Why cracks in the Chinese market could be hard to paper over (and why this matters)

The all-time highs reached in May by America’s headline S&P 500 and NASDAQ indices continue to grab most of the headlines, while France is getting in on the act, with its CAC-40 reaching a new post-crisis peak just ahead of Emmanuel Macron’s victory in the country’s Presidential election.

But in total return terms, in sterling, the best-performing region of 2017 to date (and the past 12 months, for that matter) is Asia Pacific ex-Japan.

Asia Pacific ex-Japan is the best performing region in 2017 to date

(Based on total returns in sterling terms).
Source: Thomson Reuters Datastream.

Remarkably, the best performing Asian market is South Korea, which is brushing aside the impeachment of its President, a scandal which is reaching into the upper echelons of Samsung and causing wider corporate governance concerns to power higher.

Next come India, buoyed by Prime Minister Narendra Modi’s reform programme and seemingly not overly inconvenienced by last year’s currency change, and the Philippines, where the economy seems to be strong enough to offset any concerns over President Rodrigo “Dirty Harry” Duterte’s abrasive and unpredictable leadership style.

For all of that it is the identity of the worst performer which really catches the eye – China’s Shanghai Composite index.

South Korea is the best, and China the worst, performing Asian market in 2017 to date

(Based on total returns in sterling terms).
Source: Thomson Reuters Datastream.

In fact, the Chinese benchmark is heading rapidly back toward the 3,000 level which has proved a consistent source of support since 2015’s mini melt-up turned into a mini-meltdown.

Advisers and clients should therefore continue to pay attention to China. Its place in the pecking order of global risk factors may have largely been taken by European elections, Brexit and President Trump’s trade policies but a fresh attack of the jitters in the Middle Kingdom is one potential catalyst for the spike in volatility which many commentators believe may be just around the corner after a stunning swoon in America’s VIX.

The so-called ‘fear index,’ which measures market expectations of volatility in the coming 30 days, stands below 10, well below its historic average near 20.

The VIX, or ‘fear’ index, stands very close to all-time lows

Source: Thomson Reuters Datastream.

Mangled metals

The latest stumble in Chinese stocks is coinciding with fresh weakness in a broad spread of commodity prices ranging from oil to gold to iron ore.

This may be no more than just that – a coincidence – but weakening raw materials prices and fresh questions over the health of China’s markets and economy sit uneasily alongside the enthusiasm which continues to carry developed stock markets higher.

Chinese equities are tumbling just as commodity prices are swooning

Source: Thomson Reuters Datastream.

It is possible that the two are linked. Chinese inter-bank lending rates have spiked sharply this year, as the authorities have sought to cool an economy which got a huge boost in 2016 from a loosening of both fiscal and monetary policy.

Chinese interbank rates are rising

Source: Thomson Reuters Datastream.

Balancing act

The Communist Party therefore faces a tricky balancing act. It will be keen to ensure that the country meets its 6% to 7% GDP growth target in this year of all years, as autumn sees the 19th Party Congress. These twice-in-a-decade meetings are vital staging posts for ambitious party members.

The 63-year old Xi Jinping looks like a shoo-in for a second term as General Secretary of the Party and President of the Republic but he will tread carefully, as he juggles his desire to stamp out corruption, as well as manage the dangers posed by easy-money policies, with the need to keep growth and employment up to expectations.

As experienced Fidelity fund manager D.J. Phadnis put it to me in a meeting earlier this month: “The President wants to clean up corruption, debt and financial excess but the Communist Party’s credibility rests on growth and jobs. This means China’s economy could continue to be very stop-start, as the authorities are likely to panic on signs of any slowdown. Total debt to GDP could therefore continue to rise.”

Phadnis, who runs the Fidelity Emerging Markets Asia fund, adds: “China is a closed system so it won’t blow up but current rates of growth don’t look sustainable with debt-to-GDP ratios above 250%. The economy does look set to slow down at the margin and that could be a potential negative for commodities and those countries and markets which rely on them.”

Phadnis builds his fund strictly bottom-up, looking at individual companies’ competitive positions, their management acumen and governance and then finally valuation. As a result, he still has selective Chinese exposure, through holdings such as therapeutics play China Biologic and white goods maker Midea, but India seems to hold a stronger appeal for him, owing to what he terms its superior potential for sustainable growth. Key Indian holdings include leading private sector bank HDFC Bank and railway logistics company Container Corporation of India.

The Indian stock market is still responding to Prime Minister Modi’s reform programme

Source: Thomson Reuters Datastream.

Valuation

The Fidelity fund’s approach does show just how different Asia’s markets are, even if the temptation is to lump them all together. One way in which they are at least similar is relatively low levels of government debt to GDP, a legacy of the lessons learned from the 1997-98 financial crisis (although the Chinese figure is deceptive, as the debt here seems to be parked at the State-Owned Enterprise Level, halfway between government and corporations):

Asian governments have relatively low debt burdens

Source: Factset, March 2017, IMF’s World Economic Outlook, November 2016 and Fidelity International

That might to help reassure advisers and clients who are nervous about the West’s ballooning debt piles, while it is also possible to argue that emerging markets overall still represent a pocket of value after an eight-year-plus bull run in global stocks.

Phadnis’ colleague Nick Price of the Fidelity Emerging Markets fund flags data which shows the MSCI Emerging Markets index, of which China, Korea, Taiwan and India represent 63%, is trading pretty much in line with its 10-year average rating on a price-to-earnings or price-to-book value basis, at around 1.6 times and 13 times respectively.

Those multiples represent discounts of around 30% to the MSCI World benchmark, compared to the parity or even premium ratings enjoyed in 2007-08.

Ways to access

The good news is that advisers and clients have a wide range of fund options from which to choose, in the event they feel that Asian equities fit with their overall investment strategy, target returns, time horizon and appetite for risk.

Best performing Asia ex-Japan OEICs over the last five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for Asia ex-Japan Equity category.

Best performing Asia-Pacific investment companies over the last five years

* Share price. ** Includes performance fee
Source: Morningstar, The Association of Investment Companies, for the Asia Pacific, ex-Japan category.

Best performing Asian ETFs over the last five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for the Asia ex-Japan Equity and Asia ex-Japan Equity categories.

Yet advisers and clients still need to do their research. The danger is the gap is closed not by emerging markets rising but by them standing still (or falling more slowly) in the event of a correction in the West.

Value-conscious advisers and clients may look to further research emerging markets and Asia in particular, especially if they do think developed markets are overdue a wobble, although they will have to do so with one close eye on China.

Independent economist and commentator George Magnus, who is also an associate at the China Centre of Oxford University (and a former colleague at UBS investment bank), continues to warn of the seemingly inexorable growth in China’s liabilities and the need to ultimately deleverage (cut borrowings), even at the expense of growth.

Echoing the views of D.J. Phadnis he concludes a recent blog: “The alternative [to a managed slowdown] is an event-driven denouement … The catalyst could be capital flight, property prices, political or a trade shock in which there’s a scramble to withdraw liquidity. No Lehman moment as such in a state controlled financial system, but most likely the precursor to a much more difficult and protracted growth slowdown. No one can time this. The good news is it’s not imminent or likely before the Party Congress. The bad news is that it’s probably not more than 2-3 years away if there isn’t a material change in economic policy and management.”

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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