Mizuho Week Ahead – Immunity lapse

By Vishnu Varathan, Head, Economics & Strategy | Asia & Oceania Treasury Department | Mizuho Bank, Ltd., Week-in-brief: Immunity Lapse Despite soothing balm from dovish FOMC assurances last week, the conspicuous shortfall on immunity remains a worrying vulnerability to the fragile recovery thus far in most of EM Asia is a theme that will reverberate in nervy EM Asia markets.This immunity lapse pertains not only to obvious Covid-related setbacks from delta outbreaks in under vaccinated ASEAN, but crucially also contagion from China's regulatory/policy storm. Chinese regulators cracking down on property, tech and private education not only accentuate spill-over risks from credit tightening, but more worrying introduce heightened uncertainty with regards to "who's/what's next?"; given harder-to-predict, socially motivations. While rational investors may recognize scope for rollback/relaxation if economic pain gets acute, the trouble is that pain thresholds may be higher now. And Beijing inflicting steel exports tariffs over the weekend highlights this willingness to trade off economic growth. Iron ore prices are the most proximate casualty here. But undeniably, the policy hit on commodities will very likely ricochet to hit Australia, which begs the question of whether Beijing may in fact also been incentivized by such political by-products that it welcomes. ASEAN too reveals troubling susceptibility to political risks; although much of ASEAN's imminent political risks are home-grown/self-inflicted. The most conspicuous being Malaysia' s political upheaval with PM Muhiyiddin defiantly ignoring threats of "no confidence" motion and the King's admonishment (over mishandling of Covid amongst other allegations). Apart from obvious political instability issues, the most tragic aspect of this untimely political upheaval is that muddled Covid response amid political expedience/selfish survival tactics could plunge Malaysia into a deeper Covid crisis, resulting in unduly prolonged pain. Street protests resuming in Thailand amid worsening Covid outbreak is no less worrying; and immunity lapse at every level - from the virus and political risks - will present as escalating THB pressures that the BoT will increasingly focus on; as maintains a dovish hold (Wed). Philippines re-instituting the tightest iteration of lockdown in Greater Manila highlights the lack of Covid immunity spreading as wobbles in recovery and additional fiscal pressures; with attendant lapses in immunity against negative credit ratings risks. Numerous setbacks for Australia, constituting widening lockdowns, China's steel tariff knock on iron ore and fading fiscal stimulus, the RBA (Wed) will be unequivocal about maintaining stimulus; although having just extended QE/anchoring YCC, fresh easing is not on the table this time. The RBI (Fri) too will maintain status quo. But this is partly as elevated and "sticky" inflation constrain policy options. The RBI will rightly recognise that despite a weak economy, it is not immune to inflation risks; and the attendant threats to marco/rupee stability risks that follow. As much as vaccination headlines are turning more positive at the margin, current markets are defined and driven by lapses in immunity. US Treasuries: Risks Underpin Bull Flattening Bull flattening (falling yields led by the long end) in the UST yield curve post-FOMC reveals the efficacy of Fed Chair Powell's messaging on the dovish stance. Mostly, it had to do with the rhetoric being understood to defer "taper" risks a little further out into late-Q4 from Q3 - Aug (Jackson Hole)/Sep (FOMC) earlier. To be sure, dovish Fed bet as a driver for downside in yields appears to be stretched given that inflation expectations stabilizing ~2.1%-2.3% in in fact consistent with 10Y UST yields at least 30-60bps higher than it is now. That said, short USTs bets (positioning for sharp upswing in UST yields) could continue to be the "widow-maker" trade in these markets. Here's why. For one, "risk off" trades continue to swirl (intermittently dominating) amid delta, China regulatory, US-China and threats undermine confidence and conviction. What's more, flush liquidity conspiring with hesitant credit growth means that money flows directed to USTs (safe returns) may be pressuring yields. The upshot is that despite the Fed's policy inching towards "taper", markets are focused on delays to normalisation and risk-driven yields in the mean time. For now, we expect 10Y UST yields to be in the 1.16%-1.38% range. FX Theme: Calibration, Not Capitulation Despite a dovish Fed, the calibration in USD strength is not poised for capitulation. In other words, USD bulls are merely re-grouping with an open mind, not lurching down a cliff to abdicate their seats for USD bears; attributable (albeit not fully) to T.I.N.A (there is no alternative). Fact is, there is no alternative to the USD that offers the best of safe-haven refuge as well as policy divergence advantages (that is expected to spill-over as currency strength). What's more, there are non-US factors that also synch with this view. For one, ECB's dovish posturing dilutes Q2 EZ GDP upside surprise to take some wind out of EUR. In addition, China slapping exports tariffs on steel meeting Beijing's regulatory crackdown adds to negative demand risks; undermining commodity currencies. Notably, tumble in iron ore prices has knocked AUD on to its back foot; even though AUD bulls have been denied boost from iron ore upside earlier. And more directly, China's regulatory crackdown risks a wider "risk off" environment in which USD may be preferred; as capitulation from EM Asia high-yield space (not than just calibration of EM Asia exposure) suggests that EM Asia FX will defer to USD in any case. In particular, CNH getting off the lows, while a source of relief for other EM Asian currencies, it will fall short as a lasting catalyst for EM Asia FX surge. A plethora of COVID and political risks in ASEAN suggest that MYR, THB and PHP in particular could be compromised. Specifically, AXJ gains on episodes of USD pullback are likely to be opportunistic and shallow given the underlying risks warn against being caught long in EM Asia FX bets. Meanwhile, there may be some related buoyancy in JPY and CHF if "risk off" continues to linger. Simply put, capitulating risk appetite is not consistent with significantly stronger. Instead calibration in relative FX positions as US bulls re-group is more viable. China Regulations: Of Crackdown & Capitulation Amid the onslaught of regulatory crackdown in China, global investor consternation about Beijing's regulatory overreach is understandable amid a conspiracy of brutal tightening in property, wide-ranging tech crack-down, prohibition of "for profit" private education. This not only accentuates contagion risks, but threatens to prompt a major re-assessment of China's risk premium; if investors perceive that "capitalism with Chinese characteristics" is subject to state misappropriation and/or regulatory confiscation/prohibition. And so, the bar to assuage markets by convincingly reining in regulatory risks ought to be higher. Specifically, it must probably entail signs that there is a regulatory about-turn. Especially given that authorities' appetite for economic pain/trade-off may be greater as financial and social stability now feature more prominently in policy rhetoric. What this means is that barring clarity on what is currently mercurial regulatory crack-down, global investors remain subject to further adverse regulatory shocks.Especially as the VIE (variable interest entity) structure of most of the offshore listing vehicles of Chinese firms disadvantages their recourse to onshore assets and revenues of these firms. In turn, this is likely to translate as amplified downside and volatility in CNY; likely even more accentuated in CNH (given weaker PBoC anchor relative to CNY). Wider EM Asia spill-over of FX and asset market risks remains as a clear and present danger meanwhile. Indonesia Q2 GDP: Its All About That Base Indonesia's Q2 GDP may be set for a solid print around 5.5% YoY; but this is flattered by favourable base effects and should not be mistaken for a sustainable recovery. Crucially, the Covid outbreak taking a turn for the worse discounts Q2 recovery as the uncertainty around the outlook in all likelihood delaying and diminishing the recovery. In reality, the near-complete collapse in exports growth/industrial activity and slump in domestic activity in Q2 2020 set the stage for misleadingly flattering base effects. And this is crucial context for the jump in export growth ~56% YoY in Q2 (Q1: 17.2%) that will lift contribution to YoY GDP from external demand; annual surge (from an extremely low base) in cement consumption and capital goods point to investments boost to GDP. Moreover, domestic demand led by retail sales as well as motor vehicle sales surging in comparison to the "shut down" last year will register a sizable boost to private consumption. But this does not distract from the fact that Q2 GDP growth boost belies the headwinds to growth as Indonesia, hit by Covid outbreak, require