Trade / BOP
President Trump’s meeting with his Chinese counterpart Xi Jinping at last week’s G20 summit in Buenos Aires is nothing more than an agreement to begin negotiations. Nevertheless, ags – particularly grains – are poised to benefit from an “immediate” and…
While the trade-war cease-fire agreed at the G20 summit between the U.S. and China boosted grain markets – particularly as China agreed to begin “substantial” purchases from the U.S. – the future of the trade relationship remains uncertain. The agreement to work out an agreement only holds for 90 days, and there’s a lot to get through. An increase in Chinese purchases of U.S. ag products could realign prices for the grains traded on the Chicago Mercantile Exchange with their global counterparts, by reversing the inefficiencies created by the 25% tariffs announced last summer, particularly re soybean trade flows. However, until concrete steps are announced, this remains nothing more than a hope at present. Then there’s the USD. We expect a stronger dollar in 1H19 to continue to weigh on ag markets, by keeping U.S. exports relatively expensive versus foreign competition. We continue to believe the market underestimates the number of rate hikes the Fed will deliver next year – our House view calling for four policy-rate increases next year is higher than the market consensus – and that positive news on the trade front will be offset by relatively tighter financial conditions in the U.S. Highlights Energy: Overweight. We continue to expect OPEC 2.0 to agree cuts of 1.0mm to 1.4mm b/d at its meeting in Vienna today and tomorrow. Our $82/bbl Brent forecast for 2019 remains in place. Base Metals: Neutral. Zinc treatment charges in Asia hit a three-year high of $170 to $190/MT in November, a one-month gain of $50/MT. Chinese smelters are keeping capacity offline in the wake of lower prices for the metal and holding out for higher treatment charges, according to Metal Bulletin. Precious Metals: Neutral. Gold’s rally to $1,240/oz is consistent with a more dovish read on Fed policy. Nonetheless, we continue to expect a December rate hike, and four more next year. Ags/Softs: Underweight. Grain markets are hopeful for a reprieve following the G20 rapprochement between presidents Trump and Xi. However, a strong USD remains a headwind for U.S. exports. Feature Throughout 2018, ag markets have been in the cross-hairs of Sino – U.S. geopolitical warfare. President Trump’s meeting with his Chinese counterpart Xi Jinping at last week’s G20 summit in Buenos Aires is nothing more than an agreement to begin negotiations. Nevertheless, ags – particularly grains – are poised to benefit from a “substantial” increase in Chinese purchases “immediately.” Although uncertainty regarding the U.S. – China trade relationship will drag on into 2019, we are likely to see at least a thaw in ag markets. Apart from trade, U.S. financial conditions will continue to impact ags. More Fed rate hikes than are currently priced in by markets, which will keep the U.S. dollar well bid relative to the currencies of other ag exporters, will weigh on these markets. Weather will remain a wildcard. The World Meteorological Organization (WMO) assigns an 80% probability to an El Niño event occurring this winter, which, in the past, has led to higher volatility in ag markets due to flooding and droughts. Overall we would not be surprised to see some upside in the short term as Chinese consumers resume purchases of American crops. However, this will be muted when markets begin reassessing Fed policy expectations, and pricing in more hikes than the two currently anticipated over the next 12 months. American Farmers Breathe A Sigh Of Relief … In our most recent assessment of ag markets, we argued that while trade policy had weighed on the ag complex, further downside in these markets was unlikely.1 So far, this narrative has played out. Soybeans, corn, and wheat prices fell 22%, 19%, and 11%, respectively between the end of May and mid-July (Chart of the Week). By Tuesday of this week, they had rebounded, gaining 12%, 13%, and 8%, respectively. Chart of the WeekBetter Days To Come? Grain prices now are more in line with fundamentals. Moreover, the signing of the United States-Mexico-Canada Agreement (USMCA), which replaces NAFTA and eliminates uncertainty in agricultural trade within the North American market, was a market-positive development. The potential breakdown of North American trade was a significant risk to U.S. agriculture: Mexico is the second-largest destination for U.S agricultural exports, accounting for 13% of all U.S. exports of agricultural bulks (Chart 2). Canada makes up a smaller 2% share. Chart 2Trade Negotiations Hit American Farmers Hard Away from the USMCA, the agreement to a trade truce between the U.S. and China at the G20 summit is a ray of hope. President Donald Trump agreed to postpone hiking rates from 10% to 25% on the second round of tariffs imposed by the U.S. on Chinese imports until March 1, in exchange for a promise by President Xi Jinping to pursue structural changes to its economy, and that China will raise its imports from the U.S. – specifically of agricultural goods. While the current truce could be an opening salvo to a more favorable trade relationship, BCA Research’s geopolitical strategists warn that this development is inconsistent with their structurally bearish view of the U.S. – China relationship. Given the obstacles still in place, they are skeptical that the truce will endure.2 While China did agree to buy “substantial” agricultural products from U.S. farmers immediately, it is still unclear whether China will remove the tariffs on imports of American grains as part of the truce.3 For now, China’s 25% tariff on its imports of U.S. soybeans, corn, and wheat is still in place. Apart from state-owned enterprises acting in response to government orders to purchase U.S. ags, Chinese traders are unlikely to fulfill this promise on their own unless the tariffs are removed. In any case, there are high odds that this will happen – in order to make room for Chinese traders to purchase the grains, as well as to show of good faith in negotiations with the U.S. … Thank You President T The current global ag landscape mirrors the disputes shadowing the world’s two largest economies. The trade rift – highlighted by the 25% tariff on China’s imports of U.S. grains and other ags – has created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. This dichotomy is evident in physical markets. Take soybeans, an especially vulnerable crop, given that almost 60% of U.S. exports have traditionally been consumed in China. While Brazil is facing a shortage amid insatiable Chinese demand, a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 3). This comes at a bad time as the global trend over the past few years has been an increase in land devoted to soybeans at the expense of corn. Further evidence of the impact of the tariffs are as follows: Chart 3A Soybean Glut In The U.S., Tight Supplies In Brazil China’s total soybean imports technically do not qualify as having collapsed. However, the 0.5% y/y decline in volumes so far this year is in stark contrast with the average 10% y/y growth over the past four years (Chart 4). Chart 4China Has Been Shunning American Beans Chinese consumers are clearly avoiding beans sourced in the U.S. China’s soybean imports from America over the September-to-August 2017/18 crop year are significantly lower than last year’s volumes. There is clear seasonality in China’s sourcing of soybeans, with the U.S. crop gaining a larger share in the fall and winter (Chart 5). Nevertheless, this year is a clear outlier. Previously, in October, ~ 20% of China’s soybean imports were generally from the U.S. This year, the share stands at a mere 1%. Instead, China has been relying on Brazilian-sourced beans. Chart 5Unusual Trade Flows For This Time Of Year These factors are creating strong demand for beans from Brazil, where crushers are reportedly suffering from a lack of soybean supply and tight margins. The premium