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The governor of the Reserve Bank of India’s sudden resignation took the markets by surprise.
Summary
Market update
China
Chinese equity markets see-sawed through the quarter, with the MSCI China TR Index (US dollar) registering monthly performance returns of -11.47%, 7.33% and -6.05% for October, November and December respectively, culminating in a -18.75% headline return for 2018. Domestically, a myriad of concerns ranging from slowing demand to escalating US-China tariff tensions to confusion over the direction of monetary and fiscal policy all resulted in a substantial market valuation de-rating through the second half of 2018. Negative investor sentiment was exacerbated by an acceleration in aggregate corporate earnings downgrades during the period under review.
Beijing’s ‘deleveraging’ initiative was arguably far more responsible than the trade war for the pain being felt across China’s economy in 2018. The good news is that progress has been made in lowering aggregate levels of state owned enterprise (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 towards private firms. This should lead to an acceleration in small and medium sized enterprises (SME) capital expenditure, particularly in the area of automation.
The net result of the above is that MSCI China’s sector-neutral forward P/E has de-rated sharply since the beginning of the year, to 10.5x currently, hovering at the lowest levels since 2011. Meanwhile, downward earnings revisions have driven consensus earnings forecasts for 2019 down by 7%. Looking at sector performance in 2018, a healthy degree of rotation has not been surprising. Internet and e-commerce, autos and real estate stocks, the big outperformers in 2017, underperformed sharply during 2018 on growth and valuation concerns. Meanwhile, defensive sectors such as utilities, telecom and energy outperformed.
India
Volatility was elevated globally, which had repercussions for India’s equity market moves in October, however, by the close of the month, the mid-caps had begun to demonstrate greater resilience on the back of the Q2FY19 earnings season and were moving higher, while the large-caps began a more muted recovery. The easing of sanctions on Iranian oil for a small collection of countries, including India which is greatly exposed to the vagaries of the oil markets, was the major positive factor aiding the recovery of Indian equity valuations.
November was relatively flat for Indian equities with the focus on the US mid-term election results and the ‘will they, won’t they’ back and forth of US-China trade wars, while the falling oil price continued to offer assistance to Indian corporates.
Indian market watchers were holding their breath ahead of the five state election results which were due on 11 December 2018. However, they were caught spluttering just one day beforehand with the shock resignation of the Reserve Bank of India’s governor, Dr Urjit Patel, departing the role he took on in September 2016 and thus, not completing his three-year term. Despite the government and the RBI being at loggerheads for a while, it was not expected that the governor would resign.
Since the resignation Indian markets have shown improved returns with the new governor Mr Shaktikanta Das, a former bureaucrat who held positions in the finance ministry, seemingly calming fears of a continuation of the animosity between government and the central bank. The new governor has already taken pragmatic steps to improve liquidity within the system, and should lean towards a more growth orientated set of policies, whilst still maintaining the institutions’ independence.
Fund activity
Our capital allocation model seeks to generate positive alpha on balance, through cycles, by actively tilting the country exposure to China and India. The three ‘modes’ are; overweight China/underweight India, neutral, and overweight India, underweight China. This decision framework is taken within the context of 65%/35% maximum/minimum exposure limits. The allocation model produces less than two signals per annum on average, and is ‘neutral’ c.65% of the time. The current model signal is neutral, advocating a close-to 50% allocation to both countries. This position will be maintained as closely as possible within the Fund as we enter 2019.
In terms of the China equity portfolio, industrials, utilities and real estate sectors represent major overweight positions at quarter-end, whilst consumer discretionary, communication services and financials sectors are major underweight exposures, relative to the MSCI China Index benchmark. It is worth repeating that sector allocation is a function of bottom-up stock selection, and does not represent a macro/thematic discretionary view.
Sector allocation and stock selection in aggregate produced positive alpha on the quarter, with consumer discretionary and the real estate sectors adding more than 1% relative alpha each. Healthcare and financials positioning detracted modest exposure, relative to benchmark returns. Stock selection in aggregate detracted value over the quarter, albeit modestly. In terms of individual stocks, Sinotruk and China Coal Energy comprise Q4 2018’s major ‘sinners’.
Following a frustrating period of awaiting a turnaround in the valuations, the patience on some counters has delivered outperformance over the course of December, and in-line performance of Indian stocks for the quarter.
Earlier in the quarter and 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. Frustratingly, shortly after the sale, the US introduced a temporary easing of the Iran 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 on, again with little ability to pass on in a very margin sensitive environment.
Outlook
The 2019 outlook, with a focus on the first quarter, essentially revolves around four key components; the outlook of US-China trade talks; China’s economic and policy outlook; the trend of earnings revisions; and market sentiment. Prospects for a near-term tactical rally on improving market sentiment most likely hinge on the trade talks.
The trade war manifested from a tail-risk event to a baseline scenario in 2018. An agreement between the US and China is certainly possible in Q1 2019, predicated on key concessions from both sides. These might include the US agreeing to cancel future tariff hikes and even removing some/all existing tariffs in exchange for China agreeing to reduce tariff and non-tariff barriers for imports, gradually open up selected sectors, strengthen IP protection and/or refrain from conducting the forceful transfer of technologies. Any substantial change to the current ‘Made in China 2025’ strategic policy objective or renminbi policy however, are highly unlikely.
The state election disappointment for Modi and his party will focus efforts ahead of the upcoming national elections, with the opposition parties feeling rejuvenated. We would anticipate that a continuation of favourable policies will garner greater attention and Modi will do his utmost to ensure re-election is secured in the coming quarters so that he can continue his revival of the Indian economy, from top to bottom.
The falling oil price, a US Federal Reserve that has indicated a possible slowing of rate rises and the Indian rupee showing greater resilience are all factors that create a more positive investment environment for investors in India. Additionally, the government and central bank will be seeking to focus on growth enterprises, meaning the outlook for the New Year appears constructive. Concerns would be that Modi is unable to resume his role as PM following the springtime elections and the perception is a return to frustrating coalition politics. We are sanguine on Modi’s chances for re-election, however, should that not be the case, Indian politicians have typically sought to build upon what has gone before, and thus a new government will likely pick up from the progress made under Modi, as Modi himself has done since 2014 with schemes such as the Unique Identification Scheme (Aadhaar), GST and the Bankruptcy Bill implementation.
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