Summary

• EM underperformed US and international markets through 2023 – posting a 10.3% return in USD terms versus 26.3% for the US, 18.9% for EAFE and 22.7% for Europe ex-UK.
• China was down 11% for the year, while Taiwan was up 31.3%, India 21.3%, Brazil 31.5% and Mexico 41.6%.
• EM equities trade at 11.9x next 12m P/E against a 20-year average of 12.6x, while China trades at 9.3x against a 20-year average of 12.5x.
• Brent crude closed the year at US$80 per barrel, pulling back sharply from its spike above US$90 in October following the outbreak of conflict between Israel and Hamas.
• China held its Central Economic Work Conference in December, with top officials and economic advisers meeting to set growth targets for 2024. Government advisers have told the press that officials are targeting a range between 4.5% and 5.5%, with most favouring around 5% (the same as for 2023). The official target is set to be officially endorsed at the Two Sessions in March.
• As reported in the Financial Times, BYD sold a record 526,000 battery-only EVs to Tesla’s 484,000 during the fourth quarter of 2023. This is the first time BYD has surpassed Tesla in quarterly sales.

“Goldilocks thinking”

Earlier this year, we emphasised our caution with respect to market expectations for the economy and inflation, warning that a Wile E. Coyote moment was a real risk for investors lured into the idea of a “miraculous disinflation” or “no landing” scenario. Bets on the combination of falling inflation, a resilient economy and rate cuts in 2023 were the fuel for a Santa rally propelling tech stocks and cyclicals.

In line with our forecasts, inflation has fallen rapidly as suggested by broad money growth with the usual two-year lag. What has surprised us is the resilience of the US economy despite monetary tightening, which appears partly to reflect consumption driven by savings built up during the pandemic. Improvements in the global supply chain have also supported industrial production.

G7 inflation rates fell by more than most expected during 2023, mirroring a big decline in money growth during 2021 – inflation heading for an undershoot by end 2024

Source: NS Partners & Refinitiv Datastream.

Better inflation news has allowed the Fed to stay on hold since July despite strong Q3 GDP growth and a still-tight labour market. With inflation likely to continue to fall, investors are more hopeful of a soft landing coupled with rate cuts in 2024 and have rerated risk assets accordingly.

Based on the monetary and economic data that we track, our view is that market sentiment is excessively bullish and at risk of a correction. In his latest memo, Easy Money, published on January 9, Oaktree’s Howard Marks struck a similar tone, warning against “Goldilocks thinking”:

“At present, I believe the consensus is as follows:

• Inflation is moving in the right direction and will soon reach the Fed’s target of roughly 2%.
• As a consequence, additional rate increases won’t be necessary.
• As a further consequence, we’ll have a soft landing marked by a minor recession or none at all.
• Thus, the Fed will be able to take rates back down.
• This will be good for the economy and the stock market.

Before going further, I want to note that, to me, these five bullet points smack of “Goldilocks thinking”: the economy won’t be hot enough to raise inflation or cold enough to bring on an economic slowdown.”

We certainly agree. While our analysis suggests that inflation has further to fall and rate cuts should be coming this year, global manufacturing PMI new orders are likely to decline further. Additionally, money trends are yet to suggest a significant subsequent recovery.

Economic “resilience” partly reflected pandemic catch-up effects, but is consistent with historical experience following monetary tightenings, suggesting greater H1 weakness

Source: NS Partners & Refinitiv Datastream.

G7 annual real narrow money momentum led industrial output momentum by an average 12m at major lows historically, suggesting that the full impact of recent weakness won’t be apparent until mid-2024.

We continue to believe that hard landings are possible in the US / Europe, with resilience to date not inconsistent with historical lags for monetary weakness and yield curve inversion. Against this backdrop, we expect quality and defensive sectors to outperform in the near term on a view that hopes of a soft landing may prove to be premature.

