WHAT S REALLY HAPPENING IN EMERGING MARKETS?

Transcription

1 For Professional Investors I November 2015 I #03 WHAT S REALLY HAPPENING IN EMERGING MARKETS? THE CHINA FACTOR Patrick Mange Head of Strategy Emerging Markets BNP Paribas Investment Partners (Chief Editor) Welcome to our third edition of the Quarterly What's Really Happening in Emerging Markets? Using our unrivalled local network of teams across the globe, we aim to provide you with insights on important themes and debates in the emerging world. This issue focuses specifically on China. Fed funds, the US dollar and commodities are strong drivers for emerging market equities. But as recent events have shown, events in China are also becoming increasingly important. The bursting of the Chinese A-share equity bubble and the surprise devaluation of the renminbi fuelled market concerns about a hard landing for the economy. The combination of rapid credit growth and the shrinking of State - Owned Enterprise (SOE) profitability, leading to an accumulation of bad loans, has raised the spectre of a possible banking crisis. A financial crisis is unlikely in our view. Not only has China sufficient fiscal and monetary ammunition to counter any meaningful economic slowdown - and a strong political commitment to avoid such an outcome - banks are also almost entirely in public hands and have rather solid fundamentals. In this edition we detail not only the above views, but also explain how our emerging market equity portfolio adapts to the China factor.

