Chinese equities rallied 24% in USD terms through September, much of this in the final week of the month following the announcement of significant monetary and fiscal easing by the PBoC and Politburo respectively. Leading the move were the prime victims of China’s deflationary slump, including online securities broking company East Money (up 90%), property developer Vanke (82%), consumer laggards such as JD.com (57%) and Meituan (46%), along with names in banking, insurance and construction.

Our more cash generative and growing holdings surged, just not as much as the wider market. This included pan-Asian life insurer AIA Group (27%), energy drink beverage maker Eastroc (20%), Spring Airlines (24%), and tech giant Tencent (17%).

The majority of GEM investors, who have been significantly underweight Chinese equities for years, were caught out by the vertiginous rally fuelled by hopes the policy measures signalled a shift from the CCP towards domestic reflation.

GEM investors have maintained underweight positioning in China

Source: EPFR October 2024

We flagged in our Q2 commentary that despite the risks of institutional quality deteriorating under Xi Jinping, the market was incredibly cheap and positive earnings revisions were beginning to come through:

Instead of allowing a market clearing to resolve supply and demand imbalances in Chinese property, Beijing is attempting a “managed” deleveraging. The issue is that a long and drawn out unwind threatens to entrench deflationary forces that undermine efforts to rebalance the financial system. Further complicating this is that efforts to prevent capital outflows through currency management limit Beijing’s monetary policy flexibility. We wrote in Q1 that a CAPE of 10x for Chinese equities likely signals the build-up of risks that prompts a shift in policy priorities to prevent a bust. While the shift to reflationary policy may indeed be a positive catalyst for unloved Chinese equities, the timing is uncertain.

Hence, we decided to stick with a defensive equal weight exposure in China, on a view that a policy pivot could come at any time and spark a sharp rally.

Our chief economist Simon Ward flagged in Money Moves Markets a few days before the rally that monetary growth was potentially bottoming, and that a falling USD/strengthening yen was opening up space for Chinese policymakers to act:

A key reason for expecting money / credit reacceleration is that the yen rally has relieved pressure on the RMB, easing monetary conditions directly and opening up space for further PBoC policy action. The balance of payments turnaround is confirmed by a swing in the banking system’s net f/x transactions, including forwards, from sales of $58 billion in July to purchases of $10 billion in August. This series captures covert intervention via state banks (h/t Brad Setser) and an August reversal had been suggested by a sharp narrowing of the forward discount on the offshore RMB, which has remained lower so far in September.

Source: LSEG Datastream

The stage was set for the largest rally in Chinese equities since 2008.

The rally reflects the significance of the monetary and fiscal policy announcements, which signal a shift in the way Xi Jinping views the state of China’s economy and the approach needed to break the malaise. How far is he willing to go?

Structural policy shift the fuel for a rally

Our view is that to break deflation, and for this rally to be anything more than just a liquidity driven trading opportunity, monetary and fiscal measures must be truly forceful. This would represent a structural shift in policy, and even the abandonment of a managed exchange rate in order to free up more room to stimulate. We aren’t so sure how likely this is. Although a falling USD and Fed rate cuts will certainly make a shift easier.

The signals from Beijing are certainly positive and indicate that a new approach is being embraced. Notably, the government is preparing to inject liquidity into the commercial banking system to expand balance sheets and boost money growth. In addition, the Politburo has pledged to deploy the fiscal bazooka to support local governments, small businesses, property and families (and not infrastructure).

Perhaps what is most significant is that Xi himself acknowledged the severity of China’s deflationary spiral and has taken up responsibility for fixing it. Will consumers and entrepreneurs respond, or will the stimulus be more pushing on a string? If the response is weak, Xi may feel compelled to do more lest he look incompetent.

Overall, the relative attraction for Chinese equities has increased. The rally has been short and currently looks overbought. We expect pullbacks to provide opportunities to add to China exposure and become less defensive, while favouring A-shares which should pick up some of the running from here.

The recent push by Mexico’s ruling Morena Party to undermine the country’s judiciary is a perfect example of why relying on company fundamentals alone in emerging markets can leave investors exposed to being whipsawed by macro factors.

We covered election risks across EM In July – Political risks in EM spike as Indian, South African and Mexican elections surprise – and flagged that outgoing president AMLO and president-elect Claudia Sheinbaum threaten to undermine Mexico’s institutional quality through a series of regressive reforms. The most damaging of these is the proposal to overhaul the country’s judicial system through having all judges elected by popular vote, along with relaxing the term limits and age/experience hurdles for Supreme Court justices.