Taiwan’s DPP returned to the presidency but lose the legislature

Taiwan held elections on January 13, with William Lai Ching-te of the Democratic Progressive Party (DPP) winning the presidency, taking 40% of the vote against 33% for Hou Yu-ih of the Kuomintang (KMT) and 26% for Ko Wen-je of the Taiwan People’s Party (TPP).

Credibility on management of cross-strait relations to safeguard Taiwan’s democracy was a key issue, and the key factor behind the DDP presidency win. However, voters (particularly younger generations) expressed their dissatisfaction with the DDP on a host of domestic issues that cost the party its hold over the legislature, now controlled by the KMT. Issues include prohibitively expensive property prices, a rapidly ageing population (see chart below), stagnant wage growth and debate over the length and quality of military conscription.

Taiwan faces demographic headwinds

Source: CIA Factbook 2024.

In addition, a host of DPP officials have been caught up in scandals in recent years, including misuse of party funds, academic plagiarism by a legislator subsequently promoted by President Tsai to vice president of the government and an extramarital affair forcing another legislator to step down.

What does China make of it? While China has repeated the rhetoric that “reunification is inevitable”, the election result is unlikely to provoke any material military response from Beijing in the near term, although some PLA muscle-flexing is to be expected in the coming months. Predictably, the Party is claiming the result as a win from its perspective, pointing out that the result signals voter dissatisfaction in the electorate after eight years of DPP rule, with Lai’s win in part owing to Taiwan’s first past-the-post electoral system. The majority of voters went for the KMT (Beijing’s favoured candidate) and political upstart TPP.

Perhaps the most notable development was the rise of the TPP, founded less than five years ago by prominent surgeon and quirky political pragmatist Ko Wen-je. Clever rhetoric and deft use of social media was key for Ko to connect with younger voters, to foreground domestic issues in his campaign over relations with China, effectively counter-positioning with the DPP and KMT.

On China, Ko has shifted over the years from alignment with the DPP towards the KMT, arguing that Taiwan is part of a greater China while disagreeing with Beijing over which state should rule the territory.

Over the next term, Ko and his party have eight seats in the legislature, setting the TPP up as kingmaker to either the KMT with 52 seats or DPP with 51, and a pivotal player on issues such as energy policy, defence expenditure and kickstarting wage growth in the service sector.

Looking further ahead, the TPP may signal the breakdown of old, inherited voting patterns and the emerging base of young voters who identify primarily as Taiwanese but, at least for now, are more focused on domestic economic, social and political issues.

Summary

• Treasury yields retreated through the month on inflation data that undershot market expectations (in line with our forecasts), with stocks and bonds celebrating the news.
• We remain cautious and view the exuberance with scepticism, and expect a weakening global economy and earnings downgrades to test the bulls.
• On a brighter note, rapid disinflation and the prospect of rate cuts in 2024 will precipitate a recovery in money numbers that could be the signal to tilt away from current defensive positioning.

Institutional quality is key to unlocking development

Analysis of qualitative macro factors in emerging markets is a cornerstone of our process, which is critical to identifying the potential for downside shocks that can wipe out investor returns (irrespective of how attractive a company’s fundamentals may appear). Given the relative fragility of institutions in EM, politics can have an outsized impact on a country’s progress up (or down) the development ladder, with elections often serving as critical junctures.

This month we saw the conclusion of national elections in Argentina, with right-wing libertarian and economist Javier Milei crushing the incumbent Perónists on a platform of radical economic reform. While markets have celebrated the development, does Milei’s election truly represent a structural turning point given the institutional forces that stand in his way?

Argentina a case study of the vicious cycle

A hundred years ago, Argentina was one of the richest countries on the planet, with the young and dynamic South American country outstripping the likes of even France and Germany. The rise and dominance of the left-wing populist Perónists in the 20^th and 21^st centuries (interrupted by a succession of military juntas in the 1970s and 80s) put an end to this.