2 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 2 CHINA MOVES TO CENTRE STAGE Patrick Mange Head of Strategy Emerging Markets BNP Paribas Investment Partners Emerging market (EM) equities have disappointed for quite some time. As of today, they have underperformed their developed market (DM) peers for almost five years in US dollar terms. The main reason lies in the evolution of commodity prices and the US dollar, both incidentally highly inversely correlated: commodity prices have plunged, while the US dollar has gained. History highlights this clearly. Commodities experienced what is now referred to as their golden age between February 1999 their cyclical trough and February 2008 when they reached an all-time high. Over this time span, commodities, as measured by the Bloomberg commodity index, rose by around 220% (or about 13% annualised), while EM equities, as measured by the MSCI index in USD, gained almost 425%, i.e. close to 19% annualised. The Great Financial Crisis in late 2007 abruptly interrupted this stellar run by commodities and EM equities, while boosting the US dollar in its role as the world s safe-haven currency. Although the epicentre of the crisis was in developed economies, emerging equities still underperformed their developed market counterparts during this period. The first quantitative easing wave (QE1) in late 2008 led to a liquidity-driven rebound in all asset classes and EM equities found enough support from both a weakening US dollar (i.e. strengthening local currencies) and increasing commodity prices to outperform their developed market peers. But in late 2010, commodities started to slowly weaken again, with the US dollar gaining once more, and EM equities suffered. More recently, some new occurrences have added to this unfavourable trend for emerging markets. First was the collapse in oil prices in mid-2014, this time mainly driven by excess supply. Then, talk emerged of a tightening of US monetary policy, which lifted the US dollar further and heightened investor uncertainty about the prospects for EM external debt funding. The third and arguably the most important factor was the reappearance of latent fears over the pace of GDP growth in China, triggered by the bursting of the Chinese A-share equity bubble in mid-june 2015 and more importantly by the devaluation of the renminbi in August. It is not so much the slowing of China s economy that raises concerns; it s more the sense that this slowdown is uncontrolled, fuelling market worries about a hard landing of the economy. Our view on global rates, the US dollar and commodities is broadly constructive. Provided China does not fall into recession, commodities prices will likely stabilise at low levels before gradually rising due to a narrowing demand/supply gap. Similarly, excluding the occurrence of any detrimental exogenous shock to global growth, the US Federal Reserve (Fed) might take the plunge and increase its benchmark interest rates, possibly as soon as December. But we believe a new series of US monetary policy tightening moves would take a gradual course and be accompanied by highly cautious rhetoric. In fact, Fed officials, in comments echoed by the International Monetary Fund (IMF), are worrying that an overly strong tightening of monetary reins by the US could drive the world economy into recession. Thus the upside on the US dollar looks rather limited. These views do however depend on events in China, which is why in this quarterly we are focusing more closely on the prospects for this country. 13 th Five-Year Plan reaffirms commitment to reforms We believe China will not experience a hard economic landing. We expect the transformation of the Chinese growth model from one based on debt leverage and investment to one based on consumption and services to be accomplished without the country suffering a financial crisis. As our China senior economist Chi Lo argues in this edition, a liquidity crisis in China triggered by a loss of foreign investor trust, causing international funding to dry up, looks unlikely given that China is running a comfortable (and growing) current account surplus and is a net creditor to the rest of the world. A bank intermediary crisis or a loss of confidence of depositors leading to a bank run look rather improbable in our view since the banking system is almost entirely in public hands, the loan to-deposit ratio is still low and bank deposits have been protected by deposit insurance since May 2015 for amounts of up to RMB (USD ). That said, China s recent actions and reactions have contributed to an increase in uncertainty. It would be fair, we think, to expect a further depreciation of the renminbi in the long run. Indeed, the tradeweighted renminbi still looks overvalued to us and the exchange rate should be determined more by market forces if it is to join the IMF s Special Drawing Rights basket, as we believe it will in time. Furthermore, while it seems clear that growth will slow further in part as the price to pay for transitioning from an export-oriented to a more domestically-driven economic framework it is increasingly unclear how quickly this will happen. The authorities poor handling of the equity market collapse and a less supportive labour market have raised doubts about the pace of reforms. Indisputably, China has more than enough fiscal and monetary ammunition to counter any meaningful economic slowdown and there is a strong political commitment to avoid such an outcome. However, to put the complex Chinese economy and thus its financial markets on a more sustainable growth path, it looks increasingly necessary to move to an economy in which the allocation of resources is dictated more by the market than by the Central Committee of the Communist Party. The recently announced 13 th Five-Year Plan hints in this direction. Measures include the important relaxation of the one-child policy and further expansion of pension and healthcare coverage. It reiterated the goal of doubling GDP by 2020 from 2010, implying a more realistic, but still ambitious growth objective of 6.5% for the next five years compared to 7% so far. Key reforms include boosting innovation, entrepreneurship, quality and efficient development. Fiscal and financial reforms and particularly SOE reforms received relatively little attention despite the latter being seen by investors as the top priority. We are confident that the full details of the plan, to be released after ratification by the National People s Congress in mid-march 2016, will include a precise agenda and full liberalisation of prices in the competitive sectors. How should investors best adapt their portfolios in this period of rising uncertainty over China? Don Smith gives his views in this edition. He is constructive on China s ability to reform, but cautious on growth and the currency. This is reflected in his stock pic