As the Financial Times put it in September (FT: Mexico’s retrograde path on the rule of law):

Mexico is barrelling ahead with one of the world’s most radical shake-ups of a legal system, alarming investors and citizens alike. In his final month in office, President Andrés Manuel López Obrador is using his coalition’s congressional supermajority to ram through constitutional changes to change the entire supreme court and several thousand state, federal and appeal court judges with replacements elected by popular vote. Candidates for some posts will need only a law degree, five years of undefined “legal experience” and a letter of recommendation from anyone in order to run.

 Lawmakers have been on strike in recent months protesting the move, but to no avail. In September, Morena wielded supermajorities in both the lower house and Senate to push the reform through, which will see thousands of judicial positions up for election over the next three years. Rather than officials working their way up the legal hierarchy, the judiciary will now be exposed to the corruption, bribery and intimidation of Mexico’s cartels, according to critics.

Snatching defeat from the jaws of victory

Mexico should be in prime position to benefit from supply chain reshoring following the pandemic and ratcheting-up of the Sino-US dispute. Indeed, FDI (much of it from China – Why Chinese Companies Are Investing Billions in Mexico – The New York Times (nytimes.com) was pouring into the country to pursue a bright trade story. We saw this in the sharp appreciation of the Mexican peso and a bull market in Mexican equities through 2023 (MSCI Mexico up 42% in USD terms) with the market a favourite among foreign investors.

US imports from Mexico have outpaced imports from the rest of the world
US imports, index Jan. 2017 = 100

Source: GBM Nearshoring Barometer, August 2024.

Mexico a favourite for foreign equity investors through 2023

Source: EPFR

 Sentiment soured on deterioration in the political outlook as Morena’s dominant performance in Mexican elections in June emboldened the party to pursue a series of regressive policies. As we noted in June:

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.

Currency overvaluation correcting in Mexico and Brazil
Real broad effective exchange rates, % deviation from 5y ma

Source: NS Partners and LSEG Datastream

From being one of the consensus overweights among EM investors last year, Mexican equities have been hammered in 2024. MSCI Mexico is down 21% in USD terms to mid-September, while the broader index is up 7%.

Source: Bloomberg

Losing the FDI beauty pageant

As one trade official explained to us on a recent research trip in India, competing for FDI is a beauty contest where participants must maximise their appeal relative to their competition to attract those seeking to deploy capital. China’s retrogressive turn to favour state-owned enterprises rather than the entrepreneurs that fuelled its economy’s meteoric rise is a golden opportunity for ambitious leaders in other emerging markets to step up and attract capital and supercharge development. We are seeing this across ASEAN and in India, eastern Europe and the GCC.

But none have Mexico’s advantage of geographic proximity to an economic juggernaut in the US. President-elect Sheinbaum has talked up Mexico’s nearshoring potential and support for private investment in recent months. However, the rhetoric belies an agenda to undermine Mexico’s institutions, which has unnerved key trade partners and investors.

Nothing scares investors and compromises progress up the development ladder more than attacks on key institutions such as the judiciary. In August, the US Chamber of Commerce warned the Mexican government that the reforms would be likely jeopardise trade relations:

 “The U.S. Chamber of Commerce respectfully calls on the sovereign Government of Mexico to continue deliberations with the private sector, academics and legal experts on the package of reforms the new Mexican Congress intends to consider in September. This dialogue is essential to ensure that the proposed reforms contribute to strengthening the rule of law and conditions for economic growth in Mexico.

 Given our longstanding commitment to Mexico’s growth and prosperity, the U.S. business community is an important stakeholder in the reform process. American companies represent by far the largest source of foreign direct investment in Mexico and provide good jobs to millions of Mexicans. Whether operating in the U.S., Mexico or anywhere else in the world, American businesses depend on respect for the rule of law as the foundation of a vibrant investment climate, sustainable development, and job creation.

 While there is a broad consensus about the need to strengthen Mexico’s judicial system, we strongly believe that certain constitutional and legal reforms currently proposed by the Mexican government – in particular, the judicial reform and the proposed elimination of independent regulatory agencies – risk undermining the rule of law and the guarantees of protection for business operations in Mexico, including the minimum standard of treatment under the U.S.-Mexico-Canada Agreement. The reforms also put at risk Mexico’s obligations under other international treaties to provide all with the right to a competent, independent, and impartial judicial system.