For us, Argentina’s downward spiral from such an enviable position to today underlies the importance of institutional quality as the key determinant of whether a country climbs or slides down the development ladder. Vicious and virtuous circles of development (where political and economic institutions become either more extractive or inclusive) can form momentum that is hard to break. For EM investors in particular, who deal with countries with relatively more fragile institutions than DM counterparts, it pays to be mindful of what kind of cycle is at play in a country.

The book “Why Nations Fail” by Acemoglu and Robinson provides an excellent summary of these vicious/virtuous circles:

“Rich nations are rich largely because they managed to develop inclusive institutions at some point during the past three hundred years. These institutions have persisted through a process of virtuous circles. Even if inclusive in a limited sense to begin with, and sometimes fragile, they generated dynamics that would create a process of positive feedback, gradually increasing their inclusiveness. England did not become a democracy after the Glorious Revolution in 1688. Far from it. Only a small fraction of the population had formal representation, but crucially, she was pluralistic. Once pluralism was enshrined, there was a tendency for institutions to become more inclusive over time, even if this was rocky and uncertain process.” (Why Nations Fail, p364)

Clearly nothing of the sort occurred in Argentina over the last century. Instead, a confluence of economic and political crises from the 1930s onwards saw the country follow nearly half a century of growth with a lapse into domestic upheaval, the rise of Perónism and extreme political choices that fuelled a vicious circle causing Argentina to backslide.

Rise of the Perónists

While it is possible for countries to grow under extractive institutions, this will begin to falter at more advanced levels of development. Improving institutional quality is essential to break through to the next level.

“It is true that Argentina experienced around fifty years of economic growth, but this was a classic case of growth under extractive institutions. Argentina was then ruled by a narrow elite heavily invested in their agricultural export economy … [involving] no creative destruction and no innovation. And it was not sustainable.” (Why Nations Fail, p385)

Becoming Minister of Labour in 1943 following a military coup, Juan Domingo Perón was elected president in 1946. He then set about attacking Argentina’s institutions much as the previous military junta had done before him. He started by gutting the Supreme Court to remove any checks to his power, and sidelined the main opposition party by arresting its leader. The Perónists emerged as a new elite which shaped extractive institutions to their benefit.

“The Perónists won elections thanks to a huge political machine, which succeeded by buying votes, dispensing patronage, and engaging in corruption, including government contracts and jobs in exchange for political support. In a sense this was a democracy, but it was not pluralistic. Power was highly concentrated in the Perónist Party, which faced few constraints on what it could do, at least in the period when the military restrained from throwing it from power.” (Why Nations Fail, p385)

Is Milei’s election a critical juncture?

Following 28 of the last 40 years under Perónist rule, the country today battles its worst economic crisis in two decades as inflation spirals, poverty rates climb and – in the words of President-elect Javier Milei – the peso “melts like ice cubes in the Sahara.” Such is public frustration for perpetual economic catastrophe that Argentinian voters dumped the incumbents for libertarian rockstar economist Milei, who attracted 56% of the second-round vote, the most votes garnered by any candidate since 1983.

Source: NS Partners & LSEG Datastream

Milei campaigned on the promise of radical change and economic shock therapy. This includes dollarising the economy and eliminating the politicised central bank, putting the “chainsaw” to public spending, privatising state-owned companies, along with a host of controversial conservative social and libertarian reforms. Clearly, breaking the vicious cycle in play in Argentina will require radical policy change. Well implemented dollarisation could indeed work (with a deep recession) to restore economic order, working to reduce inflation, increase consumer buying power, and stabilise the economy in a way that enables better long-term economic planning while attracting foreign investment.

