China equity markets remained relatively resilient during May as trade tensions, US dollar currency strength and renewed uncertainty in the Italian political arena weighed on equity markets. The MSCI China universe has started to outperform again in a regional context, following a consolidation in the first quarter. Thus, the MSCI China index has risen by 4.5% in US dollar terms since bottoming on 26 April, compared with a 0.97% gain in the MSCI Asia ex Japan index and -1.81% for the MSCI Emerging Markets index over the same period.
Alongside the potential fallout from the domestic deleveraging policy, another development has been the growing number of bond defaults, a practical consequence of the government’s deleveraging agenda. Investors are clearly asking the question as to whether a watershed moment has arrived for China, namely the genuine removal of Beijing’s implicit guarantee as far as credit is concerned. The central government has sent out the message this year that it is willing to let local government financing vehicles (LGFV’s) default, especially in cases where the entity’s legal structure is questionable and has not been specifically guaranteed by the local government.
The reality of bond defaults is a double-edged sword; government intent to unwind government guaranteed funding that has led to profligate lending practices in the shadow banking arena (lending outside the formal channels) is clearly a positive. So too is the emergence of price discovery and credit risk, necessary for China’s long term capital market development. In the short-term, however, perceived negative liquidity conditions for China’s stock market are a negative. Ultimately, the key to China’s long-term investment case rests on the government’s ability to manage the deleveraging process while avoiding a systemic crisis.
In India, the market moved slightly lower, although the final week of the month saw a recovery off the lows, with large caps marginally outperforming the mid and small caps. The most significant news flow was the election result in the state of Karnataka, which after much horse-trading resulted in the Congress party forming an alliance with the JDS to form the state government. The key portfolios are yet to be agreed and the situation remains unstable, which could play into the hands of the BJP, as was witnessed in the state of Bihar in the last 18 months.
Other election manoeuvres in the month have elevated the level of political uncertainty, with by-poll election losses unsettling the landscape with now less than 12 months before the next general election. Consideration should be given to the financial straits in which some of the opposition parties now find themselves following the 2016 demonetisation event creating havoc for political funding, something which has again played into the hands of the BJP.
Crude price increases, as well as the deterioration of the Indian rupee (INR67.4v USD1 at the month end) has put pressure on multiple sectors, while the healthcare sector, a significant exporter, has navigated the existing currency pressures. Consumer discretionary and Industrials saw a pullback, likely given the concerns on crude prices moving upwards.
The China market model turned ‘bullish’ on 10 May, motivating an overweight allocation to China, underweight India at the country level, through exposure to equities and futures. In terms of the equity portfolio, we have a strong bias to domestically focused China companies. Real estate, energy, materials, utilities and healthcare are major overweight positions, almost entirely funded by an underweight to the technology and e-commerce sector. Stock selection served the strategy well on the month.
Given the sharp move in crude pricing, and another month of FII equity exits, we remain underweight India within the fund. No trading has been enacted over the month but we have made a post-month sale of Gateway Distriparks after disappointment following management’s acquisition of Blackstone’s entire shareholding in the Gateway Rail Freight business. The valuation did not tally with consensus estimates and the environment for the stock more broadly has deteriorated in the past few months, hence a complete sale of this stock. We continue to identify valuation opportunities across sectors and will be looking to add to existing holdings and introduce new investments in coming weeks.
For China observers, a key development worth monitoring will be the propensity for sentiment to turn more negative as bond defaults mount and collateral damage to the economy becomes a realistic prospect. An example of this is the sharp decline in infrastructure investment growth so far this year as LGFV financing has been squeezed. Infrastructure fixed asset investment rose by 7.6% in the first four months of this year, compared with 18% YOY in the first four months of 2017. To date, this has been offset by a sharp rise in residential real estate investment, up 14.2% YOY. What seems to be happening here is consolidation, with bigger players taking share from smaller developers who are facing funding pressures for projects.
Turning to India, it could be argued that the now completed earnings season is yet another disappointment, not fulfilling the promises of 12 months ago of Nifty earnings growth in the high-teens, with the year ending with an EPS growth figure of just 5.2%. However, strip out a banking sector weighed down by additional provisioning as directed by the Reserve Bank of India (RBI), and weakness in the Oil & Gas sectors and the results are better, for example Nifty PAT rose by 9.8%, which was ahead of most expectations. Q4 of the financial year ending 31 March was a healthy quarter, with ex-financials growth near 18%. The estimates for FY19 and FY20 are at 20% and 20% respectively, and with provisioning nearing its end following the first completion of the liquidation process, the financials sector, representing 23% of the index, will be in a healthier position moving forward.
The GDP YOY announcement at the end of month was further encouragement, returning a figure of 7.7% for the quarter, versus an estimate of 7.4%. The full year at 6.7% was also moving in the right direction. We expect the volatility induced by crude prices and the rupee move to subside given the over-reaction initially witnessed, and provide opportunities to allocate fresh capital to India, and reduce the current marginal underweight position.
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