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Market update
China
MSCI China rallied 7.33% during a November that delivered the strongest aggregate EM/Asian market performance since January 2018. President Trump’s tweet on 1 November alluded to a positive telephone conversation with Chinese President Xi that touched on the North Korea issue, and indicated he was looking forward to attending the G-20 Summit and meeting with Xi in early December. The tweet raised the expectations of market participants over the prospect of some sort of interim US-Sino deal on trade that may delay the next proposed round of US tariff increases on Chinese exports. To recap, the next round of increases is scheduled for 1 January 2019 when tariffs on US$200bn of imports from China are set to increase from the current 10% to 25%. President Trump also threatened to impose 10-25% tariffs on the remaining US$267bn of imports from China if a deal is not agreed.
We have alluded to the negative economic impact of China’s domestic deleveraging campaign in previous monthly commentaries. Indeed, Beijing’s ‘deleveraging’ initiative was arguably more responsible for the pain felt across China’s economy in 2018 than the trade war. The good news is that progress has been made in lowering aggregate levels of state-owned enterprises (SOE) debt, avoiding a ‘Minsky Moment’ and reducing the country’s dependency on debt-fuelled growth. With that said, China’s overall debt ratio has continued to rise, driven primarily by local government and household debt. Deleveraging will continue next year but the focus will switch from curbing shadow banking to redirecting credit flows away from local government financing vehicles (LGFV’s), SOE’s and households and moving them towards private firms. This should lead to an acceleration in small and mid-size enterprise (SME) capital expenditure, particularly in the area of automation.
India
With India importing close to 80% of its oil requirement its markets were buoyed by the crude oil price rapidly declining 20% over the month. Temporary “resolution” of the Iranian oil sanctions imposed by Trump for a collection of countries, China and India included, saw the trajectory of crude pricing reverse spectacularly in November, with India a clear beneficiary. A weaker oil price assists corporates who budgeted for sub-US$70bbl, but more importantly, it provides relief for the government heading towards state and national elections in the coming months.
The second quarter of earnings results were completed in November, with FY 2019 expectations for the Nifty Index lowered by 5%, the largest cut since demonetisation in 2016. The cuts were largely a result of margin pressures as raw materials and higher fuel costs have suppressed earnings, and the weaker rupee has not helped. The Nifty now trades at 16.5x one-year forward earnings, still a premium to the long-term historical figure.
One bright area to note was the private sector banks. Blighted in recent years by non-performing loans (NPL) and deals written in the 2000s, we are finally seeing light at the end of the tunnel. The NPL cycle is believed to have peaked, with slippages easing, and in conjunction with the bankruptcy bill provides greater transparency for the future for these institutions. With new management teams in place at both Axis Bank and ICICI Bank, prospects are improving, and expectations for a continued turnaround remain.
Fund activity
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 2 November and remained in bullish mode into month-end, suggesting that the path of least resistance for share prices is now higher.
Moving to the equity portfolio composition, there is a strong bias to domestically focused China companies. Industrials, energy and healthcare sectors represent major overweight positions, whilst consumer discretionary, communication services and financial sectors are major underweight exposures, relative to the MSCI China Index benchmark. It is worth mentioning again that sector allocation is a function of bottom-up stock selection, and does not represent a macro/thematic discretionary view. Both allocation and stock selection in aggregate produced modest negative alpha on the month. Not owning Tencent (a non-consensus view that has been in place for 18 months) hurt relative portfolio performance this month, with China Coal Energy and China Taiping Insurance companies being this month’s other major ‘sinners’.
Following a turbulent journey, we took the decision to sell Indigo Aviation, a stock purchased in early 2018. It had come under increasing pressure with a rising oil price, and after a rebound off the lows in early October it technically stacked up as a time to exit the stock, with the funds being re-allocated to the holding in Coal India Limited. Frustratingly, shortly after the sale the US introduced a temporary easing of the Iranian oil sanctions and, as one would expect, highly oil sensitive companies such as airlines performed well in the immediate aftermath.
Following disappointing port traffic results the decision was made to carefully exit Navkar Corp, a stock held for a number of years. The expected freight flows have not yet materialised and a higher diesel price, which has not been fully passed on, has hurt margins. In addition, leased rake rent prices were hiked, again with little ability to pass on in a very margin sensitive environment.
Outlook
This month there were significant positive developments on two key market risks; worries over the US Federal Reserve hiking beyond the neutral rate, and the escalation of a global trade war, which have coincided with reasonably cheap valuations and skewed positions. Research by JP Morgan suggests that equity positioning of systematic strategies (volatility targeting/CTA/risk parity) as well as the net equity exposure of hedge funds remains very low. This combination should be seen as positive for the market into year-end. Turning to China specifically, equity market valuations relative to emerging markets and history, depressed investor sentiment and the technical picture all point towards the increasing possibility of the market marking an intermediate low. As we pointed out previously, the path of least resistance for equity prices is now higher.
India’s government will be seeking to capture meaningful vote share with populist measures in the 2019 national elections. And with a lower oil price leading to a reduction of fuel subsidies it will allow the government the ability to focus on other supportive measures, however, as has been seen throughout this term of government, there is a distinct reluctance to jeopardise the fiscal deficit.
Five states are in the process of voting with results due on 11 December. Despite the state election results not having a meaningful impact come the national elections, commentators and investors will be seeking an indication of whether Modi and his Bharat Janata Party have done enough in this opening five year term to warrant a strong mandate to 2024, hence there will likely be a period of caution as we move through the election results period and into the new year.
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