This sounds great in theory and markets have cheered the election results, but can Milei actually translate his victory into policy that passes through parliament when his party holds just 39 of 257 seats in the lower house and 8 of 72 in the senate? An alliance with centre-right former president Macri and his Republican Proposal party still won’t constitute a governing majority, but it will boost the chances of pushing through the reform agenda. For this to happen, however, it is likely that compromises will need to be made with Macri’s moderates and other neutrals. Will Milei, a libertarian firebrand who has gained so much popularity from demonising the political elite, be able to stomach a watered-down agenda?

How do we implement development theory in EM investing?

Our approach to macro analysis is not to place bets on such uncertain outcomes, but instead to assess the direction of travel and mark conviction in that country up or down accordingly. If Milei can beat the odds, then Argentina may gradually emerge as a hunting ground for investment opportunities.

For now, the reality is that powerful structural forces suffocate the country’s potential and make for a fragile environment that can easily wipe out investors lacking a robust approach to accounting for macro risk.

Summary

• EM equities fell over the month, with the MSCI EM Index down -4% over the period.
• Declines were led by markets with higher exposure to commodities and oil such as Latin America and the GCC.
• Quality stocks in China outperformed, while value names dominated by State-Owned Enterprises (SOEs) continued to cool following outperformance through the first half of the year. Chinese growth stocks remain laggards.
• Stocks in Poland rallied hard after former prime minister and European Council president Donald Tusk led a centrist coalition to victory in national elections, promising to restore ties with the European Union.
• Weakening narrow money momentum over the period suggests downside surprises to economic growth are likely. Our portfolio exposure remains defensive given this backdrop, underweight commodities and oil, favouring high quality and sustainably growing businesses that can weather a downturn.
• Unexpected economic weakness in the months ahead may force central banks to reconsider tight policy settings.

“It’s never too late to catch the China train – you can still ride the dragon to heaven.”
– Wang Jianjun, China vice-chair of the China Securities Regulatory Commission

Our team visited China and Hong Kong through September and October, seeing over 100 companies, policy makers, strategists and research analysts. The trip provided an opportunity to gauge sentiment on the ground and test our conviction on portfolio companies, while uncovering new risks and opportunities.

It’s safe to say that the team didn’t leave feeling quite as bullish as the vice-chair of China’s securities regulator at a conference we attended (quoted above). It remains difficult to build strong conviction for the longer-term outlook, but our sense is that a slow burn post-pandemic recovery is still in play. We were reminded by several Chinese executives that we are only a little over half a year into this recovery and that it will take time for green shoots to emerge.

Below is a summary of some key headlines which emerged over the trip.

Politics – domestic discontent evident while geopolitical risk stabilising
China’s economic slump marks the first real recession since reform and opening up under Deng Xiaoping in the late 1970s. What is notable is rising dissatisfaction spreading outside of investment circles, with frustration over a lack of visibility or conviction on economic policy direction bubbling up in the middle-class, entrepreneurs and elites. Current economic woes are increasingly blamed on policy missteps as opposed to unfavourable economic conditions.

Public mourning over the death of former premier Li Keqiang in early November provided an outlet for public venting of frustration. Mourners in Li’s home town of Hefei spoke about Li’s more moderate approach to politics, which has been interpreted by many China watchers as thinly veiled criticism of the more authoritarian turn political and economic institutions have taken under Xi.

While geopolitical risks stemming from Sino-US confrontation remain elevated, there are signs of stabilisation. Xi is set to meet US President Biden at the APEC summit in San Franciso in November. This follows dialogue between several members of the US administration and their Chinese counterparts, and an agreement between the US and China to prohibit the development of autonomous AI weaponry.

The CCP’s propaganda arm has also been hard at work. Chinese film Lover’s Grief Over the Yellow River (1999) has started airing on Chinese television recently. The plot centers on the story of a US pilot falling in love with a Chinese woman during the Second World War. It appears that the Party is seeking to keep a lid on anti-US and nationalistic sentiment ahead of the summit.

Source: Lover’s Grief Over the Yellow River, IMDB.