paid for Brazilian beans over CBOT prices reached a record high in September (Chart 6). Chart 6Record Premiums For Brazilian Beans In 2018 While Brazilian farmers are benefiting from the U.S. – China standoff, American farmers are suffering significant losses. U.S. soybean exports to the world are severely behind schedule for this time of the year. This is a clear consequence of weak demand from China, which has completely died down (Chart 7). Even though American farmers are searching for alternative destinations to replace China – and despite exports to countries other than China being double last year’s levels for this time of the year – they are not yet sufficient to compensate for the loss of sales there. Chart 7The Rest Of The World Does Not Compensate For Chinese Bean Purchases A normalization of agricultural trade between China and the U.S. – if it were to emerge as a consequence of the trade truce – would go a long way toward reversing these trends. However, exogenous factors likely will keep soybean prices, in particular, under pressure: Chinese demand for soybeans – which it uses as feed for its massive pig herds – will likely take a hit due to an outbreak of African Swine Flu. Soybean inventories in China have grown significantly (Chart 8). This is a sign that buyers there had been frontloading imports in anticipation of weaker imports from the U.S. over the winter period, when Brazilian supply dies down. Chart 8Chinese Buyers Well Stocked Ahead Of The Winter In addition, Brazilian farmers have raised their soybean plantings for next year. According to latest USDA estimates, Brazilian production in the 2018/19 will come in at 120.5mm MT, up from 119.8mm MT and 114.6mm MT in the previous two years, respectively. Similarly, exports from Brazil are projected to stand at 77mm MT, up from 76.2 and 63.1mm MT, in the previous two years, respectively. In its November World Agriculture Supply and Demand Estimates – published prior to the trade truce – the USDA projected U.S. exports will come down sharply from 59.0mm MT and 58.0mm MT in 2016/17 and 2017/18, respectively, to 51.7mm MT in the 2018/19. As a result, global ending stocks will swell to a record 112.1mm MT in the next crop year. Thus, even if there is a swift resolution to the trade war, soybean supplies will remain abundant, keeping a lid on prices. Even so, a resolution to the trade war likely would return the spread between Brazilian and American bean prices to their historical mean. In fact, globally the soybean market is projected to remain in a surplus again next year – the volume of which represents 4% of total production (Chart 9). As such, inventories measured in terms of stocks-to-use, are projected to continue rising, setting a new record surpassing 30% (Chart 10). Given that soybean supply is in abundance globally, a resolution in the trade war likely will not be accompanied by a significant rebound in soybean prices. Chart 9Another Global Surplus In Beans... Chart 10... Will Push Inventories To New Record High On the other hand, corn and wheat, which are less susceptible to trade disputes with China, are expected to be in deficit next year which will bring down their inventories. However, since global stocks levels are already so elevated, we don’t expect much upside on the back of these deficits. Bottom Line: It is too early to call an end to Sino - U.S. trade tensions just yet. However, an increase in Chinese purchases of U.S. ags will go a long way in reversing the inefficiencies created by the 25% tariffs announced last summer. This will move ags traded on the Chicago Mercantile Exchange more in line with their global counterparts. The Other Factors Driving Ags In addition to the trade war, which has created winners and losers out of Brazilian and American farmers, respectively, currency markets are also more favorable for the former compared with the latter. As such, U.S. financial conditions will remain an important determinant of ag prices. The Fed’s monetary policy decisions impact ags both directly – through changes in real rates – as well as indirectly, through the U.S. dollar. We expect the Fed will make decisions consistent with its mandate to contain inflation. As such, there will likely be more interest rate hikes over the coming twelve months than the market’s current expectation of two. This will affect agricultural markets as follows: Higher real rates increase borrowing costs for farmers, discouraging investment, and research and development. Tighter credit can weigh on growth. This depresses consumption and demand for goods and services in general, and to some extent agricultural commodities as well. In addition to this direct channel of impact of Fed policy on the agricultural markets, U.S. monetary policy decisions vis-à-vis the rest of the world will drive ags through its impact on the U.S. dollar. Moreover, weak global growth in 1H19 will keep a floor under the dollar. When global growth lags U.S. growth, it is usually associated with a strong dollar. These factors suggest upside potential for the dollar over the coming 6 months. This will continue as long as U.S. growth outperforms the rest of the world. Since farmers’ costs are priced in local currencies while commodities – and thus sales -- are priced in U.S. dollars, a stronger dollar vis-à-vis domestic currency raises revenues of non-U.S. farmers. This incentivizes plantings, raising supply, and in turn weighing down on prices (Chart 11). This explains the inverse relationship observed between the U.S. dollar and agricultural prices (Chart 12). Chart 11A Strong Dollar Will Incentivize Planting... Chart 12...And Weigh Down On Prices As always, weather is the wildcard in agricultural markets and can destroy and damage crops. The Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) recently lowered its wheat production forecast by 11% on the back of a drought. This will be the smallest crop in a decade. The El Niño event expected this winter will likely prolong the drought into early next year. Thus the risk of an El Niño event is especially relevant. This weather phenomenon occurs when there is an increase in sea surface temperatures in the central tropical Pacific Ocean which increases the chances of heavy rainfall and flooding in South America and drought in Africa and Asia. According to the World Meteorological Organization, there’s a 75-80% chance of a weak El Niño forming this winter. This raises the possibility of damage or destruction to crops, which could bid up agricultural prices. Bottom Line: A stronger dollar, at least into 1H19, will weigh on ags. Thus, ag markets will be hit with headwinds as the market begins to appreciate the possibility of a greater number of rate hikes than is currently priced in. This will mute the impact of positive news on the trade front. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Uncertainty Could Trump Ag Fundamentals,” dated July 26, 2018, available at ces.bcaresearch.com. 2 Please see BCA Research’s Geopolitical Strategy Weekly Report titled “Trade Truce: Narrative Vs. Structural Shift?” dated December 3, 2018, available at gps.bcaresearch.com. 3 The USDA has not changed its plan to provide the second round of its aid package to farmers in attempt to offset losses from the trade war. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table TRADES CLOSED IN 2018 Trades Closed in Summary of Trades Closed in 2017
