Trade / BOP

The fiscal spending impulse in China is still positive but receding. The nation's productivity and potential GDP growth are bound to decline due to a rising role of government in capital and resource allocation. Hence, cyclical stabilization could well be overwhelmed by a structural slowdown. Another bubble is forming in China, this time in the corporate bond market. The amelioration in Korean and Taiwanese exports is due to the technology sector/semiconductors, and does not reflect broad-based improvement in global trade.

The populist backlash, if left unchecked, could spiral out of control, leading to severe losses for investors. Concerns about lax financial regulation, rising inequality, unfettered globalization, and fiscal austerity are understandable. Addressing these grievances will hurt corporate profits short-term, but could lead to a more resilient economy longer-term. Investors should position for modestly higher inflation and steepening yield curves. Near-term, equities are technically overbought, but will benefit from the shift to more stimulative fiscal and monetary policies.

Brazilian risk assets have rallied on the back of investor optimism about the impeachment of President Dilma Rousseff. But the political games have just begun. With all politicians looking to the October municipal elections and 2018 general elections, the Michel Temer administration is unlikely to impose fiscal and structural reforms. Debt dynamics are set to worsen, and we continue to short Brazilian equities.

With 88 days to go until the U.S. presidential election our client meetings are starting to steer towards "all Trump, all the time." In this report we present evidence that Trump's electability is correlated with the chief global safe haven, the 10-year Treasury. Markets may be overreacting, however. Trump has a chance, but Clinton is the clear favorite. We also bust five myths about China's political system, in a continuation of our coverage of rising geopolitical risks in East Asia.