 Further deliberation to address these concerns is needed to avoid jeopardizing the incoming Mexican government’s ability to generate shared prosperity and to tap into the potential of nearshoring to strengthen the country’s economic growth and development.”

Macro matters – downgrading Mexico

Our process involves scoring the level of team conviction for every emerging market each month and includes an assessment of the direction of travel for politics in the short run and institutional quality in the long run. The trajectory is negative on both counts, and we think souring sentiment could have some way to run.

We have been underweight and defensively positioned in Mexico for well over a year, on a view that a slowing US economy would be an economic drag for Mexico. The deteriorating political backdrop flows through to a downgrade of our conviction rating for Mexico, and consequently a reduction in exposure. The market is already trading at a significant valuation discount to the 10-year average, but we think it can get cheaper still.

Portfolio activity

We sold our defensive staple Walmex last month, in favour of shale oil producer Vista Energy. While listed in Mexico, Vista is actually an Argentinian company boasting a growing production profile. Its shale assets in the Vaca Muerta (Spanish for Dead Cow) geologic formation are some of the best in the world. In contrast to Mexico, there are also some signs that the political backdrop in Argentina is improving under libertarian president Javier Milei, including efforts to deregulate the oil and gas sector which could provide an additional tailwind for Vista.

The race is on

As Mexico falters, we expect competition to reap the fruits of reshoring to heat up. ASEAN, the GCC and India are all banging on the door for foreign investment flows. Political stability, as well as safeguarding and improving institutional quality, will be the keys to success.

The questioning of the no/soft economic landing narrative and the partial unwind of the yen carry trade have seen equity markets whipsaw in recent weeks. While we are always scrutinising the fundamentals of the companies we own, and the wider investment universe, it is in periods of high uncertainty like this where our incorporation of macro analysis is vital. This helps us navigate the risks, opportunities and regime change which can occur when volatility skyrockets.

VIX Index explodes as US recession fears rise and yen carry reverses
Source: NS Partners & Bloomberg

Goldilocks thinking unravelling

Last October we published a piece warning against complacency in markets, given a poor monetary backdrop signalling economic weakness ahead – Is this a Wile E. Coyote moment for markets?

Our view was that central banks were maintaining policy that was unnecessarily tight and that a rosy consensus on the macro outlook appeared misguided:

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 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.

This underpinned a shift to a more defensive portfolio exposure in the expectation that economic growth was set to surprise to the downside over the next “3-6 months.”

In hindsight this was slightly early. What we missed was the buffer provided by the huge stock of money built up during the pandemic, cushioning the economy from rapid monetary tightening.

However, as you can see in the chart below, this stock has been burnt down below the pre-pandemic trend.

Money stock below trend

Source: NS Partners & LSEG Datastream

The effects of tighter liquidity are now flowing through to the real economy, with global manufacturing PMIs falling sharply in July.

PMI dip corresponds to low in six-month real narrow money momentum a year earlier

Source: NS Partners & LSEG Datastream

Investors panicked in late July as deteriorating US employment data set off calls for the Fed to deliver an emergency rate cut before the September FOMC meeting.

Unemployment boosted by a sharp rise in temporary layoffs (ex-temp rate is also trending higher)

Source: NS Partners & LSEG Datastream

Japan’s attempt to exit zero interest rate policy (ZIRP) roils markets

Meanwhile in Tokyo, the Bank of Japan announced that it would take steps to end decades of unconventional monetary policy by raising rates, with an eye to acting against signs of inflation and currency weakness. The hawkish turn saw the yen surge relative to the USD, blowing up speculators shorting the yen. It also forced the unwind of some carry trades exploiting lower interest rates in Japan by borrowing in yen, and then investing in currencies with high rates such as the USD, Mexican peso or Brazilian reai.

JPY surge leaves it still lagging collapsing yield spreads

Source: NS Partners & LSEG Datastream

Japan’s decades-long deflationary trap has been the basis for BOJ monetary experiments going back to the 1990s, which gave rise to the yen carry trade phenomenon. Financial historian Russell Napier recounts the “rise of carry” in his book The Asian Financial Crisis, emphasising its tendency to yank liquidity from markets in response to shifts in monetary policy:

What has changed to turn global equity markets bearish? The only surprise over the past few weeks has come from Japan. In the United States, the bond market has been well behaved, the shape of the yield curve unchanged and Greenspan’s comments supportive. Earnings growth in the United States has been ahead of expectations. However, in a three day period, the yen rallied 3.1% against the US dollar on speculation that Japanese interest rates would rise. This currency movement would appear to be the catalyst for the sell-off.

The sudden strength of the yen is indicating that the flow of excess liquidity out of Japan had been the source of liquidity which had been driving the US equity and bond markets. The reason that the flows overseas are probably abating is that the economic recovery in Japan is requiring these funds. The period of history when an accommodative stance by the BOJ drove markets is over.

The experience of July 1996 that Napier recounts rhymes with today’s volatility, fed by speculators who had borrowed yen to finance investments in the US and other markets forced to liquidate positions to buy yen and reduce yen borrowings.

Tech names routed

When liquidity drains out of a market, it is often the “speculations of choice” which are hit hardest, as investors sell profitable trades to raise cash. Names with exposure to the boom in enthusiasm for AI technology were among the victims of the unwind, an example of where liquidity can overwhelm even stellar fundamentals.

July pullback for tech as defensive sectors such as healthcare outperform

Source: NS Partners & LSEG Datastream

Buy the dip or steer clear?

In the lead up to July, we had been steadily reducing our above-benchmark exposure to IT names in the GEM strategy, and now maintain a modest overweight. Much of this shift has been through selling down more niche semiconductor names which rallied hard on demand for AI chips. The highest quality names such as TSMC were hammered through July despite posting outstanding results, and look attractive at these levels.

Our view is that the risks of carry trade unwind will ultimately be constrained by economic realities in Japan (despite the domestic unpopularity of yen weakness).

Broad money weakness suggests that the BoJ’s latest attempt to exit ZIRP will be no more successful than previous efforts in 2000 and 2006

Source: NS Partners & LSEG Datastream

The monetary backdrop in Japan suggests that all is not well in the economy, and that raising rates will make the situation worse. However, it is entirely possible the BOJ will look to push its luck again. In addition, while speculative bets against the yen have been reduced significantly, JGB yield spreads versus US Treasuries suggest potential for further yen strength. Given this backdrop, our bias is to avoid reflexively buying dips here.

Implications for EM

Last month’s commentary made the case that the vicious cycle weighing down emerging market equities was coming to an end: Are emerging markets on the cusp of a “virtuous circle”?

It emphasised the importance of a weak dollar and supportive liquidity as key drivers of EM outperformance. While the slowing economy and carry trade volatility warrant some caution over the next few months, they may also support a shift to a backdrop more supportive of EM equities in the long run.

Big move down in the USD on slowing US economy and carry trade unwind

Source: NS Partners & Bloomberg

It argued that the balance of factors we monitor to assess prospects of EM vs DM equities (relative money growth, global excess money, valuations, earnings, industrial momentum, commodity prices and USD strength/weakness) favours EM for the first time in years. Recent downward moves in Treasury yields and the dollar support the positive trend. Although global money growth has slipped with poor numbers in China and Japan.

Favour liquidity sensitive exposure

The tech cycle upswing and the story of India’s rise up the development ladder have dominated EM returns in recent years. While these trends remain intact, a falling dollar and Fed cuts are likely to see other winners emerge. This easing is set to take pressure off EM central banks forced into tight monetary policy to stabilise their currencies. This should boost the prospects of more liquidity sensitive economies, which are typically open, trading economies with managed exchange rates.

Indonesia is a potential winner in this respect. Its central bank surprised investors with a Q2 rate rise to support the rupiah, leading to a market selloff. US Fed cuts and a dollar bear market should allow for a shift to monetary easing in Indonesia to prevent excessive appreciation of the currency that would harm the competitiveness of its exporters.

US Treasuries yields falling

Source: NS Partners & Bloomberg

As well as rate cuts, easing would likely involve the central bank buying US dollars from Indonesian commercial banks, crediting the banks’ reserve accounts in payment. Additional reserves would encourage bank lending and money creation, with positive follow-through to asset prices, economic growth and corporate earnings, consistent with the virtuous circle sketched out below. While fundamentals matter, we think it pays to understand how liquidity can often act to shape these fundamentals, particularly in emerging markets which are highly sensitive to the monetary backdrop.

Virtuous liquidity circle

Source: NS Partners

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.