The underperformance of emerging markets equities relative to the US has tested the patience of even its most diehard advocates of the asset class over the past few years. While EM equities posted a respectable 9.9% return in USD terms in 2023, this looks anaemic next to a roaring 26.3% for the S&P 500.

The disparity between the US and EM over the past decade tempts investors into the behavioural trap of building conviction for future returns based on what has performed well in the recent past. It is easy to forget that the annualised returns from 2000 to end-2023 for EM were 7.6% versus 7.8% for the US, both outpacing 6.2% for MSCI World. The risk here is that a pro-cyclical mindset can lead to perverse thinking where conviction strengthens for a popular asset class as the likelihood of a good result decreases, and vice versa.

US equities outperformed on a decade of stronger economic growth out of the GFC, fed by a new credit cycle and strong fiscal deficits fuelling stronger corporate earnings and a dollar bull market, along with multiple expansion. On the flipside, EM moved through a painful deleveraging compounded by foreign reserve managers chasing US exceptionalism and buying dollars which choked EM further.

Several contrarian market commentators have recently pointed out that the fundamental picture in EM in many ways looks more compelling than in the US – lower valuations, trough earnings, cheap currencies, lower inflation, as well as greater fiscal and monetary discipline.

So what explains the continued underperformance, and is there anything that can break this cycle?

Vicious and virtuous circles in EM equities

George Soros’s theory of Reflexivity provides an explanation for how biases and preconceptions interacting with economic reality can distort market pricing and create extended periods of disequilibrium. For EM, the combination of weaker fundamentals coupled with a perception of US exceptionalism has led to the formation of a self-reinforcing feedback loop which has been a major headwind for the asset class. Below is a rough schematic for how this loop has played out.

Source: NS Partners.

Our view is that this cycle is coming to an end. Indeed, we believe that there is potential for a shift into a “virtuous circle” for EM, outlined below.

Source: NS Partners.

This outlook is based on a set of signals which we have used to advise clients invested in our DM and EM strategies looking to tweak the balance of exposure between the two. For context, our checklist is based on the idea that EM equities are a cyclical asset class and so tend to outperform when the global economy is strengthening (industrial cycle, commodity prices) and there is liquidity to chase the EM story (excess money, falling USD). They should also do better when economic prospects and earnings momentum are stronger than in DM (real money growth gap, revisions gap) and valuations are attractive.

Our latest update to the checklist (as of June 30, 2024) is below.

EM versus DM checklist
Source: NS Partners.

The balance of factors we monitor now favours emerging market equities for the first time in years.

Our two cents – don’t wait around until everything goes green, as you will have missed the sharpest part of the rally.

Two checklist factors deserve special attention, given their historical usefulness in signalling an improving environment for EM equities.

Liquidity

The E7 / G7 real money growth gap has been in favour of EM for some time, underpinned by better monetary policy making since 2020. This was reflected in better relative inflation performance for EM over DM, which has meant less need to tighten aggressively through the inflationary upswing, and potentially plenty of room to cut as the Fed eases.

Positive E7-G7 real money growth gap
Source: NS Partners and LSEG Datastream.

Additionally, the global excess money backdrop – proxied by the gap between real money and industrial output growth – may now be entering positive territory because of inflation peaking and industrial momentum weakening. The surplus liquidity can find its way into unloved financial assets, including EM equities. Prospective central bank pauses / reversals will sustain the trend.

Global “excess” money turning positive?
Source: NS Partners and LSEG Datastream.

This is what we call a “double positive” liquidity environment, and could signal improving prospects for EM equities. In periods where these two monetary indicators have lined up this way, EM equities have outperformed MSCI World by an average of 10.5% per annum. Periods of EM outperformance are indicated in the shaded areas of the chart below. They line up nicely with the double positive.

EM relative performance & monetary indicators
Source: NS Partners and LSEG Datastream.

King Dollar

The vicious and virtuous cycle diagrams above hint at just how important the dollar is as a driver of price and fundamental momentum in emerging markets.