Consumption – fragile recovery remains intact

Trends are incrementally better than in the first half of 2023. Demand for leisure, travel and restaurants remains resilient and travel has exceeded pre-COVID levels. Tier-1/2 city shopping malls are very crowded on weekends, with long queues at popular restaurants. However, there are clear signs of consumption trade-down, e.g., fewer high-ticket item purchases, quiet high-end restaurants, and more subdued spending during online promotional seasons as we see platforms ramp up subsidies/incentives. Overall, consumption appears in line with our expectations and on track for a gradual recovery.

Property – momentum fading but the situation appears manageable
July’s Politburo meeting acknowledged the risks in the property sector and set off an improvement in the policy backdrop. The sector is looking less bearish on the relaxation of the downpayment ratio for property purchases and falling mortgage rates. These measures set off a temporary spike in secondary transaction data but it has since faded. Property prices have not yet reached a clearing price and market participants remain cautious. We found that those with more than one property are looking to sell, and those who want to buy now are only upgrading from their existing home. Speculative demand has evaporated.

Private developers are at risk of further defaults on offshore bonds but the government will not allow for onshore defaults (mainly via restructuring rather than outright capital injections). A systemic crisis appears unlikely, and the backdrop looks set to improve from here in T1/2 cities. Lower tiers will take significantly longer to recover.

Key themes
We found a lack of conviction generally among domestic investors in China, who are focused on high-frequency data and rotating quickly through sectors and stocks. Consensus buy and hold names were rare, and while the SOE reform story had been a popular trade in the first half of 2023, several portfolio managers we spoke to were broadly sceptical of these names. We agree that low valuations and a lack of momentum in other areas are unlikely to be sustainable drivers for these stocks.

While the sentiment among investors remains flat, there are several compelling trends that are likely to shape China’s investment landscape in the years to come.

• EVs – Chinese specialist EV makers (BYD in particular) are playing a different game to the rest. EV penetration of new car sales is already at nearly 40% in China, offering competitive pricing and the potential to go global (with the promise of higher margins in foreign markets).
  

Source: Bernstein Research, 2023.

• BYD stood out as a company working so hard to play down expectations that their IR team almost seemed depressed! They are likely trying to tread softly as they push into more lucrative foreign markets, being very cautious in their communications on growth assumptions and deliberately vague on margin upside outside of China. The company is the dominant player in the mass market segment for EVs, and boasts 37% market share of NEV sales in China (Tesla in 2nd place with 10%, albeit targeting higher-end consumers).

• Risks include intense levels of domestic competition in a market that is due significant consolidation. On current trends, BYD and Tesla are looking like winners, at the expense of traditional international OEMs that have been slow to pivot to EVs.

Consolidation is on the way

Source: HSBC Research, 2023.

• Autonomous driving – Pony.ai is preparing for its IPO, fuelled by the excitement around partnerships with leading carmakers to incorporate its level 4 autonomous driving software. The aim is to produce the first large-scale robotaxi networks, with operations already running in Beijing and Guangzhou: China’s capital city is letting the public take fully driverless robotaxis – and has bigger rollout plans, startup Pony.ai says.
• Other themes include high-end manufacturing, industrial automation, semiconductor supply chain localisation, export-driven business in niche markets, as well as belt and road infrastructure.

Korean stocks hit by a wave of margins calls

Korean stocks were also hit hard through the month, down -7% in USD terms in part due to forced selling/margin calls as brokers revised up margin loan hurdles. The margin calls exacerbated an already challenged environment for names in the battery supply chain which is working through a downcycle. Stocks favoured by retail investors such as battery materials producer Ecopro (down -31%) and steelmaker POSCO (which is investing in the battery supply chain, down -23%) unwound.

Source: CLSA, 2023.

Our exposure to batteries is limited to Materials company, LG Chemical, and its subsidiary, LG Energy Solution, the world’s second-largest battery maker. While we don’t think battery makers are out of the woods just yet (especially as many of the key names are yet to make it through a full cycle since being listed), valuations in the sector are beginning to look tempting.

LG Chemical now trades at <1x price/book, which is its lowest valuation ever. According to JP Morgan, the company’s stock now trades at a 58% discount to its 82% stake in LG Energy Solution, while valuing its petrochemicals, advanced materials and biotech businesses at 0. Recent results also suggest operational performance might be approaching a bottom, with third-quarter results positively surprising. We are maintaining current levels of exposure while looking for more evidence of an upturn in batteries and petrochems.

Source: Bloomberg and NS Partners.

The oil price is telling you something

Brent crude finished October lower despite the outbreak of tensions in the Middle East following the October 7 attacks by Hamas against Israel. While risks of escalation remain, oil is looking like the dog that didn’t bark.

Does this tell us something about the global demand picture? Consumers are responding to high oil prices by curbing consumption, with demand for gasoline and diesel in the US falling.

It may also signal ample supply growth outside of the OPEC cartel. The shale boom continues in the Permian Basin, while the US is lifting embargoes on Venezuelan oil.

How much global production share will OPEC be willing to cede to competitors before abandoning supply discipline? We saw Saudi Arabia do exactly that during the COVID pandemic in response to Russia’s refusal to curb supply, which saw the oil price go negative.

This suits the US just fine, on a view that lower oil prices will squeeze opponents like Russia and Iran while easing inflationary pressures further.

Oil just one indicator of a deteriorating backdrop

The global economy is likely to surprise to the downside while liquidity remains poor. The Materials and Energy sectors were weak through the month, in line with our view that cyclicals look vulnerable here.

Historically, while cyclical sectors can hold up over a short period following the conclusion of a hiking cycle, their underperformance over the medium term is stark. As our Chief Economist Simon Ward has pointed out, cyclical sectors underperformed following the last five US rate peaks, though not always immediately.

Source: Refinitive Datastream and NS Partners.

While the money numbers have been signalling downside risks to the economy for some time, other leading indicators, including consumer and manufacturing expectations, have slipped. Excessive tightening by central banks is now also feeding through to backward-looking data, such as unemployment and payrolls, which are starting to crack.

Are we on the cusp of central banks beginning to ease? Inflation has been rattling back globally, which is good news. However, in the absence of a financial accident (which is certainly possible given the liquidity backdrop), it has historically been the labour market that has prompted the central banks to start cutting.

Summary

• EM equities were down through the month, with Chinese equities continuing to drag.
• Foreign investors dumped over US$3 billion of Chinese stocks through the month, despite better-than-expected retail sales figures (up 4.6% year on year) and industrial production numbers (up 4.5% year on year) for August.
• Manufacturing PMIs also ticked up to 49.7 from 49.3 (above 50 points signals expansion).
• New issues from Chinese banks also surged, beating expectations.
• Industrials, staples and communications names in India outperformed wider EM, as did AI-linked semiconductor names in Taiwan and Korea.

Don’t look down

Is this the Wile E. Coyote over the canyon moment for markets? The delayed impact of vertiginous rate hikes across DMs on all maturing debt is now hitting consumption and investment. Yet central banks continue to talk tough and market pundits fret over the implications of “higher for longer rates.” It certainly feels like we are in a critical juncture for markets and the economy. Resilience of assets outside of fixed income appear out of step with the reality of higher rates and a weakening global economy, as illustrated by global PMIs falling for a fourth consecutive month.

Poor money numbers globally suggest that further economic contraction is likely. Despite this, central banks continue to talk tough on rates and many investors cling to hopes of a no landing/immaculate disinflation scenario unfolding, despite the cracks emerging in the global economy. 

Echoes of the GFC

Some market commentators are comparing the complacency in markets to the 2006-7 period where investors bought into the idea of a soft landing, just as the lagged effect of excessive interest rate hikes began to roll through the economy.

