BCA, Independent Investment Research Since 1949

Same Macro Headwinds

New York Fed Governor Dudley’s comments yesterday underscored what we already know: that the Fed is unlikely to lift interest rates while markets panic. But ultimately, the same global macro headwinds, and poor final demand conditions persist.



Dudley’s soothing words, along with a late day surge in Chinese equity prices, has shifted investor sentiment in a positive direction for now. But we maintain that the dynamics of the global economy have not materially changed. The Fed backing off from September could give financial markets some breathing room, but unless the dollar weakens substantially, the poor U.S. profit picture is unchanged.

In addition, DM equity markets are no longer ignoring the risks from China and EM. As highlighted in the next Insights, our EM strategists believe the EM selloff has further to run, implying that a cautious DM approach is still warranted.

Chinese Stocks: The New Unknown

There are two forces driving Chinese stocks:


  • The PBoC is among the few major central banks that can engage in further monetary easing, and China’s ongoing fiscal stimulus programs will likely shift into high gear in the coming months. This, together with a stable household sector and service industries, should preclude major growth disappointments.
  • But investors are no longer just worried about the growth slowdown. Even though the flash manufacturing PMI last week may have contributed to the selloff in Chinese shares, the growth slowdown is not new news, and should not have caused such dramatic market reactions. The new unknown is the Chinese authorities’ willingness and ability to keep things “under control”. Notoriously poor policy transparency has further worried investors, leaving fear and anxiety dominating sentiment. As a result, anything China related is aggressively liquidated.

Our China strategists expect that the growth outlook will eventually matter for stock prices from a cyclical point of view, but it will be an uphill battle for the Chinese authorities to regain credibility. Until then, the risk premium attached to Chinese equities will stay elevated.

ECB: A QE Update

Apart from setting a date (March 9th) for the beginning of its asset purchase program, the ECB filled in some other details around its policies.

In the press conference introductory statement, President Draghi announced upward revisions to growth over the next year, but revisions to inflation forecasts were down (to 0% for 2015). But it was in the Q&A that more light was shined on QE policy. The major point gleaned from the Q&A is that the central bank is not prepared to buy bonds yielding less than the deposit rate.

That stipulation then begs the question: What happens if there is not enough liquidity for the ECB to buy €60 billion per month if the central bank will not buy any asset with a yield below the deposit rate? One answer is that the ECB could lower the deposit rate. We believe that given the choice between a lower deposit rate or not attaining the €60 billion in monthly purchases, the ECB would likely do the former. The ECB will be disposed to finishing the 19 months of quantitative purchases in order to protect its credibility, unless of course the economy is strong enough to warrant stopping early.

So far, the ECB is not showing concern that there will not be enough sellers of high-quality bonds for the ECB to buy. Draghi more or less dismissed the question during the Q &A and also alluded that he thought there were plenty of foreign sellers.

We have pointed out in Daily Insights that, in fact, the shortage of government paper is acute, especially in Germany, where there will be very little net new issuance. The government last week issued a 5-year Bund for the first time sporting a negative nominal yield (-8 basis points). Almost 30% of the continental European bond market is currently trading in negative territory, and the ECB hasn’t even started buying yet.

Negative yields are helping keep the euro weak, which, much like QE elsewhere in the world, is giving a definitive boost to local growth, and for the time being, equity markets. We maintain overweight positions in euro area stocks relative to the U.S. and global benchmarks.

Chinese Monetary Policy And Stocks

While the latest rate cut is clearly positive and is long overdue, the PBoC is still behind the curve. Monetary conditions remain far too tight, and further easing is likely.

Speaking at China’s annual parliamentary hearing, Premier Li Kequiang noted that, “The downward pressure on China’s economy is intensifying,” and that 2015 would be a tough year for growth. Indeed, the Chinese government downgraded its official target for growth to ‘around’ 7%.

Amidst this sober evaluation, China’s monetary conditions index has continued to deteriorate, driven by both rising real rates and a rising currency. This is disconcerting for asset prices, especially domestic A shares, as the market has rallied strongly since mid last year and is no longer cheap. The rally has partly been driven by expectations of policy easing and an improvement in monetary conditions – which have clearly failed to materialize.

For now our China strategists maintain a neutral rating on domestic A shares, as the risk-return profile of this asset class is roughly balanced. On one hand, there is a strong case that the PBoC should continue to ease, which will eventually lead to improvement in monetary conditions and a bid up in stock prices. On the other hand, the market may disappoint if investors decide that policy easing so far has not been effective and the PBoC continues to drag its feet. In this environment, any aggressive directional bet would be premature.

Deteriorating monetary conditions also bode poorly for investable Chinese stocks, but the case for this asset class is strengthened by attractive valuation. Chinese investable shares are still trading at hefty discounts to their historical averages – which justifies risk-taking, especially within the broader backdrop of monetary easing. The case for relative outperformance of Chinese investable stocks versus the EM benchmark is more compelling. China is among the few countries that have ample room for monetary easing, and Chinese stocks are still trading at discounts to their EM and global peers despite the past two years’ sharp outperformance. Chinese investable stocks will likely continue to be positively rerated going forward.

(Part I) EM Credit Spreads: Unsustainable Divergence

EM sovereign and corporate credit markets have so far defied the selloff in EM equities and foreign exchange markets, but the odds of material spread widening are considerable.


As G7 central banks have crowded out global fixed-income investors from G7 bond markets by depressing yields, investors have rotated into other segments of global fixed-income markets and bid up prices of hard-currency denominated EM sovereign and corporate bonds. Our EM strategists believe the stampede into EM credit markets has gone too far, and that these divergences between EM currencies and stocks on the one hand and EM credit markets on the other will not be sustainable.

Today, EM countries’ private sector foreign debt levels (as a share of GDP) are not lower than at the end of 1996 and early 1997, when the emerging Asian crisis commenced. This is not to argue that the EM world is headed for a similar crisis like what transpired in 1997-’98. The point is that currency depreciation raises foreign debt burdens and as such should lead to a re-pricing of credit risk – i.e., wider corporate spreads.

Although the EM public sectors’ foreign debt burden is very low, most developing nations’ fiscal positions will deteriorate going forward. This will occur because the growth slowdown will drive down corporate profits and consequently governments’ tax intake. In the meantime, political pressure to keep the population happy will lead many EM governments to loosen the fiscal purse. All in all, government debt and budget deficit dynamics will worsen, justifying higher spreads on sovereign credit.

Weaker EM growth and commodity prices also represent a menace to EM credit markets. Please see the next Insight, (Part II) EM Credit Spreads: Unsustainable Divergence.