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Summary
Market update
India
Indian equities were amongst the top emerging market performers since the spring lows through to mid-September. However, news of domestic private equity fund manager IL&FS running into re-financing issues jolted the market and for some brought back fears of systemic risk and thoughts going back ten years to the global financial crisis. While this is more than likely an over-reaction and an excuse for those looking to book profits in the Indian market, it reminds us of our responsibility to ensure we are investing in good quality management teams, with strong franchises and delivering upon their strategies.
Unfortunately, the timing of the IL&FS news coincided with the Reserve Bank of India (RBI) announcing the non-extension of the existing Chairman of Yes Bank when his term ends later this year, which further unsettled the market. Additional news flow from the central bank towards the end of the quarter did not quell the immediate unease, hence the market correcting by more than 5% in the final fortnight of the quarter. Recent government announcements confirming a lower level of borrowing than forecast helped to reduce 10 year bond yields to 8%.
Oil prices remain a further question mark for economies such as India, particularly with Saudi Arabia seemingly comfortable with crude around the US$80bbl mark. India imports around 75% of its oil requirement and a higher oil price will add additional concern on the market, while also applying pressure to the Indian rupee which is close to all-time lows.
China
China’s equity markets remained under pressure during the quarter, with the MSCI China TR Index registering a loss of -7.42% for the period. Investors continue to 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 President Trump and team. A further announcement arrived on 17 September that the US would impose an additional 10% tariff on US$200b worth of Chinese imports, starting 24 September. In addition, Trump threatened to hike the tariff further to 25% at the beginning of 2019, and potentially expand into a ‘phase three’ element, whereby further tariffs would be imposed on another US$267b of imports should China retaliate.
China Customs Tariff Commission of the State Council responded on 18 September with retaliatory measures to impose additional duties of 5-10% (slightly lower than the 5-25% levels mentioned previously) on US$60b worth of imports from the US, also applicable from 25 September. In terms of scale, the new expansion of tariffs on US$200b covers 40% of Chinese exports to the US currently, which is roughly 7% of all Chinese exports. According to work by the Bank of America Merrill Lynch, when combined with the earlier tariff on the US$50b list under Section 301, these new tariff measures could collect approximately US$75b in 2018-19.
What was instructive from a capital markets perspective was the benign market reaction to the latest tariff announcement. Indeed, the MSCI China TR Index and the domestic Shanghai A-Share Composite rallied 5.3% and 6.7% into month end from intraday lows made on 18 September. Arguably the most interesting observation was the decision by US policy-makers to omit key consumer electronic products, such as smartphones, from the tariff lists. This could suggest that the Trump administration is far more worried about the negative impact of tariffs on American consumers than previously admitted. It also points towards a signal from the market that a political incentive for the US and Trump to ‘deal’ is growing. Only time will tell.
Fund activity
Capital First, a non-banking financial corporation (NBFC) was sold in August ahead of its impending merger with IDFC Bank. The company is focused on small loans to households, as well as tapping the 2-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 August 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. However, 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 larger private banks such as ICICI and Axis Bank should see some benefit from the implications as borrowing for smaller finance organisations has increased following the IL&FS news.
In late August the Fund initiated a position in Coal India, the world’s largest pure play coal miner. With India oil imports currently represent 75% of its needs, putting the economy at risk should global oil prices spike. Hence 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. We will continue monitoring the position to look at opportunities to build the position size.
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 has remained in bearish mode since, suggesting that the path of least resistance for share prices is lower.
In terms of country positioning, this translated to an underweight China allocation via index put options, although the options expired with little contribution to overall portfolio value in late September. Given market conditions in recent weeks and months, the outcome is disappointing, but as the great trader Paul Tudor-Jones once said, ‘match your investment ideas to your trade time horizon’. We will redouble our efforts to learn more and explore the potential of the options arena.
Moving to the equity portfolio composition, there is a strong bias to domestically focused China companies. Materials, industrials and real estate sectors continue to represent major overweight positions, almost entirely funded by an underweight to financial stocks and the newly formed MSCI communication services sector, although it should be noted that the sector allocation is a function of bottom-up stock selection, not a discretionary view. Both allocation and stock selection in aggregate produced +1.61% alpha on the month, with Sinotruk and China Railway Group companies the major positive contributors.
Outlook
Structurally nothing has changed over the summer months in India. Despite negative news on specific banking organisations, we see no evidence of further systemic risks to the banking sector. We are now into the final few months before the next round of state elections, thus we anticipate that Prime Minister Modi will target specific voter groups with initiatives to secure votes come the state and the national elections in 2019.
The corrective moves of late September, coupled with positive affirmations from the government should dampen down any near-term weakness, however, as we head to the state elections we should expect the market to be slightly unsettled. The rupee post the month end retreated through the 73 level to the US dollar, which should favour the export orientated sectors, especially IT which has had a stellar period of outperformance. Exports picked up in the latest data, with inflation numbers lower than expected.
Typically heading towards national elections, it has been a period when Indian equity markets underperform global indices, however, in the 12 months following the election, performance markedly picks up, thus the data would indicate that these unsettled periods are opportune moments to accumulate a position to India. The long-term outlook remains positive, with Modi likely to win the election, demographics increasingly supportive of an increasing growth trajectory for the country, and technology aiding the development of sectors such as consumption through new channels such as e-commerce.
The bigger question in terms of the trade tariff war is what happens next? The major threat is that tariffs are elevated from 10% to 25% which would be more damaging to corporate America. From an equity market perspective, the pain would come from a genuine confidence shock, whereby companies freeze investment entirely on the back of the tariffs. As of now, the data suggests we are not seeing this reaction at the aggregate level. A shift in President Trump’s stance is likely only if a significant deterioration takes place in his public support (approval ratings have been weakening materially in recent weeks), the US economy or the US stock market.
Meanwhile, major developments have taken place in the context of China’s representation in global bond indices. China has long identified foreign purchasing of China bonds as a primary way of developing long-term capital inflow to offset the continued capital outflow pressure facing the mainland economy. During mid-September, a number of measures were announced by the mainland authorities (including an upgraded settlement system and the launch of block trade allocations), which pave the way to inclusion in the Barclays Global Aggregate Index from next April. To give investors an idea of the potential scale of flows, there is approximately US$2.7t tracking this index and China could account for 5.7%.
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