Highlights Just ahead of the attempted coup d'état in Turkey, the international press was largely complementary of the political situation in the country. For example, a Bloomberg headline read "Once Spurned, Turkey Stocks Find Love As Political Risk Ebbs" mere hours before the coup!1 Feature Politics Stay The Same: Not Good BCA's Geopolitical Strategy has challenged the sanguine narrative on Turkey since 2013.2 The ruling Justice and Development Party (AKP) - once a reformist beacon in emerging markets - has become a political vehicle for President Recep Erdogan's political power grab - Erdogan has been planning to turn Turkey into a presidential republic, giving himself more powers - since 2013. Protests erupted that year against the government, in large part due to growing suspicion among secular, and mainly urban, middle classes that Erdogan and his Islamist AKP were evolving the country towards soft authoritarianism. Since the protests in 2013, the country's politics have been off track: A vast corruption scandal ensnaring the ruling AKP, including Erdogan's family, erupted in late 2013, prompting then-Prime Minister Erdogan to blame the moderate Islamist Gülen movement and its allies in the judiciary; Erdogan won a closer-than-expected presidential election in 2014, becoming the first democratically-elected president in modern Turkish history, and immediately set out to award himself greater powers through constitutional reform; AKP then failed to win a majority in the June 2015 general election; The election was immediately followed by a manufactured anti-insurgency campaign against ethnic Kurds designed to reduce support for moderate pro-Kurdish parties and allow the AKP to win a majority in the next election; In November 2015, the AKP finally won a majority; Many reformist members of the AKP have since been sidelined, including Erdogan's predecessor as President Abdullah Gül, and his successor as Prime Minister Ahmet Davutoglu. Despite the political turbulence, markets have largely looked through the risks (Chart 1). And, this is not even including the geopolitical risks engulfing Turkey's neighbors, including the souring relations with Russia, Israel, and the EU, due to Ankara's role in the migration crisis. Investors have largely given Turkey the benefit of the doubt, despite Erdogan's penchant for heterodox monetary policy and lack of focus on structural reforms. The AKP - which swept into power in the early 2000s on an agenda of promoting democracy, moderate Islamist cultural values, and economic reforms - has essentially become completely focused on the single goal of enhancing Erdogan's power. The failed coup is a silver lining for Erdogan as it will allow him to accomplish what electoral politics could not (he has in fact referred to the coup as a "gift of God"). Thousands of military, law enforcement, and judicial professionals have been arrested since the uprising. It is very likely that Erdogan will use the event as a pretext to undermine whatever checks and balances still exist in the country. In addition, it would appear that relations between Turkey and the West are also set to sour. First, Erdogan has demanded that the U.S. extradite moderate cleric Fethullah Gülen, who Erdogan sees as a chief rival, despite the fact that Gülen has not lived in Turkey since 1999. Second, the government has arrested the Turkish commander in charge of the Incirlik Air Base, which hosts U.S. forces, grounding U.S. air operations against the Islamic State. Third, the EU could pull the plug on its deal with Turkey which would see Ankara limit the migrant flows into the bloc, which Turkey had agreed to in exchange for visa-free travel, progress in negotiations for EU membership, and EUR 3 billion. The deal was signed in March, well past the point at which the migrant flows to Europe peaked (Chart 2), which suggests that the deal may not be as relevant to stopping the flow of migrants as most pundits claim. The EU's post-coup statement emphasized support for democracy in Turkey, but also stopped short of backing Erdogan personally. Chart 1Investors Should Stay##br##Underweight Turkish Assets Investors Should Stay Underweight Turkish Assets Investors Should Stay Underweight Turkish Assets Chart 2Migrant Flows: No Longer##br##A Bargaining Chip For Turkey bca.ems_sr_2016_07_18_s1_c2 bca.ems_sr_2016_07_18_s1_c2 Bottom Line: Investors who hoped that the November election would resolve political intrigue in Turkey and focus Ankara on structural reforms will be disappointed. The coup gives Erdogan the excuse to use extra-judicial methods to grab as much power as he can and to concentrate on rooting out enemies in the judiciary and the armed forces. Economic And Financial Headwinds While President Erdogan will consolidate power and finalize the formation of an authoritarian regime, the economic and financial challenges facing the government will intensify. A negative confidence shock is the last thing Turkey needs: The country runs a current account deficit of US$ 27 billion, or 4% of GDP (Chart 3). Any country running a current account deficit relies on foreign funding in order to grow. If foreign funding diminishes, the country will have to reduce domestic demand. This will be achieved via a weaker currency, higher interest rates, or a combination of the two. A weaker currency will depress imports by making them more expensive for residents, while higher interest rates will curtail domestic demand. Given recent political developments, it is reasonable to assume that foreign investors will reduce their appetite for Turkish assets. This will weigh on the currency and potentially force interest rates higher. Furthermore, tourism makes up 22% of total exports and 4% of GDP. Tourism revenues will be hit more in the following months (Chart 4), aggravating their current nose-dive. Chart 3Turkey Is Heavily Reliant##br##On Foreign Funding Turkey Is Heavily Reliant On Foreign Funding Turkey Is Heavily Reliant On Foreign Funding Chart 4Plunging Tourist Arrivals Will##br##Weigh On The Currency's Value bca.ems_sr_2016_07_18_s1_c4 bca.ems_sr_2016_07_18_s1_c4 The central bank only has US$12 billion of net foreign exchange reserves - equivalent to 0.6 months of imports - to defend the exchange rate. The gross value of foreign exchange reserves (US$ 103 billion) published by the central bank includes commercial banks foreign currency deposits at the central bank (Chart 5). These foreign currency resources do not belong to the central bank. The authorities might use them to defend the lira, but that could undermine investor confidence and reduce their willingness to hold Turkish assets. Finally, the funding of Turkey's current account deficit is not of high quality. Net FDI has amounted to US$ 9 billion over the past 12 months, with net portfolio investment at US$ -5 billion, and net errors and omission at US$ 2 billion. Overall, odds are that the foreign flows will diminish in the wake of political uncertainty and the lira will depreciate. As this occurs, local market-driven interest rates - bond yields and money-market rates - will rise. This will force banks to hike their lending rates and credit growth, which has been running at an annual pace of 10%, will decelerate further (Chart 6). This will weigh on the economy and thus odds of recession are not trivial. Chart 5Turkey Is Low On Hard Currency Reserves Turkey Is Low On Hard Currency Reserves Turkey Is Low On Hard Currency Reserves Chart 6Credit Growth To Slow Further bca.ems_sr_2016_07_18_s1_c6 bca.ems_sr_2016_07_18_s1_c6 Chart 7The Credit-Led Growth Boom Is Over The Credit-Led Growth Boom Is Over The Credit-Led Growth Boom Is Over As growth deteriorates following a 10-year credit boom (Chart 7), bank non-performing loans (NPL) and provisions will have to rise, and bank balance sheets will weaken noticeably. With bank stocks accounting for 38% of the MSCI Turkey equity index, poor banking health will weigh on the stock market. Bottom Line: Asset allocators should stay underweight Turkish stocks and sovereign credit within their respective EM benchmarks. We also recommend maintaining short positions in both the Turkish lira versus the U.S. dollar and Turkish bank stocks. Marko Papic, Managing Editor marko@bcaresearch.com Arthur Budaghyan, Managing Editor arthurb@bcaresearch.com 1 Please see Bloomberg, "Once Spurned Turkey Stocks Find Love As Political Risk Ebbs," dated July 13, 2016, available at bloomberg.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Political Recapitalization Rally - Turkey: Canary In The EM Coal Mine?," dated June 13, 2013, and BCA Geopolitical Strategy Special Report, "Emerging Markets: No Curtain To Hide Behind," dated September 11, 2013, available at gps.bcaresearch.com.

A number of divergences have emerged in global financial markets. These gaps are unsustainable. The recent improvement in Asian trade/manufacturing has been largely due to firming demand for electronics/semiconductors. Meanwhile, demand/output for industrial goods and basic materials - the areas leveraged to Chinese capital spending - remain weak. Fixed-income traders should bet on yield curve steepening in India: receive 1-year/pay 10-year swap rates.

MSCI Inclusion should have no meaningful immediate impact on foreign demand for A share, but it fits into the big picture of an inevitable growing presence of Chinese assets in world financial markets.

The RMB has been steadily depreciating versus the U.S. dollar and has dropped to a new cyclical low versus its trade-weighted basket. All the while, Chinese domestic interest rates have lately drifted higher. When global investors wake up to these dynamics, global share prices and EM risk assets will likely sell off anew. In Mexico, initiate a new yield curve trade: receive 10-year / pay 1-year swap rates.

All three of Trump's signature policy proposals - increased deficit-financed infrastructure spending, a more restrictive immigration policy, and trade protectionism - are dollar bullish. These policies could cause the U.S. economy to overheat, forcing the Fed to raise real rates more than it otherwise would. Equities could rally in the near term following a Trump victory, but are likely to face stiff longer-term headwinds. Treasurys would still suffer modest losses, while, ironically, the one asset that could suffer the most from a Trump victory is gold.

Historically, carry trades have generated very large profits with limited volatility. Since 2008, this has not be the case. Going forward, carry trades should continue to underwhelm.