The Coming Year The chart shows that AA- bond yields would have to rise approximately 215 bps over the coming year before investors suffer a negative total return, which would be an enormous rise that has a near-zero probability of occurring due of tighter monetary policy. As such, defaults (or the pricing of default risk) remains the only real credible source of potential capital loss from these bonds over the coming year. Our bet, with high conviction, is that holders of Chinese corporate bonds hold a put option that will prevent this from occurring. Bottom Line: Fade investor concerns about rising defaults, and stay long Chinese corporate bonds over the coming 6-12 months. We acknowledge that idiosyncratic risk is likely to be elevated for this asset class, and we recommend that investors take a diversified, portfolio approach when investing in China's corporate bond market. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 For example, please see "In China, Less Than 20% Defaulted Bonds Have Been Paid Back" by Bloomberg News, August 27, 2018 2 Pease see China Investment Strategy Weekly Report "A Shaky Ladder", dated June 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights The primary trend for both Chinese stock prices and CNY-USD remains captive to negative surprises related to the trade war between the U.S. and China. Considerable uncertainty remains on this front, but our outlook is that the situation is likely to get worse, not better. It remains too early to forecast a durable stabilization in the exchange rate. It is an open question whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. There is some evidence to suggest that China can control both the interest and exchange rate should it choose to do so, but analyzing the issue is significantly complicated by the approach Chinese policymakers are using to manage the impossible trinity. There is room for Chinese short-term interest rates to rise modestly if the worst of the U.S./China trade war does not materialize. This would be consistent with the goal of avoiding significant releveraging of China's private sector. For now, investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe. Feature We noted in our August 22 Weekly Report that the persistent weakness of the RMB appeared to be one important factor weighing on Chinese stocks, particularly the domestic market.1 We presented some tentative evidence that part of the decline in CNY-USD since mid-June has been policy-driven (despite the PBOC's statements that it had not been depreciating the currency), but also noted that the RMB had now likely fallen outside the comfort zone of policymakers. The PBOC's re-introduction of its "counter-cyclical factor" when fixing the yuan's daily mid-point supports this view, and suggests that monetary authorities are now aiming for a broadly stable exchange rate (or are aiming to limit further downside). Chart 1 highlights that there have been some, albeit modest, signs of success. Whether they succeed will, first and foremost, be largely determined by what appears to be an imminent decision by the Trump administration to levy tariffs on an additional $200 billion in imports from China. Our previous analysis of potential equilibrium levels for CNY-USD suggests that investors have already priced in the imposition of a second round of tariffs, but the key factor for markets will be whether the tariff rate applied is 10% or 25%. In the first case it is possible that the RMB has overshot to the downside; in the latter case, CNY-USD will very likely come under renewed pressure that would be difficult for the PBOC to fully counter. Chart 1Some Modest Signs Of Currency Stability Chart 2Interest Rate Differentials And CNY-USD: A Tight Link But an additional question is whether the PBOC will be forced to change short-term interest rates in order to guide the currency in their preferred direction. Both our Global Investment Strategy and Emerging Markets Strategy services have highlighted that USD-CNY has broadly tracked the one-year swap differential between the U.S. and China over the past few years (Chart 2). This suggests that, at a minimum, there is some link between the interbank market and the exchange rate, despite the fact that capital controls are still tight in the Chinese economy. It also seems to imply, ominously, that the PBOC may have to choose between potentially significant releveraging and a significant re-appreciation in the exchange rate. Revisiting The Impossible Trinity "With Chinese Characteristics" The exact nature of this interest/exchange rate link is difficult to analyze, because of how China has chosen to manage the "impossible trinity" following the August 2015 devaluation of the yuan. The upper portion of Chart 3 illustrates the standard view of the impossible trinity, which posits that policymakers must choose one side of the triangle, foregoing the opposite economic attribute. For example, most modern economies have chosen "B", allowing the free flow of capital and independent monetary policy by giving up a fixed exchange rate regime. Hong Kong has chosen "A", meaning that its monetary policy is driven by the Fed in exchange for a pegged exchange rate and an open capital account. Chart 3The Possible Trinity? China historically has chosen "C", an economy with a closed capital account, a fixed exchange rate, and independent monetary policy. There is no causal link between interest and exchange rates in the world of option C, but following the PBOC's move in 2015 towards a more market-oriented approach for the exchange rate, it was accused by many market participants of trying to pursue all three goals simultaneously. In short, market participants have not been able to clearly discern what option China has chosen following over the past few years. China, in effect, answered these criticisms by arguing that it was not bound by the standard view of the impossible trinity, but rather one "with Chinese characteristics". The lower portion of Chart 3 presents this theory, which posits that policymakers must distribute a 200% adoption rate among three competing choices. The chart depicts a possible scenario where policymakers are relatively tolerant of capital flow, partially adopting two measures in addition to fully independent monetary policy: quasi-floating exchange rates highly subject to the interest rate dynamics shown in Chart 2, and loosely enforced capital controls. The chart also shows what ostensibly occurred in response to significant capital flight in 2014 and 2015, i.e. a crackdown on capital control enforcement and a less market-driven exchange rate. To the extent that this framework still applies, Charts 4 - 7 suggest that this capital flow crackdown has not abated and that the PBOC may be able to