In January 2015, we published an update on our views to support our allocation to Asia, a favoured region within our overall emerging markets strategy. Since that date, movements in both the financial and economic environments have had an impact. We assess what's changed and what's next for our portfolios.
In January 2015 we published a piece discussing our allocation to Asia as a favoured area within Emerging Markets (EM) (Moving East - January 2015). A quick re-cap:
- We moved overweight to Emerging Markets at the start of summer 2014, where valuations were at a considerable discount to the developed market - the MSCI EM Index was 25% below its 2007 peak and trading at a P/E of 11.5x, compared to the S&P 500 25% higher than 2007, with a P/E ratio of 17x.
In Q3 2014, the price of oil fell by 15%, the broader commodity index followed suit. In response, at the start of October 2014, we shifted our Emerging Market allocation towards the commodity importers in Asia, and away from the commodity exporters in Latin America, Eastern Europe, the Middle East and Africa.
At the start of 2015, we added specific allocations to China and India. In China, valuations were even more attractive than broad Emerging Markets, with the added catalyst of the government’s move towards increasingly open economy and market. Over time, this is likely to stimulate additional investment in Chinese capital markets by foreign investors. In India, the story was one of political change and structural reform – the election of Narendra Modi promised a similar story to the positive impact of Mr Abe becoming Japanese Prime Minister in December 2012.
The financial and economic environment has had a fair few ups and downs since that article, and next we look at how these impacted the positions mentioned above.
The valuation gap mentioned in the first bullet point has yet to close – both MSCI EM and the S&P 500 index remain around the levels of two years ago. We had anticipated that, as investor optimism grew about a low, but steady, growth world, we would see a rotation from expensive defensive developed equities, to cheaper cyclical EM positions. This return of confidence was damaged by the rising strength of the US Dollar at the same time as the continued decline in commodities prices. The first created doubts about the economic stability of EM economies (similar to the 1998 EM crisis), whilst the latter caused a more widespread concern about a lack of global demand. In this nervous environment, US equities continued to attract capital, and the S&P 500 has ground out an 8% total return since June 2014, compared to a 17% decline for the MSCI EM index.
Within the Emerging Market allocation our tilt towards Asia was correct, in as much as it fell less than our Emerging Market benchmark. As shown in the chart below, Asian stocks (white) had a negative return of 7.5%, as opposed to the 15% drawdown in EM EMEA (orange), and the 26% fall in value of Latin American companies (yellow). In addition to the low commodity exposure of Asian economies, the (relative) political stability also played a part, whereas various problems with government further damaged investor appetite for countries such as Brazil, Russia, Turkey and South Africa.
One of the key struts of our investment theory for China was that it would become more involved in the global economy as time went on. This transition has proceeded in line with our expectations: the Chinese currency has been accepted by IMF as an international reserve currency; China has launched the Asian Infrastructure Investment Bank, alongside founder members such as the UK; the weight of Chinese companies within the benchmark Emerging Market index has increased and is due to increase again in the next month; and, restrictions on foreign participation in Chinese capital markets have been eased. However, the economic benefits of China’s global integration are mostly in the long-run. In the media, meanwhile, China has gone from being a peripheral concern to being centre-stage, for the wrong reasons. No self-respecting market commentary has been complete without a China scare-story somewhere. The negative press surrounding the volatile Chinese stockmarket, the slowing economic growth rate and the August mini-devaluation of the Renminbi has contributed to the Hang Seng China Enterprises index sitting nearly 25% below our entry point last year. Our Indian equity position has suffered from a slower pace of structural reform than anticipated given Mr Modi’s large majority – with political setbacks occurring at a state level. While outperforming the broad Asian index we hold, MSCI India has still had a negative 4.5% return since January 2015.
Now, eighteen months later, with tilts to Asia, and China and India still in place, we lay out our justifications for continuing to hold these positions.