3 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 3 Chart 2: Foreign exchange reserves still > 40% of GDP in June CHINA IN CRISIS? Chi Lo Senior Economist Greater China BNP Paribas Investment Partners Many observers believe that China is in a financial and economic meltdown. Such a concern is causing anxiety and panic everywhere. China is the world s second largest economy and largest trading nation. Given its growing economic influence around the world, bearish observers clearly think that when China sneezes, the rest of the world may catch a cold. But what do the facts tell us about this gloomy narrative? Essentially, there are two kinds of financial crisis: 1) an external account crisis, which arises when foreign investors/creditors lose confidence in a country s economic fundamentals and profligate government, or 2) a banking crisis, which usually stems from the wholesale market funding an asset bubble that aggravates a country s bank balancesheet mismatch problem when the bubble bursts. To remedy an external account crisis, the country concerned usually has to devalue its currency and restructure its foreign debt. With banking crisis, the remedy typically involves recapitalizing the country s domestic banks to contain systemic panic. As China has neither a fully convertible capital account nor a fully floating exchange rate, such as closed system reduces the likelihood of a fullblown financial crisis in its economy. USD billion Mar 89 Dec 90 Sep 92 Chart 3: China has little foreign debt foreign debt % GDP 70,0 60,0 50,0 40,0 30,0 20,0 10,0 0,0 Jun 94 Mar 96 Dec 97 Sep 99 Jun 01 Mar 03 Dec 04 Sep 06 Jun 08 Mar 10 Dec 11 Sep 13 June 15 China India Philippines S. Korea Indonesia Taiwan Thailand Malaysia sources: CEIC, Bloomberg, BNPP IP (Asia) Chart 4: General government debt (2014) 300,0 Clearly, China does not face an external account crisis. Its basic surplus (i.e. current account balance plus net foreign direct investment inflows) amounts to 4% of GDP and its foreign exchange reserves amount to more than 40% of GDP (Charts 1 and 2). These levels are enough to cover more than two years of imports (compared to the safety norm of three months-worth of imports). Its short-term foreign debt is only 8% of GDP (Chart 3), despite its rapid accumulation in recent years; total (local and central) government debt is just 52.8% of GDP (Chart 4), which is below the danger threshold of 60%. Chart 1: China external balances (% of GDP) 16,0% % GDP 250,0 200,0 150,0 100,0 50,0 0,0 Australia S. Korea China Germany sources: CEIC, IMF, BNPP IP (Asia) Euro zone UK France US Italy Japan 14,0% 12,0% 10,0% 8,0% 6,0% 4,0% 2,0% 0,0% current account basic balance* * Current a/c + net FDI inflows So rather than an external account crisis, market fears have centred on the risk of China suffering a banking crisis. But evidence shows that such a risk is within manageable limits. China s asset bubble has not been funded by excessive bank lending, as seen by the loan-to-deposit ratio remaining well below the 0.75 regulatory cap (Chart 5) when the property and stock market bubbles were inflated. The banking sector s balance sheet mismatch has improved in recent years (Chart 6), and its average capital adequacy ratio is high at over 10% (Chart 7). The system s average loan-loss provision remains at 200% of bad assets, despite some drop-off from a peak of 300% and rising non-performing loans (Chart 8).

4 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 4 Chart 5: No lending binge by Chinese banks 0,78 Chart 8: Loss provision ratio still over 200% 350 2,5 loan-to-deposit ratio 0,76 0,74 0,72 0,70 0,68 0,66 0,64 regulatory cap* on loan-to-deposit ratio (0.75) *abolished in September 2015 actual loan-to-deposit ratio Dec 10 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Mar 15 Jun 15 Chart 6: Banking sector's balance sheet mismatch has improved share of total loans 80,0% 70,0% 60,0% 50,0% 40,0% 30,0% 20,0% 10,0% 0,0% Jan 99 Dec 99 short-term* medium- & long-term** Nov 00 Oct 01 Sep 02 Aug 03 Jul 04 Jun 05 May 06 Apr 07 Mar 08 * < 3 years ** 3 to 5 years and > 5 years Chart 7: Strong capital adequacy ratio* capital -asset ratio 14,0 13,0 12,0 11,0 10,0 9,0 8,0 7,0 6,0 Dec 07 capital adequacy ratio Jun 08 Dec 08 Jun 09 Dec 09 * commercial banks Feb 09 Jan 10 Dec 10 Nov 11 Oct 12 Sep 13 Aug 14 Jul 15 Tier 1 capital ratio Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14 Jun 15 provision coverage ratio Mar 09 Aug 09 Jan 10 Jun 10 NPL ratio (RHS) loss provision coverage ratio (LHS) Nov 10 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 May 13 Oct 13 Mar 14 aug 14 Jan 15 Jun 15 Meanwhile, China s property market correction has not seen a collapse in property prices (Chart 9) like that in the US property bust in which caused undue financial stress in the banking system. This may likely be a result of a lack of excessive leverage in China s property bubble and the government s implicit guarantee policy, which is designed to prevent a loss in public confidence in the banks. Chart 9: Chian's property prices did not collapse %YoY 25,0 20,0 15,0 10,0 5,0 0,0-5,0-10,0 Jan 11 Apr 11 Jul 11 Oct 11 Tier 2 cities** Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 others * Beijing, Shanghai, Gaungzhou, Shenzhen ** Tianjin, Chongqi, Chengdu, Wihan, Xiamen Apr 13 Jul 13 Oct 13 Jan 14 Tier 1 cities* Apr 14 Jul 14 2,0 1,5 1,0 0,5 0,0 Oct 14 Jan 15 Apr 15 Jul 15 So any perceived China crisis seems to be stemming from the fear of capital flight by local Chinese. In our view, this is unlikely because China s capital account is still relatively closed, and most Chinese investors can still get a 5%-6% yield on local wealth management products. They would also have to pay 3%-4% for currency conversion charges to take money out of the country. The trade would be worthwhile only if they expect the renminbi to fall by more than 10%, which we believe is unlikely 1. Rather than a financial and economic meltdown, China is seeing an overdue correction in its asset market. Allowing the correction to take place is part of the process of China further opening up its financial system to market forces. The recent sell-off of Chinese assets reflects the frictions from economic rebalancing and liberalisation, rather than being a sell-off in view of the fundamentals of the Chinese economy. 1 See Chi Time: How Serious is China s Capital Flight? 4 March 2015, and Chi on China: The Tide of the Renminbi is Turning, 23 September 2015.

5 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 5 In the coming months if Beijing manages to keep the renminbi stable, if China s economy starts to stabilise, and if the renminbi is admitted to the International Monetary Fund s Special Drawing Rights basket, the market will have to admit that China s economic growth had not crashed, thanks to a stabilising property market and the continued expansion of the service sector that has kept wages, job and consumption growth stable. Those who have sold China short may then wonder why they were involved in a negative carry-trade based on fundamentals that are not as bad as they had hoped for and given that those imagined catalysts never materialised. When they start covering their short positions at a time when the renminbi is under-owned and when China runs the largest trade surplus in the world, Chinese asset prices and the renminbi exchange rate will have to rise.

6 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 6 China exposure PLAYING CHINA S LONG TERM THEMES Don Smith Chief Investment Officer, Global Emerging Markets Equities BNP Paribas Investment Partners Our process The Global Emerging Markets Equity team uses an investment process that is focused on bottomup stock selection. We seek to invest in well-run, quality companies that are mispriced relative to their long-term earnings growth and cash flow generation potential. Our approach focuses on financially sound companies and we carry diversified investments across emerging markets. As the portfolios are constructed at the stock level, we do not actively target a specific country weight in China. Our emphasis on longer-term earnings potential allows us to see beyond short-term market volatility and concentrate on the true economic productivity of a company. While macroeconomic and geopolitical factors can impact corporate performance, opportunities for investment arise when market participants overreact to nearterm noise and uncertainty. We select investments when we believe our bottom-up assessment of individual companies longterm prospects differ from the market view of those companies. We pay particular attention to companies with strong business models and competent management as these qualities tend to strengthen their longer-term competitive positioning during turbulent macroeconomic periods. China Over the course of 2015 our team took the broad view that while credit conditions in China have remained tight, the government s easing measures (reserve requirement ratio cuts, interest rate reductions), financial reforms and various stimulus measures would gradually gain traction and result in modest economic improvement. The year has progressed with no lack of surprises and volatility, and not without a few missteps by the Chinese authorities including the indelicate handling of the A-share market and loosening of the renminbi trading bands. Our approach has been to focus on company fundamentals, which has led to maintaining an active exposure through the recent turmoil, targeting specific areas of the Chinese economy including services, food production, logistics and infrastructure. Our portfolio exposure to China is broadly diversified across market sectors and industries through investments in companies whose growth potential is not fully discounted at the individual stock level. While our country weight in China does not vary dramatically from that of the general emerging markets indices, our stock holdings expose the portfolio to the areas that our team believe have the best structural growth potential over the long term. We have judged each of our stocks to possess a combination of specific characteristics that the team has identified as critical drivers of investment success. Certain areas of emphasis in the portfolio are service-oriented segments such as internet, telecommunications and packaged food manufacturing and distribution. In a broad sense, the individual securities held across the portfolio benefit from one or more of three distinct themes currently present in China s changing economy: Transition from a capital-intensive, asset-heavy growth model to a services-focused economy driven by consumption State-owned entreprise reform and consolidation Targeted infrastructure development The Chinese economy can be seen to be making a clear longterm shift away from manufacturing and toward consumption and services (see Figure 1). Although China s purchasing managers index (PMI) readings have generally been weaker than expected, service industries (including insurance, entertainment and tourism) have been more resilient. Figure 1: Share of China nominal GDP (annualised) (%GDP) Secondary industry Tertiary industry Primary industry dec. 92 june 93 dec. 93 june 94 dec. 94 june 95 dec. 95 june 96 dec. 96 june 97 dec. 97 june 98 dec. 98 june 99 dec. 99 june 00 dec. 00 june 01 dec. 01 june 02 dec. 02 june 03 dec. 03 june 04 dec. 04 june 05 dec. 05 june 06 dec. 06 june 07 dec. 07 june 08 dec. 08 june 09 dec. 09 june 10 dec. 10 june 11 dec. 11 june 12 dec. 12 june 13 dec. 13 june 14 dec. 14 june 15 Source: CEIC Data, CLSA, National Bureau of Statistics June 30, 2015 Research by the Global Emerging Markets Equity team has highlighted that the structural trend of changing consumer spending habits can lead to increased consumption of more advanced financial products and services. This has resulted in defined investments by the team in the financial services sector. Specifically, the portfolio holds investments in companies with a distinct quality bias and an orientation towards the increased penetration of financial services products such as life insurance. Beyond financials, the portfolio is positioned in investments that

