Colombia
Falling oil prices and fiscal tightening will cause the Colombian economy to slow down in the next 12 months. What’s more, a depreciating peso and sticky inflation will prevent the central bank (Banrep) from frontloading rate cuts to mitigate the downtrend. The Colombian peso is making new cyclical lows and more weakness is in the cards. While the currency is slightly cheap according to the real effective exchange rate based on unit labor costs (Chart III-1), our negative view on oil prices entails further currency depreciation. Colombia is still very heavily reliant on oil exports – the current account deficit is 4.3% of GDP with oil, but 8.4% excluding it (Chart III-2). Moreover, a chunk of FDIs are destined for the energy sector, and foreign portfolio flows are contingent on exchange rate stability. Therefore, falling oil prices and a weaker peso will result in diminishing FDIs and foreign portfolio flows, reinforcing downward pressure on the currency. Chart III-1The Colombian Peso Is Not That Cheap Chart III-2Current Account Deficit Is Large And Widening Notably, there is a significant pass-through effect from the currency to inflation (Chart III-3). Even though Banrep does not target the exchange rate, having both headline and core inflation above the 3% central target will constrict it from cutting interest rates soon. On the whole, odds are that Colombia’s business cycle has reached a top and growth will slow considerably in the next 12 months. The yield curve is signaling an economic slowdown ahead (Chart III-4). Chart III_3The Exchange Rate And Inflation Chart III-4Domestic Demand Is About To Roll Over Our credit and fiscal spending impulse might be peaking, signifying a top in domestic demand growth (Chart III-5). The impulse is rolling over primarily due to the substantial fiscal tightening. Duque’s administration has slashed expenditures and the latter are contracting in inflation-adjusted terms (Chart III-6). Chart III-5A Top In The Business Cycle? Chart III-6Severe Fiscal Tightening Government revenues are highly dependent on oil exports, and the recent fall in oil prices will bring about a contraction in fiscal revenues. This, and the government’s strong adherence to fiscal surplus, implies no loosening up on the fiscal side. Finally, our proxy for marginal propensity to spend for businesses and households is indicating that growth is about to roll over (Chart III-7). Auto sales are also weakening, and housing sales are contracting (Chart III-8). Chart III-7The Business Cycle Is Peaking Chart III-8Colombia: Certain Segments Have Turned Over Given that both fiscal and monetary policies are unlikely to be relaxed soon, the peso will come under renewed selling pressure, acting as a release valve for the Colombian economy. Investment Recommendations We are downgrading this bourse from neutral to an underweight allocation within a dedicated EM equity portfolio. In its place, we are upgrading Peruvian stocks from underweight to neutral. Continue shorting COP versus RUB. This trade has generated a 14% return since its initiation on May 31st of last year. Finally, within EM local currency bond and sovereign credit portfolios, Colombia warrants a neutral allocation. We also recommend fixed-income investors continue to bet on further yield curve flattening: receive 10-year / pay 1-year swap rates. Juan Egaña, Research Associate juane@bcaresearch.com
Chart III-1Fiscal Policy Will Tighten In 2019 The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-2BoP Dynamics Are Deteriorating Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-4Colombia Is Unlikely To Outperform LATAM Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com
Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel). Chart I-8China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
We published a Special Alert report titled Turkey: Book Profits On Shorts yesterday. The link is available on page 18. This report is Part 2 of an overview of the cyclical profiles of emerging market (EM) economies. This all-in-charts presentation illustrates the business cycle conditions of various developing economies. The aim of this report is to provide investors with a quick assessment of where each EM economy stands. In addition, we provide our view on each market. The rest of the countries were covered in Part 1, published last week (the link to it is available on page 18). Chart I-1 Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As...Malaysia: Keep Underweight For Now As... Malaysia: Keep Underweight For Now As... ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside ...Bank Shares Have Significant Downside...Bank Shares Have Significant Downside Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: Underweight Equities & Bonds Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Indonesia: The Sell-Off Is Not Over Yet Thailand: Stay Overweight Thailand: Stay Overweight Thailand: Stay OverweightThailand: Stay Overweight Thailand: Better Positioned To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Thailand: Better Positioned ##br##To Weather The EM Storm Philippines: Inflation Breakout Philippines: Inflation BreakoutPhilippines: Inflation Breakout Philippines: Inflation Breakout Philippines: Neutral On Equities Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold Conditions Philippines: Neutral On Equities ##br##Due To Oversold ConditionsPhilippines: Neutral On Equities ##br##Due To Oversold Conditions Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Labor Shortages & Wage Inflation Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - Overweight Central Europe: Robust Growth - OverweightCentral Europe: Robust Growth - Overweight Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: Robust Growth - Overweight Equities Chile: No Inflationary Pressures Chile: No Inflationary PressuresChile: No Inflationary PressuresChile: No Inflationary Pressures Chile: No Inflationary Pressures Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Currency Will Be A Release Valve Colombia: Credit Growth Remains A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Colombia: Credit Growth Remains ##br##A Headwind For Economy - NeutralColombia: Credit Growth Remains ##br##A Headwind For Economy - Neutral Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peru: Vulnerable To External Developments Peruvian Equities - Underweight Peruvian Equities - Underweight Peruvian Equities - UnderweightPeruvian Equities - Underweight
The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com
Highlights The global trade slowdown will intensify, even if U.S. domestic demand remains robust. The large emerging Asian bourses will recouple to the downside with their EM peers. Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. In Chile, receive 3-year swap rates. Continue to overweight stocks relative to the EM benchmark. Short the Colombian peso versus the Russia ruble. Stay neutral on Colombian equities and local bonds but overweight sovereign credit within their respective EM universes. Feature Performance of large equity markets in north Asia - Korean, Taiwanese and Chinese investable stocks -- has been relatively resilient compared with other EM bourses. Specifically, the EM ex-China, Korea and Taiwan equity index has already dropped 16% in U.S. dollar terms, while the market cap-weighted index of investable Chinese, Korean and Taiwanese stocks is down only 8% from its peak in late January.1 These three markets account for 60% of the MSCI EM stock index. A pertinent question is whether these North Asian markets will de-couple from or re-couple with the rest of EM. Our bias is that they will re-couple to the downside. Global equity portfolios should continue to underweight Asian stocks versus the DM bourses in general, and the S&P 500 in particular. That said, dedicated EM equity portfolios should overweight Korea and Taiwan and maintain a neutral stance on China and Hong Kong relative to the EM and Asian equity benchmarks. The Global Trade Slowdown Will Intensify Emerging Asian stock markets are very sensitive to global trade cycles. Slowing global trade is typically negative for them. There is growing evidence that the global trade deceleration will intensify: The German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart I-1). Chart I-1Global Trade Slowdown Will Persist Export volume growth has already slowed across manufacturing Asia (Chart I-2). The most recent data points for these series are as of April. Asia's booming tech/semiconductor industry is also slowing. Both Taiwan's export orders growth and Singapore's technology PMI new orders-to-inventory ratio have relapsed (Chart I-3). Chart I-2Asian Exports Growth: Heading Southward Chart I-3Asian Tech: Feeling The Pinch One of the causes of weakness in the global semiconductor cycle could be stagnating global auto sales (Chart I-4). The latter are being weighed down by weakness in auto sales in China and the U.S. Cars require a significant amount of semiconductors, and lack of improvement in global auto sales will suppress semiconductor demand. So far, China has not been at the epicenter of investors' concerns, but this will soon change as its growth slowdown intensifies. Credit conditions continue to tighten in China, which entails downside risks to mainland capital spending and consequently imports. China's imports are set to slump considerably, reinforcing the global trade downturn.2 First, China's bank loan approvals have dropped considerably in the past 18 months, suggesting a meaningful slowdown in bank financing and in turn the country's investment expenditures (Chart I-5). Chart I-4Global Auto And Semiconductor Sales Chart I-5China: Bank Loan Approval And Capex Second, not only are bank loan standards tightening but costs of financing are also rising. The share of loans extended above the prime lending rate has risen to a 15-year high (Chart I-6, top panel). This represents marginal tightening. Finally, onshore corporate bond yields as well as offshore U.S. dollar-denominated corporate bond yields have broken to new highs in this