Highlights China’s old economy is set to decelerate in the first half of 2019, regardless of the recent tariff ceasefire. Our base case view is that growth will modestly firm in the second half of 2019, but timing the trough will depend on the dynamics of a battle between debt-focused policymakers and a credit-driven economy. Renewed weakness in China's currency has the potential to rekindle (and reinforce) the now-dormant concern of widespread capital flight. Investors should be alert to its re-emergence, as it would likely have implications for a broad range of financial assets (not just the exchange rate). A tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted over the coming three months. The conditions for a cyclical overweight stance (6-12 months) are not yet present but may emerge sometime in 2019, particularly if money & credit growth begin to pick up. Defaults in China’s onshore corporate bond market will rise next year, but will likely positively surprise investors. We continue to recommend a diversified position in this asset class for domestic investors and qualified global investors in hedged currency terms. Feature BCA recently published its special year end Outlook report for 2019,1 which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we expand on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme # 1: The Battle Between Reluctant Policymakers And A Weakening Economy We presented a stylized view of China’s recent mini-cycle late last year (Chart 1), and argued that while an economic slowdown was underway it would most likely be a benign and controlled deceleration. Chart 1China’s Growth Profile Has Largely Been In Line With What We Forecasted Last Year… Chart 2 highlights that this view has broadly panned out, although the trade war with the United States has ironically (and only temporarily) boosted economic activity over the past several months. When measured by nominal GDP growth, the chart shows that the Chinese economy has retraced roughly 40% of the acceleration that occurred from late-2015 to early-2017, which is entirely consistent with the benign slowdown scenario that we presented a year ago. However, when measured by the Li Keqiang index, the chart shows that growth momentum stumbled quite significantly earlier this year, only to somewhat recover over the past two quarters. Chart 2...But Growth Stumbled In The First Half Of 2018 Chart 3 suggests that this recent recovery in the coincident data has been strongly driven by trade front-running. The chart shows an average of nominal Chinese import and export growth alongside growth in freight volume and manufacturing fixed-asset investment, and makes it clear that the recent pickup in activity has been due to persistently strong trade growth that is unlikely to continue. Chart 3Trade Front-Running Has Clearly Boosted Economic Activity This weekend’s short-term tariff ceasefire between the U.S. and China means that the trade shock will be of considerably reduced intensity than originally feared during the negotiation period. Nonetheless, the front-running effect is set to wane regardless of the existence of negotiations, implying that China’s old economy is set to recouple with our BCA Li Keqiang leading indicator in the first half of 2019. While the indicator has recently ticked up, this is almost entirely due to the recent depreciation in the RMB, as money and credit growth remain flat. For now, investors should focus on the level of the indicator, which is predicting a slowdown in economic activity over the coming several months (Chart 4). Chart 4A Slowdown In China's Old Economy Is Coming Our judgement is that a true deal between the U.S. and China next year that durably ends the trade war remains unlikely, although the odds have certainly increased as a result of this weekend’s announcement. But Chinese domestic demand had been slowing prior to the onset of the trade war, a fact that the market ignored until the middle of this year when it moved to price in both the underlying slowdown and the trade situation (Chart 5). This raises two questions: how much of a deceleration in growth will ultimately occur, and at what point will the economy bottom? Chart 5Investors Ignored A Slowing Economy Until The Trade War Emerged The answers to these questions are subject to the outcome of a battle between policymakers who are reluctant to push for sizeable releveraging, and an economy that appears to be strongly linked to money and credit growth. We have highlighted in several previous reports why Chinese policymakers want to avoid another sharp increase in the private-sector debt-to-GDP ratio,2 reasons that have solid grounding in both political and economic fundamentals and that become more pertinent if a trade deal between the U.S. and China is in fact negotiated. Still, Chinese policymakers, like those in any other country, will forcefully act to stabilize their economy (using whatever policy tools are required) if they conclude that conditions are about to deteriorate past the “point of no return”. Forecasting exactly when or whether this will occur is difficult, but both policymakers and investors will know more once the front-running effect on coincident activity wanes, and the true outlook for the external sector comes into view. For now, our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. We will be closely monitoring the incoming macro data in the first quarter of the year to judge whether it is consistent with our outlook. Key Theme # 2: Renewed Investor Scrutiny Of China’s Capital Controls Prior to the G20 summit, our expectation was that a break above the psychologically-important threshold of 7 for USD-CNY was imminent, likely in response to the escalation of the second round tariff rate to 25% on January 1. This catalyst has now clearly been deferred for the next three months, at least. However, Chart 6 shows that a resumption in the trade war is not the only source of potential weakness in the RMB. The chart illustrates the tight link between USD-CNY and the short-term interest rate differential between China and the U.S., and that the latter fell sharply in advance of the collapse in the former. Chart 6Interest Rate Differentials And USD-CNY: A Tight Link The true nature of the relationship between the two variables shown in Chart 6 remains a source of debate within BCA, as classic, open-economy interest rate arbitrage (the dynamic that enables currency carry trades) does not apply to countries that have officially closed capital accounts. But to the extent that the relationship holds over the coming year, Fed rate hikes alone have the potential for USD-CNY to rise above 7, as it would imply that the 1-year swap rate spread between the two countries will fall to zero (assuming no change in Chinese monetary policy). Regardless of the catalyst, renewed weakness in China's currency has the potential to rekindle (and reinforce) the narrative of capital flight that was last present following the August 2015 devaluation of the RMB. Global investor scrutiny of China's capital controls is likely to intensify significantly in such a scenario, and could contribute to negative investor sentiment towards China. As we noted in a September Weekly Report,3 several measures suggest that the capital flow crackdown that China initiated following the severe outflow pressures in 2015 and early-2016 has been successful. However, some other proxies of capital flight show persistent outflow since 2015 (Chart 7), with at least one measure having deteriorated rather significantly over the past few months. Chart 7Some Proxies Of Capital Flight Suggest Persistent Outflow Since 2015 Compiling an exhaustive inventory of different capital flow metrics (and their reliability) is part of our ongoing research efforts, and we hope to publish a Special Report on the topic early in 2019. For now, investors should be alert to any signs suggesting that a capital outflow narrative is becoming more prominent, as it is likely to have broader implications for financial markets than just the bilateral exchange rate. Key Theme # 3: Timing When (And Whether) To Go Long Chinese Stocks On A Cyclical Basis Many global investors are strongly focused on the question of when to go outright long Chinese stocks (either the domestic or investable market), on the basis of a substantial improvement in valuation, deeply oversold technical conditions, expectations of further action from policymakers, and a belief that the trade war with the U.S. will soon be resolved. This weekend’s agreement between the U.S. and China still does not make a trade deal probable,4 but we acknowledge that the odds have increased. This, coupled with the fact that Chinese stocks are still roughly 