Trade tensions and renminbi weighed on Chinese equity markets in July but Indian equity markets rose.

Summary

• A resumption of trade tensions and the subject of the renminbi were key issues that weighed on Chinese equity markets through July.
• The People’s Bank of China (PBOC) has eased up on the shadow banking squeeze, announcing some relief on funding support for infrastructure and SME’s, which should lead to resumption of credit flow.
• Post the month end Indian equity markets have continued to rise further, with Q1 FY19 earnings results filtering through daily.Initial results are encouraging, and the Year on Year data also demonstrates improvements, which given the introduction of the Goods and Services Tax (GST) in July 2017 was to be expected.

Market update

A resumption of trade tensions and the subject of the renminbi were key issues that weighed on Chinese equity markets through July. The Chinese currency depreciated by 8.4% against the US dollar since the end of Q1 and is down 4.7% year to date to end of July. Speculation remains widespread that authorities in Beijing have adopted a devaluation policy in response to an escalation in trade conflict with the US, propelled by President Trump. Fears of a speculative attack on the currency, such as the type witnessed in late 2015 - early 2016 have resurfaced, although China’s foreign exchange regulator, the State Administration of Foreign Exchange (SAFE), was quick to downplay the move, suggesting there was no evidence of strong capital outflow pressure.

The People’s Bank of China (PBOC) has eased up on the shadow banking squeeze, announcing some relief on funding support for infrastructure and Small to Medium Enterprises (SME’s). 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 SME’s, and follows the recent collapse in infrastructure investment which is down to 3.3%  Year on Year (YoY) growth in the first half of 2018 (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 1 October, which should significantly boost the disposable income of middle-class households.

India’s equity markets continued their summer recovery, reaching all-time highs towards the end of the month.  These moves are predominantly large cap biased, with the mid and small cap markets still some way shy of their highs made in early 2018.  Having said that, the mid and small caps did begin to see the return of both foreign (US$76m) and domestic (US$615m) buyers in July.

Market breadth remains extremely narrow, with the outperformers coming from a very compact group, which are also heavyweights in the index.  This combination has weighed on the performance of the Indian stocks in the Fund. 

Fund activity

China

To recap, we fall back on the high level of rigour and discipline that underpins our quantitative decision making framework to allocate capital and manage risk in China. Our China market model seeks to provide timely buy and sell signals, on balance, through cycles; the model turned ‘bearish’ on 20 July and remained in bearish mode through month-end.

In terms of country positioning, the deterioration in our market timing model has motivated the managers to move from a neutral China allocation to underweight via the purchase of index put options. The premise for this decision was that options remain a more attractive instrument to express the view than moving to a modest level of cash.

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 an 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. Stock selection in aggregate produced negative alpha on the month, with industrials and healthcare companies the worst offenders. 

India

Close to 50% of the underperformance of the Fund for July was attributable to non-ownership of Reliance Industries, India’s leading oil refining company.  Reliance surpassed Tata Consultancy Services, India’s leading IT company, in market cap size this past month.  Reliance does not pass our corporate governance screening and will not form part of the Fund despite it being more than 10% of the index.

We have selectively booked profits in a couple of stocks over the period to realign the exposures.  The current market direction, large caps leading the way is very reminiscent of the taper tantrum days of the summer of 2013, pre-Prime Minister Modi.  At that time mid and small cap stocks were under sustained pressure, with outflows driven by external factors and misinformation, in a weakening rupee environment.  At that time we held our nerve on our multi-cap portfolio believing that the Indian population would vote for change in the general election of 2014 and that the mid and small caps would drive the performance of the market, and the Fund.

We remain focused on continuing to identify those stocks that are aligned with domestic growth, while also cognisant of the factors playing out more globally and how they can have an indirect impact on our Indian holdings.

Outlook

What is clear is that the Chinese government has moved towards easing mode in recent weeks, evidenced by developments in the corporate bond market, looser wealth management product rules and an acceleration of approvals for investment projects. Looking back at recent history, there have been three major turnarounds in market sentiment triggered by policy easing: 1) late 2008, 2) late 2011 and 3) 2014-16 (source: BOAML). All involved significant levels of monetary easing, fiscal stimulus and pro-housing policies. Looking at current aggregate property price levels and high levels of local government debt, Beijing’s options appear to be more limited now.

With that said, Ashburton does not rely on any economic data or forecasting in our decision-making framework to allocate capital and manage risk in China. The managers continue to pay close to attention to our models that solely utilise market internals. As of now, China country positioning reflects a bearish signal, one that is deteriorating rapidly in strength. We remain cognizant of the fact that the equity market landscape can change quickly and we will be swift to act should we be required to do so.

Post the month end, the Reserve Bank of India (RBI) once again raised interest rates to 25bps, following a similar rate increase at the start of June.  The RBI continues to worry about inflation picking up, particularly after the Minimum Support Prices (MSP) hikes that will undoubtedly stoke food price inflation.  The rate hike at this juncture makes sense given the trajectory of the data points leading to this decision, and also with the upcoming election cycle possibly reducing opportunities to act.

Noise impacting India’s markets continues to be from external factors.  Rising global yields allied to the on-going trade wars rhetoric from the US remains a nuisance, in spite of India receiving a “special partner” tag from the US.  We can expect persistent volatility as President Trump continues to make waves across the globe.  The tapering of the oil price and a moderation of the Indian rupee weakness has also helped to assuage investors of the India opportunity, two factors that will have contributed to the net buying by foreigners and domestics.