JP Morgan’s Marko Kolanovic was quoted in the UK’s Financial Times noting the magnitude of change in interest rates in this cycle is around 5x the increase over 2002-2008 (FT Alphaville: Is it good when Wall Street compares today to 2007?). Kolanovic also pulled archive strategy commentary from 2007 which speaks to some of the risks markets face today:

“The economy provides compelling evidence that it is more resilient than many had earlier believed. … [R]enewed momentum is confirmed as economic data over the balance of December 2006 and January 2007 show an economy shaking off the effects of higher interest rates and high commodity prices. Market participants give up the ghost on their hopes for easings, accept that the Fed has engineered a soft landing, and buy (literally) into the view that a Goldilocks economy is in the making. Economic growth is solid at around 3% and led by a reinvigorated consumer; the residential housing sector slowly stabilises; corporate earnings growth moderates but doesn’t collapse; and inflationary pressures ease off but do not dissipate. Risky assets trade at full valuations and remain in a narrow, low vol range. We’ll call this the “head fake” phase — everything feels too good to be true because it is. In case you didn’t notice, this is where we are right now.”

As the article notes, history tends to rhyme rather than repeat and the availability heuristic of taking short cuts through sketchy historical analogies to explain the situation today can lead investors astray.

Indeed, the 1970s were a far from perfect comparison to post-pandemic inflation – we were flagging last year that a crash in broad money numbers would see inflation rattle back and even undershoot in 2024 (see chart below). This forecast remains on track despite the anxiety over rising energy prices. In contrast, broad money (our primary leading indicator for inflation) remained persistently high in the 70s.

In the pre-GFC era, central banks were signalling their commitment to keeping inflation in check while acknowledging that stresses in the system were starting to materialise. Talking tough today about “higher for longer” rate settings looks to us like the equal and opposite error to the excessively loose policy coming out of COVID lockdowns.

We question the widely held assumption that the global economy can muddle through without any shift in monetary policy in the months ahead. Our best bet is that global economic growth is likely to surprise to the downside in the next 3-6 months.

Green shoots

However, there is a silver lining. Unlike in 2007, most of the debt resides with governments and central banks rather than corporates and households. Price insensitive authorities can “extend and pretend”, socialising losses and thus providing some cushion to the impact of rate hikes. It may suggest why rapid rate increases haven’t yet bitten as hard as we initially expected.

Another positive trend (particularly for EM) is a likely bottoming in the global stock building cycle.

Excessively high inventories in industries from semiconductors to apparel have been in a clean out phase amid weaker consumer demand, which in turn puts downward pressure on commodities prices.

Emerging markets provide the bulk of these goods and commodities, and will therefore benefit from a bottoming out of this downcycle in the next few months.

In Taiwan and Korea, we have seen semiconductor names rallying on reports that the sharp post-COVID inventory destocking cycle is approaching its end, and boosted by demand for high performance chips that power AI. In apparel, Nike recently reported a US$9 billion decline in inventories (down -10% year on year). Nike has up until now been forced to rely on discounts and promotions to clear inventory amid a period of subdued demand and higher competition from rivals like Adidas. Nike will now start to restock with new lines to be sold at higher prices, boosting profitability. Competitors are likely to follow suit, which collectively will boost EM companies that dominate the apparel supply chain.

The long term picture is bright for EM

While the near-term risks brought about by a global slowdown underpin our cautious positioning, there are compelling reasons to expect EM to outperform DM on the other side of this slowdown. Low inflation and higher rates in EM will open the door to rate cuts, while valuations and earnings are supportive. China looks oversold and could rally on more meaningful stimulus. Growth elsewhere, in Southeast Asia and countries like India, look set to outstrip their developed counterparts. As inflation continues to fall and the tightening cycle ends, global money numbers can revert into positive territory. This will be the key ingredient for an emerging market resurgence, as excess liquidity will flow to the superior fundamentals on offer in EM.

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.