Summary

• The MSCI EM Index was down -6.13% in US$ terms for August, led by a negative month for Chinese equities.
• Stock picking in China was positive for the portfolio, as value stocks in China pulled back and quality stocks bounced following a run of poor performance through most of 2023 (chart below).
• The Materials sector had a down month on softer economic data globally, reflected in the performance of markets with heavy exposure to commodities, including Brazil, Chile and South Africa.
• Tech in Korea and Taiwan cooled following a strong run in 2023, fuelled by surging sentiment for AI.

India’s moon landing marks its rise

Stock picking in India was again a contributor for the portfolio, with our Indian equities flat over the month (MSCI India down nearly -2%). India celebrated a successful landing on the moon, a marker of the country’s rapid ascension – it’s the first nation to land a rover to explore the moon’s southern polar region (and on a budget of less than US$74 million). Just days earlier, Russia failed in a similar attempt.

Does BRICS+ matter?

The 15^th BRICS summit took place this month, with Russia’s Putin notably absent. As a member of the International Criminal Court (ICC), South Africa would have theoretically been required to arrest Putin over ICC accusations of Russia’s alleged deportation of Ukrainian children.

The concept of the BRICS was expanded with the inclusion of Saudi Arabia, Iran, Ethiopia, Egypt, Argentina and UAE. While the idea of a body to represent and promote the interests of the “global south” is logical, some claims of what this group can achieve are wildly overstated.

Indeed, calls that this meeting marks a coherent challenge to Western predominance of international relations is overstated given the divergent economic and political interests of member states. Of the core members, only the giants China and India – strategic competitors and at times outright adversaries – offer meaningful economic and political heft to the group, while Russia, Brazil and South Africa have all gone backwards since former Goldman analyst Jim O’Neil coined the term “BRICS” in 2001. The introduction of a number of states with equally divergent views risks making the BRICS concept even more amorphous.

Early signs of recovery in China’s quality stocks

Our decision to lift portfolio exposure to a modest overweight in China last year as the economy reopened favoured higher-quality names. This reflected the view that China’s reopening would not be a V-shaped boom like what we saw in the West. Money numbers were positive and better than the rest of the world, but not especially strong in absolute terms. The authorities had also refrained from turning on the fiscal and monetary taps through lockdowns and reopening for fear of sparking the inflationary boom we have experienced in the West. Hence, we added primarily to high-quality names with robust and sustainable returns on capital as opposed to more cyclically geared stocks, given the likelihood this recovery would be fragile.

However, as the chart below illustrates, it is quality in China which has been abandoned by foreign investors over the past year. Despite the majority of our holdings posting solid results through the period, investor fears over economic malaise in China and further deterioration of Sino-US tensions saw investors sell indiscriminately as it became clear China’s path to recovery would not be so straightforward.

The chart also illustrates the divergence between performance of quality and value stocks in China, which became particularly stretched in Q2. Their outperformance since early April appears to coincide with the announcement of an SOE reform drive. Beijing is launching yet another push (one of dozens going back decades to Deng Xiaoping’s time as leader) that aims to boost the sub-par returns of these often bloated and highly inefficient companies.

In the absence of other positive stories in China, momentum-oriented domestic mutual fund managers piled into SOE stocks. While this was difficult from the perspective of relative performance for the strategy, we remain happy holders of some very strong franchises that have been posting robust results and now trade at very attractive valuations. In addition, we remain sceptical that the latest reform drive for SOEs will close the wide productivity gap between state firms and private enterprises in any meaningful way.

We remain focused on owning businesses with high returns on invested capital, low debt and management aligned with minority shareholders. This is especially important in the testing economic environment that China is in today. Our businesses should be well-positioned to weather a soft economy, while SOEs inevitably face the risk of being called up for national service by Beijing.

While only over a very short period, it was pleasing to see quality stocks in China bounce sharply in August as policies supporting the economy continue to trickle through. 

Steady drip feed of policy support continues in China

Last month’s commentary covered Beijing’s slow and reactive economic management, while noting signs that authorities are steadily getting a policy response into gear. Investors running for the exits may find themselves whipsawed back into China should authorities accept economic reality and act decisively. For us, while sentiment and news flow are undoubtedly poor, we remain focused on the alpha opportunity that lies between expectations and reality. A shift in the narrative from dire to very bad could be enough to spark a rally given how badly beaten up Chinese equities have been this year.

With this in mind, policy trends through the month were positive (although not exactly decisive) in August:

• It appears that property stimulus is gathering steam on the demand side, with the PBoC lowering the minimum down-payment ratio for first and second-time homebuyers to 20%/30%, respectively.
• The PBoC also cut key policy rates for the second time in three months, which appears to support our analysis that authorities are acting to reverse their misguided policy tightening in late 2022 and early 2023.
• This is translating into lower rates for home loans and should provide some support to the property sector – will this help tier 1 city transactions pick up more meaningfully and move the needle for homebuyer sentiment?
• Providing some support on the supply side (i.e. struggling private property developers like Country Garden) would also help to shore up confidence, but we are yet to hear anything concrete.
• The State Council announced increases in personal income tax deductions for infant and children’s education and elderly care, to help ease the cost of living burden for the middle class.

None of these measures are the policy bazooka that we think can draw a line under China’s slump, but the direction of travel is positive and additional measures to address local debt challenges and ease fiscal policy should emerge in the coming months.

Thailand’s Move Forward blocked from forming government

Former real estate mogul and Pheu Thai party member, Sretta Thavisin, was sworn in as Thailand’s prime minister, having formed a 10-party coalition which includes several pro-military leaders that were previously rivals of the party. The confirmation comes hours after ousted PM and the founder of Pheu Thai’s precursor party, Thaksin Shinawatra, returned to Thailand following a 15-year exile, having fled corruption charges that have now been watered down by the monarchy.

This follows the parliament’s failure to confirm Move Forward’s leader, Pita Limjaroenrat, as the new PM in July. Despite having won the election in May, Limjaroenrat’s confirmation bid to become PM was rejected twice by parliament, driven by opposition to Move Forward’s proposal to reform laws banning criticism of the monarchy. Thaksin’s return appears to signal that a deal has been done with the monarchy to keep Move Forward out of power.

Summary

• Emerging markets were stronger through July, led by a bounce in Chinese equities on announcements from a Politburo meeting that authorities would step up support for the economy.
• Materials, energy and consumer discretionary sectors performed well on talks of a global economic soft landing and China stimulus.
• We are not tempted to chase the rally in more cyclical parts of the market. The global monetary backdrop suggests risk of a head fake for investors expecting a soft or no landing, our view being that global PMIs are likely to roll into the end of 2023.
• Brazil is the first major emerging market to initiate rate cuts, with the Central Bank surprising markets with a 50 bps cut to the Selic policy rate, which now stands at 13.25%.
• While positive and signalling the capacity for many major emerging markets to ease policy as DM central banks pause, Brazil is vulnerable to weak commodities prices as the global economy slows. Narrow money numbers in Brazil are also very weak and indicating risk of a sharp domestic slowdown, while the currency looks vulnerable to a pullback from elevated levels.

Despite the bounce, bearish sentiment for Chinese equities prevails, with headlines dominated by foreign investor revulsion over the perceived fragility of the economic recovery and geopolitical overhang. This has been a tough market for our fund, with many of the high-quality names we hold underperforming as foreigners exit, and while domestic mutual fund investors favour SOEs on hopes that a government-backed reform drive will act as a catalyst for more dynamic management of what have historically been highly inefficient businesses. The low-hanging fruit for the SOEs will be cost cutting, with bloated headcounts being the obvious target. However, we question whether the political appetite for this exists in Beijing given high levels of national unemployment (with youth unemployment of at least 20%). 

We have been writing for nearly a year on China’s monetary backdrop, which while not inspiring in absolute terms, looks much better than many other parts of the world, especially relative to major developed markets. While EM and global investors have been disappointed by the absence of a reopening boom in consumption akin to what we saw in the West, economic recovery is indeed underway.

