Asian indexes underperform as dollar rises
The consequence of an increase in US monetary tightening expectations and the market’s view China stands to lose out from a tit-for-tat tariff war has culminated in a period of renewed US dollar strength and sharp Chinese renminbi weakness.
This has gone hand in hand with underperformance by Asian and EM equities, reminding investors of the longstanding negative correlation (-0.70 since 2000) between the American currency and the MSCI Emerging Markets Index.
Concerns have also arisen over the amount of EM offshore US dollar borrowing. US dollar-denominated EM international debt securities outstanding have risen by 271% from $819bn at the end of 2008 to $3.04trn at the end of Q1 2018 and China’s by 26x from $30bn to $768bn over the same period.
This coincided with concerted Chinese government efforts to deleverage the economy, raising anxiety amongst investors over its ability to initiate a controlled economic slowdown without triggering a systemic crisis.
The two-year-long deleveraging campaign and related clampdown on the shadow-banking sector have begun to impact the economy in a meaningful way, which has led to policy easing.
Financial institutions will be able to continue issuing Wealth Management Products (WMPs) in their current form until the end of 2020, allowing credit to flow to infrastructure projects and SMEs. Beijing will also initiate its biggest ever tax cut in personal income tax, likely to take effect from 1st October 2018. This should significantly boost disposable income for middle-class households.
Weakness opens up buying opportunity
The MSCI China Net Total Return Index is now well below peaks registered in January. But we must remind ourselves the same index returned over 80% from lows registered in December 2016 to 26 January 2018, leaving equity prices vulnerable to a correction.
Valuations are currently back to just under historical averages. In this context, value is beginning to emerge. And although earnings momentum slowed in China this year, it remains superior to momentum in 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 and sharply deteriorating market prices.
It is clear tail-risks are rising and China will not be immune to capital market stress, regardless of the long-term structural drivers. That said, recent events are setting up an attractive long-term entry point to access one of the world’s most compelling investment stories.
Expensive equities warranted
Indian equity markets experienced a period of correction following all-time highs at the end of August. Profit taking, fears Saudi Arabia is comfortable with present oil prices at about $80 and further losses by the Indian rupee sent markets lower in recent weeks.
Despite this, India’s forward P/E ratio remains above the historical average and one could conclude equity prices are still on the expensive side. However, with growth recovering and earnings showing signs of strength, we believe India’s slight equity premium is warranted.
A number of factors support this, including India’s comparatively strong corporate governance across multiple sectors, Prime Minister Narendra Modi’s reform agenda and growth opportunities in the globe’s fastest growing major economy.
Expect more choice in broadening market
It should be noted all-time highs are largely driven by a limited number of index heavyweights. As evidence of recovery and re-rating unfolds, we should witness a broadening of the upward moves across sectors.
The drivers of the recovery in Indian equities from the 10% correction witnessed in the early stages of the year are different from those which pushed Indian markets to new highs between early 2016 and the start of 2018. Mid and small-cap stocks were largely responsible for the latter, but recent moves have been propelled by a very narrow band of large caps, which form a sizeable part of the index.
This recovery is now beginning to broaden into a more diversified range of sectors, as well as market caps. India has been a notable outperformer amongst other EMs year-to-date, largely due to external factors, such as trade wars, impacting India less than its peers.
Domestic buyers remain optimistic on their home market, while recent reallocation of capital from foreign institutional investors to India has further buoyed share prices.
Craig Farley, lead manager & Simon Finch, co-manager of the Ashburton Chindia Fund