EM Growth Scare Before Year End?

If EM/China credit growth decelerates, it will not only cap inflation but also cause a growth scare.

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Given China’s onshore corporate bonds rallied dramatically in 2015-16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015. This could cause corporate bond issuance and other non-bank financing to slump at time when bank loan growth is already decelerating.

Ultimately, higher borrowing costs along with regulatory tightening of banks’ off-balance-sheet operations may cause a slowdown in China’s domestic credit flows in the second half of 2017. This could spill over to other EM economies due to lower mainland imports and declining commodities prices.

In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation.

Bottom Line: A renewed slump in China/EM growth later this year will warrant an underweight position in EM risk assets across equities, credit and currencies according to our EM strategists.

Are Eurozone Banks A Buy?

Buying Europe at the expense of America has been a widow maker trade since the depths of the Great Recession, but factors finally appear to be falling into place for a preference shift away from the U.S. and toward the Eurozone.

Given the relative regional outlook, buying euro area banks/financials at the expense of U.S. banks/financials should be a winning pair trade.

Nevertheless, we would rather err on the side of caution and boost euro area financials to overweight in global equity portfolios.

The euro area is lifting out of the economic doldrums. The ECB’s easy money policies have finally coaxed the economy close to a self-sustaining recovery. The latest manufacturing PMI data were very strong, signaling that real GDP growth should accelerate. In addition to easy monetary policy, fiscal policy has also contributed to GDP growth. Keep in mind that in calendar 2016, the euro area’s real GDP grew faster than the U.S. A healthy economic backdrop typically spurs loan demand, which is positive for bank profitability (see chart).

Moreover, inflation is at the ECB’s target. Headline CPI has accelerated…

For additional details, please see the February 24th Report titled “Nearing Stall Speed”, available at gss.bcaresearch.com.

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