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Focus on...
Craig Farley and Simon Finch

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What’s eating emerging markets?

23 Aug 2018
With recent economic and political events buffeting equity markets in the Asia and emerging market (EM) space, Simon Finch and Craig Farley flag some of the key issues that investors may be grappling with and how these affect the positioning of the Chindia Equity Fund.

1. It’s been an unsettling time for Asian and EM, with the Hang Seng down from its January peak and the Shanghai Composite index officially in bear market territory. What is causing this?

Conditions have become more difficult for investors in recent quarters, particularly within an Asia and EMs context. In the case of China, attention has migrated towards several key developments in the US, namely the Federal Reserve monetary policy dynamic and an escalation of trade tariff tensions propelled by President Trump. The consequence of an increase in US monetary tightening expectations (driven by US inflation, employment and wage data) and the markets view that China stands to lose out if it Beijing continues a proportional retaliatory tariff response has culminated in a period of renewed US dollar strength and sharp Chinese renminbi weakness. This has gone hand in hand with underperformance by Asia and EMs, reminding investors of the longstanding negative correlation (-0.70 since 2000) between the American currency and the performance of the MSCI Emerging Markets Index.  

In a related context, concerns have arisen over the amount of offshore US dollar borrowing which has grown dramatically over the past decade. EMs’ US dollar-denominated international debt securities outstanding have risen by 271% from US$819b at the end of 2008 to US$3.04t at the end of Q1 18. Within that total, China’ US dollar-denominated international debt securities surged 26x from US$30b to US$768b over the same period, with non-financial corporate debt accounting for US$388b or 51% of the total (source: Bank of International Settlements). This has coincided with concerted Chinese government efforts to deleverage the economy, raising anxiety amongst investors over the ability of authorities to maintain its delicate balancing act of initiating a controlled economic slowdown without triggering a systemic crisis.

2. How worried should we be about the possibility of a long-term trade war between the US and China or will Congress check Trump’s protectionism?

Our view on President Trump’s trade agenda, directed principally but not exclusively at China, has not changed since the outset. From a negotiation perspective, the fundamental issue is that the list of demands sought from both sides makes it difficult to envisage a swift resolution. Add to this the bargaining stance of Peter Navarro, a key figure in the US negotiating team, who is on record as saying the US is ‘’going after China’s 2025 Development Goals’’, a non-negotiable Chinese Party slogan policy.  

As events have unfolded, China appears hamstrung by physical limits in terms of the tit-for-tat retaliation strategy it has adopted. US imports from China totaled US$525b in the 12 months to June 2018, while China imported US$163b of goods from America. Beijing will hoping for Trump to cede ground and declare a victory ahead of the mid-term November elections, predicated on higher rising prices for American voters and the President’s typical negotiating style of extreme posturing followed by a softer resolution. Ultimately, the real risk lies in the unpredictability of the outcome. We like the analogy of Italian politics: it never really goes away, and periodically spikes up as source of market risk.

3. China has tightened monetary policy and Japan seems to be moving away from money printing. How worried should investors be about monetary tightening – or can they expect that companies in Asia will still make good profits?

In recent weeks we have seen acknowledgment from Beijing that the two year long deleveraging campaign, and related clampdown on the shadow banking sector, have begun to impact the economy in a more meaningful manner, leading to an easing (not a continued tightening) of policy. First, the central bank stated that most financial institutions can continue to issue Wealth Management Products (WMP’s) under the old format before the end of 2020. This should allow credit to continue to flow to infrastructure projects and SMEs, and follows the recent collapse in infrastructure investment which is down to 3.3% YoY growth in 1H18 from 16.8% YoY in 1H17. Beijing is also seeking to initiate its biggest ever tax cut in personal income tax, which is likely to take effect from October 1. This should significantly boost the disposable income of middle-class households.

From a corporate earnings perspective, the slowing Asian revisions profile witnessed at the start of year have not reversed, with revisions turning flat over the past three months and negative last month. While topline revisions remain positive, margins are being cut in aggregate. Given the escalating trade war risk between the US and China, revisions are likely to face downside risk for 2H18. In that context, profitability will vary significantly between countries and sectors. Investors will need to be very selective.