25% below their January high (Chart 8), suggests that a near-term sentiment-driven rally is possible. Over a 3-month time horizon, a tactical overweight stance towards Chinese stocks (either the domestic or investable market) within a global equity portfolio is probably warranted. Chart 8A Sentiment-Driven Rally Over The Next 3 Months Is Possible However, several points suggest that a long cyclical position (i.e. over a 6-12 month period) is currently pre-mature: We noted above that the Chinese economy is set to decelerate further over the coming several months, suggesting that earnings uncertainty is likely to rise. This, in combination with reactive policymakers, already-slowing earnings momentum, and the fact that 12-month forward earnings have only just started to be adjusted downward (Chart 9), suggests that investors have not yet observed the true point of maximum bearishness for Chinese stock prices. Chart 9The Earnings-Adjustment Process Is Only Beginning The 2014-2016 episode shows that China-related financial assets rallied prematurely in advance of a durable and broad-based improvement in the Chinese macro data, and the belief on the part of investors that a short-term rebound in Chinese stock prices over the coming 3 months is the beginning of a sustained upleg could be a repeat of this mistake. Chart 10 shows our BCA Market-Based China Growth Indicator compared with our Li Keqiang Leading Indicator, and shows that Chinese-related financial assets clearly jumped the gun in the first-half of 2015, and then lagged the improvement in the leading indicator. In the case of 2015, it was the August devaluation in the RMB that caused a severe deterioration in investor sentiment towards China; in the first-half of 2019, a failed attempt at a trade deal coupled with a further slowdown in domestic activity may do the same. Chart 10A Near-Term Rally Will Likely Fizzle, Like In 2015 While a near-term rally in CNY-USD may occur, the currency may come under renewed pressure if the interest rate differential effect shown in Chart 6 becomes the dominant driver of the exchange rate. For global investors managing their equity portfolios in unhedged terms, further declines in the RMB will negatively impact U.S. dollar performance. Finally, Chart 11 shows that, based on a trailing earnings and cash flow basis, the investable market is not as cheap relative to the global benchmark as it was in early-2016, casting some doubt on valuation as a rally catalyst. Undoubtedly, part of this discrepancy reflects the substantial rise in the BAT stocks (Baidu, Alibaba, Tencent) as a share of investable market capitalization, which are priced at a premium but also viewed by many investors as largely immune to a slowdown in China’s old economy. But the fact that the trade war largely reflects the decision of the Trump administration to crack down on Chinese technology transfer and intellectual property theft suggests that the market share of these companies could be negatively impacted by any successful trade deal, implying that a higher risk premium for the tech sector is warranted today than in the past. Chart 11Investable Stocks Aren't Massively Cheap We do not rule out the possibility that conditions will justify shifting to an overweight cyclical stance (6-12 month time horizon) for Chinese stocks sometime in 2019, particularly if money & credit growth begin to pick up. But for now, this is something that remains on our watch list for next year, rather than a recommendation to act on today. Key Theme # 4: Onshore Corporate Bonds – Position For Positive Default Surprises Our fourth theme for 2019 is a highly contrarian view that is, to some, at odds with our pessimistic view of the Chinese economy. BCA’s China Investment Strategy service has maintained a long China onshore corporate bond trade since June 2017, and we continue to recommend a diversified portfolio of these bonds for domestic investors and qualified global investors in hedged currency terms. The fear of sharply rising defaults stemming from refocused efforts to reform China’s financial system is the basis for the predominantly bearish outlook for onshore corporate bonds. The value of defaulted bonds reportedly rose to 100 Bn RMB in 2018, a sharp increase (of approximately 70 Bn RMB) from 2017,5 and many market participants have argued that defaults will be even higher next year. We do not dispute that China’s onshore corporate bond default rate is rising, and it is certainly possible that the rate will be even higher in 2019. To us, the problem with the bearish corporate bond narrative is that 100 Bn RMB amounts to a default rate of approximately 0.4%, whereas investors are pricing the onshore market for a 4-5% default rate over the coming year (Chart 12). In other words, domestic investors appear to be expecting over a tenfold increase in corporate defaults over the coming 12 months from what occurred this year, a scenario that we believe is extremely unlikely. Chart 12Allowing Market-Implied Default Rates To Occur Would Be A Huge Policy Error 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 a domestic economic slowdown. 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 4-5% over a year in any economic environment, particularly the current one. We therefore do not see a long recommendation favoring Chinese corporate bonds as being at odds with a slowing economy, because spreads are more than pricing in what is likely to be a modest worsening in corporate defaults. In short, defaults will rise, but will likely positively surprise investors. As a final point, our positive view towards the onshore corporate bond market should not be taken as a positive sign for the offshore US$ market. BCA’s Emerging Market Strategy service has recently reiterated its recommendation to position defensively within EM US$ sovereign and corporate bonds,6 and China accounts for roughly 1/3rd of the latter. Chart 13 highlights the difference in spread between the onshore and offshore market, the latter proxied by the Bloomberg Barclays China Corporate & Quasi-Sovereign index. The chart shows that the onshore market substantially led the offshore market in terms of pricing in a deterioration in credit fundamentals, with the latter only now starting to catch up to the former. As such, we have a clear preference for the onshore market, and would not argue against a bearish offshore corporate bond view. Chart 13Onshore Corporate Bonds Offer More Compelling Value Than Those Offshore Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see BCA Special Report "Outlook 2019 Late-Cycle Turbulence," published on November 27, 2018. Available at cis.bcaresearch.com. 2 Pease see Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus?,” published August 15, 2018; Geopolitical Strategy/China Investment Strategy Special Report “China: How Stimulating Is The Stimulus? Part Two," published August 15, 2018; and China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” published August 29, 2018. All available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Weekly Report “Moderate Releveraging And Currency Stability: An Impossible Dream?," published on September 5, 2018, available at cis.bcaresearch.com. 4 Pease see Geopolitical Strategy Weekly Report “Trade Truce: Narrative Vs. Structural Shift?,” published December 3, 2018, available at gps.bcaresearch.com. 5 Please see “China Bond Defaults Surpass 100 Billion Yuan For 1st Time”, Bloomberg News, November 29, 2018. 6 Pease see Emerging Markets Strategy/Global Fixed Income Strategy Special Report “EM Corporate Health And Credit Spreads,” published November 22, 2018, available at gfis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations
Highlights So What? The U.S.-China tariff ceasefire is a net positive, but a final deal is by no means assured. Why? In the near term there may be a play on global risk assets, but beyond that we remain cautious. Global divergence remains the key theme, and China now has less reason to stimulate. What to watch for a final deal: Trump’s approval rating, China’s structural concessions, and geopolitical tensions. We recommend booking gains on our long DM / short EM trades. Go long EM oil producers on OPEC 2.0 cuts. Feature U.S. President Donald Trump and Chinese President Xi Jinping have agreed to a trade truce at the G20 summit in Buenos Aires. The deal includes: Tariff Ceasefire: A 90-day ceasefire – until March 1 – on hiking the second-round tariffs from 10% to 25% on $200bn of Chinese imports. Substantive Talks: The talks will center on structural changes to the Chinese economy, including forced tech transfer, IP theft, hacking, and non-tariff barriers. Vice-Premier Liu He, Xi Jinping’s key economics and trade advisor, may visit Washington in mid-December. Imports: China has agreed to import more goods to lower the U.S. trade deficit, including agricultural and capital goods. This harkens back to the failed May 20 “beef and Boeings” deal. As with the previous deal, there are no deadlines or quantities promised. Not included in the two-and-a-half-hour dinner between Trump and Xi was a substantive discussion on geopolitical tensions. While Chinese statements following the summit did reaffirm Chinese commitment to the U.S.-North Korean diplomacy, there was no broader agreement on tensions, particularly in the South China Sea. The U.S. has recently demanded that China demilitarize the area. Should investors “play” the summit? Tactically, there is an opportunity to play global risk assets in the near term. Cyclically and structurally, however, both economic fundamentals and the underlying trajectory of U.S.-China relations call for caution over the course of 2019. Will The Truce Hold? There are five reasons to doubt the sustainability of the truce: Trade imbalance: It is highly unlikely that the trade imbalance between China and the U.S. can be substantively altered over the course of 90 days. The U.S. economy is in “rude health,” the USD is strong, unemployment is low and pushing up wages, and the output gap is closed. These are the macroeconomic conditions normally associated with an elevated trade imbalance (Chart 1). Chart 1Trade Deficit To Rise Despite Tariffs Domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues throughout the election season, but not on the issue of his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair, unlike trade with other countries (Chart 2). As such, President Trump will have to produce a convincing deal in order to ensure that his base, and many Democrats, support the deal. Chart 2Americans Are Focused On China As Unfair Structural tensions: U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the G20 summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.1 The report was an update to the original investigation that launched the Section 301 tariffs against China. Lighthizer’s report therefore provides a road-map for what the U.S. will want to see over the course of 90 days. High-tech transfers: The Department of Commerce announced on November 19 a “Review of Controls for Certain Emerging Technologies.” This review will conclude on December 19 when the public comment period ends. In the report, the federal government lists biotech, AI, genetic computation, microprocessors, data analytics, quantum computing, logistics, 3D printing, robotics, hypersonic propulsion, advanced materials, and advanced surveillance as technologies with potential “dual-use” that may be critical to U.S. national security and thus might merit consideration for export control.2 As such, the U.S. may decide to impose export controls on technologies that China deems critical to accomplishing its “Made in China 2025” goals within the period of the 90 day talks. If those export controls were to include critical items – such as semiconductors, which are critical to China’s export-oriented manufacturing (Chart 3) – negotiations may become more complicated. Geopolitics: The trade truce did not contain any substantive resolution to ongoing strategic tensions between the U.S. and China. These tensions precede President Trump: we have detailed them in these pages since 2012.3 As such, the U.S. defense and intelligence community will have to be on board with any trade deal and that may suggest that Beijing will be asked to make geopolitical concessions over the course of the next 90 days. Chart 3China Accounts For 60% Of Global Semiconductor Demand Despite the above, the trade truce is a meaningful and substantive move away from an open trade war. Yes, the U.S. will retain tariffs on $250bn Chinese imports, with China maintaining tariffs on $66bn of U.S. imports (Chart 4). No, the U.S. did not rule out a third round of tariffs covering the remaining $267 billion of Chinese imports, if things go awry. Nevertheless, the 90-day truce implies that the U.S. will not ratchet up the tensions for now. Chart 4U.S.-China Trade Hit By Tariffs The truce also allows China to make substantive changes to its domestic economic policies that may satisfy some of the structural concerns cited in the above U.S. Trade Representative report. The soundest basis for a durable deal lies in China recommitting to structural reforms: this would both be positive for China’s productivity and would assuage some of Washington’s underlying anxieties about China’s state-backed industrial policies. Significantly, China’s Ministry of Foreign Affairs now says that it will “gradually resolve the legitimate concerns of the U.S. in the process of advancing a new round of reform and opening up in China.” When would this new round of reform occur? The upcoming Central Economic Work Conference, and the 40th anniversary of Deng Xiaoping’s reforms, should be watched closely for new initiatives. Also, the new March 1 tariff deadline lines up with the calendar for China’s National People’s Congress (NPC). The NPC meets every year and is the occasion when any major new domestic reforms would need to be laid out. Thus, any Chinese compromises on structural issues could be rolled out as part of a more general reform agenda in March. This is important because the U.S. administration is determined to focus on implementation and not to let China delay resolution of differences through endless rounds of dialogue. As such, investors should watch the following issues over the course of the next three months in order to gauge the likelihood of a substantive deal that not only rules out new tariffs but also rolls back the existing ones: Polls: President Trump is focused on his 2020 reelection. As such, he will want to see political gains from the easing of pressure on China, both in the general populace and amongst his GOP base (Chart 5). A slump in the polls, or a threatening turn in the Mueller investigation, may justify a shift in the narrative come March-April and thus end the truce. Chart 5Trump’s Approval Will Affect Trade Talks Big ticket announcements: China is going to have to make big-ticket item purchases. A huge order of Boeing airplanes, a massive ramp-up in the purchase of agricultural products, a raft of direct investments in manufacturing in the heartland … these are the type of announcements that President Trump could use to sell a substantive deal to his base. Structural changes to the Chinese economy: China will have to prove that it is addressing the concerns outlined in the U.S. Trade Representative report. We suspect that Lighthizer issued the report ahead of the G20 summit so as to set the benchmark for what the U.S. wants to see from Beijing. It is a high benchmark as it includes: An end to cyber theft, hacking, and corporate espionage; Substantive, rather than merely “incremental,” improvements to U.S. market access, including increased ownership of ventures; Serious changes to state-subsidized industrial programs that utilize stolen technology, particularly the so-called “Strategic Emerging Industries” program and “Made in China 2025”; An end to China’s state-backed investment campaign in Silicon Valley. No new U.S. embargoes: The public comment period for the newly proposed U.S. export controls ends on December 19. That suggests that high-tech restrictions could emerge over the course of the first quarter of 2019. These could exacerbate tensions. No new geopolitical tensions: Geopolitical tensions, such as over human rights in Xinjiang or the militarization of the South China Sea, would obviously make a deal less likely. Bottom Line: The trade truce could lead to a substantive trade deal between China and the U.S. However, many impediments remain. Investors have to answer three key questions: is the deal politically useful for President Trump ahead of the 2020 election? Does the deal resolve the concerns laid out in the U.S. Trade Representative’s Section 301 report? And will geopolitical and national security tensions ease? Since 2012, we have had a structurally bearish view of the Sino-American relationship. This view is based on long-term structural factors that we do not think can be resolved over the course of 90 days. That said, every structural view can have cyclical deviations. The question we now turn to is how to play such a cyclical deviation in terms of the markets. What Does The Truce Mean For The Markets? In our view, the trade war has been of secondary importance to global markets. Far more relevant to the BCA House View that DM assets will outperform EM has been our conclusion that U.S. and Chinese economies would experience policy divergence. The U.S. economy has been buoyed by pro-cyclical stimulus, whereas Chinese policymakers have created a macro-prudential framework that has impaired the country’s credit channel. This divergence has led to the outperformance of the U.S. economy over the rest of the world, leading to a substantive USD rally (Chart 6). Chart 6U.S. Outperformance Should Be Bullish USD While this view has worked out well in 2018, it appears to be fraying as the year comes to the end: Chart 7U.S. Growth Weakening? Fed dovishness: Our recent travels to Asia, the Middle East, Europe, and the Midwest have revealed unease among investors regarding the health of the U.S. economy. Some recent data, such as the woeful core durable goods orders (Chart 7) and weak housing, have prompted calls for a more dovish Fed. On cue, Fed Chair Jay Powell delivered what was perceived as a dovish speech. BCA’s Chief Global Strategist, Peter Berezin, makes a strong case for why investors should fade the enthusiasm.4 Specifically, Peter thinks that investors are focusing too much on the unknown – the neutral rate – and not enough on the known – the budding inflationary pressures (Chart 8). Nonetheless, in the near-term, the narrative of a “Fed pause” may overwhelm the data. Chart 8Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Chinese stimulus: Evidence of a broad-based, irrigation-style, credit stimulus is scant in China’s data. Nonetheless, many investors we have met on the road are latching on to higher local government bond issuance (Chart 9) and a positive M2 credit impulse (Chart 10). Moreover, Q1 almost always brings a boost in new lending in China. Our colleague Dhaval Joshi, BCA’s Chief European Strategist, has recently pointed out that the global credit impulse has hooked up, suggesting that EM underperformance is over (Chart 11).5 We do not think that China can turn the corner on a slumping economy without a substantive increase in its total social financing, which remains subdued both in growth terms and as a second derivative (Chart 12). However, we concede that the narrative may have shifted sufficiently in the near term to warrant some tactical caution on our cyclical House View. Chart 10China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM Trade truce: Trade concerns have had a clear impact on the outperformance of U.S. equities relative to the rest of the world (Chart 13). As such, a trade truce may alter the narrative sufficiently in the near term to change the direction. In this report, we cite why we are cautious regarding the truce leading to a substantive deal. However, we are biased by our structural perspective that Sino-American tensions are unavoidable. The vast majority of our clients and global investors does not share this view. In fact, the trade war has caught the investment community by surprise. As such, we would argue that investors are biased towards a “win-win” scenario. Therefore, investors may not be cautious, but may in fact project a much higher probability of a final deal into their market decisions. Chart 12China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War Over the course of 2019, we do not think the global risk asset bullishness is sustainable. In fact, a reprieve rally now is going to make global growth resynchronization less likely and continued policy divergence more likely. Why? First, Chinese policymakers will have less of a reason to deploy an irrigation-style credit stimulus if fears of an accelerated trade war abate. Second, the Fed will have less of a reason to back off from its hiking trajectory if both the DXY rally and equity market volatility ease. That said, we are going to close our long DM / short EM trades for the time being. This includes: Our long DM equities / short EM equities, for a gain of 15.70%; Our long U.S. Dollar (DXY) index for a gain of 0.56%; Our long USD / Short EM currency basket for a loss of 0.76%; Our long JPY/GBP call, for a gain of 0.32%. Our hedge of being long China play index ought to outperform on a tactical horizon, so we are leaving it open despite its paltry return so far of 0.32%. Also, we are keeping our long Chinese equities ex. Tech / short EM equities trade, as Chinese assets should rally on the back of the truce. Note that, as outlined above, China’s tech sector is not out of the woods yet. Our decision to close these recommendations is to preserve profits, not change our investment stance. On a cyclical horizon, we remain skeptical that global risk assets will outperform DM, and U.S. assets in particular, over the course of 2019. In the end, we do not believe that a mere narrative shift will be sustainable, especially given the robustness of the U.S. labor market (Chart 14) and the tepidness of Chinese stimulus (Chart 15). Chart 14A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Finally, a word on oil prices. The G20 was crucial for the oil call, as well as the trade war, given that Saudi Arabia and Russia suggested that their OPEC 2.0 union would produce supply cuts at the upcoming Vienna meeting on December 6. This proves that fundamentals were more important than the narrative that Saudi leadership “owed” a favor to President Trump. In particular, the Saudis have fiscal constraints given their budget breakeven oil price is around $80-$85 per barrel. As such, we are reinitiating our long EM energy producers (ex-Russia) / short broad EM (ex-China) equity call. We are excluding Russia from the “long” due to lingering geopolitical concerns – sanctions and Ukraine – and China from the “short,” as we are now tactically bullish on China. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 2 Please see The Federal Register, “Review of Controls for Certain Emerging Technologies,” dated November 19, 2018, available at www.federalregister.gov. 3 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?,” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?,” dated March 28, 2017, available at gps.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018, available at gis.bcaresearch.com. 5 Please see European Investment Strategy Weekly Report, “DM Versus EM, And Two European Psychodramas,” dated November 22, 2018, available at eis.bcaresearch.com.
China’s strong October trade data (released earlier this month) likely frustrated investors, as it revealed that market participants will have to wait for clarity on the magnitude and duration of the upcoming shock to exports. The strong October trade data…
