Trade / BOP
Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession Chart 8Protectionist Measures ##br##Are On The Rise Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades
Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Trump's election victory means that there is potential for policy settings to flip from "easy money, tight fiscal" to "tight money, easy fiscal" The market implications of that shift are dollar bullish, bond bearish and equity mixed. The major risk is that violent currency and bond market moves rekindle emerging market stress and/or choke off the recovery before fiscal spending kicks in. Trump's trade reform risks being a tax on growth. Businesses may opt to automate instead of hire. A variety of factors now make small caps appealing relative to large caps. Feature Contrary to the pre-election consensus, Donald Trump's election victory has prompted a risk-on rally, based on the notion that Trump's vision of fiscal largesse will be realized (Chart 1). Ultimately, it will only become clear what policy changes are on the table once Trump takes office in January. The consensus at BCA is that Trump will be "unbound" in his first two years as President. Thus, if Trump lives up to his campaign promises, fiscal stimulus and trade restriction will be tabled early in 2017. Chart 1Trump Moves As we argue below, trade restrictions should be viewed as a tax on growth. We have doubts about the link between job creation and tariffs. If anything, imposing tariffs on imports could incite a more intense wave of automation. After all, the cost of capital is still attractive relative to labor costs. Meanwhile, fiscal spending - if delivered even close to the size and scope that Trump has hinted at in his pre-election speeches - will boost GDP growth well above trend in 2017. If that occurs, the dynamic that has existed since 2010, i.e. "tight fiscal, exceptionally easy money policy" will rapidly flip to "easy fiscal, tight money". For the bond market and the U.S. dollar, the investment implications are clear: Treasuries are likely to head higher, and the pressure will be for the U.S. dollar to rise. Implications for equities are less certain. If the U.S. dollar rises, it might rekindle emerging world financial stress and undermine U.S. corporate profits. The rapid rise in yields may not easily be digested by the equity market and it is notable that corporate spreads have not rallied along with other risk assets in recent days. We are comfortable maintaining a defensive stance. Donald Trump said a lot of things to a lot of people during the campaign process. He can't possibly deliver on all of his promises, but earlier this week, BCA sent out a Special Report to all clients, outlining the implications of the election results and what we expect he can accomplish.1 We believe there are three that are especially important for investors to monitor: the potential for trade restrictions, gauging fiscal stimulus and monetary policy settings in this possibly new environment. Stagflation? Trump has repeatedly signaled his intention to restrict American openness to international trade and the U.S. president can revoke international treaties solely on their own authority. Trump can also impose tariffs. All of this is of course inflationary, and it's the nasty kind. We have repeatedly written in this publication that, historically, the U.S. economy only falls into recessions for two reasons. The first is growth-restrictive monetary policy and the second is an adverse supply shock that acts like a tax on growth, e.g. an oil price spike. Tariffs are akin to the latter. Chart 2 shows that as import penetration rose over the past 30 years, tradeable goods price inflation steadily fell. A simple read of the chart suggests that with barriers in place and as import penetration recedes, the process of the past 30 years will reverse and consumer goods prices will rise. This can easily be absorbed if it is accompanied by rising wages via the "onshoring" of jobs. But that is not a foregone conclusion. Instead of bringing manufacturing jobs back to the U.S., a more logical decision might be for businesses to further automate production. After all, earlier studies have already concluded that nearly half of all existing jobs are at high risk of being automated over the next decade or so.2 As Chart 3 shows, with the price of capital equipment and software still falling and the cost of capital so low relative to the cost of labor, the incentive to automate instead of hire is high. Chart 2Trade And Inflation Chart 3Tariffs May Lead To Robots, Not Jobs The bottom line is that increased tariffs will increase prices in the near term. But it is hardly clear that this will improve the lives of voters or create a more virtuous economic recovery. Opening The Fiscal Taps... In last week's report, we explored the potential for fiscal spending to turbocharge the U.S. economy. We warned that fiscal multipliers are probably not overly high in the current environment and the effectiveness of fiscal spending is highly dependent on the type of fiscal stimulus. Trump has called for significantly lowering both income and corporate taxes, although his main pitch has been infrastructure spending. The latter tends to have the highest multiplier effects, but can often take a long time to get underway. However, one important point is that Trump will face little political restraint, at least in his first two years in office. Gridlock will not be a problem given that all three Houses are now in GOP hands. And it will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Over the past 28 years, each new president has generally succeeded in passing their signature items. Moreover, the GOP has historically not been that fiscally conservative. Overall, a Trump government will more than make up for the drag from weak state and local spending that we wrote about last week. Exactly how big of an impulse will only become clear once Trump takes office. ...And Tightening The Money Supply? Forecasts about the impact of fiscal spending on 2017 GDP growth are premature, since it is impossible to decipher an action plan from campaign rhetoric. And the severity of stagflation due to trade restrictions will be highly dependent on the form and scope of trade reform. Ergo, it is too early to make bold new assumptions about the path of Fed rate hikes. An aggressive fiscal plan that boosts GDP well above trend growth would force policymakers to revise their expected path of rate hikes higher. That would be a sea change from the past four years, when policymakers have consistently revised the neutral rate down. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked Janet Yellen and current monetary policy settings. A review of the Fed may happen at some point, but we assert that investigating the Fed will not be a priority early in Trump's mandate. Market Action The bond market has already priced in more inflation and more growth for 2017 since Trump's victory. 10-year Treasury yields have surged to 2.15% and momentum selling could lift the 10-year Treasury yield even further into oversold territory. But that is not a case to become aggressively underweight duration. Dollar strength and rising bond yields have already tightened financial conditions significantly over the past several weeks. The risk is that these trends go too far in the near term, inflicting economic damage before fiscal spending kicks in. Given the easy monetary stance of central banks around the world, lack of significant fiscal stimulus elsewhere, economic growth outperformance in the U.S. and rising interest rates, the dollar should rise in the medium term. We remain dollar bulls. We have been surprised by the equity market action since November 8. Although we repeatedly wrote that a Trump victory was unlikely to have meaningful negative consequences for risk asset prices, we did not anticipate a rally. As for equities, our cautiousness toward risk assets in 2016 has been primarily focused on the ongoing headwinds for profits in a demand-deficient economy, especially while margins are falling and valuations are elevated (Chart 4). Greater fiscal spending would surely help to alleviate our concern, although that conclusion seems premature given the lack of contour to Trump's plans so far. Perhaps the greatest downside risk is a reaction from China. After all, Trump's anti-trade rhetoric has been pointed (mostly) at China and Asia. Recall that in August, 2015, the RMB was devalued just weeks ahead of an expected rate hike from the Fed. That devaluation sent shock waves through financial markets and ultimately delayed the Fed rate hike until the end of the year (Chart 5). A similar proactive policy move from Chinese policymakers should be on investors' radars. Overall, we remain comfortable with our cautious equity stance, albeit recent market action has created an entry point in favor of small relative to large cap stocks. Chart 4Equity Fundamentals Still Poor Chart 5China: Global Stability Risk? Enter Small Cap Bias We upgraded small caps relative to large caps to neutral in August. We now recommend investors make the full switch to a small cap bias relative to large caps. Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets; we believe this provides a good entry point to a cyclical uptrend in small cap performance (Chart 6). True, at first glance, advocating for small cap exposure appears inconsistent with our overall defensive equity strategy. After all, small cap outperformance tends to be associated with risk-on phases. However, small cap stocks have a variety of other characteristics that currently make them appealing relative to larger caps. Chart 6(Part I) Favor Small/Large Caps Chart 7(Part II) Favor Small/Large Caps Small cap companies tend to be more domestically focused. We expect that U.S. growth will continue to outpace growth overseas. And particularly important, small cap companies, with their domestic focus, are better insulated from dollar strength (Chart 7). Small cap weightings are no longer geared toward cyclical sectors. As part of our cautious strategy, we remain focused on defensive vs. cyclical sectors. There are no major differences between large and small cap defensive and cyclical sector weightings (Table 1). Trump corporate tax reform, if implemented, will favor small, domestic firms. Because major corporations already have low effective tax rates, any lowering of the marginal rate will benefit small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then this would diminish their current tax advantage vis-à-vis smaller companies. Table 1Similar Weightings For Small And Large Cap Cyclicals And Defensives Bottom Line: Small cap outperformance is typically associated with risk-on equity phases. However, valuations now favor small caps. Importantly, small caps are better insulated from dollar strength and are one way to play the domestic vs. global theme. Additionally, smaller firms will be the relative winners from corporate tax reform. Small caps are set to outperform large caps. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Geopolitical Strategy Special Report "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com 2 "The Future Of Employment: How Susceptible Are Jobs To Computerisation?" Carl Frey and Michael Osborne, September 2013. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process Chart 8. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical component of the equity model still has a "buy" signal, the breadth indicator has moved into less favorable territory relative to the momentum indicator. The monetary component has also slightly weakened but retains its positive bias for equities. The earnings-driven component continues to warrant caution as expectations for the outlook of corporate profits would need to be bolstered through stronger economic stronger growth over the medium term. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. Even so, despite that the "buy signals" of the cyclical and technical components of the bond model still persist, the preference for Treasuries has diminished to some extent. Nevertheless, the valuation component continues trending towards expensive territory and a "buy signal" remains in place Chart 9. Chart 8Portfolio Total Returns Chart 9Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.
BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall Chart I-12China Is The Giant In The Room The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals Chart I-14Better Supply/Demand Backdrop For Oil We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump Chart I-16European Labor Market##br## Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades