Summary

• The official macro policy stance declared at the Central Economic Working Conference (CEWC) in December 2017 is a proactive fiscal policy and prudent monetary policy, a repeat of 2016. However, reading the fine print suggest that both fiscal and monetary policy could be somewhat tighter this year than last.
• Indian equity markets started the year strongly, however in the final days of January the markets were taken lower following broader Asian equity weakness, coupled with rising beliefs that the Budget announcement on 1 February would include the re-introduction of a long-term capital gains tax (LTCG); which was subsequently confirmed.
• Since that signal, the Chinese equity markets have rebounded in a V-shape fashion. The strength of the move has been underpinned by healthy participation and robust breadth across sectors, leading our market timing model to click in a fresh ‘buy’ signal on 5 January 2018.

Market update

China’s real GDP growth for FY2017 increased to 6.9% from 6.7% in 2016, the first annual acceleration since 2010. Consumption contributed a 58.8% share (vs. 64.5% in 2016), whilst investment contributed 32.1% (vs. 32.8% in 2016), and net exports’ share increased to 9.2% (from 2.7% in 2016).

The official macro policy stance declared at the Central Economic Working Conference (CEWC) in December 2017 is a proactive fiscal policy and prudent monetary policy, a repeat of 2016. However, reading the fine print suggest that both fiscal and monetary policy could be somewhat tighter this year than last. This could be especially so in the first few months of 2018, with Beijing’s top policymakers taking comfort from the country’s resilient growth profile. As such, the key near-term risk remains evidence of collateral damage from the renewed squeeze on shadow banking (lending outside of formal banking channels) implemented following the 19^th Party Congress in October. The latest data shows that China M2 growth slowed from 9.1% YoY in November to a record low of 8.2% YoY in December, whilst depository corporations’ claims on other financial institutions rose by 5.5% YoY in December, the slowest growth since May 2010 (source: CLSA)

Indian equity markets started the year strongly, however in the final days of January the markets were taken lower following broader Asian equity weakness, coupled with rising beliefs that the Budget announcement on 1 February would include the re-introduction of a long-term capital gains tax (LTCG); which was subsequently confirmed.

The Union Budget included a LTCG tax of 10% for all holdings owned for more than 12 months, which will commence from 1 April 2018, with 31 January 2018 confirmed as the valuation point used for calculating gains and losses.  The immediate reaction, particularly from domestic retail investors, has been to sell stocks with considerable gains, therefore the midcaps have already seen a sell-off.  We believe that this is unwarranted, given the taxable amount is a small fraction of the gains that have been witnessed in these companies, and also considering the future prospects for the Indian equity market.

Fund activity

China

Our preference in assessing underlying market conditions is to look at the internal dynamics of the equity market itself and establish prospects for healthy returns going forward. Whether China’s market internals are ‘bullish’ (‘buy’) or ‘bearish’ (‘sell’), according to our model, motivates the country skew in the Fund in the context of current maximum and minimum country thresholds of 60% and 40% respectively.

We noted last month that sharply deteriorating market internals had resulted in the first market ‘sell’ signal in almost 12 months, leading to an allocation shift to move China from aggressively overweight at the country level to a significant underweight. We also stated that ‘we remain cognisant of the fact that the equity market landscape can change quickly. We will be swift to act should we be required to do so.’

Since that signal, the Chinese equity markets have rebounded in a V-shape fashion. The strength of the move has been underpinned by healthy participation and robust breadth across sectors, leading our market timing model to click in a fresh ‘buy’ signal on 5^thJanuary 2018.

Whipsaw signals (a condition in which the market’s price heads in one direction, but is quickly followed by a movement in the opposite direction) can be frustrating and are a drawback to systematic investing. Nevertheless, they are part of a rules-based approach that instils clarity, objectivity and discipline to our investment process. As a consequence of the new signal, we have moved China to neutral country position of 50%, with sector exposure to property, materials and energy stocks significantly higher than MSCI China benchmark weights. The high tracking error reflects genuine active fund management in our quest for alpha.

India

We introduced Indian Energy Exchange (IEX) in January, a company that created the marketplace for spot power trading through its integrated platform and now commands a 94% monopoly on spot power trading in India.  The company has superior technology compared to peers, and expectations are that the Indian energy market is rapidly shifting to a marketplace exchange, with IEX in the ascendancy.  Return on equity is in excess of 40% in FY17, and volumes have grown at a cumulative annual growth rate of 30% over the past five years.  The investment was funded through the sale of TI Financial Holdings.

Outlook

Our expectation given the latest solid GDP and activity data prints is that China’s top policy makers will likely focus on reforms to promote ‘high-quality’ development, namely SSR (supply-side reform), deleveraging and the ‘Beautiful China’ campaign. In particular, the PBoC will look to maintain a tightening bias to facilitate ongoing efforts in financial deleveraging and reducing financial systemic risk vulnerability. Looking ahead, it is possible that the tighter financial conditions will gradually weigh on growth in investment demand. On the other hand, the continued global economic growth recovery should provide continued support to the export sector. That, together with relatively resilient consumption demand will help cushion the overall economic slowdown and keep above-potential growth in FY2018.

Turning to India, the short-term impact from the LTCG will undoubtedly lead to some selling pressure, however, the long-term fundamentals remain intact.  Prime Minister Modi continues to push forward with his reform agenda, supported by embedded trends such as demographics, urbanisation and industrialisation.  Earnings across sectors are now beginning to come through, and the banking sector has undergone considerable efforts to clean up their balance sheets, that will provide companies better access to affordable capital moving forwards.

The profit-taking ahead of the LTCG will likely provide favourable entry points to a number of companies that have been under scrutiny for a prolonged period.  The impacts following the introduction of the Goods and Services Tax (GST) and the 2016 demonetisation announcement are now behind us, and companies are now focused on aligning with the government initiatives as we approach the final 12 months before the next general election.