cycle (Chart I-6, bottom panels). Mounting borrowing costs and tighter credit standards in China point to further deceleration in credit-sensitive spending such as investment expenditures and property purchases. On the whole, rising interest rates and material currency depreciation in EM ex-China and credit tightening in China will prompt a considerable slump in imports, depressing world trade. EM including Chinese imports account for 30% of global imports, while the U.S. and EU together make up 24% of global imports values. Hence, global trade will disappoint if and as EM and Chinese imports stumble. A final word on the history of de-coupling among EM regions is in order. There have been a few episodes when emerging Asian and Latin American stocks de-coupled: In 1997-'98, the home-grown Asian crisis devastated regional markets, but Latin American stocks continued to rally until mid-1998 - when they plummeted (Chart I-7, top panel). Chart I-6China: Rising Borrowing Costs Chart I-7De-coupling Between Asia And Latin America In 2007-'08, emerging Asian equities tumbled along with the S&P 500, but Latin American bourses fared well until the middle of 2008 due to surging commodities/oil prices (Chart I-7, middle panel). Finally, the bottom panel of Chart I-7 illustrates that in early 2015, Asian stocks performed well, supported by the inflating Chinese equity bubble. Meanwhile, Latin American stocks plunged. In all of these episodes, the de-coupling between Asia and Latin America proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside. Bottom Line: Global trade is set to head southward, even if U.S. demand remains robust. China's growth slump will be instrumental to this global trade slowdown. Consequently, Chinese, Korean and Taiwanese equities will be vulnerable. Heeding To Market Signals Financial markets often move ahead of economic data, and simply tracking data is not always helpful in gauging turning points in business cycles. By the time economic data change course, financial markets would typically have already partially adjusted. Besides, past economic and financial market performance is not a guarantee of future performance. This is why we rely on thematic fundamental analysis and monitor intermediate- and long-term trends in financial markets to navigate through markets. There are presently several important market signals that investors should be heeding to: EM corporate bond yields are surging, which typically foreshadows falling EM share prices (Chart I-8). Meanwhile, there is no robust correlation between EM equities and U.S. bond yields. Chart I-8EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening, offsetting the drop in U.S. bond yields. Hence, a drop in U.S. bond yields is not in and of itself sufficient to halt a decline in EM share prices. So long as EM corporate and sovereign credit spreads are widening by more than the decline in U.S. Treasury yields, EM corporate and sovereign bond yields will rise, heralding lower EM share prices. The ratio of total return (including carry) of six commodities currencies relative to safe-haven currencies3 is breaking below its 200-day moving average after having bounced from this technical support line several times in the past 12 months (Chart I-9). This could be confirming that the bull market in EM risk assets is over, and a bear market is underway. Chinese property stocks listed onshore have broken down, and those trading in Hong Kong seem to be forming a head-and-shoulder pattern (Chart I-10). In the latter case, such a technical formation will likely be followed by a considerable down-leg. Chart I-9An Important Breakdown Chart I-10Chinese Property Stocks Look Very Vulnerable Further, China's onshore A-share index has already dropped by 15% from its cyclical peak in late January. Finally, both emerging Asia's relative equity performance against developed markets, as well as the emerging Asian currency index versus the U.S. dollar (ADXY) seem to be rolling over at their long-term moving averages (Chart I-11). The same technical pattern is presenting itself for global energy and mining stocks in absolute terms, and also in the overall Brazilian equity index (Chart I-12). Chart I-11Asian Equities And Currencies Are ##br##At Critical Juncture Chart I-12Commodity Equities And Brazil ##br##Are Facing Technical Resistance The failure of these markets to break above their long-term technical resistance levels may be signalling that their advance since early 2016 has been a cyclical - not structural - bull market, and is likely over. These technical chart profiles so far confirm our fundamental analysis that the EM and commodities rallies since early 2016 did not represent a multi-year secular bull market. If correct, the downside risks to EM including Asian markets are substantial, and selling/shorting them now is not too late. Bottom Line: EM including Asian stocks, currencies and credit markets are at risk of gapping down. Absolute-return investors should trade these markets on the short side. Asset allocators should