Asia equity markets, remained volatile and choppy as investors grapple with the consequence of an increase in US monetary tightening expectations, driven by US inflation, employment and wage data, and the current market view that China stands to lose out if Beijing continues a proportional retaliatory response to tariff demands by US President Trump. During the first three weeks of August, the trend of US dollar strength and sharp Chinese renminbi weakness that have been prevalent since April continued in earnest, forcing currency intervention on the part of Chinese authorities. The direction of the US dollar will likely be key to EM and Asia performance during the remainder of this year, given the longstanding negative correlation (-0.70 since 2000) between the US dollar and the performance of the MSCI Emerging Markets Index.
The latest China macroeconomic data released mid-August continues to show a slowdown in infrastructure spending which contrasts with rising private sector capital expenditure and increasing residential real estate investment. Infrastructure spending declined by 5.3% YoY in July and is up only 1.8% YoY in the first seven months of 2018, compared with 16.7% YoY in the first seven months of 2017. Arguably the most interesting development was an acceleration in both private sector fixed asset investment growth and manufacturing sector investment growth to +8.8% YoY and +6.9% YoY. Turning to structural reform, the latest credit data in China continues to demonstrate the impact from Beijing’s deleveraging campaign. Aggregate social financing outstanding growth slowed from 13.6% YoY in July 2017 to 10.3% YoY in July 2018. In volume terms, social financing volume, excluding renminbi bank lending, was a negative Rmb245b in July, the third straight month of outflows which reflects the continued squeeze on shadow banking , or lending outside the formal banking system.
At the outset of the month the Reserve Bank of India (RBI) chose to raise interest rates a further 25bps taking the repo rate to 6.5%, however remaining a neutral stance. The rise was not unexpected with the RBI indicating their focus is to remain on top of inflation which had touched 5% as recently as June 2018, higher than their 4% target rate.
India’s equity markets rose in local currency terms, however were marginally negative in US dollar terms following a weakening of the Indian rupee. Large caps were outpaced for the second consecutive month by mid and small caps, with domestic investors joined by foreign buyers during August. New highs were achieved, although into month end profit-taking was accelerated as investors grew cautious about concerns around GDP growth rates in the EM space, combined by a weaker currency.
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 throughout the month of August. In terms of country positioning, this has translated to an underweight China allocation via the purchase of index put options (expiring late September). 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. Materials, industrials and real estate sectors represent 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 on aggregate produced 1.48% alpha on the month, with Momo Inc and China Communications companies the major contributors.
Capital First, a non-banking financial corporation (NBFC) was sold ahead of its impending merger with IDFC Bank. The company is focused on small loans to households, as well as tapping the two-wheeler finance market amongst others. Despite our preference for these areas, the upcoming merger has led to a plateau in pricing in the near term, with better potential investments elsewhere preferred at this stage.
ICICI Bank position was pared towards the end of the month booking profits, yet the fund retained a position in the company as we await further news on the imminent management changes, and we will act accordingly as this unfolds. This bank, as well as other private corporate banks are appearing to have navigated a substantial passage of non-performing loans, and are coming out the other side.
The Fund initiated a position in Coal India, the world’s largest pure play coal miner. With India oil imports currently representing 75% of its needs, which puts the economy at risk should global oil prices spike. This explains the government’s decision to hold coal mine auctions in order to facilitate a more efficient distribution of coal assets in the country. The company offers a low beta, combined with a substantial dividend yield (8%), and has been an underperformer year to date (YTD), with a valuation that represents a suitable entry point.
At the time of writing, the MSCI China Net Total Return Index is now almost -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. Earnings momentum has slowed for China this year but traction 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. With that said, recent events are setting up an attractive long term entry point to access one of the world's most compelling investment stories.
Post the month end of the Indian market, the government released their GDP figure, disclosing that the economy had grown at its fastest rate in nine quarters, hitting 8.2% for the quarter ending June 2018. Domestic consumption is being supported by continued manufacturing growth. The weaker currency has also provided some respite for the export industry which has seen improvements in recent months, although it should be considered that the 2017 June ending quarter was disrupted by the upcoming introduction of the Goods and Services Tax (GST), and this will undoubtedly have a favourable impact on the quarter ending September 2018.
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