prevent significant further weakness in the currency without dramatically raising interest rates: China tightened scrutiny on trade invoicing verifications in 2016 to crack down on "fake" international trades, such as imports from Hong Kong (local firms fabricated import businesses to move money offshore). Based on the recent trend, these restrictions remain in effect (Chart 4). In addition, quarterly net flows of currency and deposits, which turned sharply negative in Q3 2015, have risen back into positive territory (Chart 5). Chart 4Blocking Capital Leakage In Trade... Chart 5...And Cash Chart 6 presents Chinese foreign reserves measured in SDRs, and highlights that reserves have been stable for the better part of the past two years. This stability is in sharp contrast to the material decline that occurred in 2015, and is supportive of the view that China can control both the interest and exchange rate, should it choose to do so. Chart 7 highlights that there are a few precedents for a divergence between interbank rates and CNY-USD. One divergence in 2012-2013 is particularly noteworthy: CNY-USD trended higher, but interbank interest rates remained flat for some time. Crucially, this does not appear to have been driven by falling U.S. interest rates, as the 2-year Treasury yield had already fallen close to zero in 2011 and did not begin to rise until mid-2013. Chart 6China Has Stabilized Its ##br##Foreign Reserves Chart 7Short-Term Interest Rates And ##br## CNY-USD Have Diverged Before Interest Rates And Moderate Releveraging Despite the evidence presented in Charts 4 - 7, the bottom line is that it is not clear whether the PBOC would be forced to raise short-term interest rates (and by how much) if it chooses to stabilize the currency. Would doing so be a death-knell for the Chinese economy? In our view, the answer is no, unless the trade war does indeed metastasize further. We have argued that the magnitude of the decline in the 3-month repo rate has been excessive, and is not currently consistent with a moderately reflationary scenario. We have argued that the repo rate decline is a side-effect of the PBOC's heavy liquidity injections, which were more likely aimed at ensuring financial system stability against the backdrop of struggling small banks. Chart 8Lending Rates Will Decline Substantially ##br## If Repo Rates Don't Rise But the current level of liquidity support carries risks to the objective of controlling private-sector leveraging. Chart 8 suggests that unless the PBOC raises the benchmark lending rate (which would be interpreted very hawkishly by the market), the magnitude of the decline in the repo rate will push the weighted average lending back to its 2016 low (when the monetary authority had turned the policy dial to "maximum reflation"). Last week's Special Report explained in detail why this would carry significant risks to China's financial stability.2 We noted that most of the private sector leveraging that has occurred in China since 2010 has occurred on the balance sheet of state-owned enterprises (SOEs) and the household sector. While the household debt-to-GDP ratio is still low, it is rising rapidly and may accelerate even further if lending rates fall significantly. The picture for SOEs is even more dire: leverage is extremely elevated, and a comparison of adjusted return on assets to borrowing costs suggests that the marginal operating gain from debt has become negative. This suggests that further leveraging of SOEs could push them into a debt trap and/or shackle the monetary authority's ability to meaningfully raise interest rates. As such, it is actually our expectation that short-term interest rates will rise modestly following a 10% rate on the second round of tariffs (instead of 25%), or if it becomes clear that there will be no third round. If the trade war escalates, however, short-term interest rates would not be expected to rise at all, and the drive to control leverage could be downshifted yet again. Investment Conclusions Chart 9Stay Neutral Towards Chinese Stocks, ##br##And Favor Low-Beta Sectors What does this all mean for our view on the RMB, and what are the implications for Chinese stocks? For now, we can draw the following conclusions: The primary trend for both stock prices and the exchange rate remains captive to negative surprises related to the trade war between the U.S. and China. We would expect further financial market weakness in response to a 25% rate on the second round of tariffs, and especially if President Trump moves forward with plans to tariff the remaining $250 billion of imports from China (the "third round"). Conversely, a 10% second-round tariff rate, or convincing signs that there will be no third round, could soon put a floor under the RMB and stock prices. On this front, the lead-up to a possible meeting between Presidents Trump and Xi in November will be important to monitor. But for now, given our view that the trade war between the U.S. and China is likely to get worse, not better, it remains too early to forecast a durable stabilization in the exchange rate, and an overweight stance towards Chinese equities in absolute terms remains premature. A-shares are deeply oversold and we are watching closely for signs to time a reversal, relative to investable stocks (at least at first). Higher Chinese short-term interest rates are not necessarily negative for stock prices, as long as the rise is modest and not in the context of a further, material uptick in trade tensions between the U.S. and China. While a moderate releveraging scenario would clearly imply a weaker earnings growth outlook than if credit accelerated strongly, earnings growth is still positive and yet Chinese equities are 20-30% off of their 1-year high in local currency terms. Modestly higher interest rates, in the context of durable RMB stability and an end to the escalation of trade threats, is likely to be equity-positive. As we wait for more clarity on the trade outlook, we reiterate our core equity investment recommendations: Investors should maintain no more than a benchmark allocation towards Chinese investable stocks within a global equity portfolio, and should continue to favor low-beta sectors within the investable universe (Chart 9). As always, we will be monitoring developments related to the timing and magnitude of the upcoming export shock, as well as further policymaker responses continually over the coming weeks and months. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "In Limbo", dated August 22, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Report "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging", dated August 29, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
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