7 #03 I WHAT'S REALLY HAPPENING IN EMERGING MARKETS I NOVEMBER 2015 I 7 could benefit from the government s plans to implement more than discrete infrastructure projects across the transportation, environmental and health care segments. The government s New Silk Road or One Belt, One Road project is a broad-based, multiyear globalisation initiative that is supportive of investment themes in China as well as in numerous partner countries. Figure 2: Sentix 1-month sentiment expectations for Chinese equities Sept4, 2015 Portfolio changes Minor adjustments have been made to the portfolio over the past quarter, as valuations have become more attractive for stocks on our focus list. Specific to China, new positions have been taken in consumer-oriented companies that are well placed to benefit from the aforementioned transition toward domestic consumption. We have also refined our internet company holdings. Concurrently, the limited exposure to investments in cyclically-oriented sectors such as materials was reduced. Near-term market volatility has provided the opportunity to open positions in a diverse group of stocks that are not directly linked to China. More specifically, recent purchases have included: A company focused on the convenience store sector in Taiwan A provider of residential and commercial security and surveillance services in South Korea Source: Sentix, Bloomberg Figure 3: Five-year price-earnings ratio (P/E) for the Hang Seng China Enterprises Index (HSCEI) A rapidly growing, low-cost airline based in Mexico Looking ahead Investor sentiment remains quite negative on the prospects for Chinese equities (see Figure 2). Global investors remain underweight China and valuations are supportive (see Figure 3). Additionally, large capitalisation H-share listed Chinese equities provide investors with a dividend yield approaching 4% on average. While classical measures of economic activity such as electricity demand and rail cargo volumes have clearly been weak, other indicators tracking segments that are ripe for equity investment such as travel, entertainment, e-commerce and health care are showing resilience. Volatility should be expected to continue on the Chinese equities markets as the economy rebalances and adjusts to a slower, albeit more reliable, growth model. Opportunities for long-term investment should emerge during this transition period and we remain constructive on the longer-term growth prospects for companies across a wide variety of domestic industries in China. Source: Bloomberg Oct 2, 2015 This document is directed only at persons who have professional experience in matters relating to investment. Opinions included in this article constitute the judgment of the author at the time and may be subject to change without notice. Any references to specific sectors should not be construed as recommendations to buy/sell or gold such sectors.

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