We still see an opportunity on valuation grounds. Despite better underlying levels of economic growth and less-indebted governments, Emerging Market companies are priced at big discounts to developed markets, and particularly low in some areas such as China. Superior growth and fiscal stability has failed to translate into earnings growth during our holding period, but this is not a problem unique to Emerging Markets and, at least, the potential is there to return to ‘normal’ levels of growth and profitability. It is certainly harder to argue this case in developed markets, where demographic trends and indebtedness are bigger headwinds. Key to unleashing economic potential is to increase the productivity of workers, and one of the key trends in this process is movement of workers from rural to urban areas, something that is happening on a massive scale across the emerging world.
Tilt to Asia
Despite the year-to-date rally in markets such as Brazil and Russia, we continue to minimise our exposure to non-Asian equity markets. The dependency of these economies on commodities is apparent in the chart below showing Brazilian equities (white), Russian equities (orange) and the price of Crude Oil (yellow) year-to-date. In addition, these double digit returns come off a very low base – on a one year view, Brazil is still down 20%, even after the rally below. We continue to prefer those countries where low commodity prices are a boon rather than a burden – which leads us naturally to the manufacturers in Asia. In terms of the political situation, it is arguably no less volatile than the summer of 2014 – although Russia has dialled back its military aggression, the Middle East is dealing with a loss of oil revenues and the rise of ISIS, whilst Latin America is seeing increasing public discontent. Compare this to Asia, where the situation is relatively benign. The global trade cycle has been somewhat disappointing, and this has held back performance of Asian markets that are often exposed to technology hardware and capital goods; however, signs of improving consumer demand in the US may provide a boost to global trade. Meanwhile, Asian equity valuations are very cheap versus history and versus other global equity markets.
Towards the end of last year, our Chief Investment Officer Chris Darbyshire published a piece regarding the long-term fundamentals at play in China (Invest In China? You Must Be Completely Rational - September 2015), in which he mentions that "China has both the ability and the willingness to address economic problems using both fiscal and monetary policy." At the National People’s Congress last month Premier Li Keqiang confirmed the governments focus on "destocking", with recent measures including:
- Converting local government debt into central obligations – in essence ensuring that the infrastructure projects undertaken by local governments remain financed regardless of regional economic strength.
Establishing an employee relocation fund for those in the steel and coal industries – encouraging workers to reskill for a more modern China.
Establishing Asset Management Companies to buy up distressed assets from banks, helping to stabilise the financial system and release capital for more productive lending.
Eased house purchase restrictions – leading to housing inventories come down across most cities in China and put a floor under the stressed construction sector.
Whilst none of these will provide an immediate positive jolt to the equity markets, they offer the prospect of something more alluring in the long term, the genuine intention to shift China’s economy towards a non-manufacturing model. While attention is often focused on the primary industries of China, such as steel manufacturing and coal-mining, consumption and services in China are growing rapidly. The rise of the service sector in China is only just beginning, and the potential for growth is staggering – just look how many Western companies are desperate to establish a foothold. The rise of the service sector in China is only just beginning, and the potential for growth is staggering – just look how many Western companies are desperate to establish a foothold.
We tweaked our Chinese equity exposure slightly in January, replacing our financials-heavy Hang Seng index futures with the more diversified MSCI China – which includes many of the ‘new economy’ companies listed overseas, such as Alibaba and Baidu. This change aligns our positioning more closely with what we believe will be the driver of economic growth over the next few decades. China is not going away – over time, listed western companies will have to deal with more and more competition from this low-cost producer and, at the very least, we should seek to protect our investors by having a foot in both camps. The exposure to potentially fast growing service companies in the MSCI China index is set to increase further in June, as US-listed Chinese stocks (such as Alibaba) will be included at their full capitalisation weight.
Our investment in India was in order to gain exposure to the potential for structural change in the economy – by its nature a long-term investment. Whilst Mr Modi hasn’t delivered all that he promised, he has managed to instil the idea that India needs to change in order to continue growing – no small feat in the world’s largest democracy. India is growing at around 9% a year, a well-educated population and has demographic advantages that China lacks. As the capital market opens up, foreign investors will likely be drawn to these attractive characteristics – we would like to beat the rush.
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