Highlights The October credit and housing market data present a gloomy picture for Chinese domestic demand. Trade remains buoyant, but exports are set to decline materially over the coming months. Many investors are focused too much on external demand and not enough on Chinese domestic demand. China's old economy has been deteriorating for two years, and it is unlikely that exchange rate depreciation alone will reverse this trend. A review of the drivers of credit growth during China's last mini-cycle upswing underscore that the country's monetary transmission mechanism is impaired. This suggests that investors are exposed to fiscal and regulatory policy inertia, as well as time lags once policymakers decide to aggressively stimulate. Chinese stocks may present an excellent buying opportunity over the coming year, but that point has not yet been reached. Stay neutral for now. Feature China's October trade data (released earlier this month) was a frustrating one for investors, as it revealed that market participants will have to wait even further for clarity on the magnitude and duration of the upcoming shock to exports. The strong October trade data has even led to some market participants questioning whether export growth will decelerate at all, a view that we strongly disagree with. It is true that there is no direct reason to expect that the impact of U.S. import tariffs will affect China's non-U.S. exports. But Chart 1 shows that Chinese exports to the U.S. are currently running above the pace that would be predicted by the overall trend in U.S. non-oil imports, a circumstance that is highly unlikely to continue in the face of mutual tariff imposition. Negative export "alpha" would imply a growth rate materially below the dotted line in Chart 1. As such, even though Chinese exports to the U.S. account for only 20% of total exports, the impact of an eventual "reversion to fundamentals" is likely to substantially effect the overall trend in Chinese export growth. Chart 1Export Frontrunning To The U.S. Continues Given the integrated nature of global trade, persistently strong export growth is also very likely supporting imports. Chart 2 shows that import growth has been closely correlated with domestic industrial activity since 2010, but is now running approximately 10-12 % above would normally be expected. This implies that China's overall trade momentum will weaken considerably over the coming months, which is likely to reverberate through key trade linkages in emerging markets and commodity-producing developed markets. Chart 2Current Import Growth Appears Unsustainable October's credit data was also highly significant, as it validated the view that we espoused in our recent report.1 We noted in response to the September credit release that a surge in the 3-month rate of change of adjusted total social financing (TSF) was driven by front-loaded fiscal spending that would not last. Chart 3 shows that special local government bond issuance in October fell by 650 bn RMB relative to the prior month, suggesting that (net) new fiscal stimulus will be required in order for local government bond issuance to materially boost overall credit growth. Chart 3September Was Not The Start Of A New Trend In LG Bond Issuance Finally last week's housing data release highlighted that residential sales and construction momentum is faltering (Chart 4), which was likely triggered in part by prior reductions in the PBOC's pledged supplementary lending (PSL) program. We noted in a September Special Report that the pullback in the PSL would negatively impact the housing market on a cyclical basis,2 and October's data certainly supports this view. Chart 4The Housing Market Slowed In October Don't Pin Any Hopes On A Trade "Ceasefire" Against this gloomy economic backdrop market participants have actually been incrementally positive about China over the past few weeks, in anticipation of a possible détente with the U.S. Last week's flurry of optimism about an apparently meaningful resumption in trade talks were somewhat diminished by comments from President Xi and Vice President Pence at the APEC summit over the weekend, but our geopolitical strategists believe that the odds of a short-term "tariff ceasefire" occurring at the G20 summit later this month are genuinely non-trivial (possibly as high as 30-40%). We define a "ceasefire" in this case as a commitment to refrain from any further protectionist action during a renewed period of negotiations, not an immediate and substantive deal that ends the trade war. We agree that any positive actions on the trade front are likely to lead to a short-term boost to Chinese stock prices (and global risk assets more generally). But the key question for investors is whether this will lead to a durable rally lasting several months. In our opinion, three factors argue against this view: A ceasefire probably will not lead to an agreement: There is no indication that either the U.S. or China has changed their positions concerning the dispute, with China reportedly having simply restated their previous offer in advance of the G20 summit. On the U.S. side, attempts to restart negotiations may reflect the desire to give China "one last chance" before moving to impose tariffs on all Chinese imports, which the administration may be planning as a rhetorical counter to any domestic pushback from rising consumer goods prices (the "Walmart effect"). A ceasefire will not roll back tariffs already in place: It is unlikely that the U.S. would impose tariffs on all remaining imports from China (the "third round") while negotiations are taking place. But a near-term shock to Chinese exports is still likely, because the existing tariffs on the first and second round would not be rolled back until a deal is successfully negotiated. It is even possible (albeit unlikely) that the administration will move ahead with the planned increase in the second round tariff to 25% at the end of the year despite the presence of negotiations. A ceasefire alone will not reverse the ongoing slowdown in Chinese domestic demand: The trade war between the U.S. and China is occurring against a backdrop of weaker Chinese domestic demand, a point that we have highlighted numerous times over the past year. As shown in Chart 2 above, the growth momentum of China's old economy peaked well before the trade war began, and a temporary "stay of execution" on the trade front is unlikely to change the downtrend in domestic activity. This last point is important, as it appears that many global investors are focused almost exclusively on China's negative external demand outlook and not nearly enough on weak domestic demand. Chart 5 vividly illustrates this point, by contrasting our new Market-Based China Growth Indicator with our leading indicator for the Li Keqiang Index. Our market-based China Growth Indicator is very similar to the highly informative China Play Index created by BCA's Foreign Exchange Strategy service to hedge against a possible countertrend correction in the U.S. dollar,3 but it is somewhat broader, has four asset class subcomponents, and has been built on a deviation from trend basis (see Box 1 for a description). Chart 5The Market Has Lagged The Macro Data Over The Past Three Years Box 1 Introducing The BCA Market-Based China Growth Indicator Chart A1 presents the BCA Market-Based China Growth Indicator, along with its four asset class subcomponents: currencies, commodities, equities, and rates/fixed-income. The purpose of the indicator is to act as a broad proxy of investor expectations for Chinese growth, and to illustrate which asset classes are providing the strongest/weakest growth signals. Chart A1Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Table A1 presents a list of the series included in each of the asset class subcomponents, all of which were tested to ensure that they were coincident or lead the Bloomberg Li Keqiang index. The indicator is made up of an equally-weighted average of the four asset class subcomponents, and each series is equally-weighted within its respective subcomponent (meaning that the 17 series do not have equal weights in the overall indicator). Table A1Components Of The BCA Market-Based China Growth Indicator Chart A1 highlights that the commodity and equity subcomponents are currently providing the most positive signals, whereas the currency component