4. Has the softer market performance in China created buying opportunities?

At the time of writing, the MSCI China Net Total Return Index is now -20%+ from the peak registered in late January. We must remind ourselves that the same index returned over 80% from the lows registered in December 2016 to 26 January 2018, leaving equity prices vulnerable to a correction. Valuations are currently at 10.4x forward P/E back to just under historical averages. In that context, value is beginning to emerge. Also, although earnings momentum has slowed for China this year, it remains superior to much of Asia, with a number of cyclical sectors witnessing upgrades.

More broadly, given recent developments in the EM space, notably in Turkey, downside pressure on share prices is the path of least resistance if we consider sentiment, investor positioning at the start of Q2 18 and a sharply deteriorating technical picture (market prices). It is clear that tail-risks are rising and China will not be immune from capital market stress, regardless of the long-term structural drivers. That said, recent events are setting up an attractive long term entry point to access one of the world's most compelling investment stories.

5. Are Indian equity prices a little expensive?

With India’s equity markets at all-time highs, and its forward P/E ratio above the historical average, one could conclude that India’s equity prices are on the expensive side.  It has been often argued that India deserves to trade at a premium, particularly to other EMs.  There are a number of factors including its comparatively strong corporate governance across multiple sectors, the reform agenda being supported by Prime Minister Modi, and of course the growth opportunity of India, the globe’s fastest growing major economy.  With growth recovering and earnings showing signs of strength India’s slight equity premium we believe is warranted.  It should be noted that the all-time highs are largely driven by a limited number of index heavyweights.  As evidence of recovery and re-ratings unfolds, we should witness a broadening of the upward moves across sectors.  Thus at present we believe there are opportunities to invest in actively managed Funds that have multi-cap exposure and can benefit from increased market breadth.

6. What has been driving the Indian equity markets to new highs in 2018?

India’s equity market has rebounded smartly from the 10% correction witnessed in the early stages of the year.  The components of the recovery are different from those that pushed Indian markets to new heights between early 2016 and the start of 2018.  Mid and small cap stocks were largely responsible for the moves during that period, however the recent moves have been driven by a very narrow band of large caps that form a sizeable part of the Index.  In the past few weeks however we are beginning to see the broadening of that recovery into a more diversified range of sectors as well as market caps, which is encouraging.  India has been a notable outperformer amongst other EMs year to date, largely attributable to the external factors such as trade wars impacting India to a lesser extent than it peers.  Domestic buyers remain optimistic on their home market, and recent reallocation of capital from Foreign Institutional Investors (FII) to India has further buoyed share prices. 

7. How are you currently positioned in light of recent events?

China

Ashburton does not rely on any economic data or apply forecasting to allocate capital and manage risk in China. Instead, we fall back on the high level of rigour and discipline that underpins our quantitative and systematic process, enabling the fund managers to strictly adhere to the decision making process during the inevitable periods of dislocation and stress.

Our market timing model for China turned ‘bearish’ in July 20. Since then, we have been at maximum levels of cash (70%) for investors in our China Equity Absolute bespoke offering, and have a healthy degree of protection in place via China index put options for our Chindia Equity Fund. Moving to the equity portfolio composition, there is a strong bias to domestically focused China companies. Real estate, energy and utilities are major overweight positions, almost entirely funded by a significant underweight to the technology and e-commerce sector, although it should be noted that the sector allocation is a function of bottom-up stock selection, not a discretionary view. We have not owned Tencent, Alibaba or Baidu for over 12 months on this basis.

India

India’s strong outperformance over EM peers, coupled with softness in the currency has given cause for caution in the short-term.  In addition, the trade deficit for July 2018 hit a five year high, due to higher oil prices and a decline in exports, especially of readymade garments and jewelry.  Given these factors we have marginally reduced our India weight within the Chindia Equity Fund and will use any notable corrective moves to allocate capital into our high conviction stocks.  Furthermore, we are looking at introducing one or two new companies into the portfolio in due course, however at this point are content to bide our time to execute at favourable valuation points.

In the medium to long term we remain confident that India will fulfill its potential and unlock the value in the economy.  The recent earnings season which is nearing completion has demonstrated signs of encouragement across multiple sectors and industries and we seek to participate at the right valuation in sectors aligned with the growth trajectory of the country.