However, recent data covering consumption, property prices and industrial production tells us that this recovery is fragile and risks rolling without further support. Following a meeting of the Politburo in late July, the authorities have signalled that concrete support is on its way. Better late than never.

Just as central banks and governments in the West were slow to turn off the monetary and fiscal taps as vaccines were rolled out and lockdowns ended, Chinese authorities have been too reactive in managing the recovery. Rather than relying on forward-looking indicators to guide proactive policy, the CCP prizes hard but backward-looking data. This is compounded by the deterioration of China’s institutional quality, as Xi’s consolidation of power has squeezed out dissenting voices in government, the wider party, economic and political think tanks, and in the private sector. This makes for slow and reactive decision-making, and many investors are not keen to wait around, adopting what we refer to as an “anything but China” footing, or ABC for short.

The risk to ABC is an unexpected policy reversal by China’s authorities that wrong-foots the market. They have form, such as the backflip on the regulation of China’s gaming sector – from “spiritual opium” in 2021 to an indispensable pillar of China’s development in 2022 – as fuel for the development of strategic technologies such as AI. Xi throwing in the towel on zero-COVID following protests set off by the tragic fire in a locked-down apartment block in Urumqi, Xinjiang, surprised investors and was the catalyst for a huge rally from October 2022 through to the end of the year.

While many investors and commentators will wait for something decisive from authorities before any pivot, there are signals that they are already taking action. Monetary policy changes in China aren’t announced (similar to the Fed decades ago). The first sign of loosening is often an easing of money market rates as the PBoC adds liquidity via open market operations. The PBoC’s reverse repo rate is supposed to act as a floor for rates, so if the PBoC allows the 7-day SHIBOR rate to trade below the reverse repo rate for any period, there is a good chance the latter will be cut. We can see this in the chart below from NS strategist and economist, Simon Ward.

7-day SHIBOR has been trading soft MTD
China interest rates

Source: Refinitiv Datastream

This suggests improving liquidity and another rate cut. We have written previously on our reservations about China’s development path and deteriorating institutional quality in particular. While this is a structural negative that hurts the longer-term picture for China, there is a potential cyclical opportunity for investors as meaningful monetary stimulus would drive a revival of animal spirits.

India’s HDFC merger makes combined entity one of the largest banks in the world

The merger of Housing Development Finance Corporation and HDFC Bank (both long-term portfolio holdings) in July was the largest in Indian corporate history. The combined loan book will stand at around 22 trillion rupees ($275.8 billion) and will make it one of the largest banks in the world by market cap – behind only JP Morgan Chase, ICBC and Bank of America. According to management, the merger synergies will outweigh the costs due to lower costs of funding, and the expansion of the mortgage business footprint by offering HDFC products across all 6,500 branches of HDFC Bank (from current presence in 2,500 branches).

A combined and more efficient entity will tap into HDFC’s status as India’s oldest and largest mortgage company, and market leader by virtue of wide distribution reach, robust asset liability management and tight control of operating costs. This leaves it well-positioned to harness multiple structural tailwinds that are set to drive growth in India’s housing market, which include:

• The rise of a massive and increasingly urbanised middle class (32% of the Indian population reside in cities, estimated to be 40% by 2030), which will act as a major structural source of demand.
• Around 66% of the population is below 35 years of age, with the average age of a home buyer being 38.
• Low mortgage penetration, with India’s mortgages as a percentage of nominal GDP at only 11% versus over 20% for broader Asia.
• Housing affordability over the past decade has improved as incomes rise while housing prices have been stagnant.

Mortgages as a % of nominal GDP

Source: HDFC investor presentation 4Q 2022

Affordability ratio (home loan payment/income ratio)

Source: Jefferies Indian housing sector research 2022

Unsurprisingly, valuations are rich for such a robust growth profile and high quality management, but have softened recently as the merger played out. The merger is likely to be accretive and allow foreigners to hold an additional 10% in the combined entity, allowing investors to increase exposure to one of EM’s strongest structural stories in the rise of the Indian middle class.