is in line with the overall indicator. The rates component, which provided the earliest warning sign this cycle that Chinese growth was likely to decelerate, remains the weakest element of the indicator and has not been rising over the past few weeks (in contrast to the other components). The chart shows that price signals from China-related assets generally followed or even anticipated our LKI leading indicator prior to 2015, but that the reverse has been true over the past three years. The gap between the two indicators became extreme earlier in the year, and only closed once investors began to react to the emergence of the trade war. But the key point from the chart is that trade is not China's only problem, as our LKI leading indicator shows that Chinese monetary conditions, money, and credit growth have been deteriorating for the better part of the past two years. Monetary Policy: Pushing On A String? One bullish China narrative that currently prevails in the marketplace is that the odds of "big bang" stimulus rise materially in lockstep with any further deterioration in the macro data. Most recently, several China analysts have speculated that the PBOC will soon cut its benchmark policy rate, which would be an unmistakable sign that the monetary policy dial has been turned towards "maximum reflation". Ultimately, we agree with the view that investors hold a put option issued by the Chinese government, but we have strenuously argued that the strike price is considerably lower than many think. On top of this, investors face another risk, namely a circumstance where the exercise price of the China put is even lower than the government intends it to be. This situation could arise if the PBOC decides to fire its bazooka, but the resulting decline in interest rates does not materially boost credit growth. Such a scenario prevailed in the U.S. several years following the global financial crisis, when many investors characterized the Fed's efforts to boost (or at least stabilize) credit growth as "pushing on a string". Chart 6 illustrates that this actually occurred in China during its last mini-cycle upswing, raising the odds of a repeat incident that results in a meaningful lag between the approval of big bang stimulus and its reflationary effect on financial markets. The chart shows the annual change in total social financing as a share of 4-quarter trailing GDP, including and excluding local government bond issuance (both measures exclude equity financing). Chart 6No Major Acceleration In "Standard" Credit Growth In 2015-2016... While adjusted TSF excluding local government bonds technically accelerated as a share of GDP from 2015 to late last year, the rise was tepid at best (in contrast to the 2012/2013 episode). It is clear from the chart that most of the acceleration in overall credit during the 2015/2016 period came from a surge in local government bond issuance, not from "standard" credit. This is an important observation, given that interest rates declined significantly over the period (Chart 7). Chart 7...Despite A Substantial Easing In Monetary Policy From a theoretical perspective, an atypical divergence between interest rates and credit growth can occur either because of abnormal loan demand or loan supply. Chart 8 suggests that it was the latter in China in 2015/2016: loan demand reportedly rose for small/micro, medium, and large enterprises (particularly among small/micro), but the trend in loan approval barely budged (unlike in 2011/2012 when it rebounded sharply). In short, Chart 8 provides support for the view that Chinese banks did not meaningfully ease lending standards during the 2015/2016 episode, despite a substantial easing in monetary policy and (ultimately) a substantial improvement in economic conditions. Chart 8Loan Demand Responded To Lower Rates, But Lending Standards Did Not Chart 9 highlights that this almost certainly occurred because of a sharp deterioration in reported bank asset quality that began in 2014. The chart shows that both the non-performing loan and special mention loan ratios rose significantly during this period, the sum of which has only modestly declined. We highlighted the potential for NPL recognition to weigh on credit growth in our two-part joint Special Report with BCA's Geopolitical Strategy service,4 as long as the ongoing financial regulatory crackdown is even half-heartedly implemented. While Chart 8 shows that loan approval modestly ticked higher in Q3, it provides no evidence of stealth easing in financial regulation. Chart 9Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality The key conclusion for investors from these observations is as follows: while China can certainly decide to stimulate aggressively in response to too-weak economic conditions, an impaired monetary transmission mechanism implies that there may be a lag, possibly a substantial one, between the decision to stimulate and its reflationary impact on financial markets. This is of crucial importance to investors aiming to maximize risk-adjusted returns over a 6-12 month time horizon, and weighs heavily on our recommendations. Investment Strategy Recommendations Chart 10 shows our Li Keqiang leading indicator within its component range, a chart that remains at the core of our efforts to predict China's business cycle. The indicator has been built in such a way that a decision of policymakers to push for more local government bond issuance (like in 2015/2016), or an improvement in the efficacy of China's monetary transmission mechanism, are likely to be captured by one or more of its components. Chart 10Only A Narrow Pickup In Our LKI Leading Indicator As we noted in our November 7 Weekly Report,5 the rise in the indicator has been driven by its two monetary conditions components, which have in turn mostly been driven by the substantial weakness in the RMB over the past four months. Given that the ultimate impact of the U.S. tariffs on Chinese exports remains obscured by trade frontrunning, it is unclear if China's exchange rate depreciation will be sufficiently reflationary even to counter the upcoming export shock, let alone reverse the ongoing domestic demand slowdown. As a result, investors should be closely watching for signs of a pickup in money & credit growth, which for now remain absent. Put differently, macrofundamental support for the equity market is lacking. Despite this, Chart 11 highlights that both Chinese A-shares and the investable market are deeply oversold, which in combination with expectations of further monetary stimulus and the potential for a tariff ceasefire have many investors chafing at the bit to go long either market (or both!) over a 6-12 month time horizon. Chart 11Chinese Stocks Are Quite Oversold... Our advice is simply to wait. A trade ceasefire is unlikely to generate more than a short-term boost to stock prices, and our indicators provide the best bet to monitor whether an impaired banking system is responding to any further easing in monetary policy. Finally, while we agree that stocks have priced in a meaningful decline in earnings, that earnings adjustment process has yet to even begin. Chart 12 illustrates the point where Chinese stocks bottomed in relation to the last major decline in earnings, suggesting that stocks need both a valuation discount and earnings clarity before putting in a durable bottom. The latter is missing and may stay missing for several months, highlighting that an outright long position remains premature. Stay tuned! Chart 12...But We Have Yet To Even Begin The Earnings Adjustment Process Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see China Investment Strategy Weekly Report "Is China Making A Policy Mistake?", dated October 31, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Reports "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 3 Pease see BCA Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com. 4 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Checking In On The Data", dated November 7, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations