Box 7: Semiconductors: Where next for the fading 'Memory Supernova'?

Figure 108: Expected duration and depth of DRAM downcycle vs prior ones

Source: Company data, UBS estimates

Figure 109: Top-7 hyperscale capex spend

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USD bn

Source: Company data, UBS estimates (top-7 include Google, Facebook, Microsoft, Amazon, Baidu, Alibaba, Tencent)

A different size and nature of stimulus from China

Between 2015 and 2017, credit to households remained easy, which helped real estate, while that to local governments tightened, which hurt infrastructure growth. Government statements are consistent with the focus now shifting to infrastructure. Special local government bonds issuance, easier LGFV financing, and lesser scrutiny of PPP projects should drive this and lift infra FAI to 10% y/y in 2019. However, our calculations show that while EM EPS growth is even more sensitive to China housing than it is to US or European capex, its beta to China infrastructure FAI is not statistically significant (Figure 110). The coming China stimulus will bring less help, but should still offer some for China, less for the rest of EM.

China infrastructure FAI unlikely to have a significant impact on overall MSCI EM EPS

Figure 110: T-statistics of different forms of investment spending from EM EPS growth regressions

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Source: Haver, Datastream, UBS

Note: These t-statistics are based on simple linear regressions of EM EPS growth on four different indicators of investment activity.

Figure 111: Spread between AA and AAA CNY bonds vs TFS growth

Source: CEIC, UBS

Even before it is evident in TSF, a large change in liquidity settings will probably be reflected in the price and quantity of low-grade paper in the local credit market. The spread gap between AA and AAA-rated local bonds is close to its highest level since 2015, suggesting that local businesses are still suffering from the previous tightening of shadow liquidity (Figure 111). China's exports have stalled sequentially over the past three months, and new export order PMI prints do not look inspiring. Whether because of tariffs or because of the tech boom plateauing, if the external sector slows further, the possibility of further easing from China will rise.

In an adverse scenario, we expect China to 'lean against the wind'

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In 2018, EM currencies took the full brunt of slowing EM growth against improving US activity. On average, EMFX is down 9.3% YTD. EM central banks have been reluctant to hike on the back of weak growth and soft inflation, therefore carry protection is low. This broadly remains the situation today.

Growth concerns are set to intensify in 2019, but some important differences should mean the selloff would be less pronounced than in 2018. The gap between EM and DM growth continues to shrink, with DM growth slipping only recently along with the global economy. This probably limits the rise in US long-end rates. Together with ECB policy normalisation and a stronger EUR, this suggests modest positive total returns for highyielding EM currencies.

Weak trade growth points to losses in growth-sensitive Asia, including the CNY. Trade volumes are slowing, and growth in deflators is also coming off hard amid weaker commodity and semiconductor prices.

We expect EMFX to sustain 1–2% further losses against the USD in 2019, probably front loaded into the year, while sequential momentum in EM is still weakening. The second half of 2019 should be better.

That unravelled fast

The year does not have a moniker yet, perhaps because no one name sums up all the challenges EM assets have faced in 2018. The narrowing in the EM-DM growth differential on the back of better US metrics (Figure 112) was the root cause of the more obvious problems, including trade tensions, concerns about Chinese growth, notable CNY weakness, rising oil prices, a sharper-than-expected rise in US interest rates, idiosyncratic political risks…we could go on.

Using a simple weighted average, EMFX fell by 9.3% vs the USD, but the range of performance was marked (ARS -48% while THB -0.63%). As Figure 113 shows, while the fall in nominal effective exchange rates was as deep as in other recent stress episodes, the dispersion of returns was more extreme.

EM fundamentals stable, but US growth took us by surprise

The difference between the best and worst performers vs the USD is marked; a gap not seen since the early 2000’s

Figure 112: US growth, inflation and real rates rising steadily

Figure 113: Uneven returns in EM nominal tradeweighted FX (NEER) in 2018

The main source of pressure in 2018 was the rise in UST yields as the market repriced the expectations of higher policy rates in the US. As we move into 2019, the path of Fed policy is better priced (2019 Markets Outlook: Something wicked this way comes?), and therefore unlikely to generate the same degree of stress. Instead, the pressure on EMFX is set to come from slower global growth, particularly in China, with slower global trade volumes as a result. This is likely to shift the stress from higher yielders to growth-sensitive currencies, which tend to have low yields, with the implication that in 2019 we could see the rare event of MSCI EM currencies underperforming GBI EM currencies.

Our EMFX forecasts project around -0.5% (-1.9%) returns for GBI EM-weighted FX (MSCI-EM). This timid performance is a function of the challenges we expect EMFX to face in the year ahead. CEEMEA currencies are likely to outperform on appreciation against the EUR and the extra appreciation we expect in the EUR/USD pair, while small open economies in Asia are likely to underperform as the CNY weakens. A quieter election calendar in LatAm (with the notable exception of Argentina) should allow these currencies to track fundamentals more closely in 2019, especially if Brazil delivers the announced reforms (See Box 8) and uncertainty over policy making in Mexico decreases.

Likewise, our top-down model that relates EM Nominal Effective Exchange Rate (NEER) performance to EM growth, commodity prices, US rates and risk premia, projects a 2.6% depreciation in 2019 under our base-case scenario of weak export growth, 30bp higher US 1Y real rates, and softer commodity price growth (Figure 114 and Figure 115). In a negative risk scenario in which EM growth falters, commodities fall, US real rates increase and risk premia rise, currencies could fall as much as 5.2% in trade-weighted terms. What may not be captured by the model is the hit to EM ex China flows for reasons of rebalancing, not growth (See Box 9).

In 2019 the challenges for EMFX will morph from higher US real rates, to weaker Chinese growth and CNY

We expect GBI EM-weighted currencies to outperform the MSCI EM currencies