underweight EM markets relative to DM in general and the U.S. in particular. A complete list of our currency, fixed-income and equity recommendations is available on pages 20-21. An EM Equity Sector Trade: Long Consumer Staples / Short Banks EM consumer staples have massively underperformed banks as well as the overall EM index since January 2016 (Chart I-13). The odds are that their relative performance is about to reverse. Equity investors should consider implementing the following equity pair trade: long consumer staples / short banks: Consumer staples are a low-beta sector because their revenues are less cyclical. As EM growth downshifts, share prices of companies with more stable revenue streams will likely outperform. Bank stocks are vulnerable as local interest rates in many EMs rise in response to the selloff in their respective currencies (Chart I-14). Consumer staples usually outperform banks when local borrowing costs are rising. Chart I-13Go Long EM Consumer Staples / ##br##Short EM Banks Chart I-14EM Banks Stocks Are Inversely Correlated With##br## EM Local Bond Yields We expect more currency depreciation in EM, which will exert further upward pressure on local rates, including interbank rates. Further, growth weakness in EM economies typically leads to rising non-performing loan (NPL) provisions. Chart I-15A and Chart I-15B demonstrates that weakening nominal GDP growth (shown inverted on the charts) leads to higher provisioning. Hence, a renewed EM growth slowdown will hurt bank profits. Chart I-15AWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Chart I-15BWeaker Nominal GDP Growth Entails ##br##Higher NPL Provisions Our assessment is that banks in many EM countries have provisioned less than what is probably necessary following years of a credit boom. Indeed, in the last 12-18 months or so, many banks have even been reducing their NPL provisions to boost profits. Hence, a reversal of these dynamics will undermine banks' earnings. Bottom Line: Market-neutral EM equity portfolios should consider going long consumer staples while shorting banks. This is in addition to our long-term strategy of shorting EM banks versus U.S. banks as well as shorting banks in absolute terms in individual markets such as Brazil, Turkey, Malaysia and small-cap banks in China. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These calculations are done using MSCI investible stock indexes in U.S. dollars terms. 2 Please see Emerging Markets Strategy Weekly Report, "The Dollar Rally And China's Imports", dated May 24, 2018, available at ems.bcaresearch.com. 3 Average of cad, aud, nzd, brl, clp & zar total returns (including carry) relative to average of jpy & chf total returns (including carry). Chile: Stay Overweight Equities, Receive Rates 31 May 2018 Chart II-1Chilean Equities Relative Performance And Copper Prices It is often assumed that Chilean financial markets are a play on copper. While this largely holds true for the Chilean peso, it is not always correct regarding its stock market's relative performance to its EM peers. Chile has outperformed in the past amid declining copper prices (Chart II-1). Despite our negative view on copper prices, we are reiterating our overweight allocation to this bourse within an EM equity portfolio. There are convincing signs that growth in the Chilean economy is moving along fine for now (Chart II-2). While weakness in global trade will weigh on the economy, the critical variable that makes Chile stand out from other commodities producers in the EM universe is its ability to cut interest rates amid currency depreciation. Chart II-3 illustrates that interest rates in Chile can and do fall when the peso depreciates. This stands in stark contrast with many others economies in the EM universe. There are a number of factors that suggest inflationary pressures will remain dormant for some time. This will allow the Central Bank of Chile (CBC) to cut rates as and when required. Chart II-2Chile: Economic Conditions Chart II-3Interest Rates In Chile Can Fall When Peso Depreciates First, the output gap is negative and has been widening, which has historically led to falling core inflation (Chart II-4). Second, a wide range of consumer inflation measures - services and trimmed-mean inflation rates - are very low and remain in a downtrend (Chart II-5). Chart II-4Chile: Output Gap And Inflation Chart II-5Chile: Inflation Is Very Low And Falling Finally, there are no signs of wage inflation, which is the key driver of genuine inflation. In fact, wage growth is decelerating sharply (Chart II-6). Odds are that this disinflationary rout will go on for longer, given Chile's demographic and labor market dynamics. The country's labor force growth has accelerated and the economy does not seem able to absorb this excess labor supply (Chart II-7). Consistently, our labor surplus proxy - calculated as the number of unemployed looking for a job divided by the number of job vacancies - has surged to all-time highs (Chart II-8). Chart II-6Chile: Wage Growth Is Very Weak Chart II-7Chile: Rising Labor Force Chart II-8Chile: Excessive Labor Supply... Interestingly, this is not happening because of weak employment. Chart II-9 shows that the employment-to-working population ratio is at a record high, while employment growth is robust. This upholds that decent job growth is not sufficient to absorb the expanding supply of labor. All in all, a structural excess supply of labor as well as a cyclical slowdown in global trade and lower copper prices altogether will likely warrant a decline in interest rates in Chile. Consequently, we recommend a new fixed income trade: Receive 3-year swap rates. The recent rise provides a good entry point (Chart II-10). Chart II-9...Despite Robust Employment Growth Chart II-10Chile: Receive 3-Year Swap Rates The ability to cut interest rates will mitigate the effect of weaker exports on the economy. We recommend dedicated EM investors maintain an overweight allocation in Chile in their equity, local currency bond and corporate credit portfolios. For absolute return investors, the risk-reward profiles for Chilean stocks and the currency are not attractive. The peso will depreciate considerably, and shorting it versus the U.S. dollar will prove profitable. Consistent with our negative view on copper prices, we have been recommending a short position in copper with a long leg in the Chilean peso. This allows traders to earn some carry while waiting for copper prices to break down. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Colombia: The Currency Will Be A Release Valve The structural long-term outlook for Colombia is positive, as a combination of pro-market orthodox policies and reform initiatives amid positive tailwinds from demographic should ensure a reasonably high potential GDP growth rate. In the first round of presidential elections held last weekend, the gap between right wing candidate Ivan Duque and left-wing candidate Gustav Petro came out large enough to make a Duque victory highly likely in the second round to be held on June 17. His election would entail a positive backdrop for the reform agenda and business investment over the coming years. Yet despite the positive structural backdrop, Colombia is still facing a major imbalance - excessive reliance on oil in sustaining stable balance of payments (BoP) dynamics. The trade balance deficit - including oil - is $8 billion, while excluding oil it stands at $20 billion, or 7.5% of GDP (Chart III-1). Hence, if oil prices drop materially in the second half of this year - as we expect - Colombia's balance of payments will be strained. Consequently, the currency will come under depreciation pressure. The peso is presently fairly valued as the real effective exchange rate based on unit labor costs is at its historical mean (Chart III-2). Chart III-1Colombia's Achilles' Hill: Trade Balance Excluding Oil Chart III-2The Colombian Peso Is Fairly Valued The central bank has adopted a "hands-off" approach toward the exchange rate, and is likely to allow the peso to depreciate if the BoP deteriorates. Weak economic conditions will likely prevent it from hiking interest rates to bolster the peso: Even though the central bank has reduced its policy rate by 350 basis points since the end of 2016, lending rates remain restrictive when compared with the nominal GDP growth rate (Chart III-3, top panel). Fiscal policy has been tight, with government expenditures subdued and the primary deficit narrowing (Chart III-3, bottom panel). This is unlikely to change for now if conservative candidate, Ivan Duque, wins the election. Consumer and business demand has failed to pick up, and shows little sign of recovery (Chart III-4). Non-performing loans (NPL) continue to rise, forcing banks to raise their NPL provisioning (Chart III-5). Weak nominal GDP growth suggests provisions may rise further. Chart III-3Colombia: Little Sign Of Recovery Chart III-4Colombia: Little Sign Of Recovery Chart III-5Colombian Banks: NPL And NPL Provision Continue Rising Overall, banks' balance sheets remain impaired, hampering their ability to extend loans. Investment Recommendations Despite a favorable structural outlook, Colombia's cyclical growth and financial market outlooks remain poor. Chances are that the peso will come under selling pressure as the external environment deteriorates - i.e., the currency will act as a release valve. We recommend staying neutral on Colombian stocks and local bonds relative to their EM peers, and to overweight Colombian sovereign credit within an EM credit portfolio. The basis is that sound and tight fiscal policies and a continuation of supply side reforms will benefit this credit market. To capitalize on potential currency depreciation while hedging for the uncertainty of oil price decline, we recommend shorting the peso against the Russian ruble. Although Colombia's structural outlook is more promising than Russia's, the latter's BoP dynamics is healthier and its cyclical growth outlook is better than Colombia's. Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations