China’s equity markets continued to sell-off through October. The MSCI China TR Index USD returned -11.47% for the month as investor attention migrated from international to domestic issues, specifically the overhang of pledged shares, whereby shares are used by executives as collateral for loans, in the domestic Shanghai A-share market. The primary focus of local investors has been the continuing negative feedback loop triggered by margin calls from pledged shares, with the pledged share ratio in the A-share market running at close to 10%. Complicating the issue is a directive from the China Securities Regulatory Commission (CSRC) specifically forbidding intermediaries such as securities companies from selling pledged shares, effective from March 2018.
The above has raised anxiety amongst the investment community that brokers will be forced to sell other non-pledged shares, triggering a waterfall effect. It was enough to prompt the People’s Bank of China (PBOC), the China Securities Regulatory Commission (CSRC) and the combined banking and insurance regulator (CBIRC), to deliver synchronised statements on 19 October with the explicit aim of bolstering market confidence. These included measures to encourage local government-managed funds, qualified private equity funds and securities firms to support listed companies with share pledge exposure. The Peoples Bank of China (PBOC) also announced an additional 300bn renminbi to support financial institutions in expanding credit supply to small and micro enterprises (Source: CLSA).
The Indian equity markets demonstrated greater resilience over the month compared to their peers, despite all but the midcaps delivering negative absolute returns over the month. Globally, equity markets were under significant pressure, with eyes firmly focused on the US mid-term elections in early November. Elevated levels of volatility in risk assets are to be expected ahead of such influential political outcomes, with the S&P 500 Index losing close to 7% in October.
At the outset of the month the Reserve Bank of India (RBI) chose to keep rates on hold, taking the market by surprise. However, the minutes decidedly point to a continuation of the rate increases in the next couple of quarters, a trend seen elsewhere with rates going up across the globe. The Indian rupee weakened to historical lows. However, it did manage to reclaim some of that weakness towards month end to close down 2% overall. The deterioration was in part due to rate hikes in India during the year, and in part due to the increasing strength of the US dollar.
From an equity stance the focus has been on the fallout from the IL&FS default that began unravelling in September. Financial institutions are unsurprisingly under pressure to identify potential exposure to this and issues around lending capabilities, particularly in a rising rate environment. It seems that the risks are contained at present to IL&FS, however, it is a timely reminder, especially to the non-banking financial institutions that their borrowing requirements must closely match their lending patterns.
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 ‘bullish’ on 4 October, before being whipsawed and turning bearish ten days later. It remained in bearish mode into month-end, suggesting that the path of least resistance for share prices is lower.
Moving to the equity portfolio composition, there is a strong bias towards domestically focused China companies. Materials, real estate and industrial sectors represent major overweight positions, almost entirely funded by an underweight to the information technology sector, which continues to represent 37% of the MSCI China Index. It is worth mentioning again that sector allocation is a function of bottom-up stock selection, not a discretionary view. Both allocation and stock selection in aggregate produced modest negative alpha on the month, with Sinotruk and Momo Inc. companies being the major ‘sinners’.
There was no trading undertaken for new stocks in the Fund over the course of the month. We have seen foreign investors continuing to reduce their exposure to Indian equities, with levels at their lowest point during Prime Minister Modi’s tenure. Domestic investors continue to buy their home market, a trend that began with increased verve following demonetisation in 2016.
MSCI China has corrected 22% year-to-date, or 32% from the January peak. The current market valuation of 10x forward price/earnings ratio is 1.3 standard deviations below the ten year average. Viewed objectively, it could be argued that valuation, earnings and investor sentiment in China currently suggest a long-term buying opportunity is beginning to emerge, particularly given the speed and extent to which markets have shifted from optimism to pessimism. However, the technical picture which reflects the measurement of share prices suggests the path of least resistance is down in the short-term. This, and the absence of capitulation signals thus far, indicate that equity markets may need a period of consolidation, given the magnitude of the market correction this year.
The medium-term market outlook may depend to a great extent on two major impending events. The Trump-Xi Jinping meeting during the G20 Summit from 30 November to 1 December, and the 40th anniversary of China’s reform and openness policy on 18 December. The first event will give a clear indication of the evolvement of the US-China trade conflict, whilst the second event will unveil the direction of China’s strategic reform policy for the next decade or so.
India’s primary woes this year have been a rising oil price, exacerbated by a weakened Indian rupee. This has put additional pressure on corporates who are having to adjust to oil costs more than 20% higher, and all the impact that has on their supply chain. The government too have been faced with re-introducing subsidies to minimise the fallout. At the beginning of November, the US invoked sanctions against Iran were re-established, which is another potential catalyst for increased oil prices for India. Currently India imports 12-14% of its oil needs from Iran. India was able to negotiate an extension to the ban on importing Iranian oil but committing to reducing oil imports from Iran in the coming quarters. Seven other nations were also able to obtain a variety of concessions to continue importing Iranian oil for now. This has the effect of dampening potential price increases and as such aids India’s government with a lower oil cost.
As noted in previous commentaries, many of the corrective moves have been exogenous factors to India’s economy. The mid-term US elections are a case in point. The Democrats have just won the House of Representatives, with the Republicans taking a stronger position in the Senate. It is too early to determine the impact of this result, however it would be a sensible to deduce that there will be a period of uncertainty from the US, which is likely to reverberate globally.
India is heading to elections of its own in the coming weeks. State elections in five states with results due in mid-December will provide an insight into the mind-set of the voter ahead of the national elections in the first half of 2019. Early indications are that anti-incumbency pressure is weighing on Modi’s party. However, we would anticipate that Modi will take this as a cue to incentivise voters with a number of measures in the new year, with infrastructure and the consumer at the forefront of the beneficiaries, hence our over-weight to these as well as good quality financials.
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