lockdowns and wider disruptions to the recovery. In particular, the government finally biting the bullet on implementing stringent social restrictions in July only after an extended period of feet dragging, raises the risk that the "delta setback" may be somewhat more prolonged; subduing activity at least for most of Q3. More importantly, shortfall in vaccination mean that the recovery path may remain somewhat sub-optimal and most likely fraught by further delays/uncertainty. Bank of Thailand: THB On Their Mind The BoT is expected to stay on a dovish hold amid dire Covid stress from worsening outbreak and vaccination lags that prolong Covid risk exposures.Uncharacteristic under-performance in the Thai Baht, rendering it the worst performer to date in 2021, is something BOT will highlight to markets that it is watching closely. Not merely to avoid excessive volatility but also to ensure that reflexivity does not unduly amplify stress from Covid headwinds to growth and C/A surplus erosion from the tourism hit. The BoT finds itself at the other extreme, fretting COVID-related negative tourism multipliers devastating the THB. whereas 2018-19 the BoT's concerns were of excessive THB strength. Leaning against excessive THB volatility/weakness is critical to ensure macro-stability. What's more, it will mitigate misconceptions of mercantilist intent behind THB weakness; and hopefully de-escalate Thailand from the US Treasury (currency manipulation) 'Monitoring List'. For now, concerns of excessive THB weakness reaffirms the view that the policy rate is sufficiently low at 0.50; with fiscal policy assuming the primary role of Covid cushion. The BoT's main accommodation though will likely be via credit and liquidity provision. Philippines: Manila's lock down further sets back economic recovery In order to stem the spread of the delta variant and prevent overwhelming the healthcare infrastructure, the government re-imposed stringent lockdown (Enhanced Community Quarantine) in Greater Manila - comprising ~30% of GDP - for the period Aug 6-20. This lock down, which the government estimates will come at the cost of PHP105bn (~0.6% of GDP) and may more worrying be adverse for employment, is a further setback to economic recovery, which is already lagging regional peers on account of vaccination lags. Unfortunately with vaccine supplies still subject to delays, thereby hampering vaccination schedule, periodical lock downs to stymie the spread of Covid-19 may be necessary pain. In turn, this may create additional pressure on public finances to provide fiscal support, especially for hard-hit lower income groups. The most recent fiscal package, Bayanihan-3, worth PHP401bn (2.2% of GDP), passed the Lower House on 1 June but progress stalled ahead of Senate deliberations; its expedited passage is expected with Parliament resuming 26 July. Already, the budget deficit has been climbing, revised to ~9.4% of GDP from 8.9% earlier. Further strains on, and stretch of the Budget cannot be decisively ruled out as Covid variants continue to inflict pain. The biggest risk is that mounting fiscal strains may prompt hasty credit ratings downgrades; especially as the lag in Philippines' (and wider ASEAN) recovery lags the developed world, thereby casting credit metrics in a dim light. The consolation is that Philippines has built some credit ratings buffer in better economic times, and so not at risk of tipping over into non-investment grade ratings. RBA & RBI: High Inflation & Inertia Both the RBA and RBI are expected to maintain status quo next week; but motivations vary despite the superficial similarities.Both India and Australia have seen some inflation resurgence. Australia's Q2 CPI surged to 3.8% (from 1.1% in Q1) while India's June inflation at 6.3% is elevated above the 4+/-2% target range. But in Australia's case, the RBA has been quite clear about looking past transitory inflation upswing; and so policy is unfettered by the inflation headline. In contrast, while RBI has suggested that it will not respond (with premature tightening), the ability to express its dovish bias is in fact constrained by elevated (and likely "sticky") inflation. The RBA is truly on cruise control having extended QE and YCC; despite the extended lockdown likely to elicit a further extension of QE (not yet a pick-up in pace of QE). Whereas for the RBI, the ability to pair targeted liquidity/credit support will be tested. All said, the path of the virus continues to dictate (as well as strain) policy. Credit: Mizuho Bank Ltd

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