The chart below illustrates just how large a tailwind or headwind the dollar can be for the asset class.

EM outperformance during secular USD declines
Source: NS Partners and LSEG Datastream.

The relative performance drawdown for EM versus global equities during the last dollar bull market is in line with previous dollar bull markets, but the period over which this has occurred is roughly twice as long. The risk for investors fatigued from such an extended period of relative underperformance is capitulation right as the asset class is primed to outperform.

The real trade-weighted dollar is far above its long-run average and may have reached another secular peak in October 2022 – recent strength has failed to take out this high.

October 2022 USD peak?
Source: NS Partners and LSEG Datastream.

The combination of monetary easing as inflation falls coupled with a weaker US dollar would provide a favourable backdrop for the outperformance of EM equities. Likely easing by the US Federal Reserve later this year will provide further scope for emerging market central banks to cut rates, allowing the credit cycle to move from stabilisation/recovery into expansion, providing support to economic and corporate earnings growth.

Such a pick up would encourage allocators oversaturated with US exposure to send marginal flows to emerging markets. With positioning at such extreme relative lows, even a small shift would be significant and another potential catalyst for entry into a virtuous cycle.

The futility of pollsters was on full display in India, Mexico and South Africa this month. Prime Minister Narendra Modi’s BJP fell short of expectations for a landslide in India. In Mexico left-wing party Morena took the presidency as expected, but came surprisingly close to a supermajority in Congress. In South Africa, the dismal performance of ruling party ANC opens up a new era of coalition politics.

Political risk spiking in these countries has fuelled some wild swings in their stock markets.

All three markets took a hit on election uncertainty through May-June

Source: NS Partners and LSEG Datastream.

Political risk is a factor that we consider as part of our macro analysis, which we know is crucial in EM investing. Fundamentals alone will not save you when the macro is headed south and the risk premium spikes. Outperforming in EM is about finding the right stock in the right country.

India

India’s Modi is set to become the first Prime Minister to serve three consecutive terms since the first post-colonial leader, Jawaharlal Nehru (Congress Party). Early June exit polls sent expectations (and stocks) soaring for Modi’s BJP to storm home to victory and claim as many as 400 hundred seats out of 543 in India’s lower house. Stocks exposed to infrastructure led the way on the expectation that a strong mandate would allow Modi to pursue a growth/investment-focused manifesto.

Instead, the BJP failed to claim a majority on its own and will have to rely on the support of regional allies to form government.

Seats won in the 2024 and 2019 elections

Source: Financial Times & Indian Electoral Commission, June 2024.

BJP strongholds crumble

The BJP ran on a record of positive reform over the past decade which has fuelled economic growth that has lifted millions out of poverty, cracked down on corruption, and built out electrification and sanitation access across the country. Tax reform also led to a doubling of tax revenue that has been reinvested into developing critical infrastructure, including freight railway lines and ports. Personalised rule and a presidential-style campaign positioned Modi as the figurehead of such rapid progress. At the outset of the campaign, approval ratings for the Indian PM were among the highest for any major democracy in the world.

Yet the damaging swing against the BJP came from the party’s Hindi-speaking northern heartland. The opposition INDIA alliance was able to peel away BJP supporters by targeting poorer rural communities feeling the effects of high inflation and unemployment.

Losses in Uttar Pradesh were pivotal

Source: Financial Times, June 2024.

Positive structural story intact

Modi nevertheless claimed victory in a coalition with regional allies known as the National Democratic Alliance. Despite the surprise verdict, it is unlikely that Modi will be prevented from pursuing his agenda barring a few tweaks likely to increase social spending. This may dilute business sentiment and infrastructure spending in the near term, while consumption should remain robust.

One positive is that the result should alleviate fears Modi would use a supermajority to pursue regressive constitutional changes.  On the other hand, there also is a higher risk that a diminished Modi, a pro-growth moderate within the BJP, could cede influence to nationalist elements who will have more sway over a leadership transition.

Overall, our expectation for markets is some profit taking in the short term, while the long term structural story remains very positive.

South Africa

The African National Congress (ANC), South Africa’s dominant political party having governed since 1994, was rebuked by voters for having presided over a polycrisis in the economy, energy and law and order. The scale of the result was the surprise, while uncertainly looms over the make-up of a governing coalition.

The ANC fell a long way short of a majority, commanding only 159 seats of the 400 in the National Assembly. The graphics below illustrate just how sharply ANC support has fallen from a once commanding position.

2009 ANC National Assembly share

2024 ANC National Assembly share

Source: Daily Maverick, May 2024.

The result could mark the beginning of a new era of politics in South Africa. Much like with the decades-long decline of the Congress party in India, the ANC as a post-colonial liberation movement finds itself out of step with the challenges that confront the country today.

Uncertainty and opportunity

The horse trading to form a coalition government within the next two weeks is now underway. The worst outcome, a deal with a radical breakaway party such as disgraced former president Zuma’s MK, who wants to ditch South Africa’s constitution, is off the table, while a direct deal with Julius Malema’s socialist EFF won’t command a majority.

A coalition between ANC and the second largest party Democratic Alliance (DA) is clearly the outcome markets are cheering for, the most likely outcome is for the ANC to kick the can down the road through a multiparty alliance that should disintegrate within 12 months. The result of this may well be a broader re-alignment of South African politics. No doubt this will be a time of high uncertainty, but there is also a chance that some political creative destruction will act as a catalyst for positive change.

Mexico

While the election of Claudia Sheinbaum to Mexico’s presidency was widely expected, the surprise was her left-wing Morena party running close to a parliamentary supermajority. Mexican stocks tumbled 12% and the peso fell on the result as investors fret that a stronger mandate for Morena will allow Sheinbaum to carry on with the agenda of outgoing president Andrés Manuel López Obrador (AMLO).

AMLO’s chequered legacy

AMLO leaves office with high approval ratings owing in part to large cash transfers from the state and minimum wage hikes that lifted over five million Mexicans out of poverty during his term (The Economist (November 2023): Andrés Manuel López Obrador has reduced poverty in Mexico, but he could have done better). In contrast to India’s Modi alleviating poverty through reform-driven economic growth, critics argue AMLO achieved this by diverting funds away from education and healthcare.

Is Morena a threat to Mexico’s democratic institutions?

Crucially for investors, AMLO and Morena are pursuing policies that could threaten Mexico’s institutions. Institutional quality is a key factor in determining whether a country moves up the economic development ladder. Throughout his term, AMLO threatened to attack institutions on the notion that they have been corrupted by neoliberal partisans. His term also saw the military play a growing role in domestic affairs, becoming involved in major infrastructure projects, tourism and customs oversight, and the militarisation of domestic security as a response to rising cartel violence (which proved ineffective).

Investors fear that a strengthened mandate will allow Sheinbaum (or even an outgoing AMLO) to undermine judicial independence, and pursue plans to eliminate autonomous government agencies overseeing telecoms, energy and access to information, as well as weaken electoral supervisory bodies.

Hopes for fiscal discipline

Finance Minister Ramírez de la O has been credited with steering AMLO away from the fiscal profligacy characteristic of so many socialist leaders in Latin America. Markets have welcomed his return in Sheinbaum’s cabinet, with the leader tweeting a series of pledges concerning the economy following a recent meeting with the Minister:

1. A fiscal consolidation in 2025 of 3% of GDP to stabilize public finances and the overall debt/GDP ratio;
2. Maintain an open dialogue with the investor community and rating agencies to reiterate the new government’s priorities: economic stability, fiscal prudence and feasible fiscal targets.
3. Work closely with Pemex [state-owned oil company] and take advantage of the government’s support in Congress to “optimize the use of public resources.”
4. Reiterate to international organizations and private investors that the government’s project is based on fiscal discipline, preserving and protecting Banco de México’s independence, a commitment to the rule of law, and incentivising domestic and international private investment.

We are encouraged that the incoming administration is clearly looking to soothe frayed market nerves.

Mexico has been a favourite for most GEM managers

We have been in the minority of GEM investors to remain underweight the market on concerns over political risk, an overvalued currency and exposure to a US slowdown.

GEMs active vs. passive country allocations

Source: EPFR, June 2024.

That’s not to say there isn’t real potential – the trend of global supply chain reshoring and Mexico’s geographic proximity to the powerhouse economy of the US leaves it well-positioned to harness a major structural tailwind in the years ahead.

However, making the most of this opportunity hinges on the dynamism of Mexico’s private entrepreneurs, supported by strong institutions. The question is whether Morena under Sheinbaum can resist their worst instincts.

Profiting as an investor occurs in the delta between expectations and reality. One example is the boom in enthusiasm for AI stocks being fuelled by blockbuster earnings of industry monopolies such as Nvidia consistently outpacing consensus forecasts.

In emerging markets, India’s bull market stands out as the obvious example of this. India has long appeared perpetually expensive to investors relying on mean reversion tables. The problem with this approach is that expectations may be out of kilter with reality when there is structural change occurring – much like in the new AI frontier – and the domain of the economy is expanding. The chart from Jefferies below illustrates this structural shift.

India is climbing the development ladder – on track to be the 3rd-largest economy globally

Source: Jefferies, Q1 2024.

A succession of reforms in Modi’s India is unlocking a virtuous circle of development, including:

• Sanitation in every village empowering women in rural areas to become economic agents.
• Establishing a nationwide digital payments network accessed through biometric identification, allowing even the illiterate to transact and access welfare payments.
• That network allows the government to accurately calculate what taxes citizens owe, which has seen the state tax take double in around five years.
• Higher government revenues alongside private investment are helping to fuel a new capex cycle, targeting electrification, ports, freight and telecommunications infrastructure.

The self-reinforcing nature of these reforms fuels the growth of what will become an enormous Indian middle class, whose consumption habits will evolve as they become wealthier. This surge in new wealth is also fuelling the rise of domestic pension funds, which are biased to equities given India’s young population and long investment horizon.

Careful relying on mean reversion when there is structural change

Source: Jefferies, Q1 2024.

Local allocators are more incentivised than foreigners to drive Indian corporates to improve corporate governance and returns for minority shareholders. This feeds into improving domestic liquidity, where it is increasingly local allocators that set the price in Indian equities, not fund managers in London or New York.

As investment strategist Keith Woolcock pointed out a few months ago commenting on the AI boom, there are times when valuation is the “alpha and omega of investing but most often it is not.” The same applies to India, where simple mean reversion can mean that investors miss the potential for upside surprise when positive structural change is occurring.

Is the bear market over in China?

China presents us with the flipside of the above – 1) longer-run structural risks as institutional quality deteriorates under Xi Jinping, which risks the country getting stuck in the middle-income trap; 2) this deterioration depressing the animal spirits of consumers and entrepreneurs who are less confident about the future; and 3) the rigid commitment of authorities to fiscal and monetary orthodoxy even at the risk of a deflationary bust.

This gloomy backdrop has seen foreign investors abandon the market, with Chinese equities halving since 2021. At 10x CAPE, China now trades at a record discount to the rest of EM, pricing in a dire economic outlook.

China now trades at a record discount to the rest of EM

Source: NS Partners, LSEG Datastream.

However, prices being driven to such depressed levels eventually exhausts the sellers to the point that a market can rebound even before a recovery in the economy or corporate earnings gain real steam.

Are we starting to see this in China?

Chinese equities have outpaced even the S&P500 this year

Source: NS Partners, LSEG Datastream.

Chinese equities have so far outpaced even the US, including an S&P500 Index dominated by the Magnificent-7 tech giants.

We have been writing to our investors for some time about the gradual economic recovery taking place in China, the steady improvement in earnings growth among corporates, and ratcheting up of fiscal and monetary support (but without the stimulus bazooka). Animal spirits remain broadly depressed, and risks lurk within property and the banks. However, with much of this pain priced in and with positioning in China at such depressed levels, all it takes is for a slight pick up ahead of expectations to ignite a rally.

Short positioning in Chinese equities has begun to unwind (falling by a third in China A-shares over the period), while GEM managers tentatively reduce underweight positioning. Indeed, April was a record month for foreign flows into Chinese equities.

Foreign buying of China stocks tops record


Source: Bloomberg.

There are a number of reasons to think that the rally can be sustained:

• Positioning across GEM and global equity portfolios remains light, leaving plenty of headroom for allocators to add exposure and chase the positive momentum (forming a virtuous circle).
• Policymakers, and most importantly Xi Jinping, have acknowledged the severity of the economic malaise and have pledged more aggressive measures to avoid a bust.
• Company earnings are strengthening across several industries including travel, exporters and names aligned with key policy aims such as energy security, automation and import substitution.
• The market is (finally) beginning to reward earnings beats.

This rally could carry on for some time. However, in contrast to India where we are more willing to run winners given the positive structural tailwinds driving the market, our bias is to be more conservative in China as the longer-term structural story remains negative.

China risks getting stuck in the middle-income trap so long as Xi continues to favour greater state control over rekindling the animal spirits and creative dynamism of entrepreneurs. However, much like in Japan’s lost decades, there were opportunities to take advantage of that delta between reality and depressed expectations, which precipitated sharp trading rallies. Also much like Japan, China’s deep universe of companies will offer up a rich opportunity set for active managers to generate alpha, even when running structurally lower exposure to the market.

Calling for the turn in EM performance has long been dismissed by sceptics as investing’s tribute to Samuel Beckett’s play, Waiting for Godot. The story centres on two strangers who both happen to be waiting for a man named Godot to appear, and pass the time by contemplating the meaning of life in a seemingly endless cycle of anticipation and uncertainty.

Defenders of the asset class argue this is too harsh for such a diverse subset of countries and companies, providing ample room for stock pickers to seek out alpha.  On the other hand, EM investors have largely struggled to escape the gravitational pull of a dollar bull market that has lasted for over a decade, illustrated in the charts below.

USD has been both a key signal and driver for emerging market equities

Source: NS Partners & Refinitiv Datastream

 

Was October 2022 a USD secular peak? The recent rally has yet to breach that high

Source: NS Partners & Refinitiv Datastream

US equities have been ascendant for nearly a decade and a half, led by the superior earnings growth and profitability of the tech titans. Many large EMs have had to work through sharp recessions, deleveraging, balance of payments issues, foreign capital exodus and related currency weakness. The dynamics create a reflexive vicious circle where these negatives feed on each other, providing a poor backdrop for EM equities.

The result is global allocators herding into US stocks at the most concentrated levels since at least 1929 (see chart below), and within that weighting to the US, we saw the seven largest stocks in the S&P500 grow from 21% of the index to 30% by the end of 2023.

The current concentration of US stocks helped to drive an exceptional period of market returns

Source: Goldman Sachs, February 2024. Universe consists of US stocks with price, shares, and revenue data listed on the NYSE, AMEX, or NASDAQ exchanges. Series prior to 1985 estimated based on data from the Kenneth French data library, sourced from CRSP, reflecting the market cap distribution of NYSE stocks.

Going long US equities has been the winning trade for a long time. However, sticking solely with what has worked can risk falling into the behavioural trap of recency bias, and letting opportunities slip by.

Emerging markets have been left out in the cold, and we have hardly been banging the table over the last year or so. Everyone has heard the contrarian bull case of troughing EM economies, earnings, currencies and valuations.

Valuations are compelling

Source: NS Partners & Refinitiv Datastream

 

EM currencies look cheap (Brazil and Mexico are outliers)

Source: NS Partners & Refinitiv Datastream

We have emphasised their superior money numbers and better inflation management by EM central banks, providing plenty of room to ease from very high levels of real rates.

However, the clincher in our view is a potential shift globally to positive excess money growth (real narrow money growth in excess of economic growth). This “double positive” condition of stronger money growth in EM than DM combined with positive global excess money has historically been correlated with EM outperformance.

This dynamic is illustrated in the charts below, the first mapping our two monetary indicators to periods of EM out- and underperformance (shading highlights double positive readings), while the second reinforces this with a hypothetical EM portfolio that moves to cash whenever either of the monetary indicators is negative.

Excess money measures mixed, double positive soon?

Source: NS Partners & Refinitiv Datastream

 

Hypothetical performance of excess money switching rule

Source: NS Partners & Refinitiv Datastream

As you can see, that blue line for global excess money has been trending less negative and could be about to enter positive territory.

While it may be some time yet for the money and dollar signals to fall firmly in favour of emerging markets, our view is that point is getting closer.

With EM positioning plumbing the depths, catching the upswing in sentiment will reward those non-conformists with the stomach to embrace the uncomfortable.

Summary

• A bounce in unloved Chinese equities led a positive month for EM stocks, with the MSCI EM Index up nearly 5% in USD terms.
• Among the leaders was portfolio holding Trip.com, which surged over 25%, reflecting a recovery in consumer demand for travel in China.
• Korean stocks continued a run of strong performance fed by enthusiasm for the government’s proposed Corporate Value-up Program (covered in detail in last month’s commentary: Super-cheap Korean equities rally on market reform talks).
• With around a third of South Korea’s population actively participating in the stock market, the reforms have boosted the ruling Democratic Party’s legislative election prospects, its approval rating reaching 40% against 33% for the opposition. The chart below from CLSA shows the turnaround in fortunes since the program was announced earlier in the year.

Korea general election poll
Source: Gallup Korea &  CLSA, March 2024.

• With less than one month before the election, re-election of the Democratic Party with a mandate to press forward with the reforms could be a catalyst for further outperformance by Korean equities.

 

AI boom exposes supply chain bottlenecks

The global rush is on to harness an explosion of AI innovation, with investment by hyperscale cloud and consumer tech giants only the first wave of adoption powering demand for the technology.

Waves of AI adoption

Source: Nvidia Corporate Presentation, 2024.

 

What unleashed this step change? While some more complex neural network architectures and algorithms have emerged in recent decades, the real shift has been the rapid advances in brute processing power that enables machine learning.

The chart below illustrates the yawning gap which has opened up between the power of GPUs (green line) and conventional CPUs (blue line), with the former now capable of executing many trillions more operations per second (TOPS).

Explosion in power of high-end chips
Source: Nvidia/Arteris, 2023.

 

The chart also hints at one of the key bottlenecks to scaling AI applications like ChatGPT – aside from the difficulty of meeting the sheer scale of demand for Nvidia’s high-end GPUs –  which is “memory wall.”

To illustrate the concept, one useful analogy we have heard is to imagine an AI server as a steam train, with the GPU being the engine, data being the coal, and the network being the person shovelling the coal. Getting all the juice out of the massive GPU engine depends in large part on how quickly that coal (data) can be shovelled into the furnace.

This is where High Bandwidth Memory (HBM) comes in. HBM is physically bonded to the GPUs in stacked layers via thousands of pins which enable “massively parallel data throughout” (The Pragmatic Engineer: Five Real-World Engineering Challenges).

HBM stack
Source: Semiconductor Engineering, 2023.

 

This tech enables the data transmission at a speed of about 3TB/second, around 100 times faster than conventional data transfer architecture powering PCs. This speed is crucial given the massive amounts of data that need to be fed into large language models like ChatGPT.

The issue (and opportunity) is that this wave of demand for leading-edge computing tech to power AI is far outpacing supply. HBM costs around five times more than conventional memory, with Korean memory giant SK Hynix controlling half of global supply, and the remainder split between Samsung and Micron. Hynix is set to enjoy a margin boost driven by premium memory products such as HBM, which it forecasts to grow at a 60-80% CAGR for the next five years.

Emerging markets are home to a host of companies like Hynix, which dominate their respective niches in the AI supply chain. Opportunities exist across multiple segments including fabrication, design, and testing capabilities, as well as key components (like HBM) that form the foundations of hyperscale computing that powers AI.

Chinese stocks outperform as stimulus efforts kick into gear

Chinese stocks are plumbing the depths, now trading at a CAPE of around 10X (from 21X in 2021) discounting a deflationary outlook. While Premier Li Qiang attended the World Economic Forum meeting in Davos earlier this year to announce that China met its 5% GDP growth target for 2023, investors were fretting about steepening consumer price declines. The stock market is signalling an increasing risk of corporate bankruptcies (BBC – Evergrande: Crisis-hit Chinese property giant ordered to liquidate) and financial instability in the absence of decisive monetary and/or fiscal intervention.

Will the authorities blink? It is certainly within the Party’s wheelhouse to pivot, especially given the risk that further economic malaise stokes political instability. The abrupt end to zero-COVID policy in 2022 is the most recent pragmatic policy turn under Xi. Could he reprise Deng Xiaoping’s dictum that “to get rich is glorious” alongside an announcement of fiscal stimulus?

That is doubtful to say the least, but recent activity suggests the authorities understand there is a problem. SOE and SOE-linked names outperformed through February on the back of the “national team” (state-backed financial services companies) ploughing US$57 billion into Chinese equities so far in 2024 (China ‘national team’ ETF buying reaches $57bn this year, says UBS). The chart below from fund data provider EPFR shows flows from local Chinese investors into domestically domiciled China funds (blue line) of just under $100 billion over the 12 months to 31^st January 2024. Contrast this with negative flows for foreign-domiciled China funds (i.e. for foreign investors) over the same period.

Source: EPFR

 

During the month, Xi Jinping was briefed by the China Securities Regulatory Commission (CSRC), coinciding with the replacement of the Commission’s chief Yi Huiman in favour of former banking regulation veteran Wu Qing (known as the “broker butcher”). Bloomberg noted that the move echoed government efforts in 2016 to boost market confidence by dismissing financial regulators amid a market rout (China Replaces Top Markets Regulator as Xi Tries to End Rout).

A visit to the central bank by Xi last year preceded record levels of lending from the PBoC to the banks in Q4, followed by an earlier and larger than expected cut in the reserve requirement ratio (RRR) in January, which suggests the central bank is now back on an easing track.

Money rates responding to liquidity injection

Source: LSEG Datastream.

 

On the fiscal side, the government revealed a GDP target of “around 5%” at its National People’s Congress, suggesting further modest stimulus is on the way.

We have flagged in previous commentary the risk that deteriorating institutional quality under Xi appears to be crushing the animal spirits of entrepreneurs and consumers. Indeed, we saw Xi tighten the CCP’s grip over the private sector, announcing new anti-corruption crackdowns across a host of key sectors in January.

Tone-deaf policymaking amid a fragile economic backdrop is causing economic paralysis and interferes with the credit impulse. No one is complaining about a shortage of credit. The real issue is a shortage of confidence among consumers and businesspeople. Consumers are hoarding cash in time deposits, while banks aren’t looking to borrow short and lend long to businesses to invest. While all of this is structurally negative for China over the long term, continued policy easing at these valuations could be the catalyst for a large trading rally in Chinese equities.

MSCI China at record discount to rest of EM
Source: LSEG Datastream.

Our strategy is to maintain a modest underweight to China and position defensively while waiting